Chromatics Color Sciences International, Inc. Annual Report
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[ X ] Annual report under Section 13 or 15(d) of the Securities Exchange Act
of 1934 For the fiscal year ended December 31, 2000
or
[ ] Transition report under Section 13 or 15(d) of the Securities Exchange Act
of 1934 For the transition period from ______________ to _______________
Commission file number 0-21168
CHROMATICS COLOR SCIENCES INTERNATIONAL, INC.
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(Exact Name of Registrant as Specified in Its Charter)
NEW YORK 13-3253392
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(State or Other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)
5 East 80th Street, New York, New York 10021
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(Address of Principal Executive Offices) (Zip Code)
(212) 717-6544
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(Registrant's Telephone Number, Including Area Code)
Securities registered under Section 12(b) of the Exchange Act: None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, par value $0.001 per share
Purchase Rights for Class B Series 1 Preferred Stock, par value $0.001
(Title of Class)
Indicate by check mark whether the registrant: (1) filed all reports
required to be filed by Section 13 or 15(d) of the Exchange Act during the past
12 months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the past
90 days. Yes___X___ No_____
Indicate by check mark if disclosure of delinquent filers in response to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. ______
As of March 22, 2001, 19,033,308 shares of Common Stock, par value $0.001
per share (the "Common Stock") of the registrant were outstanding and the
aggregate market value of the voting stock (computed based on the average of the
last bid and asked price on such date) held by non-affiliates was approximately
$1,631,000.
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PART I
THIS ANNUAL REPORT ON FORM 10-K, INCLUDING ITEM 1 ("BUSINESS") AND ITEM 7
("MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS"), CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF
SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. WHEN USED IN THIS REPORT, THE WORDS "BELIEVE,"
"ANTICIPATE," "THINK," "INTEND," "PLAN," "WILL BE," "EXPECT" AND SIMILAR
EXPRESSIONS IDENTIFY SUCH FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS REGARDING
FUTURE EVENTS AND/OR THE FUTURE FINANCIAL PERFORMANCE OF THE COMPANY ARE SUBJECT
TO CERTAIN RISKS AND UNCERTAINTIES, INCLUDING THOSE DISCUSSED IN "RISK FACTORS"
BELOW AT PAGES 25 TO 28, WHICH COULD CAUSE ACTUAL EVENTS OR THE ACTUAL FUTURE
RESULTS OF THE COMPANY TO DIFFER MATERIALLY FROM ANY FORWARD-LOOKING STATEMENT.
SUCH RISKS AND UNCERTAINTIES INCLUDE, AMONG OTHER THINGS, THE SUCCESSFUL
RESOLUTION OF THE COMPANY'S CURRENT LIQUIDITY CRISIS, THE COMPANY'S ABILITY TO
OBTAIN IMMEDIATE ADDITIONAL FINANCING TO CONTINUE OPERATIONS, THE COMPANY'S
ABILITY TO IMPLEMENT ITS BUSINESS PLAN FOR VARIOUS APPLICATIONS OF ITS
TECHNOLOGIES, INCLUDING MEDICAL AND INDUSTRIAL APPLICATIONS, THE COMPANY'S
ABILITY TO ENTER INTO AGREEMENTS WITH ADDITIONAL MARKETING AND DISTRIBUTION
PARTNERS, THE OBTAINING AND MAINTAINING OF AND COMPLIANCE WITH ANY NECESSARY
REGULATORY APPROVALS OR CLEARANCES APPLICABLE TO APPLICATIONS OF THE COMPANY'S
TECHNOLOGY, THE IMPACT OF COMPETITION, THE MANAGEMENT OF GROWTH, AND OTHER RISKS
AND UNCERTAINTIES THAT MAY BE DETAILED FROM TIME TO TIME IN THE COMPANY'S
REPORTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. IN LIGHT OF THE
SIGNIFICANT RISKS AND UNCERTAINTIES INHERENT IN THE FORWARD-LOOKING STATEMENTS
INCLUDED HEREIN, THE INCLUSION OF SUCH STATEMENTS SHOULD NOT BE REGARDED AS A
REPRESENTATION BY THE COMPANY OR ANY OTHER PERSON THAT THE OBJECTIVES AND PLANS
OF THE COMPANY WILL BE ACHIEVED.
Item 1. Business
GENERAL
Chromatics Color Sciences International, Inc. (the "Company") was formed in 1984
to research, develop and commercialize certain intellectual property rights,
proprietary technology and instrumentation in the field of color science
(collectively, the "Intellectual Properties"). The Intellectual Properties
provide color measurement to a laboratory standard of accuracy, analysis and
classification of human skin, tissue, fluid, hair, teeth or biological subject
which facilitates the detection and monitoring of conditions affecting their
coloration and the classification and organization by color of various
consumer-sensitive products such as cosmetics, tooth enamel, hair color,
hosiery, clothing fashion accessories and textiles. The Company has incorporated
certain of the Intellectual Properties into a proprietary color measurement
system and software marketed for various commercial applications as the
"ColorMate(Registered Trademark) System."
The Company has developed a ColorMate(Registered Trademark) device to measure
the incremental change of the yellow content of the skin color in newborns to
monitor newborn bilirubinemia (infant jaundice) (defined as bilirubin levels or
infant jaundice in a range above that which would be considered average in a
newborn). On July 30, 1997 the Company received U.S. Food and Drug
Administration ("FDA") clearance for commercial marketing of the
ColorMate(Registered Trademark) device for non- invasive monitoring of newborn
bilirubinemia (infant jaundice) in infants by healthcare professionals in the
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hospital, institutional, pediatricians' office or home setting (the
"ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark)
System").office or home setting (the "ColorMate(Registered Trademark) TLc-
BiliTest(Registered Trademark) System").
Infant jaundice occurs in most newborns because of a combination of increased
bilirubin production, a waste product that is normally produced from the
breakdown of red blood cells, and decreased clearance of bilirubin by the liver.
Infant jaundice primarily affects infants within the first three to ten days of
life. Almost all newborn babies develop some degree of infant jaundice and very
high bilirubin levels, if left untreated, may, in extreme cases, lead to
permanent brain damage or death. Prior to birth, the bilirubin in an infant is
processed by the mother's liver and excreted. Following its birth, an infant
must eliminate bilirubin independent of its mother, and it may take an infant's
system several days to begin eliminating the bilirubin faster than it is
produced. Infants who are born prematurely, who are underfed or who belong to
certain ethnic groups are at an increased risk of developing newborn infant
jaundice. The initial screening of bilirubin levels is the observation of the
yellowing of the skin by professional care providers, which is a subjective
determination prone to errors due to differing skin colors. If the initial
clinical assessment suggests the possibility of significant elevated bilirubin
levels, the current procedure requires that a blood sample be obtained from the
infant, usually by lancing the infant's heel (heelstick). These laboratory
measurements are time-consuming, costly and a traumatic process for the infant.
In addition, repeated blood drawing in very low birth weight babies with
extremely small blood volumes may result in the need for blood transfusion.
Since infant jaundice is normally present in infants 36 to 72 hours following
birth, infants who are sent home after a short hospital stay pursuant to managed
care guidelines in the United States are at risk because the condition may not
have presented itself prior to release. Thus the Company believes a non-invasive
instrument that monitors infant jaundice in infants represents a significant
improvement in patient care. A joint statement by the American Academy of
Pediatrics and the Canadian Pediatric Society published in the February 2000
issue of Pediatrics, titled Prevention and Management of Pain and Stress in the
Neonate, urges doctors to take measures to alleviate pain in healthcare for
babies and prevent causing pain whenever possible. The statement recommends,
"Health care institutions should develop and implement patient care policies to
assess, prevent and manage pain in neonates, including those receiving
palliative care." Also, "whenever possible validated noninvasive monitoring
techniques . . . that are not tissue damaging should replace invasive methods."
The Company believes that potentially the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System could significantly reduce the number
of invasive blood tests in monitoring newborn jaundice.
Prior to marketing the ColorMate(Registered Trademark) TLc-BiliTest(Registered
Trademark) System, the Company's activities principally involved licensing the
Intellectual Properties, leasing the ColorMate(Registered Trademark) System and
marketing its own line of precisely color coordinated proprietary cosmetics ("My
Colors by Chromatics (Registered Trademark)") and proprietary color charts and
material swatchpacks (collectively, the "Beauty Aid Products") in the cosmetics,
hair color, beauty aid and fashion industries (i) in a national sales program
with Avon Products, Inc. and in limited test markets with Clairol, Inc. and
Hanes Hosiery, Inc. (all conducted prior to June 1991), (ii) under a product
development agreement with Gordon Laboratories, Inc. ("Gordon") and (iii) under
a license and lease agreement with Nordstrom, Inc. ("Nordstrom"). Presently, as
the result of its efforts to attempt to successfully market commercially the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System for
medical application, the Company has not initiated any new relationships to
distribute its Beauty-Aid Products. However, the Company's new business plan
includes renewing its efforts for commercial distribution of its Beauty-Aid
Products, and the Company has recently introduced a prototype of a new hand held
LED ColorMate(Registered Trademark) device described below, to a number of
potential customers in the Beauty Industry (See below). The Company will require
substantial additional capital and completion of the LED instrument currently in
Research and Development for mass-manufacturing to commence it's business plan
for this application.
CURRENT PRODUCTS
The Company has developed the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System for monitoring newborn infant jaundice
in infants of all races, including when under phototherapy. This device uses a
color measurement instrument in combination with certain apertures, calibration
systems, accessories and software which have been developed by the Company for
this specific medical application. The ColorMate (Registered Trademark)
TLc-BiliTest(Registered Trademark) System received FDA clearance for use in
monitoring newborn infant jaundice by measuring the color of the skin of the
newborn and periodically monitoring incremental changes in the skin color. The
legally marketable device includes the ColorMate(Registered Trademark) device
for monitoring newborn infant jaundice when operated using external power
sources with a computer and printer, and when operated as a battery- operated,
hand-held, computer assisted device. (This device together with the Company's
disposable calibration components is hereafter referred to as the
"ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System.")
The ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System is
a proprietary color measurement system containing a light source and optical
filters. Color measurements are obtained from an infant by placing the
ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System on
different physical sites of the newborn for five to ten seconds. Accuracy of the
color measurements is ensured by the TLc-Lensette(Trademark), proprietary
disposable color-calibration and verification standards consisting of a device
containing a dye deposit specially colored and treated paper, which is used
prior to each baby's measurement. Each color measurement of the skin is analyzed
by the Company's proprietary technology to provide an estimate in milligrams per
deciliter (the laboratory scale used for blood serum tests) correlating to the
newborn's serum bilirubin concentration within a clinically useful range.
The ColorMate(Registration Trademark) TLc-BiliTest(Registered Trademark) System
for monitoring infant jaundice as currently marketed by the Company's
distribution partner, Datex-Ohmeda, Inc. and its Ohmeda Medical Division has a
list price of $3,000 to $5,000 depending on the model and may be leased or used
under a limited time offer for use and evaluation of the system, all with either
purchase of minimum monthly supplies of the TLc-Lensette(Trademark) calibration
standards at $11.90 per unit or minimum monthly charges per use under a Managed
Use Program.
The Company has also developed a low-cost Light Emitting Diode (LED) instrument
that adapts its Intellectual Properties to the beauty industry. The LED
instrument uses inexpensive Light Emitting Diodes technology to measure color as
opposed to other competitive instruments that use conventional color measurement
systems with more expensive technology. The Company plans to market the LED
instrument to brand marketers in the Beauty Aid industry who will use the device
to provide their customers with a compatible skin tone match or corrective skin
tone match for their foundation makeup and compatible color cosmetics such as
lipstick, eyeshadow or blush.
The Company recently commenced its first mass manufacturing effort of the LED
device, however initial testing of the first products demonstrated further
research and development was required to provide certain additional
specifications for the light emitting diodes when ordering and assembling large
batches of these pars and manufacturing for commercial use.
In June 2000 the Company acquired an 85% equity interest in Gordon Laboratories,
Inc., ("Gordon") a Carson City, California based formulator and manufacturer of
cosmetic, hair care and other personal care products, for approximately $5.5
million in cash and shares of Common Stock and the Company is obligated to
acquire the 15% minority interest in Gordon by June 2001. Gordon formulates and
manufactures a variety of quality skin care, hair care, fragrance and liquid
products as well as cosmeceuticals and over-the-counter products such as
sunscreens, ointments, sports creams and sprays. Gordon's customer base consists
of leading brand marketers, major mass merchandisers and direct-sale marketers.
In connection with the acquisition of Gordon, Brian T. Fitzpatrick, the former
Chairman, President and Chief Executive Officer of Gordon, was named President
and Chief Operating Officer of the Company.
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In August 2000 Mr. Fitzpatrick was named Acting Chief Executive Officer of the
Company and a director of the Company.
As Gordon is a subsidiary of the Company and a separate business, Gordon is
discussed in a separate section herein (see Gordon Laboratories General
Discussion)
MARKETING AND DISTRIBUTION
In September 1997, the Company released the results of market research studies
which analyzed the existing market for methods currently used to monitor newborn
infant jaundice in infants in the United States and in the developed countries
of Europe, South America and Canada combined, and Asia. The study indicated that
the World Health Organization published annual birthrate is approximately
4,000,000 births in the United States, with approximately 10% of these births
being premature infants. The Company estimates that individual bilirubin
heelstick blood tests on newborn infants, which are not part of a general panel
blood test, total approximately 15,000,000 tests performed annually in the
United States, based on data made available by the World Health Organization,
the American Academy of Pediatrics, independent market studies commissioned by
the Company, business proposals from potential marketing partners and its
current distribution partner. Internationally, using the World Health
Organization birth rates, independent market studies and research obtained from
companies currently marketing neonatal medical devices in foreign countries, the
Company estimates that the current European market for infant bilirubin tests is
approximately the same size as the United States; South America and Canada
combined represent approximately 25% of the United States market size, and the
Southern Chinese and entire Japanese markets combined represent approximately
the same size of market as the United States.
On June 7, 1999, the Company executed a renewable, five-year agreement with
Datex-Ohmeda, Inc. and its Ohmeda Medical Division ("DO") pursuant to which the
Company appointed DO as the exclusive distributor in the United States of the
Company's Colormate (Registered Trademark) TLc-BiliTest (Registered Trademark)
System for noninvasive monitoring of bilirubin (infant jaundice) in the hospital
market, the non-consumer home healthcare market (in which the test is
administered solely by a healthcare professional), the pediatrician office
market and clinics within all such markets. The agreement also applies to the
Company's TLc-Lensette (Trademark) disposable standards that are used to
calibrate measurements taken by the ColorMate (Registered Trademark)
TLc-BiliTest (Registered Trademark) System. The terms of the agreement provide
for minimum purchases of ColorMate (Registered Trademark) System units and
TLc-Lensette (Trademark) disposable color-calibration and verification standards
for the term of the agreement. There are no financial penalties for failure to
meet these minimum levels. However, the Company has the option to terminate the
agreement if these minimums are not met. As of April 16, 2001, DO had not
achieved the minimum performance requirements set forth in the agreement and the
Company is currently in negotiations with DO regarding the terms of the
agreement.
Following the marketing launch of the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System by DO in February 2000, the Company
experienced a slower than expected hospital evaluation process for the
non-invasive technology, a reality not uncommon to other medical devices that
attempt to become the standard of care. The Company discovered that the hospital
market was taking longer to evaluate the device, which impacted its near term
revenue stream. The Company also encountered the widespread medical practice
related to the early discharge of infants, which is moving the larger market
potential to the pediatrician offices and home healthcare markets. The Company
further discovered that while healthcare professionals are certainly interested
in non-invasive devices for babies, establishing new protocols for the treatment
of infantile jaundice requires continual education and medically sponsored
awareness campaigns. The Company also received feedback that its monitoring
device would require additional redesign and modifications to accommodate the
busier hospital environment. In cooperation with our distributor, Ohmeda
Medical, the Company is working to address these issues and plans to redesign,
modify and reevaluate the product and
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explore renegotiation of the terms and conditions of the Distribution Agreement
with DO. Finally, another key issue to the acceptance of the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System was
the fact that a CPT (Current Procedural Terminology) code did not exist for a
non-invasive procedure. Healthcare providers use CPT codes extensively for
reporting medical procedures and services for administrative management and
insurance reimbursement. This past November a CPT code was issued for
non-invasive testing for bilirubin effective January 1, 2001. The new code that
is listed in CPT 2001 is 88400 bilirubin, total transcutaneous. Healthcare
providers use the CPT codes when reporting medical procedures and services under
public and private health insurance programs, and for administrative management
in claims processing and developing guidelines for medical care review according
to the AMA.
As a result of the disappointing results achieved to date in pursuing the
Company's business strategy through the distribution agreement with DO and the
limited financial resources of the Company, the Company's current objective with
regard to its medical business is to either arrive at acceptable revised terms
of our existing agreement with DO or to identify a strategic partner in the
medical industry to whom the Company could sell, for an up-front fee and ongoing
royalty, the exclusive market rights to the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System. There can be no assurance that the
Company will be able to successfully renegotiate its distribution agreement with
DO or identify such a strategic partner or to negotiate and consummate such a
sale.
Due to the problems addressed above, revenues from the sale of the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System were
minimal in 2000.
REGULATORY CLEARANCES
In June 1996, the Company retained government regulatory consultants and legal
counsel to oversee compliance with applicable federal and state regulations for
commercialization of the ColorMate(Registered Trademark) TLc-BiliTest(Registered
Trademark) System, and for complying with any applicable European Community and
other foreign government requirements. The initial clinical studies conducted at
Mt. Sinai Hospital were completed with positive results and on November 14, 1996
the Company filed its application with the FDA for the medical application of
its technologies, specifically, the non-invasive monitoring of newborn infant
jaundice. On July 30, 1997, the Company received confirmation of marketing
clearance pursuant to a "substantial equivalence" determination order, dated
July 24, 1997, from the FDA's Center for Devices and Radiological Health (the
"CDRH"), authorizing the Company to commercially distribute the system in the
United States. The "substantial equivalence" order states that the Company must
comply with all relevant statutes enforced by and regulations promulgated by the
FDA, including Quality System Regulation ("QSR") requirements, labeling, and the
statutory prohibitions against adulteration and misbranding. The order also
states that the system is a "Class II device" which may be subject to additional
"special controls." The Company intends to maintain substantial compliance with
any applicable requirements and any special controls for purposes of commercial
distribution.
The Company's FDA market clearance authorizes use of the Company's technology as
an aid to the physician in monitoring the status of newborn babies for the
development and progression of newborn infant jaundice.
Following a physician's examination of a newborn within the first hours of
birth, newborn babies would be measured initially and monitored periodically by
the ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System
for incremental changes in the yellow content of their skin color. Because the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System can
provide
6
effective non-invasive monitoring of newborn infant jaundice, it may have
significant marketing advantages toward reducing the invasive, repeated, daily
blood testing techniques currently used, which in many cases leads to blood
transfusion of the infant. See "Risk Factors." However, because the medical
community is relatively slow to adopt new technologies, there can be no
assurance that practitioners will perceive a need for, or accept, the Company's
technology, or be willing to commit funds to its development or the purchase of
any such completed technology.
Since receiving FDA marketing clearance in the United States, the Company has
undertaken the procedures to obtain required international regulatory clearances
for its ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark)
System. In March 1999, the Company received ISO-9001 and EN46001 certifications,
signifying that the Company's New York facility meets important international
quality standards for product design and development, manufacturing, servicing
and distribution. In April 1999, the Company also was granted permission by the
European Union (EU) notified body, TUV Essen, to affix the CE Mark to its
ColorMate(Registered) TLc-BiliTest(Registered Trademark) System.
MANUFACTURING
One element of the Company's business strategy is to outsource the production of
the components and final assembly of the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System and its TLc-Lensette(Trademark)
disposable calibration and verification standards to third-party manufacturers.
In November 1998, the Company reached an agreement with Nova Biomedical
Corporation for the production of the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System. Nova Biomedical is a medical device
production contractor, is ISO 9001/EN46001 certified, and has advised the
Company that it is in substantial compliance with all applicable regulatory
requirements for the contract manufacture of medical devices for the U.S. and
European Union distribution, including requirements under the FDA's Quality
System Regulation and the requirements applicable to the manufacture of medical
devices for the European Union (including ISO 9001 and EN46001).
Under this renewable, four-year medical device manufacturing agreement, the
contract manufacturer is the exclusive manufacturer/assembler and packager of
two models (a battery powered model and an electrically powered model) of the
Company's ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark)
System for distribution in the United States (subject to limited volume
exceptions with respect to one model of the instrument). The manufacturer also
has a right of first refusal to match third party bids to manufacture/assemble
and package a third model of such instrument and a further right of first
refusal to match third party bids to manufacture/assemble and package the two
models referenced above for distribution outside the United States. In this
regard, subject to any failure of Nova Biomedical to exercise its right of first
refusal to match third party bids (thus permitting the Company to use other
manufacturers), Nova Biomedical is the Company's sole source of supply for the
instruments. Under the agreement, the Company is responsible for providing to
Nova Biomedical, for assembly and packaging, certain component parts.
In February 1999, the first manufacturing run of the Company's
ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System
(under the FDA's QSR as well as ISO-9001/EN46001 manufacturing regulatory
requirements) for monitoring newborn jaundice was completed by Nova Biomedical.
The Company commenced shipping the ColorMate(Registered Trademark) TLc-
BiliTest(Registered Trademark) System to those hospitals having placed purchase
orders for the systems under a limited time price offer which allowed the
hospitals to obtain the device and evaluate its performance during a trial
period. The Company also began in-servicing at hospitals and with physicians who
placed initial orders. In the fourth quarter of 1999 the Company delivered the
first 500 commercial units purchased by DO. Sales in the year 2000 were less
than $100,000 under this distribution agreement and the Company is pursuing
alternative business strategies at this time.
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The Company believes, based on discussions with suppliers of components used in
its ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System
and published price lists, that the components can be purchased in quantities of
1,000 or more on terms acceptable to the Company. However, there can be no
assurance the Company will be able to obtain such terms or order in such
quantities. Manufacturing of limited quantities of the ColorMate(Registered
Trademark) units would be significantly more expensive due to the higher unit
cost of components ordered in quantities of less than 1,000.
To the extent the Company successfully markets the ColorMate(Registered
Trademark) TLc- BiliTest(Registered Trademark) System for medical application,
the Company will use the nonproprietary and proprietary components of a portion
of the existing ColorMate(Registered Trademark) units in its possession for the
production of a limited number of such devices under the FDA's QSR and ISO-
9001/EN46001 for early stage marketing and sales efforts and for commercial use.
In August 1995, the Company established a research and development facility in
Spokane, Washington. This office is staffed, in addition to support personnel,
by two engineers who are former principals of R.B.H. Electronics, one of the
companies which originally engineered and manufactured the Company's original
ColorMate(Registered Trademark) units. These engineers currently are primarily
engaged in developing the mass manufacture prototypes of the Bilirubin LED
Device and the ColorMate(Registered Trademark) LED Device. The Bilirubin LED
Device is expected to require additional regulatory clearances or approvals.
INTELLECTUAL PROPERTIES, PATENTS AND PATENT APPLICATIONS PENDING
The Company owns U.S. Patent No. 4,909,632 (expiring in 2007) entitled "Method
for Selecting Personal Compatible Colors," U.S. Patents Nos. 5,311,293 (expiring
in 2007), 5,313,267 (expiring in 2011) both entitled "Method and Instrument For
Selecting Personal Compatible Colors" and 5,671,735 (expiring in 2014) entitled
"Method and Apparatus for Detecting and Measuring Conditions Affecting Color."
Additional U.S. Patents were granted to the Company in 2000, namely U.S. Patent
No. 6,067,504 (expiring in 2014) entitled "Method For Correctly Identifying Hair
Color" and U.S. Patents Nos. 6,128,516 (expiring in 2014), 6,129,644 (expiring
in 2014) and 6,157,445 (expiring in 2009) all entitled "Method and Apparatus For
Detecting and Measuring Conditions Affecting Color". The Company has developed
intellectual property rights in color analysis, calibration and verification in
a number of fields including medical, biological, dental, cosmetic and materials
testing. The intellectual property rights include trade secrets, know how and 6
pending United States patent applications. The Company also has filed patent
applications in a number of foreign jurisdictions which correspond, at least in
part, to the Company's United States patents. The Company has been granted
European Patent No. 0446512 entitled "Method for Selecting Personal Compatible
Colors." That European patent has been nationalized in Austria, Belgium, France,
Germany, Great Britain, Hong Kong, Italy, Luxembourg, The Netherlands, Spain,
Sweden, Switzerland and Liechtenstein. The Company also has Australian,
Canadian, Korean and Mexican patents corresponding, at least in part, to its
U.S. Patent No. 4,909,632, Australian. Taiwanese and Korean patents
corresponding, at least in part, to its U.S. Patent No. 5,313,267 and an
Australian Patent, a Singapore patent and two Taiwanese patents corresponding,
at least in part, to its U.S. Patent No. 5,671,735 (collectively, together with
the United States patents, the "Patents").
The proprietary information claimed by the Patents includes, among other things:
(i) a method of detecting a medical condition that involves a symptomatic,
detectable change in a test subject's skin coloration, such as a method for
monitoring newborn bilirubinemia (infant jaundice) in an infant test subject,
(ii) a method and instrument for identifying skin color and categories of
individuals, (iii) a method of determining color
8
compatibility of an individual's skin with non-skin matter and (iv) a method of
assigning a skin color compatibility classification to non-skin matter and color
charts and sample assemblages made by that method. Proprietary information
claimed by the Patents is incorporated in the proprietary software and
measurement system used in the ColorMate(Registered Trademark) units. Although
many of the individual hardware components of the ColorMate(Registered
Trademark) System and the ColorMate(Registered Trademark) TLc-BiliTest
(Registered Trademark) System are public and not proprietary to the Company, the
color measurement system is manufactured to proprietary specifications of the
Company and when those individual hardware components are assembled in
conjunction with the Company's proprietary software they form the
ColorMate(Registered Trademark) System and the ColorMate(Registered Trademark)
TLc-BiliTest (Registered Trademark) System, the operation of which is covered by
the claims of the Company's patents. The Company's TLc-Lensette (Trademark)
disposable color-calibration and verification standard is entirely proprietary
to the Company because the proprietary color formulation used is uniquely
capable of effectively calibrating the ColorMate(Registered Trademark) TLc-
BiliTest(Registered Trademark) system for use on human skin colors.
The Company has registered its trademarks COLORMATE, MY COLORS BY CHROMATICS,
TLC- BILITEST and the Baby Face Design in the United States Patent and Trademark
Office ("USPTO"). The Company believes it also has established common law rights
in the following marks: CCBRC, SITE FLAG, TLC, TLC BILI, TLC-LENSETTE, TLC
LENSPAK, TLC SOFT AND TLC TOUCH and has filed applications with the USPTO to
register the following marks: CCBRC, SITE FLAG and TLC BILI, TLC-LENSETTE, TLC
SOFT and TLC TOUCH. Further, the Company believes it has copyright protection
for all of the software used in the ColorMate(Registered Trademark) System and
the ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System.
After the respective expiration date of each of the Company's Patents, the
proprietary technology and instrumentation disclosed in each Patent will be
available for use by others without compensation to the Company, unless
protected by the claims of other U.S. patents that may be issued to the Company.
The Company has not applied for patent protection for many aspects of the
Intellectual Properties (i.e., its proprietary trade secrets and other
confidential information). The Company typically imposes on its key employees,
consultants and advisers confidentiality obligations in connection with their
employment, consulting or advisory relationship with the Company. See "Risk
Factors Protection of Intellectual Property."
COMPETITION
The medical device industry in general is intensely competitive. Now that the
Company is attempting to market and distribute its ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System for monitoring newborn
infant jaundice in the United States, the Company will compete with other
providers of infant jaundice diagnostic and monitoring products.
As the Company implements its business plan to further commercialize the medical
application for its Intellectual Properties, it will be in a field characterized
by rapidly changing technology, intense competition and extensive research and
development. The Company will be competing with established companies which have
greater financial, technical, manufacturing, marketing, research and development
and management resources, including with respect to the monitoring of infant
jaundice, companies such as Minolta Co., Ltd. ("Minolta"), Air Shields,
Respironics, Inc. ("Respironics"), which acquired Healthdyne Technologies, Inc.
("Healthdyne"), and SpectRx, Inc. ("SpectRx"), among others. In addition, the
invasive laboratory blood test detection methods currently in use for bilirubin
infant jaundice, have already achieved acceptance by and are in widespread use
in the medical community, unlike the Company's proposed method. See "Risk
Factors."
The Company believes that Minolta developed and Air Shields markets a screening
device, the Minolta Jaundice Meter, to measure the amount of bilirubin in the
skin of a newborn infant to determine whether a
9
serum bilirubin measurement is required. The Company believes that the
measurements obtained by the Minolta device, unlike the ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System, are not used when the
infant is being treated by phototherapy for hyperbilirubinemia, and are affected
by the infant's race and skin color, which the Company believes significantly
limits its use in a heterogeneous population. As a result, the Company believes
that the Minolta device is in limited use in the United States and that it is
not used at all for infants who are receiving phototherapy. There can be no
assurance that Minolta will not effect improvements to its device in the future
to overcome these apparent limitations. See "Risk Factors."
Based on public filings, the Company believes that in June 1996, SpectRx entered
into a collaborative arrangement with Respironics in which Respironics was
responsible for regulatory clearance and sales of SpectRx's device for infant
jaundice analysis in the United States and Canada. Based on these filings
SpectRx's infant jaundice device is intended to be a hand-held instrument, which
incorporates a microspectrometer to collect spectroscopic information from the
infant's skin. In February 1999, SpectRx announced that it had obtained 510(k)
clearance for its device and that it would commence U.S. marketing of its device
shortly. SpectRx also announced that during the third quarter of 1998 it entered
into a distribution agreement with Atom Medical Corporation for distribution of
the company's infant jaundice product in Japan, pending regulatory clearance
from Japan's Ministry of Health and Welfare. Also, during the third quarter of
1998 SpectRx announced receipt of regulatory clearance to market its infant
jaundice product in Canada and shipments to Respironics for sale in Canada
commenced in the same quarter. The Spectrx infant jaundice device was recently
given FDA clearance for commercial marketing for babies under phototherapy. See
"Risk Factors."
The Company's success depends in large part on the acceptance by the medical
community of the Company's new technology. There can be no assurance that the
ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System will
effectively compete with any currently used systems. Furthermore, many of the
Company's competitors have substantially greater financial, research, technical,
manufacturing, marketing and distribution resources than the Company and have
greater name recognition and lengthier operating histories in the health care
industry. There can be no assurance that the Company will be able to effectively
compete against these and other competitors, including those competitors who
intend to promote their versions of non-invasive devices. Furthermore, there can
be no assurance that the Company's competitors will not succeed in developing,
during commercialization of the Company's products, devices and technologies
that permit more efficient, less expensive non-invasive analysis of bilirubin
(infant jaundice). It is also possible that one or more pharmaceutical or other
health care companies will develop therapeutic drugs, treatments or other
products that will substantially reduce the prevalence of infant jaundice or
otherwise render the Company's products obsolete. Such competition could have a
material adverse effect on the Company's business, financial condition and
results of operation.
The Company's ability to compete is affected by its product development and
innovation capabilities, its ability to maintain or obtain additional regulatory
clearances, as necessary, the marketing and manufacturing capabilities of the
Company, its distributors, and its third party vendors, its ability to protect
the proprietary technology of its products, its ability to attract and retain
skilled employees, and, for products sold in managed care environments, its
ability to maintain current distribution relationships and establish new
distribution relationships.
The cosmetics industry and fashion industry are particularly sensitive to
changing consumer preferences and demands, which are difficult to predict and
beyond the Company's control. Competition in the cosmetics industry is diverse
and fragmented, but is nevertheless dominated by a number of large, established,
well-known corporations having, among other things, significantly greater
financial, marketing and human resources than the Company. Virtually all of such
companies have in the past marketed, and continue to market, their products
based on their own color analysis system and advertised claims of "color
10
compatibility" with the personal color and/or wardrobe of the consumer. These
competitors also have established presence in the market and their own cosmetic
manufacturing facilities, unlike the Company. There can be no assurance that
consumers will prefer products based on the Company's scientifically based color
determinations, rather than the products sold by the Company's competitors based
on subjective techniques.
GOVERNMENT REGULATIONS
The Company's advertising, sales practices, cosmetic products and medical
products (including the labeling and packaging thereof) are and will be subject
to applicable federal, state and local regulation (including regulation by the
FDA, the Federal Trade Commission, and the Federal Communications Commission,
under various laws such as the Fair Packaging and Labeling Act and/or any
comparable state authority, agency or statute) and will be subject to regulation
by comparable foreign authorities if the Company markets its
ColorMate(Registered Trademark) units and products abroad. In addition, the
research, development, testing, production and marketing of the Company's
medical products are subject to extensive governmental regulation in the United
States at the federal, state and local levels, and in certain other countries,
that regulate direct selling activities. Non-compliance with applicable
requirements may result in recall or seizure of products, total or partial
suspension of production, refusal of the government to allow clinical testing or
commercial distribution of products, civil monetary penalties, injunction and
criminal prosecution.
The FDA regulates the development, production, distribution and promotion of
medical devices in the United States. The medical products being developed for
manufacture and sale by the Company are subject to regulation as medical devices
by the FDA. Pursuant to the Federal Food, Drug and Cosmetic Act (the "Act"), a
medical device is classified as a Class I, Class II or Class III device. Class I
devices are subject to general controls, including establishment registration,
device listing, premarket notification (510(k)) clearance (in some cases),
labeling requirements, QSR requirements, prohibitions on adulteration and
misbranding, and reporting of certain adverse events (known as medical device
reporting or "MDR"). In addition to general controls, Class II devices may be
subject to special controls that could include performance standards, postmarket
surveillance, patient registries, guidelines, recommendations and other actions
as the FDA deems necessary to provide reasonable assurance of safety and
effectiveness of the device. Class III devices must meet the most stringent
regulatory requirements and must be approved as safe and effective by the FDA
before they can be marketed. Such premarket (PMA) approval can involve extensive
preclinical and clinical testing to prove safety and effectiveness of the device
and generally is more costly and time consuming than a 510(k) submission.
Unless otherwise exempt, all medical devices introduced to the market since 1976
are required by the FDA, as a condition of marketing, to secure 510(k) clearance
or premarket approval through a PMA. A product will be cleared by the FDA under
a 510(k) if it is found to be substantially equivalent in terms of safety,
effectiveness, technology and intended use to another legally marketed medical
device that was on the market prior to May 28, 1976 (that subsequently did not
require a PMA application) or to a product that has previously received a 510(k)
and is lawfully on the market. If a product is not substantially equivalent to
such a medical device, and not otherwise exempt, the FDA must first approve a
PMA application before it can be marketed. An approved PMA indicates that the
FDA has determined the product has been proven, through the submission of
clinical data and manufacturing and other information, to be safe and effective
for its labeled indications. The PMA process typically takes more than a year
and typically requires the submission of significant quantities of clinical data
and supporting information. The process of obtaining a 510(k) currently takes,
on average, approximately four months from the date of submission (based on
FDA's fiscal year 1998 figures). However, the review process for a particular
product may be shorter or substantially longer depending upon the circumstances.
Moreover, there can be no assurance that a 510(k) will be cleared. A 510(k) must
include submission of supporting information, including design details and
11
draft labeling, and may be required to contain safety and efficacy data,
possibly from clinical trials. Product modifications intended to be made to a
cleared device also may require filing and clearance of a new 510(k) submission
or filing and approval of a PMA supplement, during which time the modified
product cannot be commercially distributed.
The 510(k) clearance order obtained from the FDA's CDRH indicates that the
Company's ColorMate(Registered Trademark)TLc-BiliTest(Registered Trademark)
System is a Class II device, subjecting it to "general controls" and "special
controls." Currently, the Company is unaware of any special controls applicable
to the ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark)
System. The Company is not currently developing, manufacturing or distributing
any Class III devices, although it may do so in the future. The Company also is
subject to additional FDA and foreign statutes and regulations and/or may be
subject to additional clearances or approvals to the extent the Company
continues its efforts to test, manufacture and license the Intellectual
Properties and lease the ColorMate(Registered Trademark) units to the medical
community in additional or significantly modified forms or for new uses. See
"Risk Factors."
Although the Company has received FDA clearance on its ColorMate(Registered
Trademark)TLc- BiliTest(Registered Trademark) System pursuant to a "substantial
equivalence" determination order, in the form of a letter dated July 24, 1997
from the FDA's CDRH, authorizing the Company to commercially distribute its
device for monitoring newborn infant jaundice by healthcare professionals in the
United States, the Company also must comply with the other applicable statutes
enforced, and applicable rules and regulations promulgated, by the FDA, in order
to legally market the device. The "substantial equivalence" order states that
the Company must comply with the medical device general controls, e.g., device
establishment registration, medical device listing, good manufacturing practices
(QSR requirements), medical device reporting, labeling requirements, and the
statutory prohibitions against adulteration and misbranding. In June 2000 the
Company submitted a second 510(k) submission to FDA for clearance of further
upgrades and modifications to the ColorMate(Registered
Trademark)TLc-BiliTest(Registered Trademark) System. The Company received a
request from the FDA for more information regarding this submission, including a
request for submission of post market hospital evaluation data in support of its
claims for use of the ColorMate(Registered Trademark)TLc-BiliTest(Registered
Trademark) system for patients undergoing phototherapy. The Company is currently
preparing these responses for submission.
The process of obtaining marketing clearance or approval for medical products
from the FDA can be costly and time consuming, and there can be no assurance
that such required clearance or approval will be granted for the Company's
products on a timely basis, if at all, or that FDA review will not involve
delays that would adversely affect the Company's ability to commercialize
additional or significantly modified products or to expand permitted uses of
existing products. Regulatory clearance or approval to market a product from the
FDA may entail limitations on the indicated uses of the product. The ability to
market can be challenged (and possibly withdrawn) by the FDA due to failure to
comply with regulatory standards or the occurrence of unforeseen problems
following initial clearance. The Company's current 510(k) clearances can be
withdrawn or limited by the FDA or the Company may be required to file further
marketing applications with the FDA under certain circumstances, such as the
addition of product claims or product redesign. The FDA also could limit or
prevent the manufacture or distribution of the Company's products, and has the
power to require the recall of such products, given certain circumstances. FDA
regulations depend heavily on administrative interpretation and there can be no
assurance that future interpretation made by the FDA or other regulatory bodies
will not adversely affect the Company. There can be no assurance the Company
will be able to maintain substantial compliance with FDA requirements.
In order for the Company to market its products in Europe and certain other
foreign jurisdictions, the Company and its distributors and agents obtained and
must maintain required regulatory registrations and/or approvals and must
otherwise comply with extensive regulations regarding safety, efficacy and
12
quality in those jurisdictions. Specifically, certain foreign regulatory bodies
have adopted various regulations, among other things, governing product
standards, packaging requirements, labeling requirements, import restrictions,
tariff regulations, duties and tax requirements. These regulations vary from
country to country. After receiving FDA marketing clearance in the United
States, the Company undertook the procedures to obtain European regulatory
clearances for its ColorMate(Registered Trademark) TLc-BiliTest(Registered
Trademark) System. To market its ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System in the European Union, the Company
sought ISO- 9001/EN46001 certification and the right to affix the CE mark.
ISO-9001/EN46001 certification recognizes that the Company has established a
quality system for the design, development, manufacturing, servicing and
distribution of its medical device. The CE mark is a symbol of quality and
compliance with applicable European Union medical device directives. In March
1999, the Company received ISO-9001 and EN46001 certifications, signifying that
the Company's New York facility meets important international quality standards
for product design and development, manufacturing, servicing and distribution.
In April 1999, the Company also was granted permission by the European Union
(EU) notified body, TUV Essen, to affix the CE Mark to its ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System. Prior to April 1, 1999,
the Company has passed a product inspection in February 1999 for purposes of
receiving the right to affix the CE mark to such specific inspected product.
Failure to maintain ISO-9001/EN46001 certification, CE mark rights or other
foreign regulatory registrations or approvals for the Company's medical products
would prevent the Company from marketing its medical products abroad, which
would have a material adverse effect on the Company's business, financial
condition and results of operations. There can be no assurance that the Company
will obtain any other required regulatory registrations or approval in such
countries or that it will not be required to incur significant costs in
obtaining or maintaining such regulatory registrations or approvals. Delays in
obtaining any registrations or approvals required to market the Company's
products, failure to receive these registrations or approvals, or future loss or
previously obtained certifications, rights, registrations or approvals could
have a material adverse affect on the Company's business, financial condition
and results of operations. The Company may rely on its third-party foreign
distributors to comply with certain foreign regulatory requirements. The
inability or failure of the Company or such foreign distributors to comply with
varying foreign regulations or the imposition of new regulations could restrict
the sale of the Company's products internationally and thereby adversely affect
the Company's business, financial condition and results of operations.
The Company and any third party with which it has made contract manufacturing or
other regulated arrangements will be required to adhere to applicable FDA
regulations, including the QSR requirements and similar regulations in other
countries, which include, among other things, testing, control, and
documentation requirements. Ongoing compliance with QSR requirements and other
applicable regulatory requirements will be strictly enforced in the United
States through periodic inspections by federal and possibly state agencies,
including the FDA, and in foreign jurisdictions by comparable agencies. The FDA
revised the QSR requirements in 1996 which increases the cost of regulatory
compliance for the Company. Failure to comply with applicable regulatory
requirements could result in, among other things, warning letters, injunctions,
civil monetary penalties, recall or seizure of products, total or partial
suspension of production, refusal of the government to grant premarket clearance
or premarket approval for devices, possible rescission or withdrawal of
clearances or approvals previously obtained and criminal prosecution. The
restriction, suspension or revocation of regulatory clearances or approvals, or
government enforcement actions due to any failure to comply with regulatory
requirements, could have a material adverse effect on the Company's business,
financial condition and results of operations.
Future products developed by the Company and products currently under
development may require FDA clearance through either 510 (k) or PMA application
procedures. There can be no assurance that marketing clearances or approvals
will be obtained on a timely basis or at all. Delays in receiving such
clearances or approvals could have a material adverse effect on the Company.
13
The FDA also regulates the commencement and conduct of clinical investigations
to determine the safety and effectiveness of unapproved investigational devices,
including investigations involving new intended uses of previously cleared or
approved devices. Clinical investigations are regulated by the FDA under the
Investigational Device Exemptions ("IDE") regulations. The IDE regulations
include significant requirements that must be met, including, but not limited
to, informed patient consent, institutional review board ("IRB") review and
approval of research protocols, reporting obligations to the FDA, recordkeeping
requirements and prohibitions against commercialization of investigational
devices. A sponsor must obtain FDA approval of an IDE application before
starting the investigation, unless the device is found to be a non-significant
risk ("NSR") device by the sponsor and each IRB that reviews and approves the
study. The FDA, however, has the authority to determine that a study designated
as involving an NSR device by the sponsor and IRBs involves a significant risk
device, and to require that an IDE application be submitted and approved before
the study can resume. In addition, a study of an NSR device must still comply
with the above-referenced and certain other IDE requirements. A violation of the
IDE regulations can result in a variety of sanctions, such as warning letters,
prohibition against additional clinical research, the refusal to accept data and
criminal prosecution. The Company also may provide devices for use in FDA
approved or recognized clinical trials as a contract manufacturer.
There can be no assurance that any clinical study will comply with all elements
of the FDA's regulations, including the FDA's IDE regulations, that a study will
provide evidence of the safety or effectiveness of the device, or that a study
will ultimately result in the clearance or approval of the device.
A federal law commonly known as the "anti-kickback statute" prohibits the offer,
solicitation, payment or receipt of anything of value (direct or indirect, overt
or covert, in cash or in kind) which is intended to induce business for which
payment may be made under a federal health care program, i.e., any plan or
program that provides health benefits, whether directly or indirectly, through
insurance, or otherwise, which is funded directly, in whole or in part, by the
United States Government (e.g., Medicare, Medicaid and CHAMPUS). The type of
remuneration covered by the anti-kickback statute is very broad. It includes not
only kickbacks, bribes and rebates, but also proscribes any remuneration,
whether made directly or indirectly, overtly or covertly, or in cash or in kind.
Moreover, prohibited conduct includes not only remuneration intended to induce
referrals, but also remuneration intended to induce purchasing, leasing,
arranging or ordering of any goods, facilities, services, or items paid for by a
federal health care program.
In part to address concerns regarding the implementation of the anti-kickback
statute, in 1991, the federal government published regulations that provide
exceptions or "safe harbors" for certain transactions that are deemed not to
violate the anti-kickback statute. Among the safe harbors included in the
regulations are transactions involving discounts or the payment of certain
administrative fees to group purchasing organizations. While the failure to
satisfy all the criteria for a safe harbor does not necessarily mean that an
arrangement is unlawful, engaging in a business practice for which there is a
safe harbor may be regarded as suspect if the practice fails to meet each of the
prescribed criteria of the safe harbor. Violations of the statute are punishable
by civil and criminal penalties and/or exclusion of the provider from
participation in the federal health care programs. Also, there is the risk that,
in a civil lawsuit to enforce a contract that contains a structure in violation
of the anti-kickback statute, a court might conclude that the contract is
unenforceable as against public policy. Congress directed the Secretary of the
United States Department of Health and Human Services ("HHS") to issue advisory
opinions regarding compliance with the anti- kickback statute. Failure of a
party to seek an advisory opinion, however, may not be introduced into evidence
to prove that the party intended to violate the anti-kickback statute. Several
states also have statutes or regulations prohibiting financial relationships
with referral sources that are not limited to services for which a federal
health care program pays.
While the Company believes its marketing programs meet the requirements of the
anti-kickback statute and its implementing regulations, there is no guaranty
that the HHS Office of the Inspector General would view
14
all of the Company's marketing arrangements as meeting all of the requirements
of the appropriate safe harbors. The Company has not sought, and has no present
intention to seek, an HHS advisory opinion regarding any aspect of its current
marketing arrangements. A finding of noncompliance with the anti- kickback laws
by federal or state regulatory officials, including noncompliance with
appropriate safe harbors, could have a material adverse effect on the Company.
The Company's products are intended to be purchased or leased by health care
providers or suppliers which submit claims for reimbursement for such products
or their use to third-party payors such as Medicare, Medicaid and private health
insurers. In the United States, patients, hospitals and physicians who purchase
medical devices, generally rely on such third-party payors to reimburse them for
all or a portion of the cost of the medical device or its use. Reimbursement for
devices (or their use) that have received FDA clearance has generally been
available in the United States. Third-party payors are increasingly challenging
the prices charged for medical products and services. There can be no assurance
that the Company's products will be considered cost effective and that
reimbursement to the consumer will be or continue to be available, or sufficient
to allow the Company to sell its medical device products on a competitive basis.
Moreover, obtaining and maintaining health care payors' approval of
reimbursement for the Company's products or their use, and the level of
reimbursement made available, will be an important factor in establishing
pricing, structure and market acceptance. The Company is unable to predict what
changes will be made in the reimbursement methods utilized by third-party health
care payors. Furthermore, the Company could be adversely affected by changes in
reimbursement policies of governmental or private health care payors. Although
the Company has no knowledge that third-party payors will adopt measures that
would limit coverage of, or reimbursement for, its products or their use, any
such measures that were applied to the Company's products could have a material
adverse effect on the Company.
American Medical Association ("AMA") CPT codes are generally used to facilitate
the processing of insurance reimbursement claims and to provide a simplified
reporting procedure. However, assignment of a code does not assure that the
insurer will provide reimbursement or that the AMA endorses the medical
procedure at issue. In March 1998, the Company was assigned AMA CPT Code 82250
for processing claims for use of the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System. The same code is assigned for the
reimbursement of laboratory blood tests currently used to monitor newborn
bilirubinemia (infant jaundice). Subsequently, the AMA informed the Company that
CPT Code 84999 ("Unlisted Chemistry Procedure"), not Code 82250, was the
assigned code. However, the AMA indicated that it was reviewing coding in this
area generally. Effective January 1, 2001, the AMA assigned AMA CPT code 88400
bilirubin, total transcutaneous, for use with the Company's ColorMate(Registered
Trademark)TLc-BiliTest(Registered Trademark) System. Health care providers use
the CPT code when reporting medical procedures and services under public and
private health insurance programs, and for administrative management in claims
processing and developing guidelines for medical care review according to the
AMA.
The Company is unable to predict what changes will be made in the reimbursement
methods utilized by third-party health care payors. Although the Company
anticipates that hospitals and physicians will justify the use of the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System by
clinical benefits that the Company believes will be derived from the use of the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System, there
can be no assurance that this will be the case. Because the cost of health care
delivery has been rising steadily and because the cost of a significant portion
of medical care in the United States and other countries is typically funded by
governmental insurance programs, there have been a number of government
initiatives to reduce health care costs. Congress and various state legislatures
have proposed changes in laws and regulations that, if ever enacted, could
effect major restructuring of the health care industry. Although many of these
proposals may seek to maintain or expand access to health care services, the
common objective of the proposed legislation is to achieve cost containment in
the health care sector. Changes in governmental support of health care services,
15
the methods by which such services are delivered, the prices for such services
or the regulations governing such services or mandated benefits all may have a
material adverse effect on the Company. Even if the ultimate impact of any such
changes on net sales is positive, no assurance can be given that the costs of
complying with possible new requirements would not have a negative impact on the
Company's future earnings. No assurance can be given that any such legislation
will not have a material adverse effect on the Company.
EMPLOYEES
The Company currently employs 14 persons on a full-time basis, 2 of which are
medical marketing or regulatory personnel. In order to reduce its operating
expenses while focusing on its current objectives of identifying strategic
partners for marketing its ColorMate (R) system in the beauty industry and to
purchase exclusive market rights to the ColorMate(Registered
Trademark)TLc-BiliTest(Registered Trademark) System. Since December 2000 the
Company has significantly reduced its number of employees.
RECENT EVENTS
Gordon Acquisition
On June 2, 2000, pursuant to the Agreement of Purchase and Sale, dated April 17,
2000, among the Company and the shareholders of Gordon Acquisition Corp., a
California corporation ("Gordon"), the Company completed its acquisition of
Gordon, a manufacturer of cosmetics, hair care and other personal care products.
The Company acquired from the shareholders of Gordon (i) approximately 85% of
the outstanding shares of common stock, par value $.001, of Gordon, (ii) an
obligation to purchase the remaining shares of common stock within one year and
(iii) certain notes made by Gordon in favor of certain of its shareholders. In
consideration thereof, the Company issued to the shareholders of Gordon a total
of 721,231 shares of common stock, par value $.001, of the Company and paid them
$609,000 in cash.
To determine the number of shares of the Company to be issued, the parties
negotiated a certain dollar amount, adjusted by the amount by which the
estimated adjusted net working capital of Gordon on the closing date exceeded or
fell short of the target adjusted net working capital. This dollar amount was
then divided by the agreed price per share, $6.29. Additional shares of the
Company were issued to a particular shareholder in exchange for the notes that
Gordon had made in its favor. The number of additional shares was determined by
dividing the outstanding principal amount of these notes by the agreed price per
share. All other holders of notes that the Company purchased received cash in
exchange therefor, totaling $609,000, the approximate total outstanding
principal amounts of such notes. The Company transferred the cash amount from
its own working capital.
The options to purchase the remaining shares of Gordon (the "Option Shares") are
subject to mandatory exercise by the Company on the first anniversary of the
closing date if not sooner exercised. Upon exercise, the Company will issue to
each holder of Option Shares a number of shares of the Company equal to the
quotient of (A) the sum of (i) $6.29 multiplied by the number of Option Shares
being purchased from such holder and (ii) simple interest on such amount at the
rate of 9% per annum calculated from the closing date to the date of exercise
divided by (B) the greater of (i) the average closing price of shares of the
Company over the twenty trading days ending on the trading day immediately prior
to the date of exercise and (ii) $6.29.
In addition, the Company agreed to register the shares of its common stock
issued to the shareholders of Gordon pursuant to the Agreement of Purchase and
Sale for resale under the Securities Act of 1933, as
16
amended, and to use its reasonable best efforts to have the resale registration
statement filed with the Securities and Exchange Commission on or prior to the
fifth business day after the Company has received all financial information from
Gordon and its subsidiary, H.B. Gordon Manufacturing Co., necessary to prepare
such registration statement. The Company has filed such registration statement
and it was declared effective by the Securities Exchange Commission in November
2000.
Gordon is recognized within the personal and beauty care industry as a
high-quality formulator, packager and contract manufacturer of a variety of
cosmetics and other beauty care products for branded consumer product marketers
and private label retailers. Gordon's customer base consists of leading brand
marketers, major mass merchandisers and direct-sale marketers, including such
leading names as Sears, The Gap, Kmart, Tova, Herbalife, The Body Shop, Bath &
Body Works and Victoria's Secret. The Company intends to use Gordon's
manufacturing and marketing capabilities to commercialize its color science
technology in the cosmetics and hair colorant markets and to generate expanded
revenues from laboratory product chromaticity studies, color-measuring systems
and related products.
Prior to the Agreement of Purchase and Sale, the two companies had entered into
a licensing agreement to commercialize the marketing of the Company's new,
hand-held ColorMate(R) device and system for selecting personalized colors of
cosmetics, hair color and beauty-related products, including custom- blended
cosmetic foundations.
Financial Restructuring
On October 11, 2000, the Company obtained commitments from three of its major
investors, Millennium Partners, L.P. ("Millennium"), LB I Group, Inc. ("Lehman")
and the holders (the "Holders") of its 14% Senior Convertible Debentures, dated
April 15, 1999 (the "Debentures"), to restructure the terms of their respective
securities. The purpose of this restructuring was to assist the Company in
meeting the net tangible assets requirement for continued listing of its common
stock, par value $.001 per share (the "Common Stock"), on the Nasdaq SmallCap
Market ("Nasdaq"). These commitments of the investors were subject to certain
conditions, which were subsequently satisfied on October 31, 2000, including the
Company's securing confirmation from Nasdaq of the Company's eligibility for
continued listing on Nasdaq and the closing of a proposed additional financing
with Crescent International Ltd. ("Crescent"), pursuant to which the Company
would issue and sell to Crescent, and Crescent would purchase, shares of a
newly- authorized series of preferred stock of the Company (the "Crescent
Preferred") and a five-year warrant to purchase up to 270,000 shares of Common
Stock at an exercise price equal to $1.00 per share, subject to adjustment in
certain circumstances (the "Crescent Warrant"), for an aggregate purchase price
of not less than $2,000,000. In consideration of their agreements to restructure
their respective securities, the Company agreed to issue to each of Lehman and
the Holders 200,000 five-year warrants to purchase shares of the Common Stock of
the Company at an exercise price of $1.50 per share (the "New Lehman Warrants"
and the "Holders' Warrants," respectively). The Company also agreed with the
Holders (i) not to incur or permit any future liens on any of its properties or
assets, (ii) not to grant any security interests in its future revenues and
(iii) not to consummate any future financings which contemplate the issuance of
debentures by the Company.
Millennium is the holder of (i) 641,026 shares of Common Stock (the "Millennium
Shares") issued pursuant to that certain Securities Purchase Agreement, dated as
of August 16, 2000 (the "Millennium Purchase Agreement"), and (ii) warrants to
purchase Common Stock, including a warrant (the "Adjustable Warrant") pursuant
to which the number of shares issuable upon the exercise thereof (the
"Adjustable Warrant Shares") is based upon a formula involving the closing bid
prices of the Common Stock on certain future dates (the "Adjustment Period
Price").
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Pursuant to a letter agreement (the "Millennium Letter Agreement"), the Company
and Millennium agreed to amend the Millennium Purchase Agreement and the
Adjustable Warrant to delete any provision granting Millennium the right to
require the Company to repurchase the Millennium Shares or redeem the Adjustable
Warrant Shares, as the case may be, for cash except in the event that the
Company (i) engages in a "Rule 13e-3 transaction" (as defined in Rule 13e-3
under the Securities Exchange Act of 1934, as amended) or (ii) fails to file a
request to accelerate the effectiveness of the registration statement covering
the Millennium Shares and the shares underlying the warrants issued to
Millennium promptly after securing confirmation from Nasdaq of the Company's
eligibility for continued listing of the Common Stock on Nasdaq.
The Company and Millennium further agreed to amend the Adjustable Warrant (i) to
reduce the number of dates (each, a "Vesting Date") upon which the number of
shares to be issued upon the exercise of the Adjustable Warrant would be
determined from three to two, (ii) to postpone the first Vesting Date thereunder
(the "First Vesting Date") until March 31, 2001, at which time the number of
shares to be issued thereunder would be determined based on an Adjustment Period
Price of not less than $1.00 (which subsequent to March 31, 2001, requires the
Company to issue 935,750 shares and (iii) to postpone the second Vesting Date
thereunder (the "Second Vesting Date") until November 1, 2001, at which time the
number of shares to be issued thereunder (in addition to the number of shares
determined as of the First Vesting Date) would be determined based on an
Adjustment Period Price which would not be subject to a $1.00 minimum (as was
the case on the First Vesting Date). The Company and Millennium also agreed (x)
to amend that certain Registration Rights Agreement, dated as of August 16,
2000, to eliminate the provisions imposing monetary penalties upon the delisting
of the Common Stock from Nasdaq, (y) to waive any events of default occurring
prior to the execution of the Millennium Letter Agreement that would entitle
Millennium to any monetary penalties from the Company and (z) to irrevocably
waive its right to adjust the exercise price of the Adjustable Warrant or the
number of Adjustable Warrant Shares as a result of the issuance of the Crescent
Preferred.
Lehman is the holder of (i) 25,000 shares of the Class B Series 2 Convertible
Preferred Stock of the Company and 40,000 shares of the Class B Series 3
Convertible Preferred Stock of the Company (collectively, the "Lehman
Preferred") and (ii) warrants (the "Lehman Warrants") to purchase Common Stock.
Pursuant to a letter agreement, the Company and Lehman agreed to amend those
certain Preferred Stock Purchase Agreements, dated as of June 11, 1999 and
February 11, 2000, respectively, to eliminate the provisions imposing monetary
penalties in the event that the Common Stock is delisted from Nasdaq.
The Company and Lehman further agreed to amend the Certificate of Incorporation
of the Company to delete any provision granting Lehman the right to require the
Company to redeem the shares of Lehman Preferred for cash. Pursuant to such
amendments the Company is now required to convert the shares of Lehman Preferred
into Common Stock on the third anniversary of their respective issuance dates
unless the Company elects, at its option, to extend the mandatory conversion
date to the fifth anniversary of the respective issuance dates of the shares of
Lehman Preferred. Lehman further agreed to waive its right to decrease the
conversion price of the Lehman Preferred and the exercise price of the Lehman
Warrants as a result of (i) the issuance of the Crescent Preferred and the
Crescent Warrant on October 31, 2000 for aggregate proceeds of $2,000,000 or any
future issuances of preferred stock or warrants to Crescent which do not exceed
an aggregate purchase price of $2,000,000, (ii) the issuance of warrants to the
Company's financial adviser in connection with the Crescent financing, (iii) the
issuance of the New Lehman Warrants and the Holders' Warrants and (iv) the
determination on the First Vesting Date of the number of shares of Common Stock
issuable with respect to the Adjustable Warrant. In addition, Lehman agreed (A)
that the deemed exercise price (the "Deemed Exercise Price") with respect to the
number of shares of Common Stock issuable pursuant to the Adjustable Warrant on
the Second Vesting Date would be the greater of (i) $1.00 and (ii) the exercise
price calculated in the manner set forth in that certain Letter Agreement, dated
as of August 16, 2000, by and between the Company and Lehman, and (B) to waive
its right to decrease the
18
Conversion Price of the Lehman Preferred and the exercise price of the Lehman
Warrants to a price which is less than the Deemed Exercise Price.
Pursuant to a letter agreement, the Company and the Holders agreed to convert
the entire principal amount of the Debentures, and any accrued but unpaid
interest thereon, into a newly-authorized series of convertible preferred stock
of the Company (the "New Preferred"), effective October 31, 2000. Prior to their
conversion, the Debentures had a principal face amount of $5,000,000, accrued
but unpaid interest in the amount of $1,079,167 and were due on April 15, 2002.
The Company and the Holders further agreed that (i) the New Preferred would be
convertible into shares of Common Stock at a conversion price of $4.68 per
share, subject to adjustment for stock splits, combinations and similar
recapitalizations affecting the Common Stock, (ii) with respect to the
distribution of assets on the liquidation, dissolution or winding up of the
Company, the New Preferred shall rank senior and prior to all classes or series
of capital stock of the Company issued prior thereto or thereafter issued, (iii)
cumulative dividends would accrue on the New Preferred beginning on April 15,
2002 at a rate of 8% per annum (subject to increase to 11% per annum during any
period in which such cumulative dividends are not currently paid), and (iv) the
New Preferred would be subject to involuntary conversion into shares of Common
Stock at the option of the Company at a conversion price of $4.68 per share if
the average closing bid price of the Company's Common Stock for ten consecutive
trading days exceeds $10.29. The Company also agreed with the Holders (i) not to
incur or permit any future liens on any of its properties or assets, (ii) not to
grant any security interests in its future revenues and (iii) not to consummate
any future financings which contemplate the issuance of debentures by the
Company.
Gordon has a note payable to a finance company totaling $2,714,700 at December
31, 2000 which is secured by substantially all the assets of Gordon. The note
bears interest at a fixed rate of 12.97% and is payable in monthly installments
of principal and interest of $54,100 through the maturity date of February 2005.
The note payable agreement, as amended in December 2000, provides for certain
financial covenants and also restricts Gordon from the payment of dividends and
limits the amount of capital expenditures and additional indebtedness of Gordon.
The failure by Gordon to make the regular scheduled payment due February 18,
2001 in the amount of $54,108.31 as well as the failure to pay other amounts
due, including the sum of $1,758.86 for expenses and $10,000 as an amendment
fee, constitutes an event of default under the loan agreement. In addition,
Gordon has not paid $54,108.31 of payments scheduled for both March and April.
The lender has requested full payment of the loan, which Gordon cannot afford to
pay. Gordon is currently negotiating with the lender in an attempt to
renegotiate the loan; however, there can be no assurances that Gordon can
resolve this issue.
Current Cash Requirements/Financing Proposals
On March 23, 2001, the Company announced that it is currently lacking funds to
continue material aspects of the Company's operations and business plan,
including funds and necessary personnel to complete recently required research
and development on its new LED instrument and technology discovered during its
first mass manufacturing process; complete filings, administration and
maintenance for certain intellectual properties and regulatory requirements;
supply upgraded products and sales support to its medical distributor; and
complete FDA regulatory filings for upgrades to its medical products. The
Company is currently downsizing its corporate offices and the Board of Directors
is reviewing potential proposals for financing the Company, along with
contingency plans in the event such financing cannot be completed.
The Company is currently negotiating proposals for financing the Company. One
proposal would include the purchase of 75% of Gordon Laboratories for over 1
million (with a 9-month option to the Company to purchase the shares of Gordon
back for the purchase price plus interest) and additional funds provided under a
secured loan to the Company. Another proposal would be for an equity financing.
Such proposals require negotiation of warrants to purchase the Company's stock
and are subject to satisfactory completion of due diligence, negotiation,
execution and delivery of definitive agreements by and between the parties, the
lifting of the suspension of trading of the Company's common stock on the Nasdaq
Small Cap Market (CCSI) and compliance with the Net Asset Nasdaq listing
requirement.
Trading Suspension
19
On March 23, 2001, The Nasdaq Stock Market(SM) announced that trading was halted
in the Common Stock for "additional information requested" from the Company at a
last price of 3/32. Trading will remain halted until the Company has fully
satisfied Nasdaq's request for additional information. The Company is currently
in the process of preparing the additional information requested by Nasdaq for
submission.
Board of Directors Expansion
The Board of Directors expanded the Board from the existing five to seven
members effective August 3, 2000 and appointed Mr. James Bergman in addition to
Mr. Fitzpatrick to fill these new vacancies until shareholder approval of the
expanded slate of directors at the Annual Shareholder's meeting in December 2000
and has since added two additional board members.
BEAUTY-AID PRODUCTS
The ColorMate(Registered Trademark) System. Although it is not currently
expanding in this activity as a result of its efforts to market commercially the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System for
medical application and the lack of necessary funding, the Company has engaged
in efforts to commercialize its Intellectual Properties for beauty-related
applications. The ColorMate(Registered Trademark) System consists of a color
measurement instrument to be held against a subject's skin, hair, teeth or
sample, a series of filters and a computer and related proprietary software all
housed in a portable briefcase. The color measurement instrument used within the
ColorMate(Registered Trademark) unit or as a handheld battery operated
instrument is utilized in the Company's medical, cosmetic and other
applications. The instrument is held against the subject's skin, hair, teeth or
sample and performs color measurement of coloration and luminosity to a
laboratory standard of accuracy. In skin color analysis, the software then
analyzes the color measurements so obtained and assigns the subject to one of
the approximately 200 skin color categories identified by the Company through
its research and development effort.
In the beauty-related applications the ColorMate(Registered Trademark) System
matches each skin color type to a range of pre-tested compatible product colors.
The unit is equipped with a printer and can provide the subject with a record of
his or her skin color category and color compatible shades of specific products
(including the Company's cosmetic products) appropriate for that skin color
category and other product colors.
The ColorMate(Registered Trademark) System also can be used to perform
chromaticity studies of various product lines in manufactured or applied forms
(for example, tooth enamel, hair coloring, hosiery, other cosmetic lines) on
behalf of licensees. This capability permits the organization of the licensee's
products into precise color categories so that the consumer can be assisted with
proper color coordination within the licensee's product line.
My Colors by Chromatics(Registered Trademark) Cosmetics Line. The Company's
cosmetics line ("My Colors by Chromatics (Registered Trademark)") divides the
product shades into four color classifications. The product shades recommended
by the ColorMate(Registered Trademark) System are individually prescribed for
color coordination with each of the approximately 200 skin color categories. The
Company's cosmetic line is precisely formulated and balanced to provide color
coordinated products for the skin color of all races. In the past the Company
has also marketed, through the use of the ColorMate(Registered Trademark)
System, a line of fashion swatch packs consisting of 36 objectively measured
colors, coordinated with each other and with the consumer's skin tone color to
aid the consumer in selecting color compatible fabrics and fashion accessories.
In December 1996, the Company entered into a lease and license agreement with
Gordon Laboratories, Inc. granting Gordon a license and lease of the Company's
Intellectual Properties and the ColorMate(Registered Trademark) System to
formulate and develop custom blended cosmetic foundations for use in a field
test retail program.
Other Potential Products and Applications. The Company has conducted research
and development and
20
developed engineering specifications for a mass manufacturing prototype
regarding a hand-held light- emitting diode version of the ColorMate(Registered
Trademark) System (the "LED Device"). This version may be marketed for medical
use after collecting further clinical testing data and is subject to FDA
approval or clearance (the Bilirubin LED Device). For non-medical applications,
the LED Device may be marketed in various industries including the dental,
beauty aid and fashion industries and also may be marketed directly to consumers
for home and personal use. The Company expects the new LED versions will also be
capable of being manufactured at a cost substantially less than the cost
incurred in manufacturing the Company's existing ColorMate(Registered Trademark)
System units because of technological improvements which have resulted in
substantially lower component part costs. The Company believes that the
Intellectual Properties and ColorMate(Registered Trademark) System have
commercial applications in (i) healthcare relating to the non-invasive detection
and monitoring of certain chromogenic diseases, such as skin diseases, and
anemia and (ii) dental care (i.e., the color matching of teeth and tooth
enamel). Additional medical applications for the Intellectual Properties require
extensive and lengthy clinical testing and will be subject to various federal
and state regulatory requirements, including FDA clearances or approvals, and
may be subject to comparable foreign regulatory approvals to the extent the
Company markets such applications abroad. There can be no assurance that the
Company will obtain any additional FDA or foreign approvals or clearances or
will be able to comply with such regulatory requirements for additional
applications.
The Company also believes that the Intellectual Properties and
ColorMate(Registered Trademark) System may have commercial applications in
industrial color measurement applications, in order to achieve and confirm
uniformity of color shades within a given product line or between two products
of the same line (i.e., paint, textile and food products). To that end, the
Company intends to increase its efforts to lease the ColorMate(Registered
Trademark) System and license the Intellectual Properties, including the
Company's chromaticity study capabilities, to industrial companies such as
paint, textile and food companies, that use or could use existing color
measurement technologies in the manufacturing and marketing of their own
products. Many companies in these industries currently use color measurement
instruments to ensure uniformity of product line colors (e.g., that
manufacturing facilities are producing different dye lots and/or goods of the
same color). These instruments are generally available at prices well in excess
of the price at which the Company would market the ColorMate(Registered
Trademark) System for such application, because the Company has been able to
mass manufacture its color measurement technology, thereby taking advantage of
the economies of scale and lower unit prices available through large volume
orders from component parts suppliers. In addition, the ColorMate(Registered
Trademark) System provides machine- to-machine stability and reproducibility
(i.e., that each machine will achieve results consistent with that of other
machines).
GORDON LABORATORIES - GENERAL DESCRIPTION
Gordon Laboratories, Inc., located in Carson, California, is a contract
manufacturer that formulates and manufactures a variety of quality skin care,
hair care, fragrance and liquid products as well as cosmeceuticals and OTC's
(Over-The-Counter Drug Products) such as sunscreens, ointments, sports creams,
and sprays. Gordon's customer base consists of leading brand marketers, major
mass merchandisers and direct-sale marketers. Gordon does not market any brands
under its own label. In April 1996, Gordon Acquisition Corp. acquired Gordon
Laboratories and in June of 2000, Gordon Acquisition Corp was purchased by
Chromatics Color Sciences International. This caused an ownership change in the
corporate structure of the Gordon. (See "Gordon Acquisition")
Gordon formulates and manufactures products for customers in the U.S. personal
care market, currently a $25.5 billion industry, which is expected to grow at an
annual rate of 6% through the year 2002. Whereas the trends and growth within
the retail personal care market drive Gordon Laboratories' sales, Gordon
competes for the available outsourcing of services - formulations and contract
manufacturing - for these
21
products. Personal care products consist of six major categories: hair care (26%
of total volume), color cosmetics and fragrances (22%), skin care (16%),
deodorants (9%), toothpaste and toothbrushes (7%), and miscellaneous (20%), a
category that includes mouthwash, shaving preparations, sun-care products, nail
products, and hair colorants. Personal care products are typically segmented
into low-priced brands, medium-priced brands, and premium-priced brands and are
sold through a variety of retail and direct market outlets.
Among the fastest growing segments of the personal products area is skin care,
growing at approximately 6.5% per year, due to a steadily aging population (baby
boomers median age is now 42), aggressive Marketers (an estimated 300+ in the
U.S. alone), and a variety of more effective high-tech ingredients. Other
factors driving the growth in the skin care category are consumers' fears of
premature wrinkling from the sun, which have spurred Marketers to incorporate
sun screens in their products; the growth in both ethnic and men's skin care
products; and the addition of natural ingredients appearing in skin care
products.
Contract manufacturing has been a fast growing sector of the Cosmetics and
Toiletries Industry due to changing economic events, expanded distribution
channels, and the extension of niche products. As a result of the last
recession, many of the larger Cosmetic and Toiletry Companies downsized their
manufacturing capacities. Consequently, the recent upturn in demand for personal
products has meant that several major manufacturers lack the room or facilities
to cope with extra volume and have chosen to employ contract manufacturers
rather than get involved in a major outlay for new equipment and facilities.
Along with the changing economy, there has been a dramatic shift in
distribution, with the mass merchandising arena clearly picking up momentum and
invading the share of market once enjoyed purely by department stores. Several
mass market chains are adding their own private label brands to increase margins
and to differentiate themselves from other retailers. Department stores, in
turn, are responding by adding their own line of cosmetic products. Sears,
Roebuck & Company and J.C. Penney Company both offer a broad scale private label
line that includes skin care, makeup, fragrance, and bath products. Specialty
retail operators such as The Gap, Banana Republic, Ann Taylor, and The Limited
also sell their own private label brands. New distribution channels have opened
as well, with the growth in alternative Marketers such as television home
shopping, infomercials, and multi-level marketing companies. As a general rule,
none of these private label Marketers have their own manufacturing capabilities
and rely solely on contract manufacturers for product.
In addition to the expansion of distribution channels, new products are being
formulated by a growing number of niche Marketers in response to consumer
trends. These opportunities consist of certain ethnic and male skin care and
toiletry products, and lotions, creams, fragrances, and hair care products made
from all natural ingredients. As these Marketers seek to extend their ranges or
enter new product areas, they are using contract manufacturers to meet their
production needs. The contract manufacturers can provide a specialized service
in a niche market, saving principal manufacturers or retailers from investing
time and money in an area with great potential for expensive mistakes. They can
also contribute valuable expertise in the research and development of new
formulations, ensuring that the product works not just in the laboratory, but
also in the commercial quantities required for a production run.
In January of 1998, Gordon implemented an aggressive growth plan designed to
accelerate revenues by attracting the larger users of contract manufacturing
services. The plan focused on significantly improving three areas of the
business that would be key to its success in obtaining agreements with this type
of customer; high quality formulation services; consistently reliable
manufacturing and functionally proficient facilities and equipment. The
transition took 18 months to complete, culminating in a move to a custom
designed, 60,000 square foot laboratory and manufacturing facility in July of
1999. With the transition now complete, Gordon believes it is competitively
positioned to leverage its strong 63 year reputation, full service product
development capabilities and extensive manufacturing capacity to rapidly expand
its business.
22
In the near future, Gordon anticipates playing a supporting role to the Company,
providing an infrastructure and customer base that helps commercialize its color
science technology in the beauty industry. Gordon will provide the private label
products for the Company's potential home shopping channel. Gordon can also provide
future production for the Company's medical components, given Gordon's FDA
certification and medical device license. Another future potential is the use of
Gordon's professionally staffed formulating laboratory, which can perform
chromaticity studies, formulate custom blended foundations and provide turn-key
private label cosmetics. Each of these future service offerings will prove to be
mutually beneficial to both organizations.
As for working capital requirements, Gordon has invested more than $750,000 in
plant and equipment over the past 18 months and estimates that it will require
an additional $200,000 in equipment in fiscal 2001, $750,000 in fiscal 2002, and
$750,000 in fiscal 2003 in order to meet its business plan. It plans to lease
this equipment to minimize its impact on cash. Gordon will require a minimum of
$700,000 in cash during the first half of fiscal 2001 for working capital to
support its business.
GORDON LABORATORIES - MANUFACTURING/PROPERTY/REGULATORY
Manufacturing is done in a 60,000 square foot facility located in an industrial
business park in Carson, California at a monthly cost of $22,800. Gordon's
lease, which expires in December, 2006, contains escalation clauses along with
options to renew thereafter. Gordon has both the manufacturing and filling
equipment to meet the production requirements of mid-sized to large batch
products, providing Gordon the flexibility to produce a wide variety of products
in various quantities, sizes and packaging for its customers. Gordon maintains a
rigorous quality control standard (cGMP) that begins with the proper product
formulation and continues through quality assurance tests for each batch product
manufactured. Production services include the compounding of raw materials in
various sized mixing kettles, and filling equipment that adapts to a wide range
of packaging components. Gordon sources its raw materials from a wide variety of
chemical suppliers whose ability to deliver chemicals is generally very good.
Gordon's backorder of business as of April 12, 2001 is approximately $1.2
million and is expected to be fulfilled within the next three months.
Gordon manufactures personal care products under several different permits and
licenses. It has an alcohol permit from the State of California to manufacture
alcohol related toiletries and manufactures these products within a specially
permitted, 5,000 square foot room within the manufacturing facility. Gordon also
has an FDA permit and license from the State of California to manufacture
over-the-counter drug products and a medical device license from the State of
California to manufacture certain products used in conjunction with medical
equipment. Both of these certifications require Gordon to perform its production
services under cGMP compliance and are subject to periodic inspections by state
and federal agencies and annual renewals for the medical device license. Gordon
is also EPA certified from the State of California and has a permit for its
Clarifier process from the County of Los Angeles and the City of Carson. Gordon
believes it is in compliance with each of its regulatory agencies.
GORDON LABORATORIES - PRODUCTS/CUSTOMERS/PROPRIETARY FORMULAS
Gordon has the expertise to formulate, manufacture, and package a wide range of
inorganically pigmented personal products. These include products such as
aftershave, deodorant, baby oil, creams, lotions, gels, bubble bath,
cologne/perfumes, color cosmetics (cheek), shampoo, conditioner, hair spray,
mouthwash, pharmaceuticals, pre-shave lotion, shaving cream, skin treatment
products, and liquid soap. Gordon currently derives 80% of its business from
premium treatment items such as creams, lotions, and skin care products, 15%
from bath gels, fragrances, and pharmaceuticals (analgesic sprays, aspercream,
etc.), and
23
5% from hair care products and makeup. Gordon manufactures solely against its
customers' purchase orders, which tend to reflect a slight seasonality factor of
45% during the first half of the year and 55% for the second half of the year.
Another key area of expertise for Gordon is its laboratory and research
department. Gordon's chemists and technicians work closely with customers to
develop proprietary formulations that will achieve the customers desired
performance. These customers are generally given an option to purchase the
proprietary formula from Gordon. The lab will also work with customers who have
their own proprietary formula to ensure that the formulation meets the intended
performance specifications in commercial quantities. Additionally, the lab works
closely with production, conducting quality assurance tests for manufacturing.
Gordon provides its contract manufacturing services to customers requiring
moderate volume production requirements and value formulating services. Gordon's
customer base includes major brand marketers, niche brand marketers, specialty
retailers and mass merchandisers (such as Sears). Due to the sensitive nature of
the Gordon's customer requirements, confidentiality precludes the Gordon from
identifying most of the key customers.
Gordon has a sales and marketing group that is responsible for selling its
services to prospective customers. Targeted customers have either their own
formulations and are seeking a reliable contract manufacturer or require
formulating services and contract manufacturing. Customers also respond to the
various licenses and permits that Gordon possesses, such as FDA, medical device
and alcohol, since these are necessary requirements for the customers'
production and tend to be indicative of quality and performance.
Gordon typically negotiates annual contracts with its larger customers with
anticipated release dates, but it is not unusual for a customer to require
orders to be shipped earlier and in larger quantities. Gordon's flexibility to
perform for its customers under these uncertain circumstances is a significant
advantage that Gordon has designed into their manufacturing process. Gordon sold
products to approximately 105 customers in 2000, of which sales to four
customers were 18%, 16%, 11% and 10%, respectively, of Gordon's sales. However,
from time to time Gordon's concentration of business with a particular customer
can exceed 18%.
GORDON LABORATORIES - COMPETITION
The contract manufacturing business is highly fragmented, with more than 125
small to medium sized manufacturers. It is estimated that 95% of these companies
are privately held with annual revenues of $12 million or less. These companies
may operate on a national, regional, or local level and tend to offer either
organically pigmented products such as lipstick, rouge, and makeups, or
inorganically pigmented products such as lotions, creams, fragrances, gels, etc.
Gordon's competition is further divided along market segments, which are defined
as high volume - low margin producers, or moderate volume - higher margin
producers, since the manufacturing equipment required to meet each of the
respected segments is different. Contract manufacturers who pursue high volume
business, generally production runs of 100,000-unit minimums, must have large
mixing kettles, high speed filling lines, and spacious facilities to handle
these production runs whereas smaller production runs require more moderate
sized equipment and facilities. Gordon competes in the moderate volume segment
where additional services, such as product formulating and production
flexibility, are important factors for the customers.
Another indirect source of competition comes from the major U.S. based Companies
such as Johnson & Johnson, Shisheido, and Alberto Culver. These Companies
periodically seek to increase their facilities' output by offering contract
manufacturing services to non-competitive brand marketers. For the most part,
24
these Companies compete in the high volume segment and are generally not a
source of competition for Gordon.
GORDON LABORATORIES - EMPLOYEES
Gordon currently employs 45 persons on a full-time basis and 15 to 25 persons
through a temporary employment service for manufacturing. Gordon has employment
agreements with 6 managers that serve as agreements for compensation but do not
provide for any severance. Gordon's President and Chief Executive Officer is Mr.
Brian Fitzpatrick, who also serves as President and COO, and more currently
Acting CEO of Chromatics Color Sciences International. Gordon's Chief Operating
Officer is Mr. Frank Redman, whose employment provides for an annual base salary
of $125,000 and a bonus as determined by the CEO. Other key managers include a
Vice President of Technology Services, Vice President of Manufacturing and a
Director of Sales and Marketing. Gordon's employees are not represented by a
union. Gordon believes that its relationship with its employees is good. Gordon
is dependent primarily on the services of its COO, Vice President of Technology
Services, Vice President of Manufacturing and Director of Sales and Marketing.
The loss of any of their services could have a material adverse effect on
Gordon.
GORDON LABORATORIES - RECENT EVENTS
In June of 2000, Gordon Acquisition Corp. was purchased by Chromatics Color
Sciences International and Gordon's CEO, Mr. Brian Fitzpatrick, became President
and Chief Operating Officer, and more currently Acting CEO of Chromatics Color
Sciences International. In an effort to expand its business, Gordon has recently
hired a Chief Operating Officer, a Vice President of Manufacturing and a
Director of Sales and Marketing. Gordon has also developed a business
relationship with 5 new customers and is currently involved with Chromatics
Color Sciences International in raising funding to support its ongoing business.
As a result of the Gordon's current cash crunch, Gordon has defaulted on its
term loan with its senior lender and is seeking to remedy the situation through
its efforts to raise additional working capital.
GORDON LABORATORIES - RISK FACTORS
Competition: The market for Gordon's products and services is extremely
competitive with respect to price and quality and Gordon's competitors generally
have greater resources than Gordon. No assurance can be made that Gordon will be
able to successfully compete in its marketplace or that it will be able to
sustain and expand its current customer base.
Operations: Gordon has sustained operating losses during its last three years
and currently has a working capital deficiency and a stockholder equity
deficiency. No assurance can be made that Gordon will ever achieve and sustain
profitability.
Loan Obligations: Gordon has defaulted on its February and March loan payment
obligations and has received notice of default from the financing institution.
The lender has requested full payment of the loan which Gordon cannot afford to
pay. Gordon is currently negotiating with the lender to renegotiate the loan.
There can be no assurance that Gordon can resolve this issue. Failure to satisfy
this obligation would have a material adverse effect on Gordon's business and
could force Gordon to close its operation and seek protection from its creditors
under applicable bankruptcy laws.
Key Employees: Gordon is dependent primarily on the services of its COO, Vice
President of Technology
25
Services, Vice President of Manufacturing and Director of Sales and Marketing.
The loss of any of their services could have a material adverse effect on
Gordon.
Customer Concentration: At December 31, 2000 Gordon had sales to four customers
which represented 55% of total revenue. From time to time Gordon's concentration
of business with a particular customer can exceed 18%. The loss of such customer
would have a material adverse effect on the Gordon's business.
RISK FACTORS
Liquidity Crisis. The Company is currently experiencing a liquidity crisis and
requires an immediate infusion of cash in order to continue operations. In
addition, Gordon has failed to pay the installments of principal and interest
for February, and March 2001 to its secured lender and the lender has declared
an event of default and demanded immediate repayment of the outstanding loan
balance in the amount of $2,714,700. This loan is secured by substantially all
of the assets of Gordon. If the Company is unable to secure an immediate
infusion of cash it may be forced to seek protection from its creditors through
a voluntary bankruptcy filing. Alternatively, creditors of the Company holding
the required minimum dollar amount of claims against the Company could commence
an involuntary bankruptcy proceeding against the Company. If Gordon is unable to
refinance its defaulted indebtedness it may be forced to seek protection from
its creditors through a voluntary bankruptcy filing. Alternatively, creditors of
Gordon holding the required minimum dollar amount of claims against Gordon could
commence an involuntary bankruptcy proceeding against Gordon. No assurance can
be given that the Company will obtain an immediate cash infusion or that Gordon
will be able to refinance its defaulted indebtedness.
Nasdaq SmallCap Market Delisting. The trading of the Company's stock in the
Nasdaq SmallCap Market is conditioned upon the Company's continuing to meet
certain asset, capitalization, earnings and stock price tests. To maintain
eligibility for trading on the Nasdaq SmallCap Market, the Company will be
required to maintain, among other things, net tangible assets of at least
$2,000,000; a minimum bid price for the listed securities of $1.00 per share; a
market value of the public float of at least $1,000,000; and at least two market
makers for its securities. Effective March 23, 2001 the Company's Common Stock
was suspended from trading on the Nasdaq Small Cap Market as a result of the
Company's failure to satisfy these conditions. If the Common Stock is delisted
from the Nasdaq SmallCap market, the prices and the holders' ability to sell
such securities would be adversely affected. If the Common Stock were delisted
and the Company desired to have it relisted, the Company would be required to
satisfy the more stringent initial listing requirements of the Nasdaq SmallCap
Market.
If the Company is delisted from the Nasdaq SmallCap Market and the price per
share dropped below $5.00, then unless the Company satisfied certain net assets
tests, the Common Stock would become subject to certain penny stock rules
promulgated by the Securities and Exchange Commission (the "Commission"). The
penny stock rules require a broker-dealer, prior to a transaction in a penny
stock not otherwise exempt from the rules, to deliver a standardized risk
disclosure document prepared by the Commission that provides information about
penny stocks and the nature and level of risks in the penny stock market. The
broker-dealer must also provide the customer with current bid and offer
quotations for the penny stock, the compensation of the broker-dealer and its
salesperson in the transaction and monthly account statements showing the market
value of each penny stock held in the customer's account. In addition, the penny
stock rules require that prior to a transaction in a penny stock not otherwise
exempt from such rules, the broker- dealer must make a special written
determination that the penny stock is a suitable investment for the purchaser
and receive the purchaser's written agreement to the transaction. These
disclosure requirements may have the effect of reducing the level of trading
activities in the secondary market for stock that becomes subject to the penny
stock rules. If the Common Stock becomes subject to the penny stock rules,
investors may find it more difficult to sell their Common Stock.
26
The Independent Accountants' Report on the December 31, 2000 financial
statements indicates the Company has incurred recurring losses for the last
several years, including $19,464,400 in 2000 and has experienced significant
problems and delays exploiting its primary technology (medical equipment). In
addition, the Company's subsidiary, Gordon Laboratories, Inc., has defaulted on
its debt service obligations and the lender has demanded payment of the entire
debt, which totaled $2,714,700 at December 31, 2000. Neither the Company nor
Gordon are able to repay the debt.
The Independent Accountants' Report further states that the above matters raise
substantial doubt about the Company's ability to continue as a going concern.
Limited Operating History. The Company has a limited operating history upon
which its prospects can be evaluated. Such prospects must be considered in light
of the substantial risks, expenses and difficulties encountered by entrants into
the medical device industry, which is characterized by an increasing number of
participants, intense competition and a high failure rate. Until 1986, the
Company was principally engaged in research and development relating to the
Intellectual Properties, ColorMate(Registered Trademark) units and the Company's
Beauty-Aid Products. From early 1986 through October 1987, the Company was
engaged in limited test-marketing of certain of the Intellectual Properties and
Beauty-Aid Products through its former licensees. From October 1987 until June
1991, the Company was principally engaged in the Avon Project. Since 1991, the
Company has been engaged in the research and development of its
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System for
the monitoring of newborn bilirubinemia (infant jaundice), the development of
prototypes of additional versions of the ColorMate(Registered Trademark) unit
and the refinement of its technologies for other applications. There can be no
assurance that the Company will generate material revenues from the sale of its
products. The Company's business is subject to the risks inherent in the
development of new products using new technologies and approaches, many of which
are beyond the Company's control, such as unanticipated development,
manufacturing and regulatory delays and expenses. There can be no assurance that
unforeseen problems will not develop with these technologies or applications,
that the Company will be able to successfully address technological challenges
it encounters in its research and development program or that commercially
feasible products will ultimately be successfully developed and marketed by the
Company.
Operating Losses. The Company has incurred significant losses from operations
for the years ended December 31, 2000 and December 31, 1999 ($19,496,400 and
12,808,000, respectively). Although the Company has recently cut back many
operating costs, the Company anticipates incurring substantially increased
operating expenses as it attempts to expand its marketing and sales activity for
beauty applications, incurs manufacturing expenses for the ColorMate(Registered
Trademark) TLc- BiliTest(Registered Trademark) System and otherwise continues to
implement its business plan, including for the medical application involving the
monitoring of newborn bilirubinemia (infant jaundice). There can be no assurance
the Company will not continue to incur such losses or will ever generate
revenues at levels sufficient to support profitable operations.
The Company will continue to incur significant additional costs and expenses in
connection with FDA applications costs and related patent application costs,
manufacturing and other regulations, state regulatory requirements and foreign
market clearances and other requirements. Additional expenses are anticipated in
connection with certain multicenter studies being conducted on the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System. See
"Business." In addition, the Company expects to incur significant expenses
relating to manufacturing expenses, product liability insurance, legal and
regulatory compliance, including QSR/GMP quality system substantial compliance,
as well as research and development for new potential applications, and
implementation of the next phase of its efforts to successfully commercialize
the medical and beauty applications of its technology. See "Liquidity and
Capital Resources". The Company will also incur additional expenses implementing
additional testing and
27
clinical trials of its technologies for the possible monitoring of other
chromogenic diseases.
No Assurance of Successful Commercialization of ColorMate(Registered Trademark)
TLc- BiliTest(Registered Trademark) System. The Company's current ability to
generate revenues and to achieve profitability and positive cash flow in the
immediate future substantially will depend on the successful distribution of the
medical application of its technology to monitor newborn bilirubinemia (infant
jaundice) or the sale of the exclusive marketing rights to a third party.
Studies have been conducted on non-invasive transcutaneous bilirubinometer
devices other than the ColorMate(Registered Trademark) TLc- BiliTest(Registered
Trademark) System and some of these devices have received FDA marketing
clearance. While the Company believes the non-invasive nature of its
ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System for
monitoring newborn bilirubinemia (infant jaundice) provides benefits to
patients, no assurance can be given that the medical community will accept and
support the Company's medical device. There is no assurance that the Company's
ColorMate(Registered Trademark) Device for newborn bilirubinemia (infant
jaundice), or other future medical applications of the Company's technology will
be capable of being produced in commercial quantities at acceptable costs. There
can be no assurance that the existing medical applications for monitoring
newborn bilirubinemia (infant jaundice), or for future applications even if all
regulatory and reimbursement approvals are obtained, will be successfully
marketed or achieve any significant degree of market acceptance among
physicians, health care payors and others. The medical community generally has
had limited exposure to the Company and its proposed medical application.
Because the medical community is generally relatively slow to adopt new
technologies, procedures or devices, the Company might be unable to gain access
to potential customers to demonstrate the operation of its Intellectual
Properties in the medical field. Even if the Company gains access to sufficient
potential customers, no assurance can be given that members of the medical
community will perceive a need for or accept the Company's proposed medical
application.
Physicians and other health care professionals will not recommend or use the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System unless
they determine, based on experience, clinical data, relative cost, and other
factors such as competitive products, that the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System is an attractive alternative for
reducing the current traumatic blood tests that have a long history of safe and
effective use or other competitive products. The Company believes that
recommendations by physicians and clinicians will be essential for the market
acceptance of these products, but there can be no assurance that any such
recommendations will be obtained. To the extent the Company is able to market
and distribute its ColorMate(Registered Trademark) TLc-BiliTest(Registered
Trademark) System, broad market acceptance of the Company's device will require
the training of numerous physicians and clinicians, and the time required to
complete such training could result in a delay of successful commercial
distribution to the medical market. Moreover, obtaining and maintaining health
care payors' approval of reimbursement for the Company's products, and the level
of reimbursement made available, will be an important factor in establishing
pricing, structure and market acceptance. In addition, purchase decisions for
the device will be greatly influenced by health care administrators who are
subject to increasing pressures to reduce costs. Some purchasers, such as
hospitals, pediatrician's offices and home health care facilities, also might be
reluctant to purchase products from a company that has not demonstrated the
ability to satisfy ongoing delivery requirements. In addition, hospitals,
clinics and pediatricians may be unwilling or unable to commit funds to the
purchase of the Company's ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System due to institutional budgetary
constraints.
User acceptance of these products will depend on many factors, including
physician recommendations, the degree, rate and severity of potential
complications, the cost and benefits compared to competing products or
alternative medical treatments, available reimbursement and other
considerations. In addition, the Company's pricing policies could adversely
impact market acceptance of these products as compared to
28
competing products and alternative treatments. If any of the Company's marketing
or development programs are not successfully completed, required regulatory
approvals or clearances are not obtained or maintained, or products for which
approvals or clearances are obtained (such as the ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System for monitoring infant
jaundice) are not commercially successful, the Company's business, financial
condition and results of operations would be materially adversely affected.
There can be no assurance that the Company will be able to successfully address
any problems that may arise during the commercialization process of its
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System.
Early Stage of Development of Other Potential Medical Applications. Although the
Company has received FDA clearance to commercially market its
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System as
described above, has conducted early stage research and commenced initial
clinical studies with respect to certain other Chromogenic Diseases identified
by the Company (See "Business"), the Company's clinical and research development
programs for other medical applications of its technology are at a very
preliminary stage and substantial additional research and development and
further clinical trials will be necessary before commercial versions of any
additional proposed products are submitted for FDA marketing approval or
clearance and produced for other such medical applications. The Company could
encounter unforeseen problems in the development of such other products such as
delays in conducting clinical trials, delays in the supply of key components or
delays in overcoming technical hurdles. There can be no assurance that the
Company will be able to successfully address the problems that may arise during
the development/commercialization process. In addition, there can be no
assurance that any of the Company's proposed products for any such other medical
application will be successfully developed, proven safe and efficacious in
clinical trials, obtain regulatory approval or clearance, or meet applicable
regulatory standards and requirements.
Assumptions Regarding Medical Business Plan and Strategy. The Company has
formulated its medical business plan and strategy based upon certain assumptions
provided by the Company's medical distribution partner and other medical
distribution companies regarding the size of the bilirubin monitoring market,
the Company's anticipated short term and eventual share of this market, the
price at which the Company believes it will be able to sell or lease its
products, and consumer acceptance of the Company's products. There can be no
assurance that these assumptions will prove to be correct. The Company's ability
to operate in the future will depend upon many factors, including technological
advances and product obsolescence; levels of competition, including the entry
into the market of additional competitors and increased success by existing
competitors; changes in general economic conditions; increases in operating
costs including costs of production, supplies, personnel or equipment; and
changes in requirements and regulations promulgated by applicable federal,
state, local and foreign regulatory authorities. There can be no assurance that
the Company will successfully obtain or apply the human, operational and
financial resources needed to manage a developing business. Failure by the
Company to manage its growth effectively could have a material adverse effect on
the Company's business, financial condition and results of operations.
Lack of Marketing and Sales Experience. The Company has not previously licensed
its Intellectual Properties for use in any industry other than the beauty aid,
hosiery and cosmetics industries and management of the Company has not had any
experience in marketing the Intellectual Properties, ColorMate(Registered
Trademark) units or Beauty-Aid Products in any other field. Prior to licensing
the Company's Intellectual Properties in any industry, including the cosmetic,
beauty aids and fashion industries, the Company will be required to develop
additional marketing skills relevant to such industries and conduct significant
further marketing activity, and in certain of these industries, overcome
regulatory hurdles, professional skepticism and develop specific practical
applications therefor. There can be no assurance its own marketing efforts or
those of the Company's medical distributors will successfully generate
commercial levels of sales. There can be no assurance that the Company will be
able to
29
successfully maintain a marketing and sales force, or that it will be able to
maintain existing distribution agreements or enter into additional marketing and
sales agreements with third parties on acceptable terms.
Dependence on Marketing and Distribution Arrangements with Third Parties. The
Company has established a medical division, which due to the cost-saving
measures discussed previously, has substantially less employees than prior
years, as well as a distribution partnership with Datex-Ohmeda, Inc. and its
Ohmeda Medical Division to support its marketing efforts and has entered into a
separate third party manufacturing agreement for the ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System. The Company's business
strategy for the commercialization of its medical products depends upon the
Company's ability to maintain existing and selectively enter into and maintain
arrangements with additional leading marketing and distribution companies in the
medical field. There can be no assurance that the Company will be able to do so.
Any revenues to be received by the Company from its ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System will be dependent on
arrangements with third parties for marketing, distribution and sales of the
products. As of April 16, 2001, DO has not achieved the minimum performance
requirements set forth in the distribution agreement. The terms of the current
medical distribution agreement with DO are now under renegotiation between the
Company and DO. There can be no assurances that terms acceptable to both parties
will be successfully completed and the Company will have a medical distribution
agreement. The obligation of any existing or additional third party to fund or
undertake the marketing, distribution and/or sale of the product covered by any
arrangements with the Company may be dependent upon the satisfaction of certain
goals or "milestones" by certain specified dates, some of which are outside the
Company's control. To the extent that the obligations of any third party to fund
or undertake the foregoing activities are not contingent upon the satisfaction
of certain goals or milestones, a third party may retain a significant degree of
discretion regarding the timing of these activities and the amount and quality
of financial, personnel and other resources that they devote to these
activities. Furthermore, there can be no assurance that disputes will not arise
between the Company and any third party regarding their respective rights and
obligations under the arrangements. Finally, there can be no assurance that a
third party will not be able, due to financial, regulatory or other reasons, to
satisfy its obligations under its collaborative arrangement with the Company or
will not intentionally or unintentionally breach its obligations under the
arrangement.
There can be no assurance that any third party will not, for competitive
reasons, support, directly or indirectly, a company or product that competes
with the Company's business. Furthermore, any dispute between the Company and a
third party might require the Company to initiate or defend expensive litigation
or arbitration proceedings.
Any significant dispute with or breach, or termination of any arrangement with
such third party would require the Company to seek and reach an agreement with
another third party or to assume, to the extent possible and at its own expense,
all the responsibilities being undertaken by the first such third party. There
can be no assurance that the Company would be able to reach an agreement with a
replacement third party. If the Company were not able to find a replacement
third party, there can be no assurance that the Company would be able to perform
or fund the activities for which the first such third party would be
responsible. Even if the Company were able to perform and fund these activities,
the Company's capital requirements would increase substantially. In addition,
the further manufacture, development, marketing, distribution and sale of the
product covered by such arrangement would be significantly delayed.
Dependence on Medical Device and other Product Manufacturers. The Company does
not itself manufacture the ColorMate(Registered Trademark) units, the
ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System or
the Beauty-Aid Products, and in the past has been wholly dependent on
third-party OEMs of parts, assemblers, cosmetics suppliers and textile
suppliers. The Company may encounter various problems in establishing and
maintaining manufacturing relationships and/or operations, resulting in
inefficiencies and delays. Specifically, companies often encounter difficulties
30
in scaling up production, including problems involving production yield, quality
control and assurance, and shortages of qualified personnel. In addition, the
manufacturing facilities retained by the Company to manufacture its
ColorMate(Registered Trademark) products for medical applications are subject to
FDA QSR requirements and other regulatory requirements, international quality
standards (such as ISO 9001/EN46001) and other regulatory requirements.
Currently, the Company is dependent on the sole source manufacturer of the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System under
the existing exclusivity arrangements. The Company will have to maintain
relationships with such manufacturer and third party suppliers of component
parts for the production of its devices. There can be no assurance the Company
will be able to maintain its relationships with its current manufacturer, or
will be able to maintain arrangements with the other parts suppliers or
assemblers on terms satisfactory to the Company. Although the Company believes
that a number of manufacturers are capable of manufacturing and assembling the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System, any
change in manufacturers, or the retention of additional subcontractors, could
result in additional costs and delays. Difficulties encountered by the Company
in subcontracting to third-party manufacturers, scaling up production or failure
by the Company to utilize manufacturing facilities in substantial compliance
with FDA requirements, international quality standards or other regulatory
requirements, could result in a delay or termination of production or regulatory
enforcement action, which could have a material adverse effect on the Company's
business, financial condition and results of operations.
In connection with manufacturing of the ColorMate(Registered Trademark) units,
the Company could be required to make significant advance payments, obtain
letters of credit, cause potential customers or licensees to advance funds under
their agreements entered into with the Company or otherwise secure its payment
obligations to third-party manufacturers. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations." Although the
Company's existing manufacturing agreement for the ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System does not require such
obligations, there can be no assurance the Company will be able to maintain the
existing relationship, or that the Company will be able to enter into
replacement agreements that do not provide for such obligations and are
otherwise on acceptable terms. There can be no assurance the Company will be
able to secure its payment obligations itself or by having customers and/or
licensees advance funds, or otherwise be able to manufacture the
ColorMate(Registered Trademark) units or obtain further manufacture of the
ColorMate(Registered Trademark) units or its products.
To the extent the Company obtains any required FDA clearance for and markets the
Bilirubin LED Device or markets the ColorMate(Registered Trademark) LED Device,
the Company will need to outsource the production and assembly of the components
of the Bilirubin LED Device and the ColorMate(Registered Trademark) LED Device
to third party manufacturers and assemblers. One of the components of the
Bilirubin LED Device is available from only one supplier. The Company is reliant
on that one source of supply and these products would require a major redesign
in order to incorporate any substitute components.
Lack of Market Penetration in Other Industries. The Company has not yet achieved
commercial market penetration in any industry, and there can be no assurance the
Company will be able to do so in the future. The Company has not achieved
significant levels of cosmetics sales from its ColorMate(Registered Trademark)
unit locations, and expects based on the de minimus cosmetics sales levels
achieved per location to date, that it will have to greatly increase the number
of ColorMate(Registered Trademark) unit installations to achieve significant
levels of cosmetics sale revenues. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations." The Company also believes, based
on its operating history since February 1993, that obtaining such increased
cosmetic sales revenue will take significantly longer to achieve than was
originally anticipated. In order to implement its marketing plans in the United
States and abroad, including in industries in which the Company does not have
prior experience,
31
the Company will have to develop additional marketing skills and incur
significant expenses on sales and marketing activities, including hiring
finders, new personnel and consultants, and entering into arrangements with
retailers and distribution companies having a regional or national presence.
There can be no assurance the Company's marketing plan will be successful.
Legal Proceedings. In April 2000 the United States District Court for the
Southern District of New York dismissed three putative class actions that had
been filed against the Company and certain of its officers and directors.
On January 16, 2001, a lawsuit was commenced against the Company and Darby
Macfarlane in the federal district court for the Southern District of New York
entitled Richard Sommers and Linda Sommers v. Chromatics Color Sciences
International, Inc. and Darby S. Macfarlane. The plaintiffs allege that certain
statements purportedly made by or on behalf of the Company concerning the
Company's success, the extent of use of the ColorMate (Registered Trademark)
System and the Company's cash flow constituted violations of Section 10(b) of
the Securities Exchange Act of 1934 and SEC Rule 10b-5 promulgated thereunder
and Section 12(a)(2) of the Securities Act of 1933 as well as common law claims
alleging fraudulent misrepresentation, concealment and nondisclosure and seek
unspecified damages in an amount to be proven at trial. On March 1, 2001, the
defendants moved to dismiss the complaint for failure to state a claim upon
which relief can be granted, for failure to plead fraud with requisite
particularity and for failure to comply with the statutory requirements for
federal securities fraud claims. No decision has been rendered by the court on
this motion. The defendants believe that the allegations of the complaint are
without merit and intend to vigorously defend this action.
Potential International Operations. To market its ColorMate(Registered
Trademark) TLc-BiliTest(Registered Trademark) System in the European Union, the
Company sought ISO-9001/EN46001 certification and the right to affix the CE
mark. ISO-9001/EN46001 certification recognizes that the Company has established
a quality system for the design, development, manufacturing, servicing and
distribution of its medical device. The CE mark is a symbol of quality and
compliance with applicable European Union medical device directives. In March
1999, the Company received ISO-9001/EN46001 certification. In April 1999, the
Company was granted permission by the EU notified body, TUV Essen, to affix the
CE Mark to its ColorMate (Registered Trademark) TLc-BiliTest (Registered
Trademark) System. Prior to April 1, 1999, the Company passed a product
inspection in February 1999 for purposes of receiving the right to affix the CE
mark to such specific inspected product.
Foreign operations are subject to special risks that can materially affect
potential sales, including currency exchange rate devaluations and fluctuations,
the impact of inflation, exchange controls, labor unrest, political instability,
import and export duties and quotas, domestic and international customs and
tariffs, unexpected changes in regulatory environments, potentially adverse tax
consequences and other risks. Changes in certain exchange rates could have a
material adverse effect on the Company.
Prior Marketing Attempts. Other than the Company's marketing efforts with Avon,
arrangements with IMS and its beauty salon placements and a lease and license
agreement with Nordstrom, the Company's own attempts to license and/or lease its
Intellectual Properties and the ColorMate(Registered Trademark) units and to
market its Beauty- Aid Products independently and/or through licensees never
proceeded beyond the test marketing stage. There can be no assurance the Company
will in the future achieve commercial leasing of its ColorMate(Registered
Trademark) units and commercial licensing of the Intellectual Properties or the
sale of the Beauty-Aid Products. In addition, other than the Company's
distribution partnership with Datex-Ohmeda, Inc. and its Ohmeda Medical Division
for the sale of its ColorMate(Registered Trademark) TLc-BiliTest(Registered
Trademark) System (which is generating insignificant revenue) and its
installation of ColorMate(Registered Trademark) units in beauty salons and
beauty-related businesses (which are generating insignificant revenue), the
Company's revenue generating activities have been primarily conducted in
conjunction with its former licensees (i.e., Clairol, Hanes and Avon), that
provided substantial economic, administrative, marketing and advertising
support. There can be no assurance that without the support of a marketing
partner with financial resources, an advertising budget, market presence and
consumer recognition, the Company will be able to achieve successful operations,
including for medical
32
applications of its products and technologies. Further, there can be no
assurance the Company will ever develop a commercial market for the licensing or
leasing of its ColorMate(Registered Trademark) units and Intellectual
Properties, for the sale of the Beauty-Aid Products or for any medical
applications of its technologies.
Competition. To the extent the Company continues to implement its business plan
to commercialize a medical application for its Intellectual Properties, it will
be in a field characterized by rapidly changing technology, intense competition
and extensive research and development. The medical products market in general
is highly competitive. The Company's ability to compete in the monitoring of
newborn bilirubinemia (infant jaundice) market depends primarily on the
acceptance by the medical community of the Company's new technology, which can
be influenced by factors such as price, product quality and features, technical
capability, breadth of product line and distribution capabilities. The Company
will be competing with companies, some of which are more established and which
have greater financial, technical, manufacturing, marketing, research and
development and management resources than the Company (including companies such
as Minolta Co., Ltd., AirShields, Respironics, Inc., which acquired Healthdyne
Technology, Inc., and SpectRx, Inc., among others), and some of which have
greater name recognition and lengthier operating histories in the health care
industry. The Company believes the only commercially available non-invasive
bilirubinometers with FDA marketing clearance in the United States are the
Minolta Jaundice Meter and the SpectRx Bilicheck. In addition, there will be
other companies with which the Company will compete regarding other potential
medical applications which the Company may pursue. Furthermore, the monitoring
methods currently in use for monitoring of newborn bilirubinemia (infant
jaundice) as well as diseases with respect to which the Company may seek
regulatory marketing clearance in the future, have already achieved acceptance
by and are in widespread use in the medical community, unlike the Company's
proposed methods. There can be no assurance that the Company's proposed methods
will be accepted by the medical community or receive regulatory clearance.
There can be no assurance that the Company will be able to effectively compete
against these and other competitors, including those competitors who intend to
promote their versions of non-invasive devices. Additionally, there can be no
assurance that the Company's competitors will not succeed in developing, either
before, during or after the commercialization of the Company's product, devices
and technologies that permit more efficient, less expensive non-invasive
detection and monitoring of infant jaundice. It is also possible that one or
more pharmaceutical or other health care companies will develop therapeutic
drugs, treatments or other products that will substantially reduce the
prevalence of infant jaundice or otherwise render the Company's products
obsolete. There can be no assurance that the Company will be able to upgrade its
medical applications and devices to compete with such competitors or with
persons who may in the future develop products or monitoring methods competitive
with the Company's proposed medical applications and devices.
The Company is competing with other companies that have experienced and
well-funded marketing and sales operations. In addition, the Company's
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System, as
well as any future medical or beauty applications marketed by the Company, will
compete with existing devices, technologies and methods in achieving acceptance
in the medical community or beauty industry and in attracting support from
independent device distribution organizations which sell equipment to the
anticipated target markets (i.e., hospitals, pediatrician's offices and home
health care services, beauty salons, consumer beauty outlets, etc.).
Independent medical or beauty supply distributors who may be retained by the
Company will distribute other products which may compete with those of the
Company or which would provide greater revenues to such distributors than would
be provided by the Company's products. In addition, many medical or beauty
supply companies with which the Company's proposed applications and devices will
compete, and which have significantly greater financial research, technical,
manufacturing, and distribution resources and broader product lines than the
Company, have their own in-house marketing and distribution capabilities and
have established relationships with potential customers for the Company's
proposed medical or beauty application, such as pediatricians and hospitals. In
addition, many of the Company's competitors offer broader product lines than the
Company, which may be a competitive advantage in obtaining contracts with health
care purchasing groups. No assurance can be given that the Company will
successfully and effectively market its products against these and other
competitors or contract with health care providers.
The cosmetics industry and fashion industry are particularly sensitive to
changing consumer preferences and
33
demands, which are difficult to predict and beyond the Company's control.
Competition in the cosmetics industry is diverse and fragmented, but is
nevertheless dominated by a number of large, established, well-known
corporations having, among other things, significantly greater financial,
marketing and human resources than the Company. Virtually all of such companies
have in the past marketed, and continue to market, their products based on their
own color analysis system and advertised claims of "color compatibility" with
the personal color and/or wardrobe of the consumer. These competitors also have
established presence in the market and their own cosmetic manufacturing
facilities, unlike the Company. There can be no assurance that consumers will
prefer products based on the Company's scientifically based color
determinations, rather than the products sold by the Company's competitors based
on subjective techniques.
Protection of Intellectual Property. The Company depends on its ability to
obtain and maintain patent protection for its products and processes, to
preserve its trade secrets, and to operate without infringing upon the
proprietary rights of third parties. The validity and breadth of claims covered
in technology patents involve complex legal and factual questions and therefore,
may be highly uncertain. No assurance can be given that the scope of any patent
protection under the Company's current patents, or under any patent the Company
might obtain in the future, will exclude competitors or provide competitive
advantages to the Company; that any of the Company's patents will not be held
invalid if subsequently challenged; or that others will not claim rights in or
ownership of the patents and other proprietary rights held by the Company.
After the expiration of a U.S. Patent owned by the Company, the proprietary
technology and instrumentation disclosed in each Patent will be available for
use by others without compensation to the Company, unless protected by the
claims of other U.S. patents that may be issued to the Company. The Company has
developed intellectual property rights in color analysis, calibration and
verification in a number of fields including medical, biological, dental,
cosmetic and materials testing. The intellectual property rights include trade
secrets, know how and 6 pending United States patent applications. These rights
also include various foreign patent applications corresponding, at least in
part, to the U.S. Patents and the U.S. patent applications. There can be no
assurance that patents will issue based on these patent applications or that any
patent claims will provide sufficient protection to exclude others from the
Company's proprietary technology and instrumentation. There can be no assurance
that the Company will not be involved in litigation to protect its trade secrets
and know how or that the Company will prevail in such litigation. There can be
no assurance that challenges will not be instituted against the validity or
enforceability of any patents owned by or issued in the future to the Company,
or that such challenges will not be successful. There can be no assurance that
patent infringement claims will not be asserted against the Company and found to
have merit, that the Company will not be enjoined from using its proprietary
technology and instrumentation and from manufacturing and selling certain of its
Products, or would not be forced to obtain a license and pay future royalty fees
as well as past damages to the party claiming infringement in amounts not
presently determinable. There can be no assurance that any such license will be
available to the Company. Conversely, to the extent third parties infringe upon
the Company's patented Intellectual Properties, the Company may have to litigate
against such third parties in order to prevent further infringement. There can
be no assurance the Company will have the resources to prosecute any such
litigation, or that any such litigation would be resolved in favor of the
Company. In the event it is unable to bring such litigation or obtain a
favorable outcome, the Company's operations could be materially adversely
affected in that the Company's failure to enforce its Patents could result in
increased competition. If the Patents are declared invalid, the Company would
lose patent protection for certain of its Intellectual Properties, which could
have a material adverse effect on its operations.
There can be no assurance that the Company's Intellectual Properties will
provide it with a competitive advantage in that it may be possible for a
competitor independently to develop non-infringing technologies, independently
duplicate the Company's unpatented technology through reverse engineering,
design around the patented aspects of the Company's technology, or otherwise
independently develop scientifically accurate processes, instruments or color
charts to measure skin coloration, skin tone color categories and conduct
comparative color analysis without infringing the Company's Patents. The
Company's U.S. Patents apply only to the United States. The Company has filed
patent applications in a number of foreign jurisdictions which correspond, at
least in part, to the Company's U.S. Patents. The Company has been granted
European Patent No. 0446512, nationalizations of that European Patent in
Austria, Belgium, France, Germany, Great Britain, Hong Kong, Italy, Luxembourg,
The Netherlands, Spain, Sweden and Switzerland and Liechtenstein, as well as
Australian, Canadian, Korean and Mexican Patents corresponding, at least in
part, to its U.S. Patent No. 4,909,632, Australian, Taiwanese and Korean Patents
corresponding, at least in part, to its U.S. Patent No. 5,313,267 an Australian
Patent, a Singapore Patent and two
34
Taiwanese Patents corresponding, at least in part, to its U.S. Patent No.
5,671,735. The Company has not yet been granted any other foreign patents for
its Intellectual Properties and there can be no assurance that it will be
granted any such patents. Consequently, wherever the Company does not have
foreign patents, third parties currently could exploit, outside the United
States, the technology disclosed in the U.S. Patents, thereby increasing
competition in such foreign markets. In addition, persons gaining access to the
Company's unpatented proprietary information and technology and who are not
bound by confidentiality agreements with the Company would have the ability to
exploit the Company's unpatented proprietary information and technology both
inside and outside the United States, thereby increasing competition.
There can be no assurance that one or more of the Patents held by the Company
will not be successfully challenged or circumvented or that the Company will
otherwise be able to rely on such Patents. In addition, there can be no
assurance that competitors, many of whom have substantial resources and have
made substantial investments in competing technologies, will not seek to apply
for and obtain patents that prevent, limit or interfere with the Company's
ability to make, use and sell its products either in the United States or in
foreign markets. If the Company's right or ability to manufacture its products
were to be proscribed or limited, the Company's ability to continue to
manufacture and market its Products could be adversely affected, which would
likely have a material adverse effect upon the Company's business, financial
condition and results of operations.
The Company has not applied for patent protection for many aspects of the
Intellectual Properties (i.e., its proprietary trade secrets and other
confidential information). The Company typically imposes on its consultants, key
employees and advisers confidentiality obligations in connection with their
employment, consulting or advisory relationship with the Company. There can be
no assurance that such confidentiality obligations will be observed or that the
Company will have adequate remedies if those obligations are breached. To the
extent that consultants, key employees or other advisors apply technological
information taken from the Company in violation of confidentiality obligations,
disputes may arise as to the proprietary rights to such information which may
not be resolved in favor of the Company. There can be no assurance that others
will not independently develop technology that is substantially equivalent or
superior to that included in the Company's Intellectual Properties which are not
protected by patents.
There can be no assurance that the Company's copyright protection for the
software used in the ColorMate(Registered Trademark) Systems will provide it
with a competitive advantage in that it may be possible for a competitor
independently to develop similar software, design around the Company's
copyrighted software or otherwise independently develop software with the
capacity to accurately measure skin tone categories and conduct comparative
color analysis.
The medical device industry has been characterized by extensive litigation
regarding patents and other intellectual property rights, particularly with
respect to newly developed technology. In addition, re-examination or
interference proceedings may be instituted in the United States Patent and
Trademark Office ("USPTO"). There can be no assurance that the Company will not
become subject to patent infringement claims brought by third parties, or
re-examination of previously issued patents by the USPTO or interference
proceedings instituted in the USPTO to determine the priority of inventions. The
defense and prosecution of intellectual property suits, USPTO re-examination and
interference proceedings and related legal and administrative proceedings are
both costly and time consuming. Litigation may be necessary to enforce patents
issued to the Company, to protect trade secrets or know-how owned by the Company
or to determine the enforceability, scope and validity of the proprietary rights
of the Company and others. Any litigation or interference proceedings brought
against, initiated by or otherwise involving the Company may require the Company
to incur substantial legal and other fees and expenses and may require some of
the Company's employees to devote all or a substantial portion of their time to
the prosecution or defense of such litigation or proceedings. An adverse
determination in litigation or interference proceedings to which the Company may
become a party, including any litigation that may arise against the Company,
could subject the Company to significant liabilities to third parties, disputed
rights to be licensed from such third parties or prevent the Company from
selling its products in certain markets, or at all. If third-party patents
containing claims affecting the Company's technology were issued, and such
claims were determined to be valid, there can be no assurance that the Company
would be able to obtain licenses to such patents at costs reasonable to the
Company, if at all, or be able to develop or obtain alternate technology.
Although patent and intellectual property disputes regarding medical devices are
often settled through licensing or similar arrangements, there can be no
assurance that the Company would be able to reach a satisfactory settlement of
such a dispute that would allow it to
35
license necessary patents or other intellectual property. Even if such a
settlement were reached, the settlement process may be expensive and time
consuming, and the terms of the settlement may require the Company to pay
substantial royalties. An adverse determination in a judicial or administrative
proceeding or the failure to obtain a necessary license could prevent the
Company from manufacturing and selling its products, which would have a material
adverse effect on the Company's business, financial condition and results of
operations.
The Company is aware that others have obtained and are pursuing patent
protection for various aspects of infant jaundice diagnostic and monitoring
products and their use, including products that are non-invasive. There can be
no assurance that the Company's technology, current or future products or
activities will not be deemed to infringe upon the patent rights of others.
Failure to Obtain and Maintain Third-Party Reimbursement. In the United States
and elsewhere, sales of medical products and their use are dependent, in part,
on the ability of consumers of these products to obtain reimbursement for all or
a portion of their cost from third-party payors, such as government and private
insurance plans. Third-party payors are increasingly challenging the prices
charged for medical products and services. As the Company brings its
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System or
other future products to market, there can be no assurance that such products
will be considered cost effective and that reimbursement to the consumer will be
or continue to be available, or sufficient to allow the Company to sell its
medical device products on a competitive basis. Moreover, obtaining and
maintaining health care payors' approval of reimbursement for the Company's
products or their use, and the level of reimbursement made available, will be an
important factor in establishing pricing, structure and market acceptance. The
Company is unable to predict what changes will be made in the reimbursement
methods utilized by third-party health care payors. Furthermore, the Company
could be adversely affected by changes in reimbursement policies of governmental
or private health care payors.
Market acceptance of the Company's products in international markets will be
dependent in part upon the availability of reimbursement within prevailing
health care payment systems. Reimbursement and health care payment systems in
international markets vary significantly by country and include both government
sponsored health care and private insurance. Although the Company intends to
seek international reimbursement approvals, there can be no assurance that such
approvals will be obtained in a timely manner, if at all. Failure to obtain and
maintain third-party reimbursement coverage for use of the ColorMate(Registered
Trademark) TLc- BiliTest(Registered Trademark) System will have a material
adverse effect on the Company's ability to commercialize its technology for
medical applications.
Government Regulations. The Company's advertising, sales practices, and
cosmetics and medical products (including the labeling and packaging thereof)
are and will be subject to applicable federal, state and local regulation
(including regulation by the FDA, the Federal Trade Commission, and the Federal
Communications Commission, under various laws such as the Fair Packaging and
Labeling Act and/or any comparable state authority, agency or statute) and will
be subject to regulation by comparable foreign authorities if the Company
markets its products abroad. The Company will also be subject to regulation by
various governmental agencies that regulate direct selling activities.
Although the Company has received FDA marketing clearance of its
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System
pursuant to a "substantial equivalence" determination order, in the form of a
letter dated July 24, 1997 from the FDA's CDRH, authorizing the Company to
commercially distribute its ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System for monitoring newborn bilirubinemia
(infant jaundice) by healthcare professionals in the United States, the Company
also must maintain such clearance and comply with the other applicable statutes
and applicable rules and regulations promulgated by the FDA, in order to legally
market the device. The "substantial equivalence" order states that the Company
must comply with the medical device general controls, e.g., device establishment
registration, medical device listing, good manufacturing practices (QSR
requirements), medical device reporting, labeling, and the statutory
prohibitions against adulteration and misbranding. The order also states that
the ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System is
a Class II device which may be subject to additional special controls.
36
In the United States, the FDA regulates the introduction of medical devices as
well as, among other things, manufacturing, labeling and recordkeeping
procedures for such products. The process of obtaining marketing clearance for
new medical products from the FDA can be costly and time consuming, and there
can be no assurance that such clearance will be granted for the Company's future
products on a timely basis, if at all, or that FDA review will not involve
delays that would adversely affect the Company's ability to commercialize
additional or significantly modified products or to expand permitted uses of
existing products. Regulatory clearance to market a product from the FDA may
entail limitations on the indicated uses of the product. The ability to market
can be challenged (and possibly withdrawn) by the FDA due to failure to comply
with regulatory standards or the occurrence of unforeseen problems following
initial clearance. The Company may be required to file further marketing
applications with the FDA under certain circumstances, such as the addition of
product claims or product redesign. FDA regulations depend heavily on
administrative interpretation, and there can be no assurance that future
interpretation made by the FDA or other regulatory bodies, will not adversely
affect the Company.
In June 2000 the Company submitted a 510(k) application to FDA for product
upgrades and other modifications to its ColorMate (Registered Trademark)
TLc-BiliTest (Registered Trademark) System. The Company received a request from
the FDA for more information regarding this submission, including a request for
submission of post market hospital evaluation data in support of its claims for
use of the ColorMate(Registered Trademark)TLc-BiliTest(Registered Trademark)
system for patients undergoing phototherapy. The Company is currently preparing
these responses for submission. There can be no assurance this application will
be given clearance by the FDA.
In order for the Company to market its products in Europe and certain other
foreign jurisdictions, the Company and its distributors and agents must maintain
required regulatory registrations or approvals and otherwise comply with
extensive regulations regarding safety, efficacy and quality in those
jurisdictions. Specifically, certain foreign regulatory bodies have adopted
various regulations, among other things, governing product standards, packaging
requirements, labeling requirements, import restrictions, tariff regulations,
duties and tax requirements. These regulations vary from country to country. To
market its ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark)
System in the European Union, the Company sought ISO-9001/EN46001 certification
and the right to affix the CE mark. ISO- 9001/EN46001 certification recognizes
that the Company has established a quality system for the design, development,
manufacturing, servicing and distribution of its medical device. The CE mark is
a symbol of quality and compliance with applicable European Union medical device
directives. In March 1999, the Company received ISO-9001/EN46001 certification.
In April 1999, the Company also was granted permission by the European Union
notified body, TUV Essen, to affix the CE Mark to its ColorMate (Registered
Trademark) TLc-BiliTest (Registered Trademark) System. Prior to April 1, 1999,
the Company passed a product inspection in February 1999 for purposes of
receiving the right to affix the CE mark to such specific inspected product.
Failure to maintain ISO 9001/EN 46001 certification, CE mark rights or other
foreign regulatory approvals for the Company's medical products would prevent
the Company from marketing its medical products abroad, which would have a
material adverse effect on the Company's business, financial condition and
results of operations. There can be no assurance that the Company will obtain
any other required regulatory registrations or approval in such countries or
that it will not be required to incur significant costs in obtaining or
maintaining such regulatory registrations or approvals. Delays in obtaining any
registrations or approvals required to market the Company's products, failure to
receive these registrations or approvals, or future loss of previously obtained
registration or approvals could have a material adverse effect on the Company's
business, financial condition and results of operations. The Company may rely on
its third-party foreign distributors to comply with certain foreign regulatory
requirements. The inability or failure of the Company or such foreign
distributors to comply with varying foreign regulations or the imposition of new
regulations could restrict the sale of the Company's products internationally
and thereby adversely affect the Company's business, financial condition and
results of operations.
The Company and any third party with which it has made contract manufacturing or
other regulated arrangements is required to adhere to applicable FDA
regulations, including the QSR requirements and similar regulations in other
countries as required, which include, among other things, testing, control, and
37
documentation requirements. Ongoing compliance with QSR requirements and other
applicable regulatory requirements will be strictly enforced in the United
States through periodic inspections by federal and possibly state agencies,
including the FDA, and in foreign jurisdictions by comparable agencies. Failure
to comply with applicable regulatory requirements could result in, among other
things, warning letters, injunctions, civil monetary penalties, recall or
seizure of products, total or partial suspension of production, refusal of the
government to grant premarket clearance or premarket approval for devices,
possible rescission or withdrawal of clearances or approvals previously obtained
and criminal prosecution. The restriction, suspension or revocation of
regulatory clearances or approvals or government enforcement actions due to any
other failure to comply with regulatory requirements would have a material
adverse effect on the Company's business, financial condition and results of
operations.
Product Liability. The medical products industry is subject to substantial
product liability litigation, and the Company faces an inherent business risk of
exposure to product liability claims in the event that the use of its products
is alleged to have resulted in adverse effects to a patient or product user. Any
such claims could have a material adverse effect on the Company, including on
market acceptance of its ColorMate(Registered Trademark) TLc-BiliTest(Registered
Trademark) System. As the ColorMate(Registered Trademark) TLc-
BiliTest(Registered Trademark) System enters commercial use, the Company will be
in a field where it may become subject to product liability claims by patients
and/or users and might become a defendant in product liability litigation.
Although the Company has limited product liability insurance, through December
31, 2000, there can be no assurance that it will be able to maintain such
product liability insurance or that such insurance would be sufficient to
protect the Company against any such liabilities.
The Company maintains its own product liability insurance with respect to
cosmetic and beauty aid applications. There can be no assurance that such
insurance will be adequate to protect the Company from claims that may be
brought against it by users of the ColorMate(Registered Trademark) units or its
Beauty-Aid Products.
The Company has not established, and the Company does not intend to establish,
any reserves against any of the foregoing liabilities. In the event of an
uninsured or inadequately insured product liability claim in the future based on
the performance of the Company's ColorMate(Registered Trademark) TLc-
BiliTest(Registered Trademark) System, its ColorMate(Registered Trademark) units
or Beauty-Aid Products, the Company's business and financial condition could be
materially adversely affected and the Company could be forced to cease
operations.
Control; Dependence on Management. The Company is dependent primarily on the
services of Darby Simpson Macfarlane, Chairperson and Chief Technology Officer,
and David Kenneth Macfarlane, Vice President, Research and Development. The loss
of either of their services could have a material adverse effect on the Company.
Although the Company has purchased key-man life insurance policies in the
amounts of $1,000,000 on the lives of both Mrs. and Mr. Macfarlane, there can be
no assurance that the proceeds from such policies would enable the Company to
retain suitable replacements for them.
Lack of Public Market; Possible Volatility of Stock Price. There is no assurance
that a regular trading market for the Company's securities will be restored or,
if restored, that it will be sustained. The market price for the Company's
Common Stock may be significantly affected by such factors as the Company's
financial performance, the results of the Company's efforts to license its
Intellectual Properties and to market its products, and various factors
affecting the color science industry, the medical communities and the beauty aid
and cosmetics industries generally. Additionally, in recent years, the stock
market has experienced a high level of price and volume volatility for many
companies, particularly small and emerging growth companies traded in the
over-the-counter market, and these wide price fluctuations are not
38
necessarily related to the operating performance of these companies.
Accordingly, there may be significant volatility in the market for the Company's
securities.
Exercise of Outstanding Placement Agent Warrants and Warrants and Conversion of
Debentures and Preferred Stock. The price which the Company will receive for the
Common Stock issued upon exercise of the Placement Agent Warrants and Warrants
and the conversion of Debentures and Preferred Stock is expected to be
substantially less than the market price of the Common Stock at the time such
Placement Agent Warrants and Warrants are exercised or such Debentures or
Preferred Stock are converted. For the life of such Placement Agent Warrants,
Warrants, Debentures and Preferred Stock, the holders thereof are given, at
little or no cost, the opportunity to profit from a rise in the market price of
the Common Stock, if any, without assuming the risk of ownership. So long as
such Placement Agent Warrants and Warrants remain unexercised and Debentures and
Preferred Stock remain unconverted, the terms under which the Company could
obtain additional equity financing may be adversely affected. Moreover, the
holders of such Placement Agent Warrants, Warrants, Debentures and Preferred
Stock may be expected to exercise (or convert, as applicable) them at a time
when the Company would, in all likelihood, be able to obtain any needed capital
by a new offering of securities on terms more favorable than those provided by
such securities. To the extent of any exercise or conversion of Placement Agent
Warrants, Warrants, Debentures or Preferred Stock, the interests of the
Company's shareholders will be diluted proportionately.
Additional Authorized Preferred Stock. The Company's Amended Certificate of
Incorporation (the "Certificate of Incorporation") authorizes the Board of
Directors to issue, without shareholder approval, up to 10,000,000 shares of
preferred stock with voting, conversion and other rights and preferences that
could adversely affect the voting power or other rights of the holders of Common
Stock. The issuance of preferred stock or of rights to purchase preferred stock
could be used to discourage an unsolicited acquisition proposal. In addition,
the possible issuance of preferred stock could discourage a proxy contest, make
more difficult the acquisition of a substantial block of the Company's Common
Stock or limit the price that investors might be willing to pay in the future
for shares of the Company's Common Stock.
Item 2. Properties
The Company's executive offices, consisting of approximately 15,000 sq. ft. of
space, are located in New York, New York and are occupied pursuant to a lease
currently under negotiation. Rentals under such lease (including storage
facilities) currently are being paid at the rate of $26,000 per month, plus
occupancy costs. Additionally, the Company leases approximately 1,500 sq. ft. of
space in Spokane, Washington which is used for research and development
activities pursuant to a month to month lease. Rentals under such lease are
$2,018 per month.
The Company also occupies approximately 2,000 sq. ft. of space located in
Riverdale, New York, which is used for research and development activities and
manufacturing administration, at a cost of $1,750 per month, which space is
subleased by the Company from Darby Simpson Macfarlane, a director, officer and
principal shareholder of the Company; such rent is equal to Mrs. Macfarlane's
actual lease cost for such premises. The Company paid $21,000 for such space in
2000. The Company also maintains approximately 1,000 sq. ft. of space at 10 Old
Jackson Avenue, Hastings-on-Hudson, New York, at the residence of Mrs.
Macfarlane which is used for research and development activities and
administrative offices for extensive overtime hours spent on management and
research and development. The Company paid approximately $10,980 for such space
in 2000.
In 2000, the Company also occupied approximately 1,000 sq. ft. of space located
in Milford, Connecticut which was leased pursuant to a month to month lease at a
cost of $1,670 per month, and used primarily as office space for the Company's
medical marketing, sales and distribution support division. The Company
39
ceased to occupy such space in February 2000.
Item 3. Legal Proceedings
In April 2000 the United States District Court for the Southern District of New
York dismissed three putative class actions that had been filed against the
Company and certain of its officers and directors.
On January 16, 2001, a lawsuit was commenced against the Company and Darby
Macfarlane in the federal district court for the Southern District of New York
entitled Richard Sommers and Linda Sommers v. Chromatics Color Sciences
International, Inc. and Darby S. Macfarlane. The plaintiffs allege that certain
statements purportedly made by or on behalf of the Company concerning the
Company's success, the extent of use of the ColorMate (Registered Trademark)
System and the Company's cash flow constituted violations of Section 10(b) of
the Securities Exchange Act of 1934 and SEC Rule 10b-5 promulgated thereunder
and Section 12(a)(2) of the Securities Act of 1933 as well as common law claims
alleging fraudulent misrepresentation, concealment and nondisclosure and seek
unspecified damages in an amount to be proven at trial. On March 1, 2001, the
defendants moved to dismiss the complaint for failure to state a claim upon
which relief can be granted, for failure to plead fraud with requisite
particularity and for failure to comply with the statutory requirements for
federal securities fraud claims. No decision has been rendered by the court on
this motion. The defendants believe that the allegations of the complaint are
without merit and intend to vigorously defend this action.
Item 4. Submission of Matters to a Vote of Security Holders
On December 18, 2000, at the annual meeting of shareholders held at the Legends
Hotel and Conference Center in McAfee, New Jersey, the shareholders (i) did not
approve an Amendment to the Company's Certificate of Incorporation for a
classified Board of Directors, as the required shareholder vote was not
received, (ii) elected seven directors of the Company to serve for a term of one
year and until their respective successors shall be elected and shall qualify,
(iii) ratified the appointment of BDO Seidman, LLP as auditors of the Company
for the year ending December 31, 2000 and (iv) approved a proposal to amend the
1992 Plan to increase the number of shares of Common Stock authorized to be
issued thereunder from 5,500,000 to 6,500,000, an increase of 1,000,000 shares,
and (v) approved a proposal to amend the Company's Certificate of Incorporation
to effect a one for three reverse stock split of the Company's issued and
outstanding shares of Common Stock.
The following table sets forth the votes cast for each proposal presented at the
Company's annual meeting:
Amendment of the Company's Certificate of Incorporation to provide
for a classified Board of Directors
--------------------------------------------------------------------------------
Votes For Votes Against Abstentions Non-Votes
--------------- --------------- ----------------- ---------------
4,795,804 837,750 24,005 11,326,761
Election of Directors
---------------------------------------------------------------------------
Votes For Withheld
---------------- ---------------
Darby S. Macfarlane 16,683,623 300,697
40
David Kenneth Macfarlane 16,683,623 300,697
Leslie Foglesong 16,698,323 285,997
Edmund Vimond 16,698,323 285,997
Edward Mahoney 16,698,323 285,997
James Bergman 16,755,623 229,297
Brian T. Fitzpatrick 16,755,623 229,297
Ratification of Appointment of BDO Seidman LLP
--------------------------------------------------------------------------------
Votes For Votes Against Abstentions Broker Non-Votes
-------------- --------------- ------------- ----------------------
16,928,194 48,626 7,500 0
Amendment of 1992 Plan
--------------------------------------------------------------------------------
Votes For Votes Against Abstentions Not Voted
-------------- ---------------- --------------- ---------------------
4,227,053 1,363,867 66,639 11,850,509
Amendment of the Company's Certificate of
Incorporation to Effect Reverse Stock Split.
--------------------------------------------------------------------------------
Votes For Votes Against Abstentions
----------------- ------------------- -----------------
16,446,170 527,160 10,990
PART II
Item 5. Market For the Company's Common Equity and Related Stockholder Matters
The Company has registered the Common Stock with the Commission under the
provisions of Section 12(g) of the Exchange Act of 1934, as amended (the
"Exchange Act"). Registration under the Exchange Act requires the Company to
comply with certain reporting, proxy solicitation and other requirements of the
Exchange Act.
Prior to February 8, 1993, the date on which the Common Stock was approved for
quotation on the Nasdaq Stock Market SmallCap Market ("NASDAQ"), there was no
public market for the Common Stock. The quotations reflect inter-dealer prices,
without retail mark-up, mark-down or commissions, and may not necessarily
reflect actual transactions. On March 23, 2001, the Company's Common Stock was
suspended from trading on the Nasdaq Small Cap Market as a result of the
Company's failure to satisfy certain
41
conditions. There were 150 holders of record of the Common Stock as of March 30,
2001, including nominees for an unknown number of beneficial holders.
Common Stock
The following tables set forth the high and low bid prices for the Common Stock
for each of the periods indicated (after giving retroactive effect to the
February 1998 3 for 2 Stock Split):
Period Price
----------------------------------------------- ---------------------------
High Low
------------ -----------
January 1, 1999 to March 31, 1999 11.500 4.625
April 1, 1999 to June 30, 1999 13.938 7.625
July 1, 1999 to September 30, 1999 8.938 5.125
October 1, 1999 to December 31, 1999 9.125 5.125
January 1, 2000 to March 31, 2000 7.938 5.375
April 1, 2000 to June 30, 2000 5.375 2.875
July 1, 2000 to September 30, 2000 5.063 0.625
October 1, 2000 to December 31, 2000 2.125 0.25
Dividend Policy
The Company has not paid, during the two fiscal years ended December 31, 2000,
and has no present intention to declare or pay, cash dividends on the Common
Stock in the foreseeable future. The Company intends to retain any earnings
which it may realize in the foreseeable future to finance its operations. The
Company has outstanding 1,380,000 shares of the Class A Preferred Stock entitled
to an annual non- cumulative dividend of $0.001 per share, when and as declared
by the Board of Directors of the Company, payable quarterly, which dividend must
be paid before any cash dividend may be paid with respect to the Common Stock.
The Company's Class B Preferred Stock is to not entitled to any dividends.
Item 6. Selected Financial Data
The following information has been derived from the Company's consolidated
financial statements. The selected consolidated financial data should be read in
conjunction with the Consolidated Financial Statements and the notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" elsewhere in this report.
42
Years Ended December 31,
-------------------------------------------------------------------------------
2000 1999 1998 1997 1996
---------- ---------- ---------- ---------- -----------
Total Assets $8,996,800 $8,110,200 $7,878,200 $10,752,600 $6,747,500
Senior Convertible
Debentures including
accrued interest - 4,661,600 - - -
Redeemable Preferred
Stock 13,800 2,942,500 13,800 13,800 3,800
Stockholders' Equity 3,386,700 (503,700) 6,569,200 9,896,300 5,942,200
(Deficiency)
Revenues 3,842,000 1,103,200 46,600 11,500 66,600
Net Loss (19,496,400) (12,808,000) (7,284,800) 5,053,100) (4,442,300)
Net Loss per share -
Basicand diluted (*) (1.40) (0.93) (0.49) 0.40) 0.51)
(*) Loss per share was retroactively adjusted to reflect the three for two split
of February 1998.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations
Fiscal Year 2000 Compared to Fiscal Year 1999
The Company incurred net losses of $19,496,400 and $12,808,000 for the fiscal
years ended December 31, 2000 and 1999, respectively. Loss per share was $1.40
for 2000 and $.93 for 1999.
Revenues for the fiscal year ended December 31, 2000 were $3,842,000 as compared
to $1,103,200 in the prior fiscal year. The Revenues for 2000 are primarily from
Gordon as a result of the acquisition of Gordon on June 2, 2000. The
consolidated financial statements of the Company include revenues from Gordon
from the date of acquisition through December 31, 2000. The revenues for the
fiscal year ending December 31, 1999 are primarily from the sale of products to
Ohmeda, which were approximately $80,000 in 2000.
Cost of sales was $3,868,400 (which includes an impairment charge of $733,100 on
the Company's inventory) for the fiscal year ended December 31, 2000 as compared
to $898,100 in the prior year. The current year's cost of sales prior to the
impairment charge relates primarily to the cost of sales for Gordon. Cost of
sales in the prior year primarily relate to the sales to Ohmeda.
In light of the serious liquidity and other problems at the Company and because
of the lack of viable levels of sales of its medical equipment and the liquidity
problems at Gordon, the Company recorded $6,784,000 of impairment charges. Of
this amount, $5,276,500 relates to write-off of goodwill relating to the Gordon
acquisition.
Sales, marketing and trade show costs were $2,047,300 in 2000 as compared to
$2,511,600 in 1999. Medical regulatory expenses were $840,100 in 2000 as
compared to $1,323,300 in 1999.
Research and development costs were $1,430,500 for the fiscal year ended
December 31, 2000 as compared to $996,300 in the prior fiscal year. The increase
in the current period is primarily a result of the continuing implementation of
the Company's long-term business plan to seek commercial applications of its
intellectual properties and technologies. In addition, the current period
includes research and development costs from Gordon.
Compensation - Officers and employees were $1,430,500 for the fiscal year ended
December 31, 2000 as compared to $803,900 for the prior fiscal year. The
increase in these costs in the current period is a result of the Company now
including the compensation of officers and employees of Gordon and the addition
of executive and senior level personnel to implement the Company's business
plan.
Total General and administrative costs were $5,809,600 for the fiscal year ended
December 31, 2000 as compared to $3,951,200 in the prior year. The increase
primarily results from the acquisition of Gordon, which costs were not in the
prior year, the above-mentioned increase in Compensation costs, an increase in
consultants, an increase in depreciation and amortization costs and the
amortization of goodwill due to the acquisition of Gordon.
Interest and non-cash financing costs were $1,682,900 in the fiscal year ended
December 31, 2000 as compared to $3,313,000 in the prior period. The decrease is
due to a reduction in the amortization of original issue discount on the senior
convertible debentures, partially offset by the increase in interest expense due
to the acquisition of Gordon.
Deemed dividend on preferred stock was $3,900,000 in the fiscal year ended
December 31, 2000 as compared to $1,558,300 in the prior year. The increase is
due to the amortization of a new series of preferred stock which was not issued
in 1999 and the impact of a new accounting release.
Although the Company has substantially reduced personnel and ongoing operating
expenses, the Company expects that it will continue to incur costs in connection
with the required research and development on its new LED instrument and
technology, complete filings, administration and maintenance for certain
intellectual properties and regulatory requirements; supply updated products and
sales support to its medical distributor; complete FDA filings for upgrades to
its medical products, and explore the possibility of either renegotiating its
current distribution agreement for its medical products or selling the exclusive
rights to its medical products and technology.
The Company anticipates that it will continue to incur net losses for the
foreseeable future as expenses are incurred in implementing its long-term
business plan.
Fiscal Year 1999 Compared to Fiscal Year 1998
The Company incurred a net loss of $12,808,000 and $7,284,800, for fiscal years
1999 and 1998, respectively. Revenues of $1,103,200 have been received
principally from sales of ColorMate (Registered Trademark) TLc-BiliTest
(Registered Trademark) Systems and TLc-Lensette (Trademark) Calibration
Standards and other products under the Company's distribution agreement with
Datex Ohmeda, Inc. and its Ohmeda Medical Division. Of the increase in net loss
from 1999 as compared to 1998, $2,740,800 represents non-cash financing costs
computed as original issue discount ("OID") on financing transactions, $495,800
represents non-cash accrued interest on senior convertible debentures and
$140,600 represents an increase in non-cash expenses relating to stock option
grants to non-employees. The resulting $2,146,000 increase in losses from 1999
as compared to 1998 (without consideration of the non-cash OID costs, the
non-cash accrued interest on senior convertible debentures and non-cash expenses
for stock option grants to non-employees), is primarily attributable to an
increased cost of $1,552,700 relating to the Company's medical division sales
force, as the Company continues the implementation of its long-term business
plan to seek commercial applications of its intellectual properties and
technologies in the medical field. The Company had a gross profit in 1999 from
sales of ColorMate (Registered Trademark) TLc-BiliTest (Registered Trademark)
Systems and TLc-Lensette (Trademark) Calibration standards and other products of
$205,100 which was offset by: the increased cost of Sales, Marketing and Trade
show expenses which include the above-mentioned fully implemented sales force at
its medical division of $1,552,700; increases in amortization of patent,
software and ColorMate (Registered Trademark) TLc-BiliTest (Registered
Trademark) System promotional expenses of $363,700 and an increase in stock
administration fees of $88,400 relating primarily to registration costs of the
1999 financing transactions. These increased expenses were partially offset by a
decrease in legal fees of $163,000.
The Company anticipates that it will continue to incur significant costs and
expenses in connection with FDA application, manufacturing and other
regulations, state regulatory requirements and foreign market clearances, other
requirements and related patent costs. In addition, the Company expects to incur
significant expenses relating to manufacturing expenses, products liability
insurance, legal and regulatory compliance, including QSR/GMP quality system
substantial compliance, as well as research and
43
development for new potential applications, and implementation of the next phase
of its efforts to successfully commercialize the medical application of its
technology. The Company anticipates significantly higher compensation expenses
in connection with increased hiring of executives and staff. The Company will
also incur additional expenses implementing additional testing and clinical
trials of its technologies for the possible monitoring of other chromogenic
diseases. The Company also anticipates further legal expenses in connection with
its defense of certain class action suits that have been brought against the
Company. See "Legal Proceedings."
In June 1999 the Company entered into an agreement for the exclusive
distribution of its ColorMate(Registered Trademark) TLc-BiliTest(Registered
Trademark) System in the hospital, pediatricians' office and home healthcare
markets in the United States with Datex Ohmeda, Inc. and its Ohmeda Medical
Division. The Company expects to generate revenue through its relationship with
Datex Ohmeda, Inc. and its Ohmeda Medical Division from the aggregate sales of
its ColorMate (Registered Trademark) TLc-BiliTest(Registered Trademark) System
and the disposable TLc-Lensette (Trademark) calibration and verification
standards which calibrate the device prior to its use.
The ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System
consists of two distinct products: the ColorMate(Registered Trademark)
TLc-BiliTest(Registered Trademark) System device and the TLc-Lensette(Trademark)
calibration and verification standards. The initial transfer prices of the
ColorMate(Registered Trademark) TLc-BiliTest(Registered Trademark) System
devices and the TLc-Lensette(Trademark) calibration and verification standards
are initially set at established minimum amounts. The Company expects to receive
additional amounts from the distributor equal to a defined percentage of the
distributor's sales of the products ("Profit Sharing Payments"). The Company
incurred a small loss in 1999 based on the initial transfer price of the
ColorMate(Registered Trademark) TLc- BiliTest(Registered Trademark) System
devices. In addition, any Profit Sharing Payments will generate additional
profits to the Company.
Liquidity and Capital Resources
Fiscal Year 2000 Compared to Fiscal Year 1999
Current Assets were $4,317,400 at December 31, 2000 as compared to $4,933,700 at
December 31, 1999. This decrease is primarily attributable to a decrease in cash
due to the cash operating losses partially offset by the increase in Accounts
receivable and Inventories primarily due to the acquisition of Gordon.
As indicated in the Consolidated Statement of Cash Flows, the Company continues
to experience significant negative net cash flows from operating and investing
activities.
The 2000 net cash outflow from operating activities is primarily attributed to
the Company's net loss (partially offset by depreciation and amortization
expense, non-cash compensation costs to consultants, non-cash interest and
financing costs, collections of accounts receivable and the impairment
provision.)
Cash flows from financing activities during 2000 principally represent
$9,152,400 of proceeds from the issuance of common stock, preferred stock and
warrants.
The Company lacks funds to continue material aspects of its operations and
business plan, including funds and necessary personnel to complete recently
required research and development on its new LED instrument and technology
discovered during its first mass manufacturing process; complete filings,
administration and maintenance for certain intellectual properties and
regulatory requirements; supply upgraded products and sales support to its
medical distributor; and complete FDA regulatory filings for upgrades to its
medical products.
The Company's current objective with regard to its medical business is to arrive
at acceptable revised terms of the existing agreement with the distributor or to
identify a strategic partner in the medical industry to whom the Company could
sell, for an up-front fee and ongoing royalty, the exclusive market rights to
the ColorMate TLc-BiliTest System.
The Company's subsidiary, Gordon, has a note payable to a finance Company
totaling $2,714,700 at December 31, 2000, which is secured by substantially all
of the assets of Gordon. The failure by Gordon to make the regularly scheduled
payment due February 18, 2001 and March 18, 2001, each in the amount of
$54,108.31, as well as the failure to pay other amounts due, including the sum
of $1,758.86 for expenses and $10,000 for an amendment fee, constitutes an event
of default under the loan agreement. The lender has requested full payment of
the loan which Gordon cannot afford to pay without additional financing. Gordon
is currently negotiating with the lender in an attempt to renegotiate the loan.
The failure of Gordon to successfully renegotiate this financing could force
Gordon to seek protection from its creditors in bankruptcy. The Company is not
responsible for payment of this loan.
The Company is experiencing a major liquidity crisis and requires an immediate
infusion of cash to continue operations. In addition, the Company's subsidiary
-Gordon, continues to experience cash flow losses. The Company is seeking
additional capital to facilitate short-term liquidity and is currently reviewing
various financial proposals and has taken steps to reduce costs. If the Company
is unable to obtain such short-term financing, or sell its assets to obtain a
cash infusion, it may be forced to seek protection from its creditors in
bankruptcy.
Even if the Company is successful in obtaining this short-term cash infusion,
the Company will require additional future financing. If the Company is not able
to attract additional future financing, generate significant revenue from
operations and/or successfully market its products and technologies, it may have
to significantly curtail and/or cease operations and be forced to seek
protection from its creditors in bankruptcy.
The Independent Accountants' Report on the December 31, 2000 financial
statements indicates the Company has incurred recurring losses for the last
several years, including $19,464,400 in 2000 and has experienced significant
problems and delays exploiting its primary technology (medical equipment). In
addition, the Company's subsidiary, Gordon, has defaulted on its debt services
obligations and the lender has demanded payment of the entire debt, which
totaled $2,714,700 at December 31, 2000. The Independent Accountants' Report
states that these matters raise substantial doubt about the Company's ability to
continue as a going concern.
The Company is currently negotiating proposals for financing the Company. One
proposal would include the purchase of 75% of Gordon Laboratories for over 1
million (with a 9-month option to the Company to purchase the shares of Gordon
back for the purchase price plus interest) and additional funds provided under a
secured loan to the Company. Another proposal would be for an equity financing.
Such proposals require negotiation of warrants to purchase the Company's stock
and are subject to satisfactory completion of due diligence, negotiation,
execution and delivery of definitive agreements by and between the parties, the
lifting of the suspension of trading of the Company's common stock on the Nasdaq
Small Cap Market (CCSI) and compliance with the Net Asset Nasdaq listing
requirement.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk.
None.
Item 8. Financial Statements and Supplemental Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
---------
44
Page
---------
Independent Accountants'
Reports...............................................................F-2
Consolidated Balance Sheets as of December 31, 2000 and
1999..................................................................F-3
Consolidated Statements of Operations for the years
ended December 31, 2000, 1999 and 1998...............................F-4
Consolidated Statements of Changes in Shareholders'
Equity for the years endedDecember 31, 2000, 1999 and 1998...........F-5
Consolidated Statements of Cash Flows for the years
ended December 31, 2000, 1999 and 1998..............................F-6
Notes to Consolidated Financial Statements............................F-7
Item 9. Changes In And Disagreements With Accountants On Accounting And
Financial Disclosure. None
PART III
Item 10. Directors and Executive Officers of the Company
Certain information concerning directors and executive officers of the Company
is set forth below:
Name Age Position
Darby Simpson Macfarlane 56 Director, Chairperson of the Board
of Directors, Chief Technology
Officer, Treasurer
Brian T. Fitzpatrick 47 Director, Acting Chief Executive
Officer, President
David Kenneth Macfarlane 54 Director, Vice President, Research
and Development
Leslie Foglesong* 45 Director, Secretary, Assistant
Treasurer
Edmund Vimond*++ 64 Director
Edward Mahoney*++ 49 Director
James Bergman 39 Director
Frank Marchese 45 Chief Financial Officer
Robert Shapiro 50 Director
James Berquist 46 Director
o Member of the Audit Committee of the Board of Directors.
++ Member of the Compensation Committee of the Board of Directors.
Directors are elected annually by the shareholders and hold office until the
next annual meeting and until
45
their respective successors are elected and qualified. Executive officers are
elected by the Board of Directors, serve at the direction of the Board of
Directors and hold office until their respective successors are elected and
qualified. There is no current arrangement or understanding between any director
or executive officer and any other person pursuant to which such person was or
is to be selected as a director or executive officer of the Company.
Mrs. Macfarlane and Mr. Macfarlane were formerly married to one another. There
are no other family relationships among the directors or executive officers of
the Company.
Set forth below is certain additional information with respect to the directors,
executive officers and certain consultants of the Company.
Mrs. Macfarlane co-founded the Company in March 1984. She has been Chairperson
of the Board, Chief Executive Officer, Chief Technology Officer, Treasurer or
Assistant Treasurer and a director of the Company since formation and also
served in the capacity of President until April 9, 1995. Prior to such time,
Mrs. Macfarlane was the co-founder in 1974 of Personalized Colors, Inc.
Commencing in 1978, Mrs. Macfarlane and Mr. Macfarlane led and directed the
Company's research and development and mass- manufacturing efforts of the color
science technology, instrumentation and cosmetic and related products now
offered by the Company.
Mr. Macfarlane co-founded the Company and is also one of the primary inventors
of the patented technologies used in the ColorMate(Registered Trademark) System.
In addition, Mr. Macfarlane developed the manufacturing, technical and
engineering specifications necessary to have miniaturized and mass manufactured
the ColorMate(Registered Trademark) System. Mr. Macfarlane has been Vice
President- Research and Development, and a director of the Company since
formation. Prior to 1984, Mr. Macfarlane held a variety of executive positions
with finance, sales, marketing, research and development and manufacturing
companies in Europe, South Africa and the United States, including International
Technical Research and Development, Ltd., and Trumach, Inc.
Leslie Foglesong has been the Secretary, Treasurer or Assistant Treasurer and a
director of the Company since its formation.
Mr. Edmund G. Vimond has previously provided consulting services to the Company.
On December 1, 1997, Mr. Vimond was appointed to the Company's Board of
Directors and currently acts as Chairman of the Company's Compensation
Committee. From 1991 to 1997, Mr. Vimond was the President and Chief Executive
Officer of Ocurest Laboratories, Inc. Mr. Vimond was responsible for managing
all functions of the business, including marketing, sales, contract
manufacturing, personnel and finance and systems. Prior to 1991, Mr. Vimond held
positions in various executive capacities with RJR Nabisco Inc., American
Cyanamid Co., Johnson & Johnson and Warner-Lambert Company. Since January 1998,
Mr. Vimond has been the principal of Edmund Vimond Associates, a business
development consulting practice. Mr. Vimond received BSBA and MBA degrees from
Northwestern University.
Edward Mahoney, a certified public accountant, was appointed to the Board of
Directors on January 26, 1998, and currently acts as Chairman of the Company's
Audit Committee. Since January 1998, Mr. Mahoney has owned and operated a
certified public accounting firm and was a tax partner with the accounting firm
of BDO Seidman LLP from 1994 to 1997 and Price Waterhouse from 1973 to 1994. Mr.
Mahoney received a Bachelor of Science in Accounting degree from Brooklyn
College of the City University of New York.
Brian T. Fitzpatrick was appointed Acting Chief Executive Officer and a director
of the Company on
46
August 14, 2000. He previously served in the capacity of President and Chief
Operating Officer of the Company, which role he assumed upon the Company's June
2000 acquisition of Gordon Laboratories, Inc., a Carson City, California based
formulator and manufacturer of cosmetics, hair care and other personal care
products. Mr. Fitzpatrick had been the President, Chief Executive Officer and
Chairman of Gordon since April 1996. Prior to Gordon, Mr. Fitzpatrick served as
President of several electronic manufacturing companies and worked for the
Polaroid Corporation in its industrial marketing division. Mr. Fitzpatrick
earned an M.B.A. in Finance and Marketing from Adelphi University in 1986 and a
B.S. in Marketing from Seton Hall University in 1975.
James N. Bergman was appointed to the Board of Directors on August 14, 2000. He
is currently the Chief Operating Officer of Lawrence Brothers, Inc., a building
hardware manufacturer, and had been a partner in the law firm of Ward, Murray,
Pace and Johnson until August 1999. He is a graduate of Northern Illinois
University Law School and has an undergraduate degree in accounting from the
University of Iowa.
Frank Marchese, a certified public accountant, has been Chief Financial Officer
of the Company since January 2000. Mr. Marchese had previously served as Chief
Financial Officer of Pharmaceutical Formulations, Inc. from 1992 until 1999,
Director of Finance for Primex Plastics Corporation from 1989 until 1992 and
Senior Manager with the accounting firm of KPMG Peat Marwick, LLP prior to 1989.
Mr. Marchese holds an MBA degree from New York University and a BBA. degree from
Pace University.
Darby S. Macfarlane and David Kenneth Macfarlane are the founders of the Company
and, as such, may be deemed "promoters" of the Company as those terms are
defined in the rules and regulations promulgated under the Securities Act of
1933, as amended. There is no family relationship among any other directors or
executive officers of the Company.
Medical Advisory Board
The Company established a Medical Advisory Board consisting of Dr. Fred W.
Billmeyer, Dr. Ian Holzman and Dr. Jeffrey Maisels, independent
consultants/advisors to the Company.
Dr. Fred W. Billmeyer, Jr., Professor Emeritus at Rensselaer Polytechnic
Institute, a color scientist and recognized expert in the color science field
for more than 40 years, has been a consultant to the Company since 1984 and is a
member of the Company's Medical Advisory Board. Dr. Billmeyer has published
numerous books and articles in the field of color science. The consulting
agreement with Dr. Billmeyer provides that he will provide color consulting
services to the Company at a fee of $125 per hour. Such services include
providing advice and supervisory assistance in connection with any further
research and development, modification, enhancement or marketing activity
relating to the ColorMate(Registered Trademark) System and Intellectual
Properties in specific applications and assisting in obtaining patent protection
for the unpatented Intellectual Properties. In addition, Dr. Billmeyer is
entitled to receive a royalty in the amount of 2% of the selling price less the
cost of manufacture of any device sold by the Company. In 1999, the Company paid
Dr. Billmeyer $4,827.
Dr. Ian Holzman, a physician with the Department of Pediatrics, Division of
Newborn Medicine, Mt. Sinai Medical Center, is a member of the Medical Advisory
Board. Dr. Holzman is presently the Chief of the Division of Newborn Medicine at
Mt. Sinai Medical Center and a member of the Attending Staff at each of Mt.
Sinai Medical Center and City Hospital Center at Elmhurst. In addition, Dr.
Holzman is a Professor of Pediatrics, Obstetrics and Gynecology and Reproductive
Medicine, at Mt. Sinai School of Medicine. Dr. Holzman has published numerous
journal articles, book chapters and medical abstracts in the field of pediatric
treatment and medicine.
47
Dr. Jeffrey Maisels, a physician with the Department of Pediatrics, William
Beaumont Hospital, is a member of the Medical Advisory Board. Dr. Maisels is
presently the Chief of the Department of Pediatrics at William Beaumont Hospital
and is also a Clinical Professor of Pediatrics at Wayne State University School
of Medicine. Dr. Maisels has published numerous journal articles, book chapters
and medical abstracts in the field of pediatric treatment and medicine including
publications relating to bilirubin infant jaundice and phototherapy.
Consultants
The Company relies on the services of certain other consultants and advisors.
The consultants are not executive officers of the Company but make or are
expected to make significant contributions to the business of the Company.
Mr. Frederick Frank, Vice Chairman of Lehman Brothers, an investment banking
firm, has been an advisor to the Company since December 1, 1997, providing
financial, strategic and business advisory services. The consulting agreement
with Mr. Frank expired December 1, 1998 but was renewed by mutual agreement of
the Company and Mr. Frank.
The Company from time to time also employs certain other consultants and
temporary personnel for various purposes such as FDA and regulatory matters, the
Bilirubin Project and marketing, engineering, research and development
associated with the Intellectual Properties, Beauty-Aid Products, the
ColorMate(Registered Trademark) Bilirubin Device and ColorMate(Registered
Trademark) units. The Company has also retained consultants to provide public
relations, shareholder relations, financial, licensing and investment banking
services. In 2000, these consultants and temporary personnel were paid an
aggregate of $250,000 and were granted warrants to purchase an aggregate of
298,718 shares of the Company's Common Stock. All consultants may be reimbursed
by the Company for reasonable out-of- pocket expenses incurred by them in
connection with the services each consultant provides to the Company.
Compliance with Section 16(a) of the Exchange Act
The Company became subject to the reporting requirements of Section 13 of the
Exchange Act on February 5, 1993 and, accordingly, the Company's officers,
directors and greater than 10 percent beneficial owners were subject to the
reporting requirements of Section 16(a) of the Exchange Act during the year
ended December 31, 1993. The Company believes that during the fiscal year ended
December 31, 2000 all filing requirements under Section 16(a) applicable to its
officers, directors and greater than ten percent beneficial owners were complied
with on a timely basis.
Item 11. Executive Compensation
Summary Compensation Table
48
The following table summarizes all plan and non-plan compensation awarded to,
earned by or paid to the Company's Chief Executive Officer and its three other
executive officers who were serving as such during and at the end of fiscal 2000
for services rendered in all capacities to the Company in the last three fiscal
years.
Long-Term Compensation
----------------------
Annual Compensation Awards
-------------------------- ---------
Name and All other
Principal Position Year Salary($) Bonus($) Options(#)(1) Compensation
--------------------- ------ -------- -------- ------------ -------------
Darby S. Macfarlane, 2000 $224,000 $20,000 0 0
Chairperson, Chief 1999 $175,000 0 0
TechnologyOfficer, 1998 $175,000 0 0
Treasurer
Arthur Guiry, 2000 $101,600 0 0 0
President(2) 1999 $200,000 0 0 0
1998 $200,000 0 0 0
David Kenneth Macfarlane, 2000 $125,000 0 0 0
Vice-President 1999 $125,000 0 0 0
1998 $125,000 0 0 0
Leslie Foglesong, 2000 $134,000 0 0 0
Secretary and Assistant 1999 $100,000 $10,000 0 0
Treasurer 1998 $100,000 $5,000 100,000 0
Frank Marchese, Chief 2000 $135,000 0 50,000 0
Financial Officer
Brian T. Fitzpatrick, 2000 $111,500(3) 0 250,000 0
Acting Chief Executive
Officer, President
(1) In February 1998, the Company effected a three-for-two forward stock split.
The number of shares issuable upon the exercise of stock options granted under
the 1992 Plan presented above give effect to the stock split.
(2) Mr. Arthur Guiry died in March 2000.
(3) For 6 months
49
Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year End
Option/SAR Value Table
The following table sets forth information with respect to stock options
exercised during the fiscal year ended December 31, 2000 and the value at
December 31, 2000 of unexercised stock options held by the Chief Executive
Officer and the other executive officers of the Company. The number of shares
presented gives effect to the Stock Split:
Number of
Securities Value of
Underlying Unexercised In-
Unexercised the-Money
Options Options at
at Fiscal Fiscal
Year-End Year-End (1)
-------------------------- -------------
Shares
acquired on Value Exercisable/ Exercisable/
Name Exercise (#) Realized Unexercisable(#) Unexercisable
----------------------- -------------- --------- ---------------- ------------
Darby S. Macfarlane 0 0 450,000/0 $0
Brian T. Fitzpatrick 0 0 0/250,000 $0
Arthur Guiry 105,000 $465,900 0 -
David Kenneth Macfarlane 0 0 300,000/0 $0
Leslie Foglesong 0 0 250,000/0 $0
Frank Marchese 0 0 16,666/33,334 $0
(1) Options were not in-the-money at year end
Compensation of Directors
Directors who are officers of the Company do not receive additional compensation
for serving on the Board of Directors or for their attendance at Board of
Directors' meetings. Edmund Vimond and Edward Mahoney each received a monthly
director's fee of $6,000. In addition, Mr. Mahoney received options to purchase
37,500 (on January 26, 1998) shares of the Company's Common Stock under the 1992
Plan and each of Messrs.. Mahoney and Vimond received options to purchase 20,000
(on October 30, 1998) shares of the Company's Common Stock under the 1992 Plan.
The stock options granted to Mr. Vimond and Mr. Mahoney vest in equal
installments on the first, second and third anniversaries of the date of grant
and are exercisable at $9.25 (Mahoney's grant on January 26, 1998) all of which
became exercisable on January 26, 2001) and $5.375 (grants on October 30, 1998)
(two-thirds became exercisable at October 30, 2001) per share, respectively. Mr.
Vimond also received 22,500 stock options on December 1, 1997, all of which
became exercisable on December 1, 2001 and expires on December 1, 2007 and are
exercisable at $9.71 per share. In addition, on July 15, 1997, Mr. Vimond
received 15,000 stock options, all of which options were fully exercisable on
July 15, 2000, expire on July 15, 2007 and are exercisable at $5.42 per share.
Employment Agreements
The Company has entered into separate employment agreements with each of Darby
Simpson Macfarlane and David Kenneth Macfarlane, providing for Mrs. Macfarlane's
employment as Chairperson and Chief Executive Officer and for Mr. Macfarlane's
employment as Vice President, Research and Development, each extendable at the
employee's option until February 1, 2003. These Agreements were amended in
August 2000 to provide for conforming severance benefits in accordance with the
terms of these employment agreements when Brian T. Fitzpatrick was appointed
Acting Chief Executive Officer and Ms.
50
Macfarlane was appointed as Chief Technology Officer and continued as
Chairperson of the Company. The agreements with Mrs. and Mr. Macfarlane provide
for annual base salaries in 2000 of $225,000 and $150,000, respectively, subject
to annual increases as provided for in their agreements. In addition, Mrs.
Macfarlane's agreement provides for a bonus payment of 33% of the first million
of the Company's net recovery in excess of $2,000,000 from the Avon Litigation.
Accordingly, Mrs. Macfarlane was to receive $361,200, all of which has been
paid. In connection with Mrs. Macfarlane's agreement to defer full repayment
until January 1, 1999, Mrs. Macfarlane also agreed to forego any discretionary
performance bonus under her employment agreement in 1999. Under the employment
agreements, the Company is obligated to provide Mr. Macfarlane with a $300,000
and Mrs. Macfarlane with a $1,000,000 term life insurance policy and disability
insurance. The Company maintains key-man life insurance on each of Mrs. and Mr.
Macfarlane in the amount of $1,000,000.
The employment agreements also provide for the payment of termination benefits
by the Company if employment thereunder is terminated (i) by the Company for any
reason other than death or disability as set forth therein or (ii) by reason of
death or disability. If Mr. or Mrs. Macfarlane's employment is terminated by the
Company or the employee for any reason the Company is required by each agreement
to pay to the terminated employee an amount equal to (a) the aggregate base
salary payable for the remainder of the employment period of the agreement and
(b) the aggregate base salary payable thereunder for three years, plus, in each
case, and for each year, an amount not less than any bonus granted by the Board
of Directors of the Company to the employee in the year immediately preceding
the year in which termination occurred. If the employee's employment is
terminated by reason of death or disability, the Company is required to pay to
Mrs. Macfarlane and Mr. Macfarlane, as applicable, an amount equal to three
years aggregate base salary in the case of Mrs. Macfarlane, and two year's base
salary in the case of Mr. Macfarlane, plus in each case and for each year, an
amount not less than the pro rata portion of any bonus granted to the employee
in the year immediately preceding the year in which such termination occurs.
In addition, the Company entered into a three-year employment agreement,
commencing on January 4, 2000, with Frank Marchese, pursuant to which he serves
as Chief Financial Officer of the Company. The term of the agreement may be
extended for an additional two years at the Company's option. The agreement
provides for an annual base salary of $135,000, plus options under the 1992
Stock Option Plan to purchase an aggregate of 50,000 shares of Common Stock at
an exercise price equal to the fair market value per share of the Common Stock
on the date of grant. The options vest in equal installments upon each of the
first, second and third anniversaries of the start date. The Company may
terminate the agreement by reason of physical or mental disability, but in such
case Mr. Marchese would remain entitled to full compensation and benefits during
the period prior to such termination. If Mr. Marchese's employment with the
Company were terminated by reason of his death, he would be entitled to any
unpaid but accrued portion of his base salary through the date of such
termination, including a pro rata portion of the bonus. If his employment were
terminated by the Company upon 30 days written notice or within one year after a
"change of control", but other than for "cause" or by reason of death or
disability, then Mr. Marchese would be entitled to his base salary for the
24-month period following such termination or for the remaining term of the
agreement, whichever is shorter, and medical benefits for one year for himself
and his immediate family.
The Company also entered into a five-year employment agreement with Brian T.
Fitzpatrick, commencing on April 17, 2000, pursuant to which he serves as the
Chief Operating Officer, President and Acting Chief Executive Officer of the
Company and Chief Executive Officer and President of the Company's subsidiaries,
Gordon Acquisition Corp. and H.B. Gordon Manufacturing, Inc. As compensation,
Mr. Fitzpatrick is entitled under the agreement to an annual base salary of
$200,000, plus options under the 1992 Stock Option Plan to purchase an aggregate
of 170,636 shares of Common Stock. The exercise price (i) for the first 99,364
options exercised is twice the closing bid price of the Common Stock on June 2,
2000 and (ii) for the remaining options is equal to such closing bid price. The
options vest in equal
51
installments upon each of the first, second and third anniversaries of the start
date. In addition, Mr. Fitzpatrick is to receive with respect to each fiscal
year a bonus to be determined by the Compensation Committee of the Company. The
Company may terminate the agreement by reason of physical or mental disability,
but in such case Mr. Fitzpatrick would remain entitled to full compensation and
benefits during the period prior to such termination. If Mr. Fitzpatrick's
employment were terminated by reason of his death, the Company would have no
further obligations under the agreement other than his stock options. If his
employment were terminated for any reason other than death, disability, "cause,"
voluntary resignation or a "change of control," then the Company would pay Mr.
Fitzpatrick his base salary for the 24 months following such termination.
Additionally, the Company entered into a four-year employment agreement with
Leslie Foglesong, commencing on December 15, 1997, pursuant to which she serves
as Secretary and Treasurer (or Assistant Treasurer) of the Company. The term of
the agreement may be extended for an additional year at Ms. Foglesong's option.
The agreement provides for an annual base salary of $100,000, subject to an
increase as of January 1, 2000 to $135,000, plus a bonus with respect to each
fiscal year to be determined by the Board of Directors, as well as options under
the 1992 Stock Option Plan. The Company may terminate the agreement by reason of
physical or mental disability, but in such case Ms. Foglesong would remain
entitled to full compensation and benefits during the period prior to such
termination. If Ms. Foglesong's employment were terminated by reason of her
death, the Company would have no further obligations under the agreement other
than allowing her stock options to be exercised by her estate for a period of
five years after such termination. If her employment were terminated for any
reason other than death, disability or "cause," then Ms. Foglesong would be
entitled to her base salary for the 24-month period following such termination
or the remaining term of the agreement, whichever is greater; in addition, her
stock options would continue to be exercisable for a period of five years after
such termination.
The agreements described above prohibit disclosure of proprietary and
confidential information regarding the Company and its business to anyone
outside the Company both during and subsequent to employment and provide certain
non-competition and non-solicitation restrictions on the employee for the
duration of employment with the Company, and for one year thereafter.
Compensation Committee Interlocks and Insider Participation
There are no reportable compensation committee (Board of Directors) interlocks
or insider participation transactions.
Compensation Committee Report on Executive Compensation
The Compensation Committee of the Board of Directors is responsible for
establishing compensation policies applicable to the Company's executive
officers; evaluating and recommending to the Board the compensation of the chief
executive officer and other executive officers; and recommending to the Board
individual stock option grants for executive officers from the 1992 Plan. The
following report relates to the Company's compensation policies and the
compensation paid to the chief executive officer for the year ending December
31, 2000.
Compensation Policies: The Company's compensation policies for all employees,
including executive officers, are designed to provide compensation levels that
are competitive with those of small capitalization early stage technology
companies, with whom the Company must compete in the recruitment and retention
of highly qualified, motivated personnel. The Company's executive compensation
program is structured to (1) compensate its executive officers on an annual
basis with a cash salary and discretionary bonus at a
52
sufficient level to retain and motivate these officers and (2) provide long-term
incentives to those executives through periodic grant of stock options.
The salary component of executive compensation and any bonuses granted in the
Company's discretion, is based on each executive's level of responsibility in
comparison to similar positions in comparable companies. The Company believes a
competitive base salary, and bonus when warranted, is essential to the
development and retention of capable management. Base salaries for executive
officers are reviewed periodically, based on a review of competitive salaries
obtained from published data and other sources, and discretionary performance
bonuses, if any, are used to augment salary in circumstances where special
achievement is to be rewarded.
The long-term incentive component recognizes the importance of stock ownership
by employees and reflects the use of stock options as an integral part of each
executive's compensation. The Company believes the opportunity for stock
appreciation through stock options which vest over time promotes the
relationship between long-term interests of executive officers and shareholders.
The size of specific grants takes into account the executive officer's salary,
number of options previously granted, and overall individual contributions to
the Company.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth, as of April 9, 2001, the beneficial ownership of
the Common Stock: (i) by each stockholder known by the Company to beneficially
own more than 5% of the Common Stock (ii) by each director of the Company; (iii)
by the Company's Chief Executive Officer; and (iv) by all executive officers and
directors of the Company as a group. Amounts presented give effect to the
February 1998 three-for-two forward stock split (the "Stock Split") (including
shares issuable upon the exercise of stock options and/or warrants). Except as
otherwise indicated below, each named beneficial owner has sole voting and
investment power with respect to the shares of Common Stock listed.
Name and Address of Common Stock Percent of
Beneficial Owner Number of Shares Class
----------------------------------------------------------- ----------------- ---------
Darby Simpson Macfarlane 1,611,895(1) 8.15%
10 Old Jackson Avenue, #28, Hastings-on-Hudson, NY 10706
David Kenneth Macfarlane 1,611,895(2) 8.15%
5 East 80th Street, New York, NY 10021
Brian T. Fitzpatrick 20,000 *
c/o Chromatics Color Sciences International, Inc.
5 East 80th Street, New York, NY 10021
Frank Marchese 16,666(3) *
c/o Chromatics Color Sciences International, Inc.
5 East 80th Street, New York, NY 10021
Leslie Foglesong 265,000(4) 1.37%
116 Lafayette Avenue, Brooklyn, NY 11217
Edmund Vimond 50,833(5) *
6967 Country Lakes Circle, Sarasota, FL 34243
Edward Mahoney 50,833(6) *
2044 Palisades Drive, Pacific Palisades, CA 90272
James Berquist 6,000(7) *
c/o Chromatics Color Sciences International, Inc.
5 East 80th Street, New York, NY 10021
Robert Shapiro 51,000(8) *
c/o Chromatics Color Sciences International, Inc.
5 East 80th Street, New York, NY 10021
James N. Bergman 468,581(9) 2.41%
2 First Avenue, Sterling, IL 61081
Gary W. Schreiner 1,498,967(10) 7.39%
2126 Melvin Drive, Rock Falls, IL 61071
LB I Group, Inc. 2,163,951(11) 10.21%
3 World Financial Center, New York, NY 10285
Janssen-Meyers Associates, L.P. 1,206,934(12) 6.20%
17 State Street, New York, NY 10001
Millennium Partners 1,726,776(13) 8.58%
666 Fifth Avenue, New York, NY 10103
Crescent International, Ltd. 1,661,304(14) 8.61%
c/o The Robinson-Humphrey Company LLC
3333 Peachtree Road, N.E., Atlanta, GA 30326
All directors and executive officers 4,152,703(15) 19.52%
as a group (10 persons)
* indicates less than 1%
(1) Includes 861,895 issued and outstanding shares of the Common Stock
beneficially owned by Mrs. Macfarlane, 450,000 shares issuable upon the
exercise of options granted to Mrs. Macfarlane and 300,000 shares issuable
upon the exercise of options granted to Mr. Macfarlane which options are
currently exercisable. As a result of a certain voting agreement between
them, Mrs. Macfarlane is entitled to sole voting power and sole power of
disposition over all shares of common stock held or acquired by Mr.
Macfarlane.
(2) Includes 861,895 issued and outstanding shares of the Common Stock
beneficially owned by Mrs. Macfarlane, 450,000 shares issuable upon the
exercise of options granted to Mrs. Macfarlane and 300,000 shares issuable
upon the exercise of options granted to Mr. Macfarlane which options are
currently exercisable.
(3) Includes 16,666 shares issuable upon the exercise of options which are
currently exercisable
(4) Includes 250,000 shares issuable upon the exercise of options which are
currently exercisable.
(5) Includes 50,833 shares issuable upon exercise of options which are
currently exercisable.
(6) Includes 50,833 shares issuable upon exercise of options which are
currently exercisable.
(7) Includes 4,000 shares indirectly owned by Mr. Berquist.
(8) Includes 13,500 shares indirectly owned by Mr. Shapiro.
(9) Includes (i) 119,491 shares of Common Stock issuable upon the exercise of
warrants which are currently exercisable and issued in the name of LB
Pension Plan and Trust, a trust for which Mr. Bergman serves as a trustee,
and (ii) 257,299 shares of Common Stock issuable upon the conversion of
Class B Series 5 Convertible Preferred Stock issued in the name of Lawrence
Brothers, Inc., a corporation in which Mr. Bergman owns forty percent of
the voting equity and for which he serves as a director.
(10) Represents 1,298,167 shares of Common Stock issuable upon the conversion of
Class B Series 5 Convertible Preferred Stock and 200,000 shares of Common
Stock issuable upon the exercise of warrants which are currently
exercisable.
(11) Represents 1,388,889 shares of Common Stock issuable upon the conversion of
Class B Series 2 and Class B Series 3 Convertible Preferred Stock and
775,062 shares of Common Stock issuable upon the exercise of currently
exercisable warrants.
(12) Based on a representation letter from Janssen-Meyers Associates, L.P. dated
March 19, 1999, and includes 636,250 shares of Common Stock held by Peter
Janssen (an affiliate of Janssen-Meyers Associates, L.P.), 145,750 shares
of Common Stock and 314,347 warrants held by Janssen-Meyers Associates,
L.P. which, in each case, are currently exercisable, 108,647 warrants held
by limited partners of Janssen-Meyers Associates, L.P. and 1,940 warrants
held by Meyers Janssen Securities Corp., which, in each case, are currently
exercisable. Peter Janssen and Bruce Meyers are deemed to be the beneficial
owners of the shares of Common Stock and warrants held by Janssen-Meyers
Associates, L.P.
(13) Includes 150,000 Warrants currently exercisable and 935,750 shares of
Common Stock issuable upon the conversion of an Adjustable Warrant at March
31, 2001 (the first "vesting date").
(14) Includes 270,000 Warrants currently exercisable.
(15) Includes 2,245,122 shares issuable upon the exercise of options and
warrants which are currently exercisable and the conversion of convertible
Preferred Stock.
Item 13. Certain Relationships and Related Transactions
Since August 1990, the Company has occupied office space leased under Darby
Simpson Macfarlane's name. The Company pays $1,750 per month under the lease
(representing the actual lease cost for such premises), which rent increased
from $1,620 in August 1999. For the year ended December 31, 1999 the Company
paid $20,090 in connection with such lease, and for the year ended December 31,
2000 the Company paid $21,000. In addition, the Company also paid approximately
$10,200 for the year ended December 31, 1999 and approximately $10,980 for the
year ended December 31, 2000 under a lease for the use of her residence as
offices of the Company, which operates after normal business hours and on
weekends.
In connection with the Avon Settlement and Mrs. MacFarlane's employment
agreement, Mrs. Macfarlane was to receive $361,200 from the proceeds from the
Avon Settlement, all of which has been paid.
Management believes that each of the transactions described above were obtained
on terms at least as favorable as could have been obtained from unaffiliated
third parties.
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) and (d)1. Financial Statements
Independent Accountant's Reports
Consolidated Balance Sheets as of December 31, 2000 and 1999
Consolidated Statements of Operations for the years ended December 31, 2000,
1999 and 1998
55
Consolidated Statements of Changes in Stockholders' Equity for the years ended
December 31, 2000, 1999 and 1998
Consolidated Statements of Cash Flows for the years ended December 31, 2000,
1999 and 1998
Notes to Consolidated Financial Statements
(a) and (d)2. Financial Statements Schedules
All schedules have been omitted because they are not applicable, are not
required or because the required information is included in the Financial
Statements or notes thereto.
(b) Reports on Form 8-K:
Form 8-K/A, dated November 3, 2000, the Company filed a Form 8-K relating to
"capital restructuring" to assist the Company in meeting the net asset
requirement test for Nasdaq.
Form 8-K, dated November 23, 2000, the Company filed a Form 8-K relative to the
private placement of a new series of preferred stock, designating Class B,
series 4 Convertible Preferred Stock, for an aggregate purchase price of
$2,000,000.
(c) The following exhibits are included in this report:
Number Description of Document
2.1 Agreement of Purchase and Sale (the "Gordon Purchase Agreement"), dated as
of April 17, 2000, among Chromatics Color Sciences International, Inc. and
the shareholders and certain noteholders of Gordon Acquisition Corp.
(incorporated by reference to Exhibit 2.1 to the Form 8-K filed on June 19,
2000).
2.2 Amendment No. 1 to the Gordon Purchase Agreement, dated May 15, 2000
(incorporated by reference to Exhibit 2.2 to the Form 8-K filed on June 19,
2000).
2.3 Amendment No. 2 to the Gordon Purchase Agreement, dated May 25, 2000
(incorporated by reference to Exhibit 2.3 to the Form 8-K filed on June 19,
2000).
2.4 Amendment No. 3 to the Gordon Purchase Agreement, dated May 31, 2000
(incorporated by reference to Exhibit 2.4 to the Form 8-K filed on June 19,
2000).
3.1 Restated Articles of Incorporation of the Company (incorporated by
reference to Exhibit 3.1 to the Form 10-Q filed on August 23, 1999).
3.1.1 Certificate of Amendment to the Certificate of Incorporation of the
Company.
3.2 By-Laws of the Company.
4.1 Specimen form of the Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to the Company's Registration Statement on Form S-1 (File No.
33-54256), filed on November 5, 1992, as amended (the "Registration
Statement")).
4.2 Shareholders' Rights Plan, adopted by the Company on December 31, 1998
(incorporated by reference as Exhibit 1 to the Form 8-A dated January 5,
1999).
4.3 Subscription Agreement, dated April 15, 1999 (incorporated by reference to
Exhibit 4.2 to the Form 8-K dated April 30, 1999).
4.4 Form of 14%Convertible Debentures Due April 15, 2002 (incorporated by
reference to Exhibit 4.3 to the Form 8-K dated April 30, 1999).
4.5 Preferred Stock Purchase Agreement, dated as of June 11, 1999, by and
between the Company and LB I Group Inc. (incorporated by reference to
Exhibit 4.1 to the Form 8-K, filed on July 1, 1999).
4.6 Warrant Agreement, dated as of June 11, 1999, by and between the Company
and LB I Group Inc. (incorporated by reference to Exhibit 4.2 to the Form
8-K, filed on July 1, 1999).
4.7 Preferred Stock Purchase Agreement, dated as of February 11, 2000, by and
between the Company and LB I Group Inc.
4.8 Warrant Agreement, dated as of February 11, 2000, by and between the
Company and LB I Group Inc.
4.9 Securities Purchase Agreement, dated as of August 16, 2000, between the
Company and Millennium Partners, L.P. ("Millennium") (incorporated by
reference to Exhibit 4.1 to the Form 8-K, filed on September 1, 2000).
4.10 Warrant, dated as of August 16, 2000, made by the Company in favor of
Millennium (incorporated by reference to Exhibit 4.2 to the Form 8-K, filed
on September 1, 2000).
4.11 Warrant No. C W 1, dated as of August 16, 2000, made by the Company in
favor of Millennium (incorporated by reference to Exhibit 4.3 to the Form
8-K, filed on September 1, 2000).
4.12 Registration Rights Agreement, dated as of August 16, 2000, between the
Company and Millennium (incorporated by reference to Exhibit 4.4 to the
Form 8-K, filed on September 1, 2000).
4.13 Warrant No. CW2, dated as of August 16, 2000, made by the Company in favor
of Wharton Capital Partners, Ltd. (incorporated by reference to Exhibit
4.11 to the Form S-3, filed on September 18, 2000).
4.14 Warrant Agreement, dated as of June 30, 2000, between the Company and
Josephthal & Co. Inc. (incorporated by reference to Exhibit 4.12 to the
Form S-3, filed on September 18, 2000).
4.15 Warrant Certificate No. W-01, dated as of June 30, 2000 made by the Company
in favor of X Securities, Ltd. (incorporated by reference to Exhibit 4.13
to the Form S-3, filed on September 18, 2000).
4.16 Warrant Certificate No. W-02, dated as of June 30, 2000, made by the
Company in favor of John O'Brien (incorporated by reference to Exhibit 4.14
to the Form S-3, filed on September 18, 2000).
4.17 Warrant Certificate No. W-03, dated as of June 30, 2000, made by the
Company in favor of Edmund Belak (incorporated by reference to Exhibit 4.15
to the Form S-3, filed on September 18, 2000).
4.18 Financial Advisory and Investment Banking Agreement, dated as of June 12,
2000, between Chromatics and Josephthal & Co. Inc. (incorporated by
reference to Exhibit 4.16 to the Form S-3, filed on September 18, 2000).
4.19 Stock Purchase Agreement, dated as of October 31, 2000, between the Company
and Crescent International Ltd. ("Crescent") (incorporated by reference to
Exhibit 4.1 to the Form 8-K, filed on November 3, 2000).
4.20 Warrant, dated as of October 31, 2000, made by the Company in favor of
Crescent (incorporated by reference to Exhibit 4.2 to the Form 8-K, filed
on November 3, 2000).
4.21 Registration Rights Agreement, dated as of October 31, 2000, between the
Company and Crescent (incorporated by reference to Exhibit 4.3 to the Form
8-K, filed on November 3, 2000).
4.22 Certificate of Amendment of the Certificate of Incorporation of the
Company, dated as of October 31, 2000 (incorporated by reference to Exhibit
4.4 to the Form 8-K, filed on November 3, 2000).
4.23 Letter Agreement, dated as of October 11, 2000, between the Company and
Millennium (incorporated by reference to Exhibit 4.1 to the Form 8-K, filed
on November 3, 2000).
4.24 Certificate of Amendment of the Certificate of Incorporation of the
Company, dated November 1, 2000, relating to the Class B Series 2 Preferred
Stock of the Company (incorporated by reference to Exhibit 4.2 to the Form
8-K, filed on November 3, 2000).
4.25 Certificate of Amendment of the Certificate of Incorporation of the
Company, dated November 1, 2000, relating to the Class B Series 3 Preferred
Stock of the Company (incorporated by reference to Exhibit 4.3 to the Form
8-K, filed on November 3, 2000).
4.26 Letter Agreement, dated as of October 11, 2000, between the Company and LB
I Group Inc. ("Lehman") (incorporated by reference to Exhibit 4.4 to the
Form 8-K, filed on November 3, 2000).
4.27 Letter Agreement, dated as of November 1, 2000, between the Company and
Lehman (incorporated by reference to Exhibit 4.5 to the Form 8-K, filed on
November 3, 2000).
4.28 Letter Agreement, dated as of August 16, 2000, between the Company and
Lehman (incorporated by reference to Exhibit 4.6 to the Form 8-K, filed on
November 3, 2000).
4.29 Certificate of Amendment of the Certificate of Incorporation of the
Company, dated November 1, 2000, relating to the Class B Series 5 Preferred
Stock of the Company (incorporated by reference to Exhibit 4.7 to the Form
8-K, filed on November 3, 2000).
4.30 Letter Agreement, dated as of October 11, 2000, among the Company and the
holders of the 14% Senior Convertible Debentures, dated April 15, 1999 and
due April 15, 2002, in the principal amount of $5,000,000, issued by the
Company to Gary W. Schreiner (incorporated by reference to Exhibit 4.8 to
the Form 8-K, filed on November 3, 2000).
9.1 Voting Proxy dated December 13, 1995, of David Kenneth Macfarlane to Darby
Simpson Macfarlane (incorporated by reference to Exhibit 2 to Schedule 13D
of Darby Macfarlane and Ken Macfarlane dated February 12, 1996).
9.2 Voting Trust Agreement dated December 13, 1995, between David Kenneth
Macfarlane and Darby Simpson Macfarlane (incorporated by reference to
Exhibit 3 to Schedule 13D of Darby Macfarlane and Ken Macfarlane dated
February 12,1996).
10.1* Form of Employment Agreement between the Company and Darby Simpson
Macfarlane (incorporated by reference to Exhibit 10.1 to the Registration
Statement).
10.2* Form of Employment Agreement between the Company and David Kenneth
Macfarlane (incorporated by reference to Exhibit 10.2 to the Registration
Statement).
10.3* Consulting Agreement, dated February 25, 1992, between the Company and Dr.
Fred W. Billmeyer, Jr. (incorporated by reference to Exhibit 10.4 to the
Registration Statement).
10.4 Form of Indemnity Agreement between the Company and its directors and
officers (incorporated by reference to Exhibit 10.6 to the Registration
Statement).
10.5 Know-How Agreement, dated September 3, 1992, between the Company, Darby
Simpson Macfarlane and David Kenneth Macfarlane (incorporated by reference
to Exhibit 10.12 to the Registration Statement).
10.6 Assignment, dated September 3, 1992 from Darby Simpson Macfarlane to the
Company regarding Intellectual Property (incorporated by reference to
Exhibit 10.13 to the Registration Statement).
10.7** Agreement, dated April 16, 1992, between the Company and IMS Cosmetics,
Inc. (incorporated by reference to Exhibit 10.14 to the Registration
Statement).
10.8 U.S. Patent No. 4,909,632 relating to Method for Selecting Personal
Compatible Colors (incorporated by reference to Exhibit 10.17 to the
Company's Annual Report on Form 10-KSB for the fiscal year ended December
31, 1994).
10.9 U.S. Patent No. 5,311,293 relating to Method and Instrument for Selecting
Personal Compatible Colors (incorporated by reference to Exhibit 10.18 to
the Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1994).
10.10 U.S. Patent No. 5,313,267 relating to Method and Instrument for Selecting
Personal Compatible Colors (incorporated by reference to Exhibit 10.19 to
the Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1994).
10.11 The Australian Patent relating to Method of Selecting Personal Compatible
Color (incorporated by reference to Exhibit 10.20 to the Company's Annual
Report on Form 10-KSB for the fiscal year ended December 31, 1994).
10.12 European Community Patent No. 0446512 relating to Method for Selecting
Personal Compatible Colors (incorporated by reference to Exhibit 10.21 to
the Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1994).
10.13 U.S. Patent No. 5,671,735 relating to Method and Apparatus for Detecting
and Measuring Conditions Affecting Color (incorporated by reference to
Exhibit 10.13 to the Amendment to the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1998).
10.14 Assignment, dated October 30, 1992, between Darby Simpson Macfarlane and
the Company relating to the Avon litigation (incorporated by reference to
Exhibit 10.19 to the Registration Statement).
10.15 Know-How Assignment, dated October 30, 1992, from Pink & Peach Computer
Corp. to the Company (incorporated by reference to Exhibit 10.20 to the
Registration Statement).
10.16 1992 Stock Option Plan (incorporated by reference to Exhibit 10.1 to the
Registration Statement on Form 8-A (File No. 333-51697)).
10.17 Consulting Agreement dated January 6, 1995, between the Company and
Janssen-Meyers Associates, L.P. (incorporated by reference to Exhibit 10.27
to the Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1994).
10.18 Warrant Agreement dated January 6, 1995, between the Company and
Janssen-Meyers Associates, L.P. (incorporated by reference to Exhibit 10.28
to the Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1994).
10.19 Warrant Agreement dated March 13, 1995, between the Company and
Janssen-Meyers Associates, L.P. (incorporated by reference to Exhibit 10.29
to the Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1994).
10.20 Manufacturing Agreement, dated November 3, 1998, between the Company and a
third party manufacturer (incorporated by reference as Exhibit 10.1 to the
Form 8-K dated November 12, 1998).
10.21 Rights Agreement, dated January 11, 1999, between the Company and
Continental Stock Transfer & Trust Company (incorporated by reference as
Exhibit 1 to the Form 8-A dated January 5, 1999).
10.22 Subscription Agreement, dated April 15, 1999 (incorporated by reference to
Exhibit 4.2 to the Form 8-K dated April 30, 1999).
10.23 Form of 14% Convertible Debentures Due April 15, 2002 (incorporated by
reference to Exhibit 4.3 to the Form 8-K dated April 30, 1999).
10.24 Preferred Stock Purchase Agreement, dated as of June 11, 1999, by and
between the Company and LB I Group Inc. (incorporated by reference to
Exhibit 4.1 to the Form 8-K, filed on July 1, 1999).
10.25 Warrant Agreement, dated as of February 11, 1999, by and between the
Company and LB I Group Inc. (incorporated by reference to Exhibit 4.2 to
the Form 8-K, filed on July 1, 1999).
10.26 Preferred Stock Purchase Agreement, dated as of February 11, 2000, by and
between the Company and LB I Group Inc. (incorporated by reference to
Exhibit 4.7 hereof).
10.27 Warrant Agreement, dated as of February 11, 2000, by and between the
Company and LB I Group Inc. (incorporated by reference to Exhibit 4.8
hereof).
10.28 Consent and Waiver, dated June 8, 1999, made by Gary W. Schreiner in favor
of the Company (incorporated by reference to Exhibit 10.23 to the Form
10-K/A filed on January 21, 2000).
10.29 License Agreement, dated September 1, 1998, between the Company and
Nordstrom., Inc. (incorporated by reference to Exhibit 10.24 to the Form
10-K/A filed on January 21, 2000).
10.30 Agreement, dated December 13, 1996, between the Company and Gordon
Laboratories, Inc. (incorporated by reference to Exhibit 10.25 to the Form
10-K/A filed on January 21, 2000).
10.31 Agreement, dated as of June 7, 1999, between the Company and Datex-Ohmeda,
Inc. (incorporated by reference to Exhibit 10.1 to the Form 8-K/A filed on
January 28, 2000).
21 Subsidiaries of the Company (incorporated by reference to Exhibit 21 to the
Company's Post Effective Amendment No. 1 on Form SB-1 to the Registration
Statement filed on January 11, 1994).
23+ Consent of Independent Accountant.
* Management contract or compensatory plan or arrangement required to be
filed as an exhibit.
** Portions subject to confidential treatment.
+ Filed herewith.
59
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
the registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
CHROMATICS COLOR SCIENCES INTERNATIONAL, INC.
By: /s/ Brian T. Fitzpatrick Date: April 17, 2001
Brian T. Fitzpatrick,
Acting Chief Executive Officer
By: /s/ Frank Marchese Date: April 17, 2001
Frank Marchese,
Chief Financial Officer
(Chief Financial and Accounting Officer)
In accordance with 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.
By: /s/ Darby S. Macfarlane Date: April 17, 2001
---------------------------
Darby S. Macfarlane,
Chairperson of the Board;
Chief Technology Officer;
Treasurer; Director
By: /s/ Brian T. Fitzpatrick Date: April 17, 2001
----------------------------
Brian T. Fitzpatrick,
Acting Chief Executive Officer;
President; Director
By: /s/ David K. Macfarlane Date: April 17, 2001
---------------------------
David K. Macfarlane,
Vice President, Research & Development;
Director
By: /s/ Leslie Foglesong Date: April 17, 2001
---------------------------
Leslie Foglesong,
Secretary; Assistant
Treasurer; Director
By: /s/ Edmund Vimond Date: April 17, 2001
---------------------------
Edmund Vimond,
Director
By: /s/ Edward Mahoney Date: April 17, 2001
---------------------------
Edward Mahoney,
Director
By: /s/ James Bergman Date: April 17, 2001
---------------------------
James Bergman,
Director
By: /s/ Robert Shapiro Date: April 17, 2001
---------------------------
Robert Shapiro,
Director
By: /s/ James Berquist Date: April 17, 2001
---------------------------
James Berquist,
Director
60
CHROMATICS COLOR SCIENCES INTERNATIONAL, INC.AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS Contents
Independent accountants' report F-2
Consolidated financial statements:
Balance sheets F-3
Statements of operations F-4
Statements of changes in stockholders' equity (deficit) F-5
Statements of cash flows F-6
Notes to consolidated financial statements F-7 - F-42
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Stockholders of
Chromatics Color Sciences International, Inc.
We have audited the consolidated balance sheets of Chromatics Color Sciences
International, Inc. and subsidiaries as of December 31, 2000 and 1999, and the
related consolidated statements of operations, changes in stockholders' equity
(deficit) and cash flows for each of the three years in the period ended
December 31, 2000. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. 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 Chromatics Color
Sciences International, Inc. and subsidiaries as of December 31, 2000 and 1999,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2000 in conformity with accounting
principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 2 to the
consolidated financial statements, the Company has incurred recurring losses for
the last several years, including $19,496,400 in 2000, and has experienced
significant problems and delays exploiting its primary technology (medical
equipment). In addition, the Company's subsidiary, Gordon Laboratories, Inc.,
("Gordon") has defaulted on its debt service obligation in 2001 and the lender
has demanded payment of the entire debt, which totals $2,714,700 at December 31,
2000. Gordon or the Company are unable to pay or refinance this debt. These
matters raise substantial doubt about the Company's ability to continue as a
going concern. Management's plans in regard to these matters are also described
in Note 2. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
BDO Seidman, LLP
New York, New York
April 13, 2001
F-2
CHROMATIC COLOR SCIENCES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31,
2000 1999
---------------------------------------------------- ------------- ------------
Assets
Current:
Cash and cash equivalents $ 1,457,800 $2,790,400
Accounts receivable - net of allowance
of $131,000 in 2000 960,500 842,300
Inventories 1,643,300 1,171,800
Prepaid expenses and other current assets 255,800 129,200
---------------------------------------------------- ------------- ------------
Total current assets 4,317,400 4,933,700
---------------------------------------------------- ------------- ------------
Property and equipment - net 1,227,900 612,200
Software development costs - net 261,400 470,500
Patent costs - net 581,100 984,000
Goodwill - net 1,352,500 -
Other amortizable assets - net 879,500 455,400
Other assets 377,000 654,400
---------------------------------------------------- ------------- ------------
$ 8,996,800 $8,110,200
==================================================== ============= ============
Liabilities and Stockholders' Equity (Deficit)
Current liabilities:
Amounts payable to related party $ - $ 256,100
Current portion of notes payable 2,963,200 -
Due to factor 184,300 -
Accounts payable and accrued expenses: -
Attorneys and accountants 458,900 394,600
Consultants 141,700 119,100
Trade 1,195,200 240,000
---------------------------------------------------- ------------- ------------
Total current liabilities 4,943,300 1,009,800
---------------------------------------------------- ------------- ------------
Long-term debt:
Senior convertible debentures - 4,165,800
Accrued interest on senior convertible debentures - 495,800
Amount payable for purchase of Gordon 653,000 -
---------------------------------------------------- ------------- ------------
653,000 4,661,600
==================================================== ============= ============
Total liabilities 5,596,300 5,671,400
---------------------------------------------------- ------------- ------------
Commitments and contingencies
Redeemable preferred stock: Class A, par value $.01
per share: Authorized - 1,400,000 shares;
issued and outstanding; 1,380,000 shares
at par and redemption value 13,800 13,800
Class B, Series 2 convertible preferred stock,
no par value: Authorized - 10,000,000 shares;
issued and outstanding 40,000 shares in 1999 -
$115 redemption value - 2,928,700
---------------------------------------------------- -------------- ------------
13,800 2,942,500
---------------------------------------------------- -------------- ------------
Stockholders' equity (deficit):
Preferred stock 11,510,800 -
Common stock, par value $.001 per share:
Authorized - 50,000,000 shares; issued and
outstanding - 19,033,308 (2000) and
15,539,117 (1999) shares 19,100 15,500
Capital in excess of par value 45,934,400 34,062,000
Accumulated deficit (54,077,600) (34,581,200)
---------------------------------------------------- -------------- ------------
Total stockholders' equity (deficit) 3,386,700 (503,700)
---------------------------------------------------- --------------- ------------
$ 8,996,800 $ 8,110,200
==================================================== ============== ============
See accompanying notes to consolidated financial statements.
F-3
CHROMATIC COLOR SCIENCES, INC. AND SUBSIDIARIES
Statements of Operations
December 31,
2000 1999 1998
----------------------------------------------- ------------------- ------------------ ------------------
Sales $3,842,000 $ 1,103,200 $ 46,600
----------------------------------------------- ------------------- ------------------ ------------------
Costs and expenses:
Cost of sales 3,868,400 898,100 -
Sales, marketing and trade show costs 2,047,300 2,511,600 958,900
Medical regulatory expenses 840,100 1,323,300 1,341,500
Research and development 1,493,700 996,300 705,000
Patent application costs 255,600 134,400 221,700
Compensation costs relating to
options granted to 690,000 984,000 843,400
consultants (non-cash)
Impairment charges 6,784,200 - -
General and administrative:
Compensation - officers and employees 1,430,500 803,900 772,200
Consultants 534,200 301,000 265,600
Legal fees 734,300 793,900 956,900
Accounting fees 204,200 79,100 51,000
Rent and storage 349,800 296,800 266,000
Insurance 329,800 222,600 194,700
Travel and entertainment 162,500 120,000 98,200
Repairs and maintenance 176,500 118,100 87,500
Depreciation and amortization 854,000 494,600 130,900
Payroll taxes 86,300 55,200 56,700
Stock administrative fees 130,500 171,700 83,300
Public relations 212,100 192,700 299,400
Amortization of goodwill 199,100 - -
Other 405,800 301,600 343,400
----------------------------------------------- ------------------- ------------------ ------------------
21,788,900 10,798,900 7,676,300
----------------------------------------------- ------------------- ------------------ ------------------
Operating loss (17,946,900) (9,695,700) (7,629,700)
----------------------------------------------- ------------------- ------------------ ------------------
Interest income (expense):
Interest income 133,400 200,700 372,000
Interest expense and non-cash
financing costs (1,682,900) (3,313,000) (27,100)
----------------------------------------------- ------------------- ------------------ ------------------
(1,549,500) (3,112,300) 344,900
----------------------------------------------- ------------------- ------------------ ------------------
Net loss $(19,496,400) $(12,808,000) $ (7,284,800)
=============================================== =================== ================== ==================
Net loss to common stockholders:
Net loss $(19,496,400) $(12,808,000) $ (7,284,800)
Deemed dividend for convertible
preferred stock (3,900,000) (1,558,300) -
----------------------------------------------- ------------------- ------------------ ------------------
Net loss to common stockholders $(23,396,400) $(14,366,300) $ (7,284,800)
=============================================== =================== ================== ==================
Weighted average number of
common shares outstanding 16,746,354 15,498,300 14,968,019
=============================================== =================== ================== ==================
Basic and diluted loss per share $ (1.40) $ (.93) $ (.49)
=============================================== =================== ================== ==================
See accompanying notes to consolidated financial statements.
F-4
CHROMATIC COLOR SCIENCES, INC. AND SUBSIDIARIES
Statements of changes in stockholders' equity (deficit)
Common Stock
Preferred Number of Par value Capital in Accumulated
Stock shares excess of par deficit
Amount outstanding value
-------------------------------------------------- ------------- -------------- ------------ ---------------- ----------------
Balances, January 1, 1998 $ - 13,814,859 $13,800 $24,370,900 $(14,488,400)
Net loss - - - - (7,284,800)
Exercise of stock options and warrants - 1,637,583 1,600 3,112,700 -
Compensation cost relating to options granted to - - - 843,400 -
consultants
-------------------------------------------------- ------------- -------------- ------------ ---------------- ----------------
Balances, December 31, 1998 - 15,452,442 15,400 28,327,000 (21,773,200)
Net loss - - - - (12,808,000)
Exercise of stock options and warrants - 86,675 100 377,300 -
Original issue discount of senior convertible - - - 3,575,000 -
debentures (below market conversion price)
Original issue discount on Class B convertible - - - 2,357,000 -
preferred stock (warrants and below market
conversion price)
Deemed dividend on Class B convertible preferred - - - (1,558,300) -
stock
Compensation cost relating to options granted to - - - 984,000 -
consultants
-------------------------------------------------- ------------- -------------- ------------ ---------------- ----------------
Balances, December 31, 1999 - 15,539,117 15,500 34,062,000 (34,581,200)
Net loss - - - - (19,496,400)
Conversion of debentures to preferred stock 6,079,100 - - - -
Issuance of preferred stock for cash 5,024,800 - - - -
Reclassification of redeemable preferred stock 2,262,700 - - - -
Exercise of stock options and warrants - 162,880 200 377,500 -
Conversion of convertible preferred stock into (1,855,800) 1,889,563 1,900 3,016,900 -
common shares
Original issue discount on convertible preferred - - - 3,858,000 -
stock (warrants and below market conversion
price)
Deemed dividend on Class B convertible preferred - - - (3,900,000) -
stock
Issuance of common stock- Gordon - 721,231 700 4,535,800 -
Issuance of common stock - other - 720,517 800 3,294,200 -
Compensation cost relating to options granted to - - - 690,000 -
consultants
-------------------------------------------------- ------------- -------------- ------------ ---------------- ----------------
Balances, December 31, 2000 $11,510,800 19,033,308 $19,100 $45,934,400 $(54,077,600)
================================================== ============= ============== ============ ================ ================
See accompanying notes to consolidated financial statements.
F-5
CHROMATIC COLOR SCIENCES, INC. AND SUBSIDIARIES
Statements of Cash Flows
2000 1999 1998
------------------------------------------------------ ------------------- ------------------ ------------------
Cash flows from operating activities:
Net loss $(19,496,400) $(12,808,000) $(7,284,800)
Adjustments to reconcile net loss to
net cash used inoperating activities:
Depreciation and amortization 938,300 494,600 130,900
Compensation cost relating to
options granted to consultants 690,000 984,000 843,400
Noncash interest and financing costs 851,200 2,740,800 -
Impairment provision 7,517,300 - -
Changes in operating assets and liabilities
(net ofeffect of acquisition in 2000):
Accounts receivable 678,600 (750,000) 100
Inventories (302,900) (293,400) (1,503,600)
Prepaid expenses and other assets (204,600) (97,100) 1,200
Accrued interest on senior convertible debentures 583,300 495,800 -
Accounts payable and accrued expenses (249,900) (222,600) 431,700
------------------------------------------------------ ------------------- ------------------ ------------------
Net cash used in operating activities (8,995,100) (9,455,900) (7,381,100)
------------------------------------------------------ ------------------- ------------------ ------------------
Cash flows from investing activities:
Software development costs - (81,300) (421,800)
Capitalized patent costs (337,100) (553,000) (540,300)
Purchase of property and equipment (85,500) (91,200) (87,700)
------------------------------------------------------ ------------------- ------------------ ------------------
Net cash used in investing activities (422,600) (725,500) (1,049,800)
------------------------------------------------------ ------------------- ------------------ ------------------
Cash flows from financing activities:
Proceeds from issuance of common stock,
net of related costs 3,672,600 377,400 3,114,300
Proceeds (payments) of amounts payable to
related party (865,100) (62,800) 25,700
Proceeds from senior convertible debentures - 5,000,000 -
Payments of notes payable (202,200) - (4,700)
Net proceeds from the issuance of preferred
stock and warrants, net of costs 5,479,800 3,727,400 -
------------------------------------------------------ ------------------- ------------------ ------------------
Net cash provided by financing activities 8,085,100 9,042,000 3,135,300
------------------------------------------------------ ------------------- ------------------ ------------------
Net decrease in cash and equivalents (1,332,600) (1,139,400) (5,295,600)
Cash and equivalents, beginning of year 2,790,400 3,929,800 9,225,400
------------------------------------------------------ ------------------- ------------------ ------------------
Cash and equivalents, end of year $ 1,457,800 $ 2,790,400 $ 3,929,800
====================================================== =================== ================== ==================
Supplemental disclosures of cash flow information:
Interest paid $ 479,800 $ 88,900 $ 1,400
====================================================== =================== ================== ==================
Reclassification of ColorMate Units - $ 1,820,100 $ 1,504,400
====================================================== =================== ================== ==================
Issuance of common stock and amount payable
for purchase of Gordon stock $ 5,189,500 $ $ -
====================================================== =================== ================== ==================
Conversion of preferred stock into common stock $ 3,018,800 $ - $ -
====================================================== =================== ================== ==================
See accompanying notes to consolidated financial statements.
F-6
CHROMATIC COLOR SCIENCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Business and Summary of Significant Accounting Policies
Since its formation in 1984, Chromatics Color Sciences International, Inc. (the
"Company") has been principally engaged in color science technology research and
development and licensing activities, seeking mass market applications for its
proprietary technology and instrumentation. In connection with the acquisition
of Gordon Laboratories ("Gordon") in June 2000, the Company also develops,
manufactures and distributes cosmetic products.
(a) Estimates and Uncertainties
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results, as determined at a later date,
could differ from those estimates. Significant estimates relate primarily
to inventory valuation and recoverability of the Company's tangible and
intangible assets.
(b) Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All intercompany balances and
transactions have been eliminated in consolidation.
(c) Patent Application Costs
The Company began capitalizing certain patent application costs, commencing
January 1, 1998, and is amortizing such costs over the remaining patent
lives, generally 10 to 15 years. Accumulated patent amortization costs as
of December 31, 2000 and 1999 are $268,200 and $109,300, respectively. The
Company assesses the continuing carrying value of these assets when events
and circumstances warrant and, in 2000, recorded an impairment charge
totaling $581,000 (see Note 18).
(d) Revenue Recognition
The Company records revenue from the sale of ColorMate TLc-BiliTest Systems
and TLc-Lensette Calibration Standards at the time of shipment at the
minimum transfer price provided in the distribution agreement. The
agreement provides for additional amounts from the distributor equal to a
defined percentage of the distributor's sales price of these products. The
Company records revenue from the additional amounts upon receipt from the
distributor. Sales of cosmetic products are recorded when the products are
shipped.
Shipping charges are included in sales. Shipping and handling costs are
included in cost of sales.
(e) Inventories
Inventories are stated at the lower of first-in, first-out cost or market.
(f) Property and Equipment and Depreciation
Property and equipment are stated at cost. Depreciation is computed using
principally the straight-line method over estimated useful lives of 5 to 7
years. The Company continually evaluates the life and carrying amount of
such equipment in light of current conditions and, in 2000, wrote off the
net book value of certain equipment totaling $257,600 (see Note 18).
(g) Software Development Costs
Once technological feasibility was established, the costs of developing
software to be marketed as part of a product was capitalized.
Capitalization ceased in 1999 when the products became available for sale.
The costs are amortized on the basis of estimated future revenues with
annual minimum charges, which is similar to the straight-line basis over
the estimated remaining useful life (three years). Accumulated amortization
of software development costs at December 31, 2000 and 1999 was $366,000
and $157,000, respectively.
(h) Goodwill and Other Intangibles
In connection with the Gordon acquisition, the Company recorded goodwill
totaling $6,800,000 and other intangible assets, primarily a favorable
lease, of $900,000 (see Note 3). The goodwill is being amortized over 20
years, using the straight-line basis and the other intangibles are being
amortized over 5 years, on the straight-line basis. In 2000, the Company
took an impairment charge for goodwill of $5,276,500 (see Note 18).
(i) Long-Lived Assets
Long-lived assets, such as intangible assets and property and equipment,
are evaluated for impairment when events or changes in circumstances
indicate that the carrying amount of the assets may not be recoverable
through the estimated undiscounted future cash flows from the use of these
assets. When any such impairment exists, the related assets will be written
down to fair value. In 2000, the Company recorded impairment losses
relating to these assets (see Note 18).
(j) Cash Equivalents
The Company considers certificates of deposit, money market funds and all
other highly liquid debt instruments purchased with an original maturity of
three months or less to be cash equivalents.
(k) Financial Instruments
Financial instruments include cash and equivalents, accounts receivable,
accounts payable and long-term debt. The amounts reported for financial
instruments are considered to be reasonable approximations of their fair
values. The fair value estimates presented herein were based on market
information available to management as of December 31, 2000.
(l) Concentration of Credit Risk/Major Customers, Supplier and
Manufacturer
The Company maintains its cash balances with financial institutions insured
by the Federal Deposit Insurance Corporation to a maximum of $100,000. The
Company's balances exceed such amount.
The Company generated approximately 98% of its revenues from one customer
in 1999 (see Note 6). Sales to this customer were immaterial in 2000. In
connection with the acquisition of Gordon in 2000, sales to four customers
were 18%, 16%, 11% and 10%, respectively, of Gordon's sales which
represented almost all of the Company's sales in 2000. Receivables at
December 31, 2000 from these customers approximated 65% of total accounts
receivable.
The Company is dependent upon one supplier for a major part of its
ColorMate TLc-BiliTest System and one company to manufacture the ColorMate
TLc-BiliTest System. The loss of these companies would materially adversely
affect the Company.
(m) Loss Per Share
The Company follows Statement of Financial Accounting Standards ("SFAS")
No. 128, "Earnings Per Share," ("EPS") which requires a presentation of
basic EPS and diluted EPS. Basic EPS excludes dilution and is computed by
dividing earnings available to common stockholders by the weighted-average
number of common shares outstanding for the period. Diluted EPS assumes
conversion of convertible debt, preferred stock and the issuance of common
stock for all other potentially dilutive equivalent shares outstanding. All
of these equivalents were anti-dilutive for all periods presented.
(n) Stock-Based Compensation
SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS No. 123")
encourages, but does not require, companies to record compensation cost at
fair value for stock-based employee compensation plans. The Company has
chosen to continue to account for stock-based compensation for employees
using the intrinsic value method prescribed in Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations. Accordingly, compensation cost for options granted by the
Company is measured as the excess, if any, of the quoted market price of
the Company's stock at the date of the grant over the amount an employee
must pay to acquire the stock. The fair value of option grants is discussed
in Note 14.
(o) Income Taxes
Deferred tax assets and liabilities reflect the net tax effects of
temporary differences between the carrying amount of assets and liabilities
for financial reporting purposes and the amounts for income tax purposes. A
valuation allowance is provided for the net deferred tax assets if it is
more likely than not that some or all of the deferred tax assets will not
be realized.
(p) Research and Development
These costs are expensed as they are incurred.
(q) Recent Accounting Standards
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities",
which establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as derivatives), and for hedging
activities. It requires that an entity recognize all derivatives as either
assets or liabilities in the balance sheet and measure those instruments at
fair value. This statement will be adopted in the Company's 2001 fiscal
year. The Company does not have any derivative instruments; accordingly,
the adoption of this statement is not expected to have a material effect on
the Company's consolidated financial position, results of operations or
cash flows.
In December 1999 the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in
Financial Statements". SAB No. 101 summarizes certain of the SEC's views in
applying accounting principles to revenue recognition in financial
statements. SAB No. 101 was adopted in 2000 and had no material impact on
the Company's revenue recognition policy.
In November 2000, the Emerging Issues Task Force ("EITF") issued consensus
number 00-27 which requires the remeasurement of the original issue
discount on preferred stock with characteristics similar to the convertible
preferred stock issued by the Company earlier in 2000 and in 1999. The
adoption of this EITF resulted in an additional imputed dividend of
$2,325,000 which was recorded in the fourth quarter of 2000.
2. Basis of Presentation
The Company's consolidated financial statements have been presented on
the basis that it is a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the
normal course of business. The Company has suffered recurring losses
for the past several years, including $19,496,400 in 2000, and has
experienced significant problems and delays exploiting its primary
technology (medical equipment). In addition, Gordon has defaulted on
its debt service obligation in 2001 and the lender has demanded
payment of the entire debt, which totals $2,714,700 at December 31,
2000. In 2001, the Company has significantly reduced its workforce and
other costs. The Company is attempting to obtain additional financing
(see Note 19). With additional funds, the Company plans to continue
exploiting its color sciences technology and possibly sell its medical
technology to a third party. There can be no assurances that
additional financing will be obtained or that the Company's other
plans will be achievable. The financial statements do not include any
adjustments relating to the recoverability and classification of asset
amounts or the amounts and classification of liabilities that might be
necessary should the Company be unable to continue as a going concern.
3. Acquisition
On June 2, 2000, the Company acquired the common stock and certain debt of
Gordon, a privately-held formulator and manufacturer of cosmetics, hair
care and other personal care products. The acquisition was for a purchase
price of $609,000 in cash used to repay Gordon debt and approximately
721,000 shares of the Company's common stock, valued for financial
reporting purposes at $6.29 per share, which approximated the market value
of the Company's common stock at the acquisition date. The Company owes a
balance of $653,000 to the former shareholders of Gordon to complete the
purchase. The amount is payable in shares of the Company's stock, valued at
$6.29 per share or 96,820 shares. This amount has been classified as a
long-term liability at December 31, 2000. The acquisition has been
accounted for under the purchase method of accounting for business
combinations. Accordingly, the consolidated financial statements include
the results of operations of Gordon from the acquisition date. The excess
of the purchase price over the assets acquired was approximately
$7,700,000, of which $900,000 was classified as other assets (such as
favorable lease, formulae and employee retention) and the balance of
approximately $6,800,000 has been classified as goodwill.
The following unaudited pro forma information presents a summary of
the consolidated results of operations of the Company as if the
acquisition of Gordon had taken place on January 1, 1999. There pro
forma results have been prepared for comparative purposes only and do
not purport to be indicative of the results of operations which
actually would have resulted had the acquisition occurred on January
1, 1999, or which may result in the future.
Year ended December 31, 2000 1999
--------------------------------- ---------------- ----------------
Total revenues $6,330,000 $ 7,767,000
Net loss (20,037,000) (13,270,000)
Net loss per share $(1.43) $(.91)
--------------------------------- ---------------- ----------------
Due to the Company's poor financial condition, the Company is negotiating a
financing with an investor which, if successfully completed, will result in
the Company receiving $3 million in gross proceeds, which includes the sale
of 75% of the shares of Gordon (see Note 19). Due to the uncertainty of the
Gordon sale and due to the deteriorating financial condition of Gordon, the
net assets of Gordon at December 31, 2000 were written down to the $1
million amount, which resulted in an impairment loss in goodwill of
$5,276,500. The Company will have an option to re-acquire the Gordon shares
from the investor. Accordingly, the operations of Gordon have not been
reflected as discontinued.
4. Inventories Inventories consist of the following:
December 31, 2000 1999
----------------------------- --------------- ---------------
Raw materials $1,996,100 $ 521,500
Work-in-process 211,000 -
Finished goods 169,300 650,300
----------------------------- --------------- ---------------
2,376,400 1,171,800
Valuation reserve (733,100) -
----------------------------- --------------- ---------------
$1,643,300 $1,171,800
----------------------------- --------------- ---------------
5. Property and Equipment
Property and equipment consist of the following:
December 31, 2000 1999
----------------------------------------- ------------------- ------------------
Machinery and equipment $1,443,800 $928,200
Furniture and fixtures 409,500 144,600
Leasehold improvements 457,000 -
----------------------------------------- ------------------- ------------------
2,310,300 1,072,800
Less: Accumulated depreciation and
amortization (824,800) (460,600)
Impairment reserves (257,600) -
----------------------------------------- ------------------- ------------------
$1,227,900 $612,200
----------------------------------------- ------------------- ------------------
Included in machinery and equipment is equipment under capital leases
with a net book value of $310,000.
Depreciation and amortization expense for property and equipment for
the years ended December 31, 2000, 1999 and 1998 is $397,900, $148,200
and $95,800, respectively.
6. ColorMate Units
ColorMate TLc-BiliTest Systems
On June 7, 1999, the Company executed a renewable, five-year agreement
with Datex-Ohmeda, Inc. and its Ohmeda Medical Division ("DO")
pursuant to which the Company appointed DO as the exclusive
distributor in the United States of the Company's ColorMate
TLc-BiliTest System ("Systems") for non-invasive monitoring of
bilirubin infant jaundice in the hospital market, the nonconsumer home
healthcare market (in which the test is administered solely by a
healthcare professional), the pediatrician office market and clinics
within all such markets. The agreement also applies to the Company's
disposable calibration standard (TLc-Lensette) that is used to
calibrate each measurement taken by the ColorMate TLc-BiliTest System
and provides that the Company will share in the sales revenues for
both products. Terms of the agreement include annual minimum market
penetration performance standards and purchasing and placement of
quantities for both the ColorMate TLc-BiliTest System and the
TLc-Lensette Calibration Standard. Sales under the agreement commenced
in July 1999.
To date, the distribution partner has not achieved the annual minimum
market penetration performance standards, nor has it purchased and
placed the minimum quantities of the ColorMate TLc-BiliTest System and
the TLc-Lensette Calibration Standards as set forth in the June 7,
1999 distribution agreement, as amended. Other than the original sales
to DO in 1999 of $1,075,300, there have been minimal sales in 2000 and
2001 to date. The Company is currently working with DO on revising the
sales and marketing strategies, as well as product improvements based
on the results of the initial launch of the products by DO. The
parties are also exploring renegotiating the terms and conditions of
the distribution agreement. However, there can be no assurances that
any significant sales will be generated from the agreement.
The agreement called for the Company to provide a certain number of
Systems to DO at no cost until sold to serve as demo units or
promotional units to assist in the sales and marketing of the Systems.
The Company maintains title of certain of these Systems, while DO
obtained ownership of the other Systems. The Company had classified
$329,000 in property and equipment, representing the cost of the
Systems for which it maintains title, and had classified $506,000 in
other amortizable assets, representing the cost of the remaining
Systems (intangible asset associated with obtaining the agreement with
DO). The amount classified in other amortizable assets was being
amortized over the life of the DO Agreement, 5 years. Given the poor
level of sales to date, the Company wrote off the balance of these
capitalized costs ($611,700) in the fourth quarter of 2000 (see Note
18).
In 1999, the Company recorded sales from both the ColorMate
TLc-BiliTest System and the TLc-Lensette Calibration Standards. The
sales were recorded at the initial minimum transfer price as defined
in the distribution agreement. The Company incurred a small loss on
the initial sales of the Systems. The Company expected to receive
additional amounts from the distributor equal to a defined percentage
of the distributor's sale of the above products ("profit sharing
payments"). However, that has not incurred to date and the Company
cannot predict when, or if, such additional amounts will be received.
ColorMate Systems
In connection with a prior license with Avon Products, Inc. ("Avon"),
Avon paid approximately $4,600,000 to purchase color measurement
instruments and related equipment for its use during the term of the
license period. Due to missing and damaged units, Avon and the Company
executed mutual releases at the termination of the license on June 24,
1991, with the principal effect that the Company received 1,947 units,
of which 1,400 were useable and not in need of significant repair. For
accounting purposes, the $700,000 estimated fair value of the
nonproprietary equipment (based upon an independent appraisal of the
complete units with allowances for the lack of a verifiable used
equipment market, varying usage, the need for refurbishment and
similar factors) was recorded as an asset. The 1,700 useable units of
nonproprietary equipment were received in the form of (i) 1,400
complete units valued at $500 per unit and (ii) 300 complete units in
need of significant repair that were assigned zero value. No valuation
of the proprietary portion of the units or of the additional 247
unusable units returned by Avon was performed.
Following the Food and Drug Administration ("FDA") marketing clearance
in 1997, the Company had decided to use certain components (consisting
of sensors, miniature printers, cables, power supplies and certain
other items) from the existing ColorMate units for use in the
ColorMate TLc-BiliTest System. The costs (which were not expected to
be material) incurred in extracting the components from the existing
ColorMate units for use in the ColorMate TLc-BiliTest System would
have been expensed as incurred.
The cost of the above units has been classified as other assets in the
accompanying consolidated balance sheets and amounted to $614,900 in
December 31, 1999. Due to the problems arising in 2000 with the sale
of the ColorMate TLc-BiliTest Systems, these Avon units have not been
utilized to date. The Company is in negotiations to sell all the units
to a third party. If consummated, the arrangement will provide no
funds in advance. Rather, the third party will pay a fee to the
Company per usage of the System. Based upon estimates of future cash
flows from this proposed arrangement, the Company took an impairment
charge in the fourth quarter of 2000 of $314,900 (see Note 18). The
net amount capitalized at December 31, 2000 totaled $300,000.
7. Notes Payable
Gordon has a note payable to a finance company totaling $2,714,700 at
December 31, 2000 which is secured by substantially all the assets of
Gordon. The note bears interest at a fixed rate of 12.97% and is
payable in monthly installments of principal and interest of $54,100
through the maturity date of February 2005.
The note payable agreement, as amended in December 2000, provides for
certain financial covenants and also restricts Gordon from the payment
of dividends and limits the amount of capital expenditures and
additional indebtedness of Gordon.
Gordon has not paid the required debt service payments in February and
March 2001 and the finance company has notified Gordon that there has
been a default under the loan agreement. The lender has requested full
payment of the loan, as well as certain other costs, which Gordon
cannot afford to pay. Gordon is currently negotiating with the lender
to renegotiate the loan; however, there can be no assurances that
Gordon can resolve this issue.
Due to the default, the entire amount of the debt as been classified
as a current liability.
The balance of the notes payable at December 31, 2000 ($248,500)
relate to various equipment capital leases.
8. Factoring Arrangement
Gordon has a factoring agreement with a finance company to sell
accounts receivable due to Gordon from its customers. Advances are
limited to a maximum of $1 million and the receivables are subject to
the acceptance of the finance company. Such receivables are sold with
recourse in the event the receivable is not paid within 90 days.
Advances are subject to a .5% factoring fee and the advances bear
interest at the prime rate plus 2%. The finance company has a security
interest in Gordon's accounts receivable and inventory.
The agreement expires in July 2001 and can be renewed.
9. Income Taxes
The Company has a deferred tax asset at December 31, 2000 and 1999 of
approximately $19,500,000 and $15,000,000, respectively. These amounts
relate primarily to net operating loss and tax credit carryforwards.
These assets have been offset by valuation allowances since their
realizability cannot be determined. At December 31, 2000, the Company
had net operating loss carryforwards of approximately $48,700,000 for
Federal income tax purposes which expire through December 31, 2020. In
addition, the Company had research and development tax credit
carryforwards of approximately $75,000 at December 31, 2000 available
to offset future Federal income taxes. The utilization of such loss
and tax credit carryforwards may be limited due to changes in control.
Included in the net operating loss carryforwards is approximately
$5,700,000 relating to the exercise of stock options. The benefits, if
any, from the utilization of this amount will be credited to
additional paid-in capital.
Loss carryforwards acquired from Gordon totaled $1,375,000 at the
acquisition date. The utilization of these losses is limited due to
the change in control. If the losses are utilized, the benefit will be
used to reduce goodwill recorded from the acquisition.
10. Senior Convertible Debentures
On April 15, 1999, the Company issued an aggregate of $5,000,000 14%
senior convertible debentures due April 15, 2002 (the "Debentures") in
a private placement. Payments of interest on the outstanding principal
amount of the Debentures were due on the earlier of the maturity date
or upon any conversion of the Debentures into the Company's common
stock. The accrued interest may be paid either in cash, shares of the
Company's common stock or a combination of common stock and cash, at
the option of the Company.
The outstanding principal amount of the Debentures (together with
accrued interest thereon) was not convertible until after the first
anniversary of the closing (except for 20%, which was immediately
convertible). At that time, the Debentures were convertible into
shares of common stock, at the option of the holder or holders
thereof, at the conversion price of $5.00. At any time after the
18-month anniversary of the closing, the Company could have prepaid
the entire amount of the Debentures or any portion thereof for a
prepayment price equal to the original principal amount of the
Debentures plus all accrued and unpaid interest. At any time after the
18-month anniversary of the closing and prior to the maturity date, in
the event the average closing bid price (as reported on the NASDAQ
Small Cap Market or such other principal market or exchange on which
the common stock is then traded) of the Company's common stock for any
10 consecutive trading days equals or exceeds $10.29, the Company
could have required conversion of the outstanding principal amount
(together with accrued interest) of the Debentures into common stock
at a conversion price of $5.00 per share. The Debentures resulted in
an original issue discount charge of approximately $3.6 million
(representing the intrinsic value of the below-market conversion
price) which was amortized over one year. In 1999, the Company
amortized $2.7 million and, in 2000, the balance of $900,000 was
amortized..
This debt was converted to preferred stock in 2000 (see Note 12).
11. Preferred Stock
Class A
The Company's shares of Class A convertible preferred stock are
entitled to noncumulative dividends, if declared, at $.001 per annum.
In February 1998, the shareholders approved an amendment to the Class
A convertible preferred stock to provide that in the event either the
Company's earnings before interest, income taxes and extraordinary
items exceed $20,000,000 for two consecutive calendar years, or the
closing bid price exceeds $31.11 for 30 consecutive trading days at
any time through December 31, 2000, each share of Class A preferred
stock shall be convertible into .979 shares of common stock. Such
shares shall otherwise be called for redemption during 120 days
following December 31, 2000 at $.01 per share plus any declared but
unpaid dividends.
In addition, the shareholders approved an amendment to the Company's
Certificate of Incorporation to (1) revise the market price conversion
feature of the Class A convertible preferred stock to provide for
adjustment upon the occurrence of certain events involving the common
stock, and (2) revise the calculation of the earnings goal needed to
trigger the conversion feature of the Class A convertible preferred
stock by deleting the exclusion therefrom of extraordinary items and
revenues and earnings generated by businesses acquired by the Company.
Class B
The Company also has authorized 10,000,000 shares of Class B preferred
stock which may be issued with such rights and preferences as the
Board of Directors may determine upon issuance.
At December 31, 2000 the Company has outstanding the following series
of Class B preferred stock:
Amount
----------------- -----------------
Shares Value
------------------------------ ----------------- -----------------
Series 2 25,000 $ 2,262,700
Series 3 40,000 3,155,000
Series 4 136 1,229,800
Series 5 48,633 4,863,300
------------------------------ ----------------- -----------------
113,769 $11,510,800
------------------------------ ----------------- -----------------
Class B Series 1 Preferred Stock
In January 1999, the Company amended its Certificate of Incorporation
to fix the relative rights, preferences and limitations with respect
to the Class B preferred stock pursuant to the Shareholders' Rights
Plan (the "Plan") adopted in December 1998 by the Board of Directors.
Under the Plan, each shareholder will receive a dividend of one right
for each share of the Company's outstanding common stock (a "Right").
Subject to the terms of the rights agreement between the Company and
its transfer agent (the "Rights Agreement"), each Right will entitle
the holder to purchase one one-hundredth of a share of the Company's
new Class B Series 1 preferred stock at an initial exercise price of
$28. Until the Rights become exercisable, they will be represented by,
and trade with, the outstanding common stock; the Company does not
anticipate issuing separate certificates for the Rights at this time.
Initially, the Rights are attached to the Company's common stock and
are not exercisable. They become detached from the common stock, and
become immediately exercisable, (i) following expiration of the Board
of Directors' right to redeem the Rights during the 10-day window
period (the "Window Period"), or any extension of the Window Period,
after any person or group (other than the exempted shareholder)
becomes the beneficial owner of 20 percent or more of the Company's
common stock (other than acquisitions which are approved in advance by
the Board of Directors), or (ii) ten days after any person or group
announces a tender or exchange offer that would result in that same
beneficial ownership level (other than pursuant to certain permitted
offers).
The distribution of Rights was made on January 11, 1999 to
shareholders of record of common stock on that date, and shares of
common stock that are newly issued after that date will also carry
Rights until the Rights become detached from the common stock. The
Rights will expire on January 11, 2009. The Rights distribution is not
taxable to shareholders. The Company may redeem the Rights for $0.001
each at any time during the Window Period, or any extension thereof,
after a buyer acquires a 20 percent position in the Company, and under
certain other circumstances.
Class B Series 2 Convertible Preferred Stock
On June 15, 1999, the Company completed a private placement of 40,000
shares of convertible preferred stock and warrants to purchase 220,690
shares of common stock to a private investor for aggregate proceeds of
$4 million. The shares of Class B Series 2 convertible preferred stock
issued on that date (the "Series 2 Shares") are convertible into
shares of the Company's common stock at a price of $4.68 per share,
subject to adjustment for stock splits, combinations and similar
recapitalizations affecting the Company's common stock and in certain
circumstances including the issuance of shares of the Company's common
stock. The Series 2 Shares were previously redeemable in cash for an
amount equal to $115 per Series 2 Share on the third anniversary of
the date of initial issuance if not sooner converted unless the
Company elects in the Company's discretion to extend the redemption
date to the fifth anniversary of the date of initial issuance. As a
result of a capital restructuring program completed on October 31,
2000 (see Note 12), the Series 2 Shares are no longer redeemable in
cash. Accordingly, the amount was classified within equity in the
fourth quarter of 2000. The Series 2 Shares are subject to mandatory
conversion into shares of the Company's common stock at the Company's
option at any time after December 15, 1999 if the average closing bid
price of the Company's common stock for ten consecutive trading days
equals or exceeds $7.02 per share. The Series 2 Shares are not
entitled to any voting rights except as otherwise required by
applicable law and are not entitled to any dividend rights unless the
Company elects to extend the redemption date of the fifth anniversary
of the date of initial issuance, in which case noncash dividends
(which increase the number of shares issuable upon redemption ) would
accrue at the rate of 8% from and after the third anniversary of the
date of initial issuance which can only be paid in shares of the
Company's common stock.
In addition to the Series 2 Shares, on June 15, 1999, the Company also
issued an aggregate of 220,690 warrants to purchase shares of the
Company's common stock to the same private investor. An additional
50,000 warrants were issued to such investor as compensation for
services rendered in connection with the placement of the Series 2
Shares. The warrants issued on that date have a five-year term unless
sooner exercised. The warrants are exercisable for shares of the
Company's common stock at a price of $4.68 per share, subject to
adjustment in the same circumstances as the Series 2 Shares described
above and are subject to mandatory exercise into shares of the
Company's common stock at the Company's option at any time after
December 15, 1999 if the average closing bid price of the Company's
common stock measured over twenty consecutive trading days equals or
exceeds $9.36.
The private placement resulted in a deemed dividend charge of
approximately $4.5 million, resulting from a below market conversion
price of preferred stock ($2,400,000), a $15 per share redemption
premium and other costs ($800,000) and the fair value (using the
Black-Scholes method) of warrants issued in connection with the
private placement ($1,275,000). Of this amount, approximately $1.6
million had been charged through December 1999, $1.8 million has been
charged in 2000 and $500,000 will be charged over the remaining
redemption period. Of the original deemed dividend charge, $.6 million
has been eliminated as a result of the conversion of preferred stock
into common stock.
In 2000, 15,000 Series 2 Shares were converted into 238,473 shares of
the Company's common stock.
Class B Series 3 Convertible Preferred Stock
On February 11, 2000, the Company completed a private placement of
40,000 shares of convertible preferred stock to the above private
investor for aggregate proceeds of $4 million. The shares of Class B
Series 3 convertible preferred stock issued on that date (the "Series
3 Shares") are convertible into shares of the Company's common stock
at a price of $4.68 per share, subject to adjustment for stock splits,
combinations and similar recapitalizations affecting the Company's
common stock and in certain circumstances including the issuance of
shares of the Company's common stock. The Series 3 Shares were
previously redeemable in cash for an amount equal to $115 per Series 3
Share on the third anniversary of the date of initial issuance if not
sooner converted unless the Company elects in the Company's discretion
to extend the redemption date to the fifth anniversary of the date of
initial issuance. As a result of the capital restructuring program
completed on October 31, 2000 (see Note 12), the Series 3 Shares are
no longer redeemable in cash. Accordingly, the amount was classified
within equity in the fourth quarter of 2000.The Series 3 Shares are
subject to mandatory conversion into shares of the Company's common
stock at the Company's option at any time after August 11, 2000 if the
average closing bid price of the Company's common stock for ten
consecutive trading days equals or exceeds $7.02 per share. The Series
3 Shares are not entitled to any voting rights except as otherwise
required by applicable law and are not entitled to any dividend rights
unless the Company elects to extend the redemption date to the fifth
anniversary of the date of initial issuance, in which case noncash
dividends (which increase the number of shares issuable upon
redemption) would accrue at the rate of 8% from and after the third
anniversary of the date of initial issuance which can only be paid in
shares of the Company's common stock.
In addition to the Series 3 Shares, on February 11, 2000, the Company
also issued an aggregate of 254,372 warrants to purchase shares of the
Company's common stock to the same private investor. An additional
50,000 warrants were issued to such investor as compensation for
services rendered in connection with the placement of the Series 3
Shares. The warrants issued on that date have a five-year term unless
sooner exercised. The warrants are exercisable for shares of the
Company's common stock at a price of $4.68 per share, subject to
adjustment in the same circumstances as the Series 3 Shares described
above and are subject to mandatory exercise into shares of the
Company's common stock at the Company's option at any time after
August 11, 2000 if the average closing bid price of the Company's
common stock measured over twenty consecutive trading days equals or
exceeds $9.36.
The private placement resulted in a deemed dividend charge of
approximately $3.5 million, resulting from a below market conversion
price of preferred stock ($1,495,000), a $15 per share redemption
premium and other costs ($990,000) and the fair value (using the
Black-Scholes method) of warrants issued in connection with the
private placement ($1,050,000). Of this amount, approximately $2.1
million has been charged in 2000 and $1.4 million will be charged over
the remaining redemption period.
Class B Series 4 Convertible Preferred Stock
On October 31, 2000, the Company consummated a private placement of
200 shares of a new series of preferred stock, designated Class B
Series 4 convertible preferred stock, par value $.01 per share
("Series 4 Preferred Stock") for an aggregate purchase price of
$2,000,000. Pursuant to the Stock Purchase Agreement between the
Company and Crescent International Ltd. (the "Purchaser"), the Company
also issued to the Purchaser a warrant (the "Incentive Warrant"), the
terms of which provide that the Purchaser has the right to acquire up
to 270,000 shares of the Company's common stock at an exercise price
equal to $1.00 per share, subject to adjustment in certain
circumstances, for a five-year period.
The Series 4 Preferred Stock will, with respect to the distribution of
assets on liquidation, dissolution or winding up of the Company, rank
(i) senior and prior to the common stock of the Company and any other
class or series of capital stock of the Company hereafter issued, the
terms of which specifically provide that shares of such class or
series shall rank junior to shares of the Series 4 Preferred Stock
(ii) on parity with any other class or series of capital stock of the
Company hereafter issued, the terms of which specifically provide that
shares of such class or series shall rank on parity with shares of the
Series 4 Preferred Stock, and (iii) junior to the Class A preferred
stock and any other class or series of capital stock of the Company
hereafter issued, the terms of which specifically provide that shares
of such class or series shall rank senior to shares of the Series 4
Preferred Stock
At any time after October 31, 2002, any or all of the outstanding
shares of Series 4 Preferred Stock will, upon written request of the
holders of a majority of the issued and outstanding shares thereof, be
subject to redemption by the Company for either, at the option of the
Company, (i) $12,000 in cash per share or (ii) the number of shares of
common stock obtained by dividing $12,000 by the lower of $.82 and 92%
of the average of the lowest three consecutive closing bid prices of
the common stock during the 22 trading day period immediately
preceding the date that redemption is requested. In addition, subject
to certain adjustments, each share of the Series 4 Preferred Stock
will be convertible at any time at the option of the holder thereof
into the number of shares of common stock determined by dividing
$10,000 by the lower of $.82 and 92% of the average of the lowest
three consecutive closing bid prices of the common stock during the 22
trading day period immediately preceding the date that conversion is
requested. The holder of shares of Series 4 Preferred Stock will have
no voting rights and, if the Company fails to deliver certificates of
shares of common stock upon redemption or conversion of the Series 4
Preferred Stock, will receive dividends at a rate of 8.0% per annum,
payable in cash in quarterly installments.
In December 2000, 64 of these shares were converted into 1,391,304
shares of common stock.
Class B Series 5 Convertible Preferred Stock
Pursuant to a letter agreement, the Company and the holders agreed to
convert the entire principal amount of the Debentures (see Note 10),
and any accrued but unpaid interest thereon, into a newly-authorized
series of convertible preferred stock of the Company (the "New
Preferred"), effective October 31, 2000. Prior to their conversion,
the Debentures had a principal face amount of $5,000,000, accrued but
unpaid interest in the amount of $1,079,167 and were due on April 15,
2002. the Company and the holders further agree that (i) the New
Preferred would be convertible into shares of common stock at a
conversion price of $4.68 per share, subject to adjustment for stock
splits, combinations and similar recapitalizations affecting the
common stock, (ii) with respect to the distribution of assets on the
liquidation, dissolution or winding up of the Company, the New
Preferred shall rank senior and prior to all classes or series of
capital stock of the Company issued prior thereto or thereafter
issued, (iii) cumulative dividends would accrue on the New Preferred
beginning on April 15, 2002 at a rate of 8% per annum (subject to
increase to 11% per annum during any period in which such cumulative
dividends are not currently paid), and (iv) the New Preferred would be
subject to involuntary conversion into shares of common stock at the
option of the Company at a conversion price of $4.68 per share if the
average closing bid price of the Company's common stock for ten
consecutive trading days exceeds $10.29. The Company also agreed with
the holders (i) not to incur or permit any future liens on any of its
properties or assets, (ii) not to grant any security interests in its
future revenues and (iii) not to consummate any future financings
which contemplate the issuance of debentures by the Company.
In December 2000, 12,158 of these shares were converted into 259,786
shares of common stock.
12. Capital Restructuring Program
Transaction Summary
On October 11, 2000, the Company obtained commitments from three of
its major investors, Millennium Partners, L.P. ("Millennium") (see
Note 13), LBI Group, Inc. ("Lehman") (see Note 11) and the holders
(the "Holders") of its 14% senior convertible debentures, dated April
15, 1999 (the "Debentures") (see Note 10) to restructure the terms of
their respective securities. The purpose of this restructuring was to
assist the Company in meeting the net tangible assets requirement for
continued listings of its common stock, on the NASDAQ Small Cap Market
("NASDAQ"). These commitments of the investors were subject to certain
conditions, which were subsequently satisfied on October 31, 2000,
including the Company's securing confirmation from NASDAQ of the
Company's eligibility for continued listing on NASDAQ and the closing
of a proposed additional financing with Crescent International Ltd.
("Crescent"), pursuant to which the Company would issue and sell to
Crescent, and Crescent would purchase, shares of a newly-authorized
series of preferred stock of the Company (the "Crescent Preferred")
and a five-year warrant to purchase up to 270,000 shares of Common
stock at an exercise price equal to $1.00 per share, subject to
adjustment in certain circumstances (the "Crescent Warrants"), for an
aggregate purchase price of not less than $2,000,000 (see Note 11 -
"Crescent Financing"). In consideration of their agreements to
restructure their respective securities, the Company agreed to issue
to each of Lehman and the Holders 200,000 five-year warrants to
purchase shares of the common stock of the Company at an exercise
price of $1.50 per share (the "New Lehman Warrants" and the "Holders'
Warrants", respectively). The value of the warrants issued in this
restructuring program was deemed to be immaterial. The Company also
agreed with the holders (i) not to incur or permit any future liens on
any of its properties or assets, (ii) not to grant any security
interests in its future revenues and (iii) not to consummate any
future financings which contemplate the issuance of debentures by the
Company.
Transaction Details
Pursuant to a letter agreement (the "Millennium Letter Agreement"),
the Company and Millennium agreed to amend the Millennium Purchase
Agreement and the Adjustable Warrant to delete any provision granting
Millennium the right to require the Company to repurchase the
Millennium Shares or redeem the Adjustable Warrant Shares, as the case
may be, for cash except in the event that the Company (i) engages in a
"Rule 13e-3 Transaction" (as defined in Rule 13e-3 under the
Securities Exchange Act of 1934, as amended) or (ii) fails to file a
request to accelerate the effectiveness of the registration statement
covering the Millennium Shares and the shares underlying the warrants
issued to Millennium promptly after securing confirmation from NASDAQ
of the Company's eligibility for continued listing of the common stock
on NASDAQ. The Company has satisfied this condition by filing such
acceleration of effectiveness on November 3, 2000.
The Company and Millennium further agreed to amend the Adjustable
Warrant (i) to reduce the number of dates (each, a "Vesting Date")
upon which the number of shares to be issued upon the exercise of the
Adjustable Warrant would be determined from three to two, (ii) to
postpone the first Vesting Date thereunder (the "First Vesting Date")
until March 31, 2001, at which time the number of shares to be issued
thereunder would be determined based on an Adjustment Period Price of
not less than $1.00 and, (iii) to postpone the second Vesting Date
thereunder (the "Second Vesting Date") until November 1, 2001, at
which time the number of shares to be issued thereunder (in addition
to the number of shares determined as of the First Vesting Date) would
be determined based on an Adjustment Period price which would not be
subject to a $1.00 minimum (as was the case on the First Vesting
Date). The Company and Millennium also agreed (x) to amend that
certain Registration Rights Agreement, dated as of August 16, 2000, to
eliminate the provisions imposing monetary penalties upon the
delisting of the common stock from NASDAQ, (y) to waive any events of
default occurring prior to the execution of the Millennium Letter
Agreement that would entitle Millennium to any monetary penalties from
the Company and (z) to irrevocably waive its rights to adjust the
exercise price of the Adjustable Warrant or the number of Adjustable
Warrant Shares as a result of the issuance of up to $4,000,000 of
financing from the Crescent Preferred.
Lehman is the holder of (i) 25,000 shares of the Class B Series 2
Convertible Preferred Stock of the Company and 40,000 shares of the
Class B Series 3 Convertible Preferred Stock of the Company
(collectively, the "Lehman Preferred") and (ii) warrants (the "Lehman
Warrants") to purchase common stock (see Note 11). Pursuant to a
letter agreement, the Company and Lehman agreed to amend those certain
Preferred Stock Purchase Agreements, dated as of June 11, 1999 and
February 11, 2000, respectively, to eliminate the provisions imposing
monetary penalties in the event that the common stock is delisted from
NASDAQ.
The Company and Lehman further agreed to amend the Certificate of
Incorporation of the Company to delete any provision granting Lehman
the right to require the Company to redeem the shares of Lehman
Preferred for cash. Pursuant to such amendments, the Company is now
required to convert the shares of Lehman Preferred into Common stock
on the third anniversary of their respective issuance dates unless the
Company elects, at its option, to extend the mandatory conversion date
to the fifth anniversary of the respective issuance dates of the
shares of Lehman Preferred. Lehman further agreed to waive its right
to decrease the conversion price of the Lehman Preferred and the
exercise price of the Lehman Warrants as a result of (i) the issuance
of the Crescent Preferred and the Crescent Warrant on October 31, 2000
for aggregate proceeds of $2,000,000 or any further issuances of
preferred stock or warrants to Crescent which do not exceed an
additional aggregate purchase price of $2,000,000, (ii) the issuance
of warrants to the Company's financial adviser in connection with the
Crescent Financing, (iii) the issuance of the New Lehman Warrants and
the Holders' Warrants and (iv) the determination on the First Vesting
Date of the number of shares of Common stock issuable with respect to
the Adjustable Warrant. In addition, Lehman agreed (A) that the deemed
exercise price (the "Deemed Exercise Price") with respect to the
number of shares of Common stock issuable pursuant to the Adjustable
Warrant on the Second Vesting Date would be the greater of (i) $1.00
and (ii) the exercise price calculated in the manner set forth in that
certain letter agreement, dated as of August 16, 2000, by and between
the Company and Lehman, and (B) to waive its right to decrease the
conversion price of the Lehman Preferred and the exercise price of the
Lehman Warrants to a price which is less than the Deemed Exercise
Price.
Pursuant to a letter agreement, the Company and the Holders agreed to
convert the entire principal amount of the Debentures, and any accrued
but unpaid interest thereon, into a newly-authorized series of
convertible preferred stock of the Company (the "New Preferred"),
effective October 31, 2000. Prior to their conversion, the Debentures
had a principal face amount of $5,000,000, accrued but unpaid interest
in the amount of $1,079,167 and were due on April 15, 2002. The
Company and the holders further agreed that (i) the New Preferred
would be convertible into shares of Common stock at a conversion price
of $4.68 per share, subject to adjustment for stock splits,
combinations and similar recapitalizations affecting the Common stock,
(ii) with respect to the distribution of assets on the liquidation,
dissolution or winding up of the Company, the New Preferred shall rank
senior and prior to all classes or series of capital stock of the
Company issued prior thereto or thereafter issued, (iii) cumulative
dividends would accrue on the New Preferred beginning on April 15,
2002 at a rate of 8% per annum (subject to increase to 11% per annum
during any period in which such cumulative dividends are not currently
paid) and (iv) the New Preferred would be subject to involuntary
conversion into shares of Common stock at the option of the Company at
a conversion price of $4.68 per share if the average closing bid price
of the Company's Common stock for ten consecutive trading days exceeds
$10.29. The Company also agreed with the holders (i) not to incur or
permit any future liens on any of its properties or assets, (ii) not
to grant any security interests in its future revenues and (iii) not
to consummate any future financings which contemplate the issuance of
debentures by the Company.
13. Sale of Common stock
On August 16, 2000, the Company sold 641,026 shares of Common stock to
a private investor at a price per share of $4.68 for gross proceeds of
$3,000,000, less fees and expenses ("first closing"). In connection
with the above transaction, the Company issued to the investor 150,000
warrants to purchase Common stock at an exercise price of $5.26 per
share. Pursuant to the purchase agreement for the above transaction,
the Company issued to the private investor an "Adjustable Warrant"
pursuant to which the number of shares issuable upon the exercise
thereof (the "Adjustable Warrant Shares") is based upon a formula
involving closing bid prices of the Common stock on certain future
dates, as amended. Prior to the amendment of the purchasing agreement
(see Note 12), the private investor had the right to require the
Company to repurchase for cash the shares and Adjustable Warrant
Shares issued to the private investors under certain defined
conditions. Accordingly, at September 30, 2000, the Company recorded
the net proceeds of $2,815,000 as redeemable Common stock. As a result
of the amendment, which eliminated the cash requirement, the amount
has been classified in Common stock in the fourth quarter of 2000.
As a result of the first adjustment of the adjustable warrant, the
Company is obligated as of March 31, 2001 to issue approximately
936,000 shares of common stock.
Also in 2000, the Company sold 79,491 shares of common stock for
$500,000.
14. Stock Options and Warrants
Stock Split
In February 1998, the Company effected a three-for-two split (the
"Stock Split"). All share and per share data included in this report
have been restated to reflect the stock split.
Stock Option Plan
The Company has a Stock Option Plan which currently provides for
options to purchase up to 6,500,000 shares of Common stock. The Plan
provides for the granting of incentive stock options to all employees
and non-incentive stock options to all employees and certain
consultants at an exercise price equal to at least the fair market
value of a share of Common stock at the date of grant for incentive
options (other than for the holders of more than 10% of the
outstanding Common stock which must be at least 110% of the fair
market value on the date of grant) and at least 85% of the fair market
value on the date of grant for nonincentive options. Stock options are
generally exercisable in 33-1/3% annual increments commencing one year
after the date of grant and generally expire five years after the date
of grant.
The Company estimates the fair value of each stock option at the grant date
by using the Black-Scholes option-pricing model with the following weighted
average assumptions used for grants in 1998, 1999 and 2000, no dividend
yield, expected volatility of 60%, 46% and 73% risk-free interest rates of
5% to 7% and expected lives of approximately 2.5 years for 1998 and 1999
and 6.64 years for 2000. The weighted average fair market value for options
granted in 1998, 1999 and 2000 was $2.26, $2.23 and $3.83, respectively. If
compensation cost for the Company's stock option plan had been determined
in accordance with SFAS No. 123, net loss would have been increased in
1998, 1999 and 2000 by approximately $470,000, $121,000 and $497,000,
respectively, and loss per share would have been increased by $.03, $.01
and $.03, respectively.
The following table summarizes information about stock options outstanding
at December 31, 2000:
Number outstanding as of
December 31, Options Options
2000 outstanding exercisable
---------------------------------- ----------------- ----------------
Weighted
average
remaining Weighted Number Weighted
contractual average price exercisable average
life (years) exercise price
----------------------------- -------------- ----------------- ---------------- --- ---------------- -----------------
Range of exercise prices:
$1.02 - $2.92 1,003,748 .80 2.87 993,748 2.88
$2.96 - $5.63 1,447,416 2.81 5.19 900,913 5.23
$6.84 - $8.25 573,834 2.40 7.64 337,665 7.81
$9.25 - $10.00 260,000 2.20 9.41 214,167 9.43
----------------------------- -------------- ----------------- ---------------- --- ---------------- -----------------
3,284,998 2.08 5.24 2,446,493 5.00
----------------------------- -------------- ----------------- ---------------- --- ---------------- -----------------
Transactions under the Stock Option Plan are summarized as follows:
Weighted
average
Shares exercise price
--------------------------------------------- ---------------- -----------------
Shares under option at December 31, 1997 2,092,248 $4.40
Granted (at $4.88 to $9.25 per share) 1,432,500 6.40
Exercised (165,700) 3.85
Canceled (at $7.46 to $8.25 per share) (247,500) 7.82
--------------------------------------------- ---------------- -----------------
Shares under option at December 31, 1998 3,111,548 5.08
Granted (at $4.68 to $9.375 per share) 160,000 6.20
Exercised (62,551) 5.39
Canceled (at $1.50 to $5.42 per share) (62,500) 4.47
--------------------------------------------- ---------------- -----------------
Shares under option at December 31, 1999 3,146,497 5.14
Granted ($1.94 to $6.84 per share) 467,500 5.75
Exercised (138,333) 3.00
Canceled at ($2.96 to $10.00 per share) (190,666) 6.98
--------------------------------------------- ---------------- -----------------
Shares under option at December 31, 2000 3,284,998 5.24
--------------------------------------------- ---------------- -----------------
Options exercisable at December 31,:
----------------------------- ------------------
1998 1,470,715
1999 2,063,497
2000 2,446,493
----------------------------- ------------------
The Company granted options to consultants and certain other
professionals who provide services to the Company. These options have
been valued in accordance with SFAS 123 and are being expensed over
the vesting period of the options. The amounts expensed in 1998, 1999
and 2000 amounted to $843,400, $984,000 and $690,000, respectively.
The activity for these options is included in the table above.
At December 21, 2000 the Company had the following warrants
outstanding:
Grant Date Amount Exercise Price Maturity Reason for Grant
----------------- -------------- ------------------ ---------- -------------------
2000 574,374 $1.00 - $4.68 2005 Preferred Stock
2000 259,491 5.26 - 6.29 2005 Common Stock
2000 400,000 1.50 2005 Refinancing
2000 298,718 4.68 2005 Other
1999 270,690 4.68 2004 Preferred Stock
Prior years 429,600 1.67 2002 various financings
--------------
2,232,873
==============
All warrants are exercisable.
15. Segment Information
With the above-mentioned acquisition of Gordon in 2000, the Company
now operates under two business segments for financial reporting
purposes. The Company identifies operating segments based on, among
other things, the way that the Company's management organizes the
components of the Company's business for purposes of allocating
resources and assessing performance. Segment revenues are generated
from the sale of CCSI Technologies ("CCSI") and the manufacturing of
cosmetics, hair care and other personal care products ("Gordon"). The
Company defines segment profit as operating income before amortization
of goodwill, interest expense and income taxes. Summarized below are
the Company's segment sales and income (loss) by reportable segments
for the year ended December 31, 2000:
CCSI Gordon Consolidated
--------------------------------- -------------- --------------- ---------------
Revenue $ 80,400 $3,761,600 $ 3,842,000
Segment income (loss) (9,956,500) (274,000) (10,230,500)
Impairment and amortization of
goodwill 7,716,400
Net interest expense 1,549,500
Net loss (19,496,400)
Depreciation and other
amortization 728,900 209,400 928,300
Capital expenditures 78,300 7,200 85,500
Segment assets 8,619,200 3,730,100 12,349,300
Elimination of intercompany
balances (3,352,500)
Assets per balance sheet 8,996,800
--------------------------------- -------------- --------------- ---------------
16. Related Party
In connection with the Avon Settlement (see Note 6) in an earlier year
and her Transactions employment agreement, Mrs. Macfarlane, the
Company's CEO and a principal shareholder, was to receive a bonus of
$361,200, of which $110,900 had been paid. The remaining $250,300
accrued interest at the rate of 10% per annum. In December 1997, Mrs.
Macfarlane agreed to delay demand for payment until January 1999, and
further extended this payment to April 2000. At December 31, 1999,
$256,100, including interest, remained due. This amount was paid by
the Company in 2000.
Approximately $31,000 per year related to rent paid to Mrs. Macfarlane
under month-to-month lease agreements. Such rent is equal to Mrs.
Macfarlane's actual cost for such premises.
17. Commitments
Leases
Gordon leases its office and warehouse space under an operating lease
expiring in December 2006. The Gordon lease contains escalation
clauses, along with options to renew thereafter. Rent expense for the
period ended December 31, 2000 was $133,500. Future minimum lease
payments approximate $290,000 per year through 2006.
The Company leases its office and warehouse space on a month-to-month
basis. Rent expense under these leases totaled $383,400, $296,800 and
$266,000 in 2000, 1999 and 1998, respectively.
Retirement Plan
In 1997, the Company adopted a defined contribution plan which
provided for discretionary Company contributions for qualified
employees. The expense relating to this plan was $-0-, $-0- and
$93,200 in 2000, 1999 and 1998, respectively.
18. Quarterly Financial Information (Unaudited)
Unaudited quarterly financial information for the two years ended
December 31, 2000 is summarized as follows:
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
--------------------------------- ------------------ ------------------ ------------------- ------------------
2000
Net sales $ 38,600 $ 667,300 $ 1,724,000 $ 1,412,100
Gross profit/(loss) 17,900 174,700 329,800 (548,800)
Net loss (3,428,700) (2,959,100) (3,023,300) (10,085,300)
Loss per share (.26) (.20) (.19) (.75)
1999
Net sales - - 362,100 741,100
Gross profit/(loss) - - 315,800 (110,700)
Net loss (2,078,600) (3,892,700) (3,145,800) (3,690,900)
Loss per share (.13) (.33) (.21) (.26)
--------------------------------- ------------------ ------------------ ------------------- ------------------
In the fourth quarter of 2000, in light of the serious liquidity and
other problems at the Company and because of the lack of viable levels
of sales of its medical equipment, the Company recorded the following
impairment charges and write-offs:
---------------------------------------------- -----------------
Inventory $ 733,100*
Property and equipment 257,600
Gordon goodwill 5,276,500
Other intangibles 1,250,100
---------------------------------------------- -----------------
$7,517,300
============================================== =================
* Included in cost of sales
Also in the fourth quarter of 2000, the Company recorded an additional
deemed dividend of $2,325,000 relating to the adoption of EITF 00-27
(see Note 1).
19. Subsequent Events
Financing
The Company is currently negotiating proposals for financing the
Company. One proposal would include the purchase of 75% of Gordon
Laboratories for over 1 million (with a 9-month option to the Company
to purchase the shares of Gordon back for the purchase price plus
interest) and additional funds provided under a secured loan to the
Company. Another proposal would be for an equity financing. Such
proposals require negotiation of warrants to purchase the Company's
stock and are subject to satisfactory completion of due diligence,
negotiation, execution and delivery of definitive agreements by and
between the parties, the lifting of the suspension of trading of the
Company's common stock on the Nasdaq Small Cap Market (CCSI) and
compliance with the Net Asset Nasdaq listing requirement.
Litigation
On January 16, 2001, a lawsuit was commenced against the Company and
Darby Macfarlane in the federal district court for the Southern
District of New York entitled Richard Sommers and Linda Sommers v.
Chromatics Color Sciences International, Inc. and Darby S. Macfarlane.
The plaintiffs allege that certain statements purportedly made by or
on behalf of the Company concerning the Company's success, the extent
of use of the ColorMate System and the Company's cash flow constituted
violations of Section 10(b) of the Securities Exchange Act of 1934 and
SEC Rule 10b-5 promulgated thereunder and Section 12(a)(2) of the
Securities Act of 1933 as well as common law claims alleging
fraudulent misrepresentation, concealment and nondisclosure and seek
unspecified damages in an amount to be proven at trial. On March 1,
2001, the defendants moved to dismiss the complaint for failure to
state a claim upon which relief can be granted, for failure to plead
fraud with requisite particularity and for failure to comply with the
statutory requirements for federal securities fraud claims. No
decision has been rendered by the court on this motion. The defendants
believe that the allegations of the complaint are without merit and
intend to vigorously defend this action. The Company can not predict
the effects, if any, of the ultimate outcome of this matter.
Nasdaq SmallCap Market Listing ("Nasdaq")
Trading of the Company's stock on Nasdaq is condition upon the
Company's continuing to meet certain financial and stock price tests.
In 2001, the Company failed to meet certain of the tests. Further, in
March 2001, trading on the Company's stock was suspended by Nasdaq,
pending the Company providing certain information to Nasdaq. The
Company is currently negotiating with Nasdaq to resume trading in its
stocks.
20. Valuation Reserves
For the year ended December 31, 2000, the Company had the following
valuation reserves:
(a) Allowance for bad debts
Opening balance (per Gordon acquisition) $131,000
Additions/deletions -
----------
Balance, December 31, 2000 $131,000
==========
(b) Inventory reserve
Balance, January 1, 2000 -
Additions (see Note 18) 733,100
----------
Balance, December 31, 2000 $733,100
(c) Goodwill and other intangible assets
Balance, January 1, 2000 -
Additions (see Note 18) 6,784,200
-----------
Balance, December 31, 2000 $6,784,200
===========