ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
OPERATION
In
this
Quarterly Report, the terms "Company" and "Diomed Holdings" both refer to
Diomed
Holdings, Inc. The term "Diomed" refers to the Company's principal subsidiary,
Diomed, Inc. and its consolidated subsidiaries. We use the terms "we,", "our"
and "us" when we do not need to distinguish among these entities or their
predecessors, or when any distinction is clear from the context.
This
section contains forward-looking statements, which involve known and unknown
risks and uncertainties. These statements relate to our future plans,
objectives, expectations and intentions. These statements may be identified
by
the use of words such as "may," "will," "should," "potential," "expects,"
"anticipates," "intends," "plans," "believes" and similar expressions. These
statements are based on our current beliefs, expectations and assumptions
and
are subject to a number of risks and uncertainties. Our actual results could
differ materially from those discussed in these statements. Our 2006 Annual
Report on Form SEC 10-KSB (the "Annual Report") contains a discussion of
certain
of the risks and uncertainties that affect our business. We refer you to
the
"Risk Factors" on pages 19 through 34 of the Annual Report for a discussion
of
certain risks, including those relating to our business as a medical device
company without a significant operating record and with operating losses,
our
risks relating to the commercialization of our current and future products
and
applications, and risks relating to our common stock and its market
value.
In
view
of our relatively limited operating history, we have limited experience
forecasting our revenues and operating costs. Therefore, we believe that
period-to-period comparisons of financial results are not necessarily meaningful
and should not be relied upon as an indication of future performance. To
date,
we have incurred substantial costs to create or acquire our products. As
of
September 30, 2007, we had an accumulated deficit of approximately $103 million
including $18.4 million in non-cash interest expense, a $1,129,000 gain related
to the adjustment of the market value of a warrant liability, and $1,080,000
in
SFAS 123R compensation expense. We may continue to incur operating losses
due to
spending on research and development programs, clinical trials, regulatory
activities, sales, marketing, litigation, and administrative activities.
This
spending may not correspond with any meaningful increases in revenues in
the
near term, if at all. As of September 30, 2007, the Company had a cash and
short
term investment balance of $7.4 million.
The
following discussion should be read in conjunction with the Unaudited Condensed
Consolidated Financial Statements and Notes set forth above in this Quarterly
Report and the audited consolidated financial statements and notes in the
Annual
Report.
(1)
OVERVIEW
We
develop and commercialize minimally invasive medical procedures that employ
our
laser technologies and associated disposable products. Using our proprietary
technology, including our exclusive rights to U.S. Patent No. 6,398,777,
we
currently focus on endovenous laser treatment (EVLT(R)) of varicose veins.
We
also develop and market lasers and disposable products for photodynamic therapy
(PDT) cancer procedures and products for other clinical applications, including
dental and general surgical procedures.
In
developing and marketing our clinical solutions, we use proprietary technology
and aim to secure strong commercial advantages over competitors by obtaining
exclusive commercial arrangements, gaining governmental approvals in advance
of
others and developing and offering innovative practice enhancement programs,
including physician training and promotional materials. To optimize revenues,
we
focus on clinical procedures that generate revenues from both capital equipment
and disposable products, such as procedure kits and optical fibers.
Our
high
power semiconductor diode lasers combine clinical efficacy, operational
efficiency and cost effectiveness in a versatile, compact, lightweight,
easy-to-use and easy-to-maintain system. Along with lasers and single-use
procedure kits for EVLT(R), we provide our customers with state-of-the-art
physician training and practice development support.
In
2001,
we pioneered the commercialization of endovenous laser treatment (EVLT(R)),
an
innovative minimally invasive laser procedure for the treatment of varicose
veins caused by greater saphenous vein reflux. In September 2001, we were
the
first company to receive the CE mark of the European Economic Union for approval
for endovenous laser treatment with respect to marketing EVLT(R) in Europe.
In
January 2002, we were the first company to receive FDA clearance for endovenous
laser treatment of the greater saphenous vein. In December 2004, we received
FDA
clearance to expand the application of EVLT(R) to other superficial veins
in the
lower extremities.
EVLT(R)
was the primary source of revenue for the nine months of 2007, and will continue
to be our primary source of revenue through the remainder of the year. We
believe that EVLT(R) will achieve a high level of commercial acceptance due
to
its relatively short recovery period, immediate return to the patient's normal
routine barring vigorous physical activities, reduced pain and minimal scarring,
and reduced costs compared to other treatments for varicose veins. We developed
our EVLT(R) product line as a complete clinical solution and marketing model;
including a laser, disposable kit, clinical training and customized marketing
programs; to assist office-based and hospital-based physicians in responding
to
the growing demand for treatment of varicose veins in a minimally invasive
manner. We have also published a health insurance reimbursement guide to
assist
physicians in the reimbursement submission process. We believe that these
attributes, in addition to EVLT(R)'s superior clinical trial results, provide
EVLT(R) with a competitive advantage over competing traditional and minimally
invasive varicose vein treatment products.
We
expect
that as the number of EVLT(R) procedures increases, so will our sales of
associated disposable items. We believe that the U.S. represents the single
largest market for EVLT(R). We target our sales and marketing efforts at
private
physician practices, hospitals, and clinics and focus on specialists in vascular
surgery, interventional radiology, general surgery, interventional cardiology,
phlebology, gynecology and dermatology.
We
primarily use a direct sales force to market our products in the United States
and in select markets internationally, we also utilize a network of more
than 30
distributors to market our products abroad. In August 2005, we entered into
a
three year agreement with Luminetx, Inc. to acquire exclusive distribution
rights to the VeinViewer(TM) Imaging System for the sclerotherapy, phlebectomy
and varicose vein treatment markets in the United States and United Kingdom.
The
VeinViewer(TM) became commercially available in April 2006.
We
have
developed and maintain a website - www.EVLT.com - to assist both patients
and
physicians. EVLT.com provides patients with education about treatment options
and benefits of EVLT(R) and provides physicians with education about the
EVLT(R)
procedure. At www.EVLT.com, patients can also locate the nearest physician
performing EVLT(R) by inputting their city and state. We also maintain a
corporate website - www.diomedinc.com - which includes information about
the
Company and our physician support initiatives, among other things.
Our
management team focuses on developing and marketing solutions that address
serious medical problems with significant market potential. Our determinations
are based upon the number of procedures that may be conducted in a market
and
projections of the associated revenue. Currently, EVLT(R) applications fall
within this guideline, and we believe that photodynamic therapy may have
the
potential to do so at some time in the future. However, EVLT(R), and not
PDT, is
the emphasis of our current business plan. Although we have continued to
focus
on the development and growth of EVLT(R) sales both domestically and
internationally, we will continue to support the development and approval
of new
applications for PDT products and the development of enhancements to our
products in order to further improve their quality, effectiveness and
manufacturability.
(2)
RESULTS OF OPERATIONS
THREE
MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER
30, 2006
REVENUE
Diomed
delivered revenue for the three months ended September 30, 2007 of $6,355,000,
increasing approximately $1,034,000, or 19%, from $5,321,000 for the same
period
in 2006. Revenue from the EVLT(R) product line increased 24% over the same
period last year, including growth of 41% in disposable procedure product
revenue, demonstrating the continued and growing acceptance of EVLT(R) by
the
medical community and patients alike.
For
the
three months ended September 30, 2007, approximately $1,878,000, or 30%,
of our
total revenue was derived from laser sales, as compared to approximately
$1,980,000, or 37%, in the same period in 2006. For the three months ended
September 30, 2007, approximately $4,478,000, or 70%, of our total revenues
were
from sales of disposable fibers and kits, accessories, service and
VeinViewer(TM), as compared to approximately $3,341,000, or 63%, in the same
period in 2006. We expect the proportion of revenue derived from disposables
to
continue to increase as we establish a larger base of installed lasers and
the
number of EVLT(R) procedures performed grows.
The
increase in revenue is attributable primarily to:
-
increased penetration in the EVLT(R) market,
-
the
compounding impact of the recurring revenue stream from disposable sales
to both
new and existing customers, and
-
the
impact of increased acceptance of the EVLT(R) procedure and expanded
reimbursement coverage by health care insurers.
COST
OF REVENUE AND GROSS PROFIT
Cost
of
revenue for the three months ended September 30, 2007 was $3,540,000, increasing
approximately $498,000, or 16%, from $3,042,000 for the three months ended
September 30, 2006. The increase in cost of revenue in 2007 was primarily
a
result of increased revenues and increased indirect overhead costs.
Gross
profit for the three months ended September 30, 2007 was $2,815,000, increasing
approximately $536,000, or 24%, over the three months ended September 30,
2006.
Gross profit for the three months ended September 30, 2007 of 44.3% increased
1.5% over the three months ended September 30, 2006 primarily as a result
of
incremental sales volume. In the future, we have targeted gross profit as
a
percentage of sales of 60%, or more, consistent with other proprietary medical
device companies, as the EVLT® product line grows.
OPERATING
EXPENSES
RESEARCH
AND DEVELOPMENT EXPENSES for the three months ended September 30, 2007 of
$467,000, increased approximately $45,000, or 11%, from the three months
ended
September 30, 2006. We expect R&D expenditures to remain relatively stable,
as we continue to drive product functionality, cost improvements, and other
enhancements.
SELLING
AND MARKETING EXPENSES for the three months ended September 30, 2007 of
$2,927,000, increased approximately $240,000, or 9%, from $2,687,000 over
the
three months ended September 30, 2006. The increase was driven by higher
sales
commissions resulting from the increased sales volume and expansion into
new
markets, including Latin America. We anticipate continued increased expenses
resulting from increased commissions from expected increases in
volume.
GENERAL
AND ADMINISTRATIVE EXPENSES for the three months ended September 30, 2007
of
$2,999,000, increased approximately $1,092,000, or 57%, from $1,907,000 from
the
three months ended September 30, 2006. The increase was primarily attributable
to increased legal costs. Total third quarter 2007 patent litigation costs
of
approximately $1,653,000 increased $456,000 from the second quarter of 2007,
with a reduction in the continuing cost of litigation against our primary
laser
competitors offset by the cost of litigation in the VNUS case, as the trial
was
originally scheduled to begin on October 29, 2007. For the three months ended
September 30, 2007, general legal and patent related costs of $1,679,000
increased $984,000 compared to the three months ended September 30, 2006
and
included $1,457,000 of VNUS Medical Technologies, Inc. (“VNUS”) litigation
related costs and approximately $196,000 in follow-on costs from the first
quarter 2007 ‘777 patent trial.
As
a
result of the factors outlined above, the loss from operations for the three
months ended September 30, 2007 was $3,578,000, increasing $840,000 from
$2,738,000 for the three months ended September 30, 2006, as the expansion
of
our sales and marketing efforts during the quarter drove incremental revenue,
which was offset primarily by increases in selling and legal costs.
OTHER
EXPENSE, NET
Other
expense, net for the three months ended September 30, 2007 was $429,000,
compared to $242,000 for the three months ended September 30, 2006. Other
expense, net for the three months ended September 30, 2007 includes $313,000
in
non-cash interest expense related to debt discount amortization, compared
to
$96,000 in the third quarter of 2006.
NET
LOSS
Net
loss
for the three months ended September 30, 2007 was $4,008,000 compared to
$2,979,000 for three months ended September 30, 2006. In addition to the
additional $984,000 in legal costs, net loss for the third quarter of 2007
includes $313,000 in non-cash interest expense related to debt discount
amortization, compared to $96,000 in the third quarter of 2006..
NET
LOSS APPLICABLE TO COMMON STOCKHOLDERS
Net
loss
applicable to common stockholders for the three months ended September 30,
2007
was $8,747,000, or $0.29 per share, compared to $6,746,000, or $0.35 per
share,
for the three months ended September 30, 2006. Net loss applicable to common
stockholders includes weighted average shares outstanding of 30,067,031 and
19,448,728 for the three months ended September 30, 2007 and 2006,
respectively.
Net
loss
applicable to common stockholders for the three months ended September 30,
2007
included a non-cash, non-operating deemed dividend of $4,740,000 for the
value
of additional shares issuable to the 2006 preferred stockholders upon conversion
in consideration of the anti-dilution rights and consent and waiver of dividends
in the recent Hercules Debt transaction.
Net
loss
applicable to common stockholders for the three months ended September 30,
2006
included a $2,980,000 deemed dividend on the exchange of the 2005 Preferred
Stock. During 2006, we were required to pay cash dividends to holders of
the
2005 Preferred Stock. These cash dividends amounted to $149,000 during the
three
months ended September 30, 2006. In addition, because the dividend percentage
was considered below market for accounting purposes, we recorded an incremental
non-cash dividend of $167,000 to reflect an effective interest rate of 16.5%.
As
a result of the preferred stock financing closed on September 29, 2006, the
2005
Preferred Stock was exchanged for the 2006 Preferred Stock which does not
accrue
dividends unless a future dilutive financing is completed within certain
terms.
Therefore, we ceased paying or accreting these dividends on a prospective
basis
subject to the terms of the 2006 Preferred Stock. Upon completion of the
2006
preferred stock financing, we recorded a one-time, non-cash, non-operating
beneficial conversion feature charge of $469,938, since the market price
of our
common stock on September 29, 2006 of $1.20 was above the $1.15 effective
conversion price of the immediately convertible preferred stock.
NINE
MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER
30, 2006
REVENUE
Diomed
delivered revenue for the nine months ended September 30, 2007 of $18,767,000,
increasing approximately $2,794,000, or 17%, from $15,972,000 for the nine
months ended September 30, 2006. Revenue from the EVLT(R) product line increased
20% over the nine months ended September 30, 2006.
For
the
nine months ended September 30, 2007, approximately $6,054,000, or 32%, of
our
total revenue was derived from laser sales, as compared to approximately
$6,125,000 or 38%, in the nine months ended September 30, 2006. For the nine
months ended September 30, 2007, approximately $12,712,000, or 68%, of our
total
revenues were derived from sales of disposable fibers and kits, accessories,
service and VeinViewer™, as compared to approximately $9,847,000, or 62%, in the
nine months ended September 30, 2006. We expect the proportion of revenue
derived from disposables to continue to increase as we establish a larger
base
of installed lasers and the number of EVLT(R) procedures performed grows.
The
increase in revenue is attributable primarily to:
|
-
|
increased
penetration in the EVLT(R) market,
|
|
-
|
the
compounding impact of the recurring revenue stream from disposable
sales
to both new and existing customers,
and
|
|
-
|
the
impact of increased acceptance of the EVLT(R) procedure and expanded
reimbursement coverage by health care insurers.
|
COST
OF REVENUE AND GROSS PROFIT
Cost
of
revenue for the nine months ended September 30, 2007 was $10,322,000, increasing
approximately $1,536,000, or 17%, from $8,786,000 for the same period in
2006.
The increase in cost of revenue in 2007 was primarily a result of increased
revenues and increased indirect overhead costs.
Gross
profit for the nine months ended September 30, 2007 of $8,445,000, increased
approximately $1,259,000 from the same period in 2006. Gross profit as a
percentage of sales of 45% was equivalent to the same period in 2006. In
the
future, we have targeted gross profit as a percentage of sales of 60%,
consistent with other proprietary medical device companies, as the EVLT® product
line grows.
OPERATING
EXPENSES
RESEARCH
AND DEVELOPMENT EXPENSES for the nine months ended September 30, 2007 were
$1,245,000, an increase of $105,000, or 9%, from the same period in 2006.
We
expect R&D expenditures to remain relatively stable, as we continue to drive
product functionality, cost improvements, and other enhancements.
SELLING
AND MARKETING EXPENSES for the nine months ended September 30, 2007 were
$9,358,000, an increase of $868,000, or 10%, over 2006. The increase resulted
from higher sales commissions from the increased sales volume and expansion
into
new markets, including Latin America. We anticipate continued increased expenses
resulting from increased commissions from expected increases in
volume.
GENERAL
AND ADMINISTRATIVE EXPENSES for the nine months ended September 30, 2007
were
$9,048,000, an increase of $3,182,000, or 54%, from the same period in 2006.
The
increase was primarily attributable to incremental legal fees of $2,499,000.
For
the nine months ended September 30, 2007, legal and patent related costs
of
$4,711,000 included $2,150,000 of ‘777 patent litigation costs and $2,269,000 of
VNUS patent litigation costs.
LOSS
FROM OPERATIONS
Loss
from
operations for the nine months ended September 30, 2007 was $11,205,000,
an
increase of approximately $2,895,000 from the same period in 2006, as
incremental gains from incremental revenue were offset primarily by increased
selling and legal costs.
OTHER
(INCOME) EXPENSE, NET
Other
expense, net for the nine months ended September 30, 2007 was $750,000, compared
to other income, net of $684,000 for the same period in 2006. Other expense
for
the nine months ended September 30, 2007 includes a $406,000 reduction of
interest expense to adjust the amortization of the debt discount for the
three
months ended December 31, 2006 and the three months ended March 31, 2007
to
reflect the effective interest rate method as it was previously amortized
on a
straight line basis.
Other
income in the nine months ended September 30, 2006 includes a $971,000 non-cash,
non-operating gain, which represents the change in market value of the warrants
issued in the private placement financing completed on September 30, 2005.
Non-cash interest expense increased $239,000 compared to the same period
of
2006, as a result of an increase in the amortization of the debt discount
on the
2004 debentures. The 2004 debenture debt discount was increased as part of
the
anti-dilution impact of the private placement equity financing completed
in
2006. Other income in 2006 also includes the non-operating impact of the
theft
of trade secrets settlement with Vascular Solutions, Inc.
NET
LOSS
Net
loss
for the nine months ended September 30, 2007 was $11,955,000 compared to
$7,626,000 for the same period 2006. The increased legal costs offset the
expansion of Diomed's sales and marketing efforts during the year which drove
incremental revenue, as well as a $971,000 non-cash, non-operating gain recorded
in the nine months of 2006 for the decrease in the fair value of the warrant
obligation entered into on September 30, 2005.
NET
LOSS APPLICABLE TO COMMON STOCKHOLDERS
Net
loss
applicable to common stockholders for the nine months ended September 30,
2007
was $16,695,000, or $0.62 per share, compared to $12,007,000, or $0.62 per
share, for the same period 2006. Net loss applicable to common stockholders
includes weighted average shares outstanding of 27,029,974 and 19,447,812
for
the nine months ended September 30, 2007 and 2006, respectively.
Net
loss
applicable to common stockholders for the nine months ended September 30,
2007
included a non-cash, non-operating deemed dividend of $4,740,000 for the
value
of additional shares issuable to the 2006 preferred stockholders upon conversion
in consideration of the anti-dilution rights and consent and waiver of dividends
in the recent Hercules loan transaction.
Net
loss
applicable to common stockholders for the nine months ended September 30,
2006
included a $2,980,000 deemed dividend on the exchange of the 2005 Preferred
Stock. During 2006, we agreed to pay cash dividends to holders of the preferred
stock. These cash dividends amounted to $447,000 during the nine months ended
September 30, 2006. In addition, because the dividend percentage was considered
below market for accounting purposes, we recorded an incremental non-cash
dividend as an increase to the carrying value of the preferred stock to reflect
an effective interest rate of 16.5%. As a result, in the nine months ended
September 30, 2006, we recorded $484,000 of non-cash preferred stock dividend.
As a result of the preferred stock financing closed on September 29, 2006,
the
2005 Preferred Stock was exchanged for 2006 Preferred Stock, which does not
accrue dividends unless a future dilutive financing is completed within certain
terms. Therefore, we ceased paying or accreting these dividends on a prospective
basis subject to the terms of the 2006 Preferred Stock. Upon completion of
the
2006 preferred stock financing, we recorded a one-time, non-cash, non-operating
beneficial conversion feature charge of $469,938, since the market price
of our
common stock on September 29, 2006 of $1.20 was above the $1.15 effective
conversion price of the immediately convertible preferred stock.
(3)
LIQUIDITY, CAPITAL RESOURCES AND CAPITAL TRANSACTIONS
CASH
POSITION AND CASH FLOW
We
have
financed our operations primarily through private placements of common stock
and
preferred stock and private placements of convertible notes and short-term
notes
and credit arrangements. We had cash and short-term investment balances of
approximately $7,409,000 and $9,933,000 at September 30, 2007 and December
31,
2006, respectively.
CASH
USED IN OPERATIONS
Cash
used
in operations for the nine months ended September 30, 2007 was $7,451,000.
Cash
used in operations reflects the net loss of $11,955,000, which includes
$4,711,000 in legal and patent fees incurred in asserting our EVLT(R) patent,
and was partially offset by non-cash charges such as $528,000 of non-cash
interest and $591,000 for stock based compensation. The cash flow impact
of the
net loss was offset by changes in working capital items totaling approximately
$2,598,000 primarily attributed to increased accounts payable for patent
litigation fees.
CASH
PROVIDED BY INVESTING
Cash
provided by investing activities for the nine months ended September 30,
2007
was approximately $2,362,000, including proceeds from maturities of marketable
securities of $3,086,000, as we limited reinvestment as a result of cash
requirements, offset by purchases of computer and demonstration equipment
of
$294,000.
CASH
PROVIDED BY FINANCING
Cash
provided by financing activities for the nine months ended September 30,
2007
includes $5,142,000 in net proceeds borrowed under the Hercules Debt
transaction.
BANK
LINES OF CREDIT
Diomed,
Ltd., our United Kingdom-based subsidiary, utilizes an overdraft facility
as
well as an accounts receivable line of credit with Barclays Bank, limited
to the
lesser of (GBP)100,000 or 80% of eligible accounts receivable. As of September
30, 2007, Barclay’s had provided a temporary increase in the overdraft facility
up to approximately $279,000. At September 30, 2007, there were no additional
amounts available under this line. The credit line bears interest at a rate
of
2.5% above Barclays' base rate (5.75% at September 30, 2007) and borrowings
are
due upon collection of receivables from customers. As security for the line
of
credit, Barclay's Bank has a lien on all of the assets of Diomed Ltd., excluding
certain intellectual property. As of September 30, 2007, there was approximately
$279,000 outstanding and at December 31, 2006, there was approximately $223,000
outstanding under this line of credit.
FUTURE
AVAILABILITY OF CREDIT
Prior
to
entering into the Hercules term loan (as discussed below), other than the
security under the Barclays Bank line of credit, our assets were not subject
to
any liens or encumbrances. Therefore, these unencumbered assets were available
as security for credit facilities we might seek in the future. However, under
the terms of the convertible debentures that we issued on October 25, 2004,
we
agreed that, so long as at least 10% of the original principal amount of
any
debenture was outstanding, we would not incur indebtedness or create a lien
that
is senior to or having an equal priority with our obligations under the
debentures, except for purchase money security interests and otherwise to
the
extent that we do so in the ordinary course of our business. As of September
30,
2007, two of the three investors who purchased debentures in 2004 continued
to
hold debentures of at least 10% of the original principal amount. Also, under
the terms of the September 29, 2006 financing transaction, we agreed that
so
long as any investor owned at least 25% of the shares of preferred stock
initially purchased, we would not incur indebtedness (other than ordinary
course
trade payables and installment loans) in excess of $1 million (including
the
Barclays Bank line of credit) without prior approval of the holders of the
65%
of the outstanding 2006 preferred stock.
During
the third quarter of 2007, we obtained waivers from both the 2004 Debenture
holders and the 2006 preferred stockholders to incur senior secured indebtedness
under the Hercules term loan. We closed the Hercules term loan on September
28,
2007, in effect monetizing the $14.7 million damages award arising out of
our
‘777 patent litigation following the jury trial during the first quarter of
2007. We borrowed $6 million on September 28, 2007, before deduction of fees
and
expenses incurred in the transaction. We have the right, at our option, subject
to the terms and conditions of the term loan agreement, to borrow an additional
$4 million between January 31, 2008 and March 31, 2008.
As
a
result of the terms of this financing transaction, we agreed that, subject
to
certain permitted exceptions, we would not incur indebtedness, prepay or
repay
the convertible debentures or any other indebtedness.
We
plan
on using our available cash, the proceeds from the ‘777 patent judgment and our
operating revenue to fund our operations. If these resources are insufficient
to
fund our operations (for example, due to a delay in receiving the proceeds
of
the patent judgment), then we may need to obtain additional financing.
We would
intend to obtain any such needed financing by way of further equity investment,
as our access to debt financing is restricted.
Because
of the indebtedness that we incurred under the Hercules loan and the security
interests that we granted to Hercules and the 2004 debenture holders in
connection with the Hercules loan, our debt outstanding and our limited
ability
to offer collateral to a prospective lender, coupled with the agreements
that we
made with Hercules and the 2004 debenture holders and the 2006 preferred
stockholders, make it unlikely that additional debt financing would be
available
to us on acceptable terms.
2007
DEBT FINANCING TRANSACTION
On
September 28, 2007, we entered into a Loan and Security Agreement (the
“
Loan
Agreement
”)
with
Hercules Technology Growth Capital, Inc. (“
Hercules
”).
The
Loan Agreement provides for a term loan (the “
Loan
”)
of up
to $10 million in two tranches, an initial $6 million tranche, which was
funded
on September 28, 2007, and an additional $4 million tranche available at
our
option at any time during the period from January 31, 2008 through March
31,
2008. The net proceeds of the Loan are for our working capital
purposes.
The
Loan
is secured by our assets, including the $14.7 million judgment awarded to
Diomed, Inc. against AngioDynamics, Inc. and Vascular Solutions, Inc. in
our
lawsuit in which AngioDynamics and Vascular Solutions were found to have
infringed our EVLT® patent. We also granted Hercules a pledge of the shares of
Diomed, Inc., and a pledge of our wholly-owned United States subsidiaries
and a
share pledge of 65% of the outstanding shares of our wholly-owned United
Kingdom
subsidiary, Diomed Limited.
The
Loan
bears interest at the prime rate plus 3.20%, will be repayable on an
interest-only basis through June 30, 2008 and will thereafter become payable
in
24 equal monthly installments of principal and interest, with the final
installment due on July 1, 2010, at which time a deferred interest charge
of
9.5% of the funds borrowed will also be payable. When we borrowed $6 million
on
September 28, 2007, we recorded the deferred interest charge based on 9.5%
of
the $6 million, or $570,000, in other long-term liabilities on our balance
sheet
and included the amount in debt discount. Upon borrowing the additional $4
million, we will record the additional deferred interest charge of 9.5% on
$4
million, or $380,000 and include that amount as an additional debt discount.
The
Loan may be prepaid at our option, subject to a prepayment fee of 3% of the
funds borrowed (if prepaid during the first 12 months), 2% of the funds borrowed
(if prepaid during after twelve months but before 24 months) or 1% (if prepaid
at 24 months or thereafter).
We
agreed
to pay $320,000 of legal fees and investment expenses incurred by Hercules
in
connection with negotiating the Loan Agreement. We also accrued other related
legal costs and listing fees of approximately $338,000, and therefore recorded
$658,000 as debt financing costs on its balance sheet. This amount will be
amortized to interest expense using the effective interest method in the
statement of operations over the period through the estimated call date of
the
loan, October 25, 2008.
As
additional consideration, we also issued to Hercules warrants to purchase
up to
86,957 shares of our common stock at an exercise price of $0.70 per share,
with
a term of five years (the “
Lender
Warrants
”).
We
valued the warrants at $52,874 using the Black-Scholes Option Pricing Model
and
classified this amount as a discount to the Loan. We reviewed the terms of
the
warrant agreement and since a net cash settlement possibility exists until
we
receive listing approval from the AMEX, we determined that liability treatment
was appropriate in accordance with EITF 00-19. We recorded a warrant liability
in current liabilities for $52,874. This amount will be marked to market
each
reporting period until we receive listing approval from the AMEX at which
time
the amount will be reclassified to equity and no longer marked to
market.
We
paid
Hercules a $200,000 commitment fee in connection with the Loan at closing,
and
have agreed to pay a success fee of $900,000 on June 30, 2008 and 1% of the
gross consideration paid for our acquisition should a change of control occur.
We recorded the $900,000 success fee in accrued liabilities as it is payable
on
June 30, 2008.
Based
on
the above, we recorded a discount against the Loan of $1,722,874 representing
the commitment fee of $200,000, the success fee of $900,000, the fair value
of
the 86,957 warrants of $52,874, and the deferred interest of $570,000. This
amount will be accreted back to the Loan through charges against non-cash
interest expense using the effective interest method in the statement of
operations over the period through October 25, 2008.
Consent
by Holders of Variable Rate Convertible Debentures
The
terms
of the outstanding Variable Rate Convertible Debentures due October 2008
(the
“
2004
Debentures
”),
issued by us on October 25, 2004, provide that we may not incur indebtedness
that is senior to or
pari
passu
with the
indebtedness represented by the 2004 Debentures or grant a security interest
in
our assets. To enable us to enter into the Loan Agreement, on September 28,
2007, we negotiated for and obtained the consent of each of the four holders
of
2004 Debentures (the “
Debenture
Holders
”)
pursuant to an Agreement and Consent (the “
Debenture
Holder Consent
”).
Pursuant
to the Debenture Holder Consent, we amended and restated the 2004 Debentures
in
the form of an Amended and Restated Variable Rate Secured Subordinated
Convertible Debenture due October 2008 (the “
Secured
2004 Debenture
”)
by (i)
increasing the rate of interest from 400 basis points over six-month LIBOR
to
the greater of 10% and 500 basis points over six-month LIBOR, (ii) reflecting
the adjusted conversion price of the Secured 2004 Debentures of $0.70 per
share,
which adjustment results from the antidilution adjustment of the 2004 Debentures
caused by the issuance of the Lender Warrants (discussed under “Impact on
Outstanding Securities,” below) and (iii) granting a security interest in all of
our assets (and, as set forth in a guaranty by Diomed, Inc. of our obligations
under the Secured 2004 Debenture and a separate security agreement, the assets
of Diomed, Inc.), subordinated to the security interest granted to Hercules.
We
made certain representations, warranties and other agreements with the Debenture
Holders, including reimbursement of their legal fees, but paid no remuneration
for obtaining the Debenture Holder Consents.
The
Debenture Holders and Hercules entered into an Intercreditor Agreement, dated
September 28, 2007, acknowledged by us, pertaining to the creditors’ respective
rights to the collateral comprising their respective security interests in
our
assets. The Intercreditor Agreement enables Hercules to block us from repaying
the Secured 2004 Debentures when they become payable (October 25, 2008),
in
which case, under the Debenture Holder Consent, we agreed to repay Hercules
with
the proceeds of the judgment in the EVLT® patent litigation case, so long as we
have received at least $10 million from that $14.7 million judgment by that
time. We expect to prevail in the ‘777 patent litigation appeal and receive an
award in excess of $10 million. Therefore, we consider this a possible call
option and since the event will cause the Hercules Loan to be repaid
before
its scheduled maturity date for a fixed settlement amount. Therefore, we
determined that the debt discount amortization should occur over the period
to
the earliest call date so that the carrying amount of the debt at that date
is
equal to the settlement amount, using the effective interest rate method.
Therefore, the discount and the debt issuance costs will be amortized through
October 25, 2008.
We
will
use the effective interest rate method to recognize interest expense over
the
period until first possible call. If during the period, we determine that
the
possible repayment will differ from October 25, 2008, we will treat that
as a
change in estimate and recognize the remaining unamortized discount over
the
revised period.
Pursuant
to the anti-dilution rights under the 2004 Debenture agreements, as a result
of
the Lender Warants we were required to reduce the conversion prices for the
2004
variable rate convertible debentures from $1.15 to $0.70 and exercise prices
for
warrants issued under prior financing transactions.
We
determined that the conversion and exercise price changes were not modifications
to the terms of their respective agreements, but were executions of certain
rights within those agreements. Under EITF 00-27 “Application of Issue No. 98-5
to Certain Convertible Instruments” (“EITF 00-27”), Issue #7, t
he
Task
Force reached a consensus that if the terms of a contingent conversion option
do
not permit an issuer to compute the number of shares that the holder would
receive if the contingent event occurs and the conversion price is adjusted,
an
issuer should wait until the contingent event occurs and then compute the
resulting number of shares that would be received pursuant to the new conversion
price.
The
Hercules Loan transaction was the second time that the anti-dilution rights
of
the 2004 Debentures were triggered. Prior to the 2006 preferred stock financing,
the 2004 Debentures were convertible into 1,620,961 shares, and after the
2006
preferred stock financing the 2004 Debentures were convertible into 3,227,826
shares, as the conversion price was reduced from $2.29 per share to $1.15
per
share as a result of the 2006 preferred stock financing. After the
Hercules Loan the 2004 Debentures became convertible into 5,302,857 shares,
as
the conversion price was reduced from $1.15 per share to $0.70 per share
as a
result of the issuance of the Lender Warrants. The resulting incremental
intrinsic value from triggering the contingent feature is calculated as the
difference of 2,075,031 shares provided to the Debenture Holders due to their
anti-dilution rights multiplied by the market price of the common stock on
the
date of the original debt commitment of $2.26, totaling $4,689,570.
However,
as a result of the 2006 preferred stock financing, we had previously increased
the discount on the 2004 debentures up to the original proceeds allocated
to the
debt and therefore, can not increase the debt discount further. The debt
discount will continue to be accreted back to debt over the remaining term
of
the 2004 Debentures through charges against non-cash interest expense in
our
Statements of Operations. The balance of the debentures at September 30,
2007
was $1,568,355, net of unamortized discount of $2,143,645.
Consent
by Holders of Preferred Stock
The
terms
of the outstanding shares of Preferred Stock issued by us on September 29,
2006
also prohibit our incurrence of debt and the issuance of Common Stock
equivalents, such as the Lender Warrants, at a price lower than $1.15 per
share
exchange rate of the Preferred Stock (a “
Dilutive
Issuance
”),
and
provide that dividends must begin to accrue and be payable in the event of
a
Dilutive Issuance.
To
enable
us to enter into the Loan and the transactions contemplated thereby (including
the amended terms of the 2004 Debentures) and to avoid being required to
pay
dividends, we negotiated for and obtained the consent of the requisite holders
of Preferred Stock (the “
Preferred
Stockholders
”),
which
consent was provided under an Agreement and Consent (the “
Preferred
Stockholder Consent
”).
Pursuant
to the Preferred Stockholder Consent, we agreed that upon exchange of the
Preferred Stock in accordance with its terms, we will issue to the holders
of
the Preferred Stock that provided their consents to the Loan, in addition
to
those shares of Common Stock issuable upon such exchange, additional shares
of
Common Stock such that the holders of Preferred Stock that provided their
consents to the Loan will receive in total the number of shares of Common
Stock
as if the exchange rate of the Preferred Stock were $0.70 per share.
Under
the
Preferred Stockholder Consents, among other things, the Preferred Stockholders
that provided their consents to the Loan (i) permitted our incurrence of
indebtedness under the Loan and the amendments to the 2004 Debentures, (ii)
agreed that they had no rights to participate in the Loan, (iii) agreed to
limit
voting of their Preferred Stock to the number of underlying shares of Common
Stock at the exchange rate of $1.15 (without giving effect to the additional
shares we agreed to issue upon conversion), (iv) agreed to permit the issuance
of the Lender Warrant even though it is a dilutive issuance and (v) agreed
that,
notwithstanding the issuance the Lender Warrant or the adjustments to the
2004
Debentures, (1) no anti-dilution adjustment to the Preferred Stock would
occur
and (2) dividends would not begin to accrue or be payable on the Preferred
Stock
as a result of the Dilutive Issuance.
Under
EITF 00-27, t
he
Task
Force reached a consensus that if the terms of a contingent conversion option
do
not permit an issuer to compute the number of shares that the holder would
receive if the contingent event occurs and the conversion price is adjusted,
an
issuer should wait until the contingent event occurs and then compute the
resulting number of shares that would be received pursuant to the new conversion
price.
As
discussed above, the Preferred Stockholders had the contractual anti-dilution
right to receive both an increase in the number of shares and a decrease
in the
conversion price of their shares. However, for anti-dilution rights and for
consideration of their consents and waivers of dividends, we provided the
Preferred Stockholders with a separate conversion price adjustment which
in
effect allows the preferred stockholders to convert their preferred shares
into
common shares as if their conversion price was lowered to $0.70. Consequently,
the Preferred Stockholders are entitled to an additional 4,330,314 shares
upon
conversion.
We
calculated the result of the anti-dilution formula as defined under the 2006
Preferred Stockholder agreement and determined that the anti-dilution adjustment
would have resulted in a decrease to the conversion price from $1.15 to $0.80
and an increase in the number of shares issuable upon conversion of 2,947,019
shares. In accordance with EITF 00-27, we multiplied the additional 2,947,019
shares by the original market price on the closing date of $1.20, for a result
of $3,536,423.
The
residual 1,383,295 shares were deemed to be issued for consideration of the
consent and waiver and were therefore valued using the closing price of the
common stock on the day of closing the current transaction, $0.87, for a
value
of $1,203,466. The sum of these two values, $4,739,890 is analogous to a
dividend and recognized as a return to shareholders and has been included
as a
dividend on the 2006 Preferred Stock in our calculation of Net Loss Applicable
to Common Stockholders and Basic and Diluted Net Loss per Share.
Impact
on Outstanding Securities
As
stated
above, as consideration for the Preferred Stockholder Consents, we agreed
to
issue additional shares of common stock upon exchange of the Preferred Stock.
There were 673.6044 shares of Preferred Stock issued and outstanding,
exchangeable for a total of 6,736,044 shares of common stock, at an exchange
rate of $1.15 per share of common at $11,500 per share of Preferred Stock
prior
to the transaction. All of the holders of Preferred Stock provided their
consents. As a result, we were required to issue up to an additional 4,330,314
shares of its common stock at such time as the Preferred Stock is tendered
for
exchange, for a total of 11,066,358 shares.
Additionally,
the terms of certain of our currently outstanding securities (the “
Anti-dilution
Securities
”)
provide for adjustments to the effective price payable for shares of common
stock upon conversion or exercise of those Anti-dilution Securities when
we
complete certain future transactions and the effective price per share of
the
common stock or common stock equivalents that are issued in the future
transaction is less than the effective price per share under the terms of
the
Anti-dilution Security.
Accordingly,
our issuance of the Lender Warrant caused the following adjustments to
Anti-dilution Securities:
|
·
|
the
conversion price of the 2004 Debentures ($3.712 million principal
amount
outstanding at September 28, 2007) was reduced from $1.15 per share
of
common stock to $0.70 per share, which, when converted, will increase
the
number of shares of common stock to be issued from to 3,227,826
to
5,302,857, or, 2,075,031 shares;
|
|
·
|
the
exercise price of the warrants to purchase 2,657,461 shares of
common
stock issued to the investors in our financing transaction completed
October 28, 2004 (the “
2004
Warrants
”)
was reduced from $1.15 to $0.70 per share of common stock;
|
|
·
|
the
exercise price of the warrants to purchase 2,272,000 shares of
common
stock issued to the investors in our financing transaction completed
September 30, 2005 (the “
2005
Warrants
”)
was reduced from $1.98 to $1.75 per share, and the number of shares
of
common stock issuable upon exercise of the 2005 Warrants will increase
from 2,272,000 to 2,572,855, an increase of 300,855 shares;
|
|
·
|
the
exercise price of the warrants to purchase 370,000 shares of common
stock
issued to the designees of our former placement agent, Musket Research
Associates, Inc., in our financing transaction completed September
29,
2006 (the “
MRA
Warrants
”)
was reduced to $1.01 per share, and the number of shares of the
common
stock issuable upon exercise of the MRA Warrants will increase
from
370,000 to 418,995, an increase of 48,995 shares;
|
|
·
|
the
exercise price of warrants to purchase 73,539 shares of the common
stock
issued to designees of our former placement agent, Sunrise Securities
Corp. (the “
Sunrise
Warrants
”),
will be reduced from $1.15 to $0.70 per
share.
|
The
following table sets forth the numbers of shares of common stock underlying
the
Preferred Stock and the Anti-dilution Securities prior to the Loan and related
Debenture Holder Consents and Preferred Stockholder Consents, and the numbers
of
shares that will underlie the Lender Warrant, the Preferred Stock and the
Anti-dilution Securities giving effect to our entering into the Loan Agreement,
the Preferred Stockholder Consents and the adjustment to Anti-dilution
Securities:
|
Description
of Security
|
|
Current
Number of Underlying Common Shares
|
|
Number
of Underlying Shares following Transaction
|
|
Net
Increase in Underlying Common Shares
|
|
|
Lender
Warrants
|
|
|
0
|
|
|
86,957
|
|
|
86,957
|
|
|
Preferred
Stock
|
|
|
6,736,044
|
|
|
11,066,358
|
|
|
4,330,314
|
|
|
2004
Debentures
|
|
|
3,227,826
|
|
|
5,302,857
|
|
|
2,075,031
|
|
|
2004
Warrants
|
|
|
2,657,461
|
|
|
2,657,461
|
|
|
0
|
|
|
2005
Warrants
|
|
|
2,272,000
|
|
|
2,572,855
|
|
|
300,855
|
|
|
MRA
Warrants
|
|
|
370,000
|
|
|
418,995
|
|
|
48,995
|
|
|
Sunrise
Warrants
|
|
|
73,539
|
|
|
73,539
|
|
|
0
|
|
|
TOTAL
|
|
|
|
|
|
|
|
|
6,842,152
|
|
EQUITY
TRANSACTIONS
During
the nine month period ended September 30, 2007, the holders of 1,061.8303
shares
of preferred stock exchanged their shares of preferred stock into 10,618,303
shares of common stock. At September 30, 2007, 673.6044 shares of preferred
stock, convertible into 11,066,358 shares of common stock, were
outstanding.
At
December 31, 2006, we had 19,448,728 shares of common stock outstanding and
as a
result of the conversions of preferred stock during the nine months at September
30, 2007 the Company had 30,067,031 shares of common stock
outstanding.
COMMITMENT
FOR LUMINETX DISTRIBUTION AGREEMENT
On
August
5, 2005, we entered into a distribution agreement with Luminetx, pursuant
to
which Luminetx appointed us as a distributor and granted us the exclusive
right
to distribute and sell the Luminetx patented biomedical imaging system known
as
the VeinViewer(TM) Imaging System. The Agreement is limited to physicians
who
perform sclerotherapy, phlebectomies or varicose vein treatments, initially
in
the United States and the United Kingdom, with additional territories to
be
negotiated as VeinViewer(TM) receives regulatory clearance in other countries,
on terms to be agreed. Luminetx agreed to supply us with a certain minimum
number of VeinViewer(TM) systems for distribution by us at specified prices
during the term of the distribution agreement, initially three years. In
May
2007, we and Luminetx amended the agreement and revised the targeted number
of
VeinViewer(TM) systems to be purchased through December 31, 2007 and through
April 30, 2008 to better reflect current market development and positioning
strategies. The agreement was also amended so that both companies may sell
to
dermatologists who are not performing EVLT®. If we fail to purchase the annual
target number of VeinViewer(TM) systems prior to May 1, 2008, for any reason,
Luminetx may terminate the distribution agreement with written
notice.
(4)
CRITICAL ACCOUNTING POLICIES
In
the
opinion of management, these unaudited condensed consolidated financial
statements contain all adjustments considered normal and recurring and necessary
for their fair presentation. Interim results are not necessarily indicative
of
results to be expected for the year. These interim financial statements have
been prepared in accordance with the instructions for Form 10-QSB, and
therefore, do not include all information and footnotes necessary for a complete
presentation of operations, financial position, and our cash flows in conformity
with accounting principles generally accepted in the United States. We filed
our
2006 Annual Report on Form 10-KSB with the Securities and Exchange Commission
on
March 20, 2007, which included audited consolidated financial statements
for the
year ended December 31, 2006, and included information and footnotes necessary
for such presentation. These unaudited consolidated financial statements
should
be read in conjunction with the audited consolidated financial statements
and
the notes thereto included in our annual report on Form 10-KSB for the year
ended December 31, 2006.
Our
discussion and analysis of our financial condition, results of operations,
and
cash flows are based on our consolidated financial statements. The preparation
of these financial statements requires us to make estimates and judgments
that
affect the reported amounts of assets, liabilities, revenues and expenses,
and
related disclosure of contingent assets and liabilities. We have chosen
accounting policies we believe are appropriate to report accurately and fairly
our operating results and financial position, and we apply those accounting
policies in a consistent manner. As discussed in Item 6, "Management's
Discussion and Analysis of Financial Condition or Plan of Operation" of our
Annual Report on Form 10-KSB for the fiscal year ended December 31, 2006,
we
consider certain policies to be the most critical in the preparation of our
consolidated financial statements because they involve the most difficult,
or
subjective judgments about the effect of matters that are inherently uncertain.
We base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances, the results of
which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results
may
differ from these estimates under different assumptions or
conditions.
During
the first quarter 2007, we adopted the provisions of FASB Interpretation
No. 48,
Accounting
for Uncertainty in Income Taxes - An Interpretation of FASB Statement No.
109.
This
interpretation addresses the accounting for uncertainty in income taxes
recognized in a company’s financial statements in accordance with FASB Statement
No. 109,
Accounting
for Income Taxes
.
It
prescribes a comprehensive model for recognizing, measuring, presenting and
disclosing in the financial statements tax positions taken or expected to
be
taken in a tax return. It requires that only benefits from tax positions
that
are more-likely-than-not of being sustained upon examination should be
recognized in the financial statements. These benefits would be recorded
at
amounts considered to be the maximum amounts more-likely-than-not of being
sustained. At the time these positions become more-likely-than-not to be
disallowed, their recognition would be reversed. This interpretation is
effective for fiscal years beginning after December 15, 2006, with the
cumulative effect of the change in accounting principle recorded as an
adjustment to retained earnings. We adopted the provisions of FIN 48 effective
January 1, 2007.
Our
practice is to recognize interest and/or penalties related to income tax
matters
in income tax expense. Upon adoption of FIN 48 on January 1, 2007, we did
not
record any interest or penalties.
We
are
subject to taxation in the UK, US and various state jurisdictions. Our tax
years for 1998 and forward are subject to examination by the US tax authorities
due to the carryforward of unutilized net operating losses.
The
adoption of FIN 48 did not have a material impact on our financial condition,
results of operations or cash flows. At January 1, 2007, we had US net
operating loss (“NOL”) carryforwards of approximately $46 million and foreign
NOLs of approximately $20 million. At January 1, 2007, we had a net
deferred tax asset of approximately $25 million related to these NOLs. Due
to
uncertainties surrounding our ability to generate future taxable income to
realize these assets, a full valuation has been established to offset our
net
deferred tax asset. Additionally, the future utilization of our US NOL
carryforwards to offset future taxable income may be subject to a substantial
annual limitation as a result of Section 382 ownership changes that may have
occurred previously or that could occur in the future. In general, an
ownership change, as defined by Section 382, results from transactions
increasing the ownership of certain shareholders or public groups in the
stock
of a corporation by more than 50 percentage points over a three year period.
Since our formation, we have raised capital through the issuance of capital
stock which, combined with the purchasing shareholders’ subsequent disposition
of those shares, may have resulted in a change of control, as defined by
Section
382, or could result in a change of control in the future upon subsequent
disposition. If we have experienced a change in control at any time since
our
formation, utilization of the NOL carryforwards would be subject to an annual
limitation under Section 382. Any limitation may result in expiration of
a
portion of the NOL carryforwards before utilization. Any carryforwards that
will
expire prior to utilization as a result of such limitations will be removed
from
deferred tax assets with a corresponding reduction of the valuation
allowance. Due to the existence of the valuation allowance,
future changes in our unrecognized tax benefits related to NOLs will not
impact our effective tax rate.