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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities and
Exchange Act of 1934
For the fiscal year ended October 31, 1995
or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___ to ____
Commission file number: 0-13907
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BIO-VASCULAR, INC.
(Exact name of Registrant as specified in its charter)
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Minnesota 41-1526554
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(State of Incorporation) (I.R.S. Employer Identification No.)
2575 UNIVERSITY AVENUE, ST. PAUL, MINNESOTA 55114-1024
(Address of principal executive offices)
TELEPHONE NUMBER: (612) 603-3700
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Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 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 pursuant 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 January 3, 1996, 9,391,175 shares of Common Stock of the Registrant were
outstanding, and the aggregate market value of the Common Stock of the
Registrant (based upon the last reported sale price of the Common Stock on that
date by the Nasdaq National Market), excluding shares owned beneficially by
executive officers and directors, was approximately $104,476,822.
Part III of this Annual Report on Form 10-K incorporates by reference
information (to the extent specific sections are referred to herein) from the
Registrant's Proxy Statement for its Annual Meeting of Shareholders to be held
March 14, 1996 (the "1996 Proxy Statement").
Tissue-Guard-TM-, Peri-Strips-Registered Trademark-, Dura-Guard-TM-, Vascu-
Guard-Registered Trademark-, Supple Peri-Guard-TM-, Peri-Guard-Registered
Trademark-, Biograft-Registered Trademark-, Flo-Rester-Registered Trademark-,
Bio-Vascular Probe-TM-, VoxelView-Registered Trademark-, VoxelGeo-Registered
Trademark-, and Voxel Animator-TM- are trademarks of the Company.
PART I
ITEM 1 - BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
Bio-Vascular, Inc. develops, manufactures and markets proprietary specialty
medical products for use in thoracic, cardiac, neuro and vascular surgery
(the "Surgical Business"). The Company's products include the Tissue-Guard
product line and the BIOGRAFT peripheral vascular graft. The Tissue-Guard
product line includes various configurations of bovine pericardium (the thin
membrane surrounding the heart of cattle) processed using the Company's
proprietary tissue-fixation technologies. The Tissue-Guard products are used
in a wide variety of surgical procedures and are designed to reinforce,
reconstruct and repair tissue and prevent leaks of air, blood and other body
fluids. BIOGRAFT is used to bypass blocked blood vessels and is produced
from modified human umbilical veins. The Surgical Business also markets and
sells two surgical tools used in cardiac and vascular surgery. In addition,
the Company has an early stage medical imaging software business which
develops, markets and supports certain software products for interactive
visualization and analysis of three dimensional ("3-D") image data (the
"Medical Imaging Software Business").
The Company's PERI-STRIPS surgical staple line reinforcement product was
added to the Tissue-Guard product line in 1994 and has been primarily
responsible for the Company's revenue growth in fiscal 1994 and fiscal 1995.
PERI-STRIPS are special configurations of tissue produced from bovine
pericardium using proprietary tissue preservation, sterilization and other
tissue-fixation techniques developed by the Company. PERI-STRIPS are used
primarily in lung volume reduction ("LVR") surgery and other surgical
procedures on the lung. LVR surgery is performed principally on patients
with late-stage emphysema who have significantly reduced respiratory
function. During the procedure, a portion of each diseased lung is removed
from the patient to provide relief from the symptoms of emphysema.
PERI-STRIPS are designed to prevent air leakage at the surgical staple line
which is essential to successful LVR surgery. Early data available to the
Company suggests that after undergoing the procedure, patients have improved
breathing capacity, improved exercise tolerance and improved quality of life.
However, there presently does not exist a statistically significant body of
clinical data from which to draw conclusions concerning the efficacy and
long-term outcomes associated with the LVR procedure. The American Lung
Association estimates that in 1992 there were approximately 1.9 million
Americans suffering from emphysema. However, only a small portion of those
suffering from emphysema have late-stage emphysema and meet certain surgical
criteria and are therefore considered candidates for the LVR procedure.
The Company also manufactures and markets a number of other products in its
Tissue-Guard product line. DURA-GUARD, a dural patch used in cranial
surgery, is designed to reduce post-surgical adhesions and fluid leakage.
VASCU-GUARD, a vascular patch used primarily in carotid endarterectomy
procedures, is designed to improve tissue integration and reduce suture line
bleeding. In addition, the Company markets SUPPLE PERI-GUARD and PERI-GUARD
as a general soft-tissue patching material for use in specialty surgical
procedures.
In May 1994, the Company acquired Vital Images, a company involved in the
development, marketing and support of certain software products for
three-dimensional ("3-D") visualization and analysis of image data. In
August 1995 the Company granted an exclusive, perpetual, world-wide source
code license for its GeoScience imaging technology to a third party and is
now focused solely on medical applications of its imaging technology. See
"Management's Discussion and Analysis of Results of Operations and Financial
Condition - Overview" on page 28 of this Annual Report on Form 10-K. The
Company initially developed its VOXELVIEW high- speed, volume imaging
software as a research tool. The Medical Imaging Software Business has
further developed VOXELVIEW to provide complete and accurate 3-D rendering of
data collected by advanced scanning devices such as spiral computed
tomography ("CT") scanners, magnetic resonance imaging devices ("MRI"),
positron emission tomography scanning devices ("PET") and ultrasound
sonagraphic devices ("Ultrasound"). This product has been licensed to
approximately 80 medical and research institutions as a research tool. In
December 1995, the Company
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received notice of clearance from the U.S. Food and Drug Administration ("FDA")
to market VOXELVIEW as a clinical diagnostic and surgical planning device
when used in conjunction with CT and MRI image data. The Medical Imaging
Software Business is continuing development and commercialization of an
improved version of VOXELVIEW, which is intended to assist physicians in
clinical diagnosis, surgical planning and patient screening.
The Company was incorporated in Minnesota in July 1985. As used herein, the
term "Company" refers to Bio-Vascular, Inc. and its wholly-owned subsidiary
Vital Images, Incorporated, an Iowa corporation. The Company's principal
executive offices are located at 2575 University Avenue, St. Paul, Minnesota
55114-1024, and its telephone number is (612) 603-3700. Vital Images'
offices are located at 505 North Fourth Street, Fairfield, Iowa 52556, and
its telephone number is (515) 472-7726.
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Company's operations are divided into two business segments: the
Surgical Business and the Medical Imaging Software Business. Financial
information about these segments is contained on page 51 of this Annual Report
on Form 10-K.
(c) NARRATIVE DESCRIPTION OF BUSINESS
SURGICAL BUSINESS
MARKETS AND MEDICAL NEED
While the trend in medicine is toward less invasive surgical procedures,
substantially all surgical procedures, whether invasive or not, involve the
cutting of tissue to access, repair or remove tissue at or from the surgical
site. Tissue which has been cut must either be repaired or replaced so that
it can heal properly. Proper repair of incised tissue is dependent upon a
number of variables, including whether (i) the repair must be leakproof,
either for air, blood or other body fluids, (ii) the incised tissue is under
tension or subject to shrinkage such that additional tissue is needed to
bridge the two tissue surfaces to be repaired, and (iii) the tissue subject
to the repair must be strengthened to accommodate the natural stresses of the
human body. In certain instances, suturing of two tissue surfaces will be
effective. In other instances, however, a patching material, whether
autologous (from the body of the patient), synthetic (from man-made
materials) or tissue-based (from processed tissue), may be needed. The
Company's tissue-based products are designed to fulfill the medical need for
repairing human tissue and preventing leaks at the surgical site in certain
existing surgical procedures, as well as offering a potential medium for
techniques and procedures currently being developed.
The Company's core competency is the development and manufacture of
tissue-based implantable medical products for use by surgeons in various
surgical procedures where reinforcing, reconstructing and repairing tissue
and preventing leaks of air, blood or other body fluids is necessary for the
achievement of a favorable outcome. Historically, surgeons primarily used
autologous tissue in situations where tissue repair was necessary.
Harvesting the autologous material, which is still performed in many
circumstances, necessarily requires that the surgeon cut into another part of
the patient's body. The second surgical site increases the cost of the
procedure and lengthens the time the patient is under anesthesia, thereby
increasing the risk of complication and resulting in additional pain and
recovery time for the patient. To the extent a surgeon is confident that the
performance of a readily available medical product, whether tissue-based or
synthetic, is equal to or is better than the patient's own tissue, the
Company believes the surgeon will choose the tissue-based or synthetic
product to avoid a second surgical site as a means of reducing costs and
improving outcomes.
Surgical procedures that are enabled or enhanced by the Company's
tissue-based products include lung volume reduction, craniotomy, carotid
endarterectomy and lower limb vascular reconstruction. Sales of the
Company's products used in these procedures accounted for 50% of the
Company's net revenue in fiscal 1994 and 54% of the Company's net revenue in
fiscal 1995.
LUNG VOLUME REDUCTION (LVR) SURGERY. Emphysema, most often caused by
cigarette smoking, is a progressive disease of the lungs characterized by
air-filled expansions or pocket-like blisters in the tissue of the lungs.
Because the air in the lungs
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cannot be fully expelled, the effort to inhale fresh air becomes increasingly
difficult, pushing the lung walls farther out and causing the lungs to expand
and lose their elasticity. The diaphragm, the major muscle used for
breathing, becomes flattened and loses its ability to function. As the
disease advances and patient health is progressively compromised, breathing
becomes more difficult. Persons with late-stage emphysema eventually become
incapable of even minor physical activity and often become dependent upon
continuous supplemental oxygen even when at rest. As a result, late-stage
emphysema can significantly reduce mobility, leaving individuals with
late-stage emphysema unable to care for themselves or engage in normal daily
activities. Because of the weakened respiratory condition of these patients,
common illnesses involving pulmonary functions can result in emergency room
visits and hospitalization.
Non-surgical therapies for patients suffering from emphysema include (i)
bronchodilators (pills and inhalers), to open up airways to temporarily
relieve wheezing or shortness of breath, (ii) steroids, to reduce
inflammation in the airways, (iii) pulmonary rehabilitation to increase
endurance, and (iv) oxygen supplements to help decrease the feeling of
shortness of breath. Each of these non-surgical therapies, however, offers
only temporary relief and each becomes less effective as the disease
progresses. Data gathered by the Company indicates that the cost of
medication and oxygen supplements for late-stage emphysema patients can range
from $5,000 to $8,000 annually. In addition, for persons suffering the
effects of late-stage emphysema, the need for periodic emergency room care
can increase costs substantially.
Lung transplantation is the only known cure for emphysema. A lung transplant
surgical procedure, however, costs up to $250,000 and is typically used only
as a last resort because of the high degree of risk associated with the
procedure, an inadequate supply of donor lungs, and the requirement that the
patient receive anti-rejection drugs for the remainder of his or her
lifetime. Only 688 lung transplants were performed in the United States in
1994.
In the 1950's, a surgical procedure was developed to treat the symptoms of
late-stage emphysema by removing damaged lung tissue. Due to air leaks
around the suture lines, these experimental LVR procedures resulted in a high
mortality rate and long, painful post-surgical recovery periods. As a
result, the LVR procedure was abandoned. In the late 1980's, various
surgeons began to develop specialized techniques for accessing and resecting
the lung. The use of surgical staples was introduced to perform the LVR
procedure more quickly, a particularly important consideration in light of
the debilitated condition of the patients requiring the surgery. Despite many
advances in the LVR procedure, multiple small air leaks caused by the staples
in the lung continued to limit the effectiveness of the procedure. In 1994,
Dr. Joel Cooper, a pioneer in lung transplant surgery, modified the LVR
procedure using strips of SUPPLE PERI-GUARD to reinforce the staple line to
prevent air leakage around the staples.
During LVR surgery, the surgeon collapses one lung, while allowing the
patient to continue breathing with the other lung with supplemental oxygen.
Using a stapling device, the surgeon removes sections of damaged tissue,
typically 20% to 30% of each lung. The Company's PERI-STRIPS, manufactured
from processed bovine pericardium, are used to strengthen these staple lines
and prevent air leakage. By removing the most diseased tissue, the remaining
lung tissue has room to expand, improving breathing capacity by, among other
things, enabling the muscles used in breathing to regain their function and
allowing the rib cage and diaphragm to return to their normal size. The
Company estimates that the current cost of an LVR surgical procedure ranges
from $30,000 to $45,000 per procedure.
The American Lung Association estimates that in 1992 there were approximately
1.9 million Americans suffering from emphysema. The LVR procedure, however,
is currently only being performed on a small portion of these patients who
have late-stage emphysema and who meet certain criteria established by the
attending surgeons. Currently, most surgeons require that an LVR candidate
be less than 75 years old, quit smoking at least six months prior to LVR
surgery, have no documented history of heart disease or previous lung surgery
and have no other major diseases. In addition, most surgeons performing the
LVR procedure require that candidates have documented lung function testing
and chest x-rays detailing the severity of the condition. The Company
believes that the patient selection criteria will continue to be refined as
surgeons become more familiar with the LVR procedure and as long-term
clinical results become available.
While LVR surgery is not a cure for emphysema, the results from the procedure
to date are encouraging based on information available to the Company.
Generally, this information suggests that patients undergoing the procedure
have reduced
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shortness of breath, improved exercise tolerance and improved quality of
life. However, LVR surgery was only re-introduced into the United States in
late calendar 1993. As a result, the number of patients who have undergone
the procedure and for whom a clinically acceptable post-operative period of
evaluation has elapsed, while growing, is still relatively small. Similarly,
the number of physicians performing the procedure and from whom data and
reporting is available is small. Accordingly, there presently does not exist
a statistically significant body of clinical data from which to draw
conclusions concerning the efficacy and long-term outcomes associated with
the LVR procedure. The Company believes that patients who have received the
LVR procedure may require an additional year or more of follow-up examination
before the procedure can be properly evaluated by the medical community.
CRANIOTOMY. Craniotomies (surgical operations involving the brain and skull)
are typically performed to treat various brain conditions, such as tumors,
aneurysms, blood clots, head injuries and abscesses. To access the brain,
the surgeon is required to cut through several of the protective layers
surrounding the brain. The dura, the fibrous protective layer below the
skull, protects the brain and spinal cord from bacterial infection and trauma
and provides a fluid tight seal. Once the surgeon has cut through the scalp
and the skull, the dura must be cut with a scalpel or scissors and resected
to expose the brain.
After the specific brain condition has been treated by the surgeon, the dura
often must be closed to prevent cerebral spinal fluid leakage. While the
dura is often closed with direct suture, surgeons who consider the prevention
of fluid leakage to be critical to the success of the operation will use a
dural patch. Dural patches currently available are either autologous or are
produced form the processed cadaver tissue or bovine pericardium. The
Company's DURA-GUARD Dural Repair Patch is designed to be sewn to the dura to
close the incision by fusing to the native dura with little or no adhesion
(an abnormal union between two tissue surfaces not intended to be joined) to
the underlying brain cortex.
The Company estimates that in the United States approximately 100,000 cranial
operations were performed in 1994. Whether a dural patch is used in such
operations is subject to surgical conditions and surgeon discretion. Dural
patching is most often used when the dura shrinks after incision such that
sutures alone may not provide adequate closure.
CAROTID ENDARTERECTOMY. Stroke is the third leading cause of death in the
United States with an estimated 500,000 new cases per year. The build-up of
atherosclerotic plaque (fat deposits with a proliferation of fibrous
connective cells along the artery walls) in the carotid arteries (the
principal arteries located in the neck that supply blood to the brain)
increases the risk of stroke. A substantial portion of strokes is caused by
a fragment of atherosclerotic plaque breaking away from the inner wall of the
carotid artery and becoming lodged in an artery in the brain.
Drug therapy is often prescribed to treat the early indications of
atherosclerotic plaque build-up. If the condition progresses to a point
where drug therapy is not effective, surgical intervention may be required.
Carotid endarterectomy is a surgical procedure used to remove atherosclerotic
plaque build-up in the carotid artery. The endarterectomy procedure begins
with an incision in the internal carotid artery. A temporary shunt may be
inserted to maintain blood flow to the brain during the surgery. Once the
artery is opened, the plaque and inner layer of the artery are carefully
removed, and the incised artery must be repaired. Although the artery often
can be closed without a patch, use of an autologous or prosthetic patch is
often suggested to expand the artery, encouraging greater blood flow. In
addition, certain patients require patching due to the small size of their
carotid arteries, or in some patients with a normal carotid artery diameter,
a patch is used to decrease the incidence of post-operative stenosis or
occlusion.
While the Company estimates that in the United States approximately 100,000
carotid endarterectomy procedures were performed in 1994, the use of a
patching material in such procedures is subject to surgeon discretion. Once
a surgeon determines a vascular patch is necessary or desirable, the surgeon
has additional discretion in determining the type of patching material to
use. Characteristics of an effective vascular patch include the ability to
imitate human tissue, to exhibit good blood flow characteristics and to
reapproximate around sutures to prevent blood leaks. The primary patching
materials include autologous tissue, synthetic patches made out of
polytetraflurothylene ("PTFE"), silicone fabric or tissue-based patches
made out of bovine pericardium, such as VASCU-GUARD.
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LOWER LIMB VASCULAR RECONSTRUCTION. Certain diseases, such as diabetes, can
cause a restriction or occlusion in the arteries which provide blood to the
legs. If left untreated, insufficient blood flow can ultimately result in the
need for amputation. If drug therapy is not deemed an effective treatment based
upon the severity of the restriction or blockage, the use of a graft in
peripheral vascular reconstructive surgery may be needed. In this type of
surgical procedure, the surgeon can bypass the blocked artery to regain blood
circulation, thereby saving the affected limb. Diabetics, in particular, are
often at risk for amputation of a lower limb due to insufficient blood flow in
the femoral artery in the thigh. By implanting a graft from the upper portion
of the femoral artery to either the lower femoral artery or to the popliteal
artery blow the knee, the surgeon is able to increase blood flow below the site
of the restriction or blockage. Long-term patency (openness), and a thrombo-
resistant surface that provides smooth blood flow are essential qualities of an
effective graft.
Saphenous veins (autologous veins from the leg) typically provide the most
effective grafting material. In many instances, however, a suitable saphenous
vein may be unavailable in sufficient quantity or quality, and a substitute
graft must be used. The primary alternative substitute grafts involve synthetic
grafts made from PTFE or bio-synthetic materials or tissue-based grafts, such as
BIOGRAFT. The Company estimates that in the United States approximately 55,000
lower limb vascular reconstructions were performed in 1994.
The following table summarizes the Company's Surgical Business product lines and
primary products, the procedures in which such products are used and the type of
regulatory clearance obtained for such products:
REGULATORY
PRODUCT LINE PRODUCT APPLICATION REPRESENTATIVE PROCEDURE CLEARANCE
- ------------ ------------ ------------------------- ----------------------------- ----------
Tissue-Guard
PERI-STRIPS Staple line reinforcement Lung volume reduction/lung 510(k)
resection
DURA-GUARD Dural repair patch Craniotomy 510(k)
VASCU-GUARD Peripheral vascular patch Carotid Endarterectomy 510(k)
SUPPLE PERI- General soft tissue patch Various surgical procedures 510(k)
GUARD
PERI-GUARD Pericardial patch Various cardiovascular 510(k)
procedures
Biograft
BIOGRAFT Peripheral vascular Lower limb vascular
bypass graft reconstruction PMA
Surgical
Productivity Tools
BIO-VASCULAR Locator of arterial Various surgical bypass
PROBE blockages procedures 510(k)
FLO-RESTER Internal vessel occluder Coronary artery bypass 510(k)
graft surgery
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The following table summarizes the net revenue contributed by the Company's
primary Surgical Business products and various product lines for the periods
indicated:
YEARS ENDED OCTOBER 31,
PRODUCT/ -----------------------------
PRODUCT LINE 1993 1994 1995
- ------------ ---- ---- ----
(IN THOUSANDS)
Peri-Strips. . . . . . . . . . . . . . $ -- $ 685 $5,550
Tissue-Guard Product (excluding
Peri-Strips) . . . . . . . . . . . . . 891 990 1,845
Biograft . . . . . . . . . . . . . . . 1,770 1,525 1,198
Surgical Productivity Tools. . . . . . 1,646 1,700 1,825
TISSUE-GUARD PRODUCT LINE. The Company's Tissue-Guard products are all produced
from bovine pericardium. Many of the product characteristics and competitive
advantages of this product line are derived from the collagen configuration of
the bovine pericardium. Collagen, which is a fibrous protein found in all multi-
cellular animals, makes the pericardium durable and provides superior fluid
interface properties, similar to autologous tissue. These characteristics allow
for effective host tissue incorporation. Host cells deposit a collagen matrix on
the surface of the pericardial product, which helps the Tissue-Guard product
integrate into the host tissue and which the Company believes enhances the long-
term tensile strength (the maximum stress a material subjected to a stretching
load can withstand without tearing) of all the products in the Tissue-Guard
product line.
The Company processes the bovine pericardium using proprietary tissue-fixation
technologies. The tissue is treated with glutaraldehyde and other proprietary
chemical treatments to prevent degradation of the tissue and to render it
biologically compatible with the host tissue. As a result of the Company's
proprietary tissue-fixation technologies, the Tissue-Guard products have a shelf
life of three years and resist infection, which potentially reduces hospital
recovery time and the need for drugs and future surgical intervention. In
addition, according to studies commissioned by the Company, the tissue-fixation
technologies used by the Company reduce the level of residual glutaraldehyde
remaining in the processed tissue to less than six parts per million, resulting
in a lower incidence of host tissue inflammatory response and promoting host
tissue incorporation similar to the body's natural healing process.
Surgeons have indicated that different pericardial patch characteristics are
useful in different surgical procedures. Accordingly, depending on the
particular tissue-fixation technology used by the Company, the bovine
pericardium is processed into either SUPPLE PERI-GUARD or PERI-GUARD. While the
raw material used is the same, SUPPLE PERI-GUARD has greater elasticity and
flexibility than PERI-GUARD, which allows for greater conformity to the surgical
site. The Company's PERI-GUARD and SUPPLE PERI-GUARD products are produced in
square or rectangular sheets of different sizes, ranging from 4 cm x 4 cm to
12 cm x 25 cm. SUPPLE PERI-GUARD is produced for use as a multi-purpose
material designed for reinforcing, reconstructing and repairing tissue and
preventing leaks of air, blood and other body fluids. Each of such products
has received 510(k) clearance from the FDA as a general soft-tissue patch.
The products in the Tissue-Guard product line described below are special
configurations of SUPPLE PERI-GUARD designed to enable specific surgical
procedures.
PERI-STRIPS. PERI-STRIPS, staple line reinforcements, are currently used
primarily in LVR surgery but are also used for lobectomy (removal of a lobe),
excision/destruction of a lesion and segmental resection of the lung. The key
competitive features of PERI-STRIPS include the following:
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- - REAPPROXIMATION. Due to the elastic-like nature of the collagen fibers in
the tissue, PERI-STRIPS reapproximate (close around) surgical staples to
prevent pulmonary air leaks at the staple site.
- - PREVENTS ENLARGEMENT. The elasticity of PERI-STRIPS prevents staple holes
from enlarging, which could lead to additional air leaks and require
additional surgery.
- - REINFORCEMENT. The use of PERI-STRIPS strengthens the entire staple line,
which makes it more durable and less likely to tear. Also, PERI-STRIPS are
thin enough to allow for staple lines to be overlapped, which is often
required during the LVR procedure.
- - SLEEVE CONFIGURATION. The sleeve configuration of PERI-STRIPS is customized
to fit disposable, reusable and endoscopic staplers of varying sizes and
produced by different manufacturers. The sleeve configuration allows for
greater ease of use and reduced surgical time resulting in lower costs.
The Company estimates its net revenue per LVR procedure to be approximately
$1,500.
DURA-GUARD. DURA-GUARD, a dural repair patch, is primarily used in craniotomy
procedures when the dura must be repaired and suturing without a patch is not
deemed sufficient. DURA-GUARD offers advantages over competitive dural patches
produced from autologous or cadaver tissue. Harvesting autologous tissue
necessarily involves a second surgical site, thereby increasing costs and
recovery time. Cadaver tissue is subject to rigorous tissue bank regulations,
which could impact upon the availability of such tissue, and is considered by
some to present a greater risk of disease transmission than bovine pericardium.
Certain other competitive advantages of DURA-GUARD relate to the specific
benefits produced by the physical properties of DURA-GUARD in connection with
the craniotomy procedure. Observations in the course of subsequent surgical
procedures on patients receiving DURA-GUARD patches have shown that there is
little or no adhesion formation on the DURA-GUARD surface that faces the
cerebral cortex, a complicating factor following any cranial surgery. In
addition, Company commissioned studies have shown that fibrous bone cells invade
the DURA-GUARD surface facing the cranium, as they do the human dura, inviting
good host tissue incorporation. The collagen configuration of the processed
bovine pericardium in DURA-GUARD reapproximates around the sutures used to affix
the patch, thereby providing a barrier between the skull and the tissue layers
underlying the dura and preventing the leakage of cerebrospinal fluid. To date,
synthetic materials have been unable to perform as effective dura substitutes
and have been associated with late subdural hematoma formation (bleeding between
the dura and the brain).
VASCU-GUARD. VASCU-GUARD, a vascular repair patch, is primarily used in carotid
endarterectomy procedures when the carotid artery must be repaired and closing
the vessel without a patch is not deemed sufficient. VASCU-GUARD offers
advantages over competitive carotid artery repair patches produced from
autologous tissue or synthetics. The use of autologous tissue necessarily
involves a second surgical site and results in increased costs and additional
recovery time. Synthetic patches, which lack the collagen configuration of
tissue, do not reapproximate around sutures as does the VASCU-GUARD product,
thereby increasing the risk of suture line bleeding and resulting in longer
operating times. In addition, unlike synthetic patches, the physical attributes
of VASCU-GUARD imitate human tissue and certain characteristics associated with
human tissue. Specifically, Company commissioned studies have shown that, once
healed, VASCU-GUARD supports endothelialization (growth of a cell layer normally
lining the interior of blood vessels) and its non-thrombogenic blood flow
surface imitates the blood flow characteristics of autologous vessels. In
addition, its pulsatility (ability to reflect movement signifying the rhythmic
pumping of the heart) allows the surgeon to readily verify normal blood flow
after implantation.
BIOGRAFT . BIOGRAFT, a peripheral vascular graft manufactured from human
umbilical veins, is indicated for use in lower limb vascular reconstructions
when a saphenous vein is not available. BIOGRAFT offers advantages over
competitive vein grafts produced from synthetics, like PTFE, due to its thrombo-
resistant surface which provides smooth blood flow and minimizes turbulence and
risk of occlusion. Other competitive advantages of BIOGRAFT include its long-
term patency and its similarity to an autologous blood vessel, minimizing
intimal hyperplasia (a build up of cells on the interior of the blood vessel
which results in restricted blood flow). In addition, a knitted and supportive
Dacron mesh is placed around the graft, which allows
8
for easier handling and promotes tissue integration for strength and stability.
SURGICAL PRODUCTIVITY TOOLS. FLO-RESTER AND BIO-VASCULAR PROBE. The Company's
FLO-RESTER products are vessel occluders manufactured from medical grade
silicone. The FLO-RESTER products are designed to interrupt blood flow in
arteries and to stent them (hold them open) during surgery, thereby facilitating
the suturing together of vessels. These products are primarily used during
coronary artery bypass graft surgeries in which blood is routed past the heart
through a heart-lung bypass machine in order to keep the heart free of blood
during surgery. During such procedures, incidental blood flow obstructs the
surgeon's view of the operative site and interferes with precise suturing. FLO-
RESTER consists of a flexible shaft with small bulbs at each end that are
inserted into the blood vessel at the point where the artery bypass is sutured
to the artery to stop the blood flow. Competitive procedures involve external
occlusion through the use of clamps, snares or tapes. The BIO-VASCULAR PROBE is
a flexible shaft with varying sizes of bulbous tips on either end. Surgeons use
the BIO-VASCULAR PROBE to locate occlusions or blockages in arteries and to
ascertain the blood flow characteristics of arteries. The BIO-VASCULAR PROBE is
inserted and fed into an artery. When the tip of the probe meets resistance, the
surgeon is able to identify the exact location of the occlusion. The BIO-
VASCULAR PROBE is then extracted and a bypass is completed below the occlusion.
In addition, the Probe can be used to atraumatically lift the edge of the
incision to assist the surgeon in accurately placing sutures, which can improve
the functioning of bypass grafts.
RESEARCH AND DEVELOPMENT
The Company generally allocates its research and development resources among
three broad functions in its Surgical Business: supporting current products
through training of Company personnel and writing and publishing research papers
on existing products; developing product line extensions by improving current
products or developing new applications for current products; and developing new
products for surgical uses that utilize the Company's proprietary technologies
and core competencies in tissue processing and bio-materials.
As an integral part of both its research and development and sales and marketing
strategies, the Company strives to involve its surgeon-customers to a large
extent in its product development activities. The Company consults with selected
surgeons frequently as to market needs and assessments of products under
development. The Company believes that this practice allows it to receive
surgeon assessments of products in development at an early stage.
The Company's Surgical Business research and development staff currently
consists of three scientists and two technicians. The Surgical Business also
expands its research and development activities through the use of external
consultants and research staff and facilities at research centers and hospitals
on an as-needed basis. The Company spent approximately $643,000, $414,000 and
$240,000 on research and development for the Surgical Business in fiscal 1995,
1994 and 1993, respectively. For information about Company-wide research and
development expenses, see the Consolidated Financial Statements on page 39 of
this Report.
MARKETING
The sales and marketing strategy of the Surgical Business includes developing
and maintaining a close working relationship with the hospitals and surgeons
which purchase and use the Company's products in order to assess and satisfy
their needs. The Company's current primary marketing focus is assisting in the
education of surgeons in the use of PERI-STRIPS in LVR surgery through
sponsorship of workshops and training programs. These workshops and training
sessions are being conducted in the United States, Canada and certain European
and Far Eastern countries. The Company estimates that approximately 500 surgeons
have been trained in LVR surgery as of the end of fiscal 1995. The Company also
sponsors surgeon workshops and training programs in the use of BIOGRAFT.
The Company's sales and marketing strategy is also designed to ensure that the
Company has an innovative "first in the mind of the customer" focus that
results in timely and effective marketing programs and new product
introductions. These programs include surgical trade shows, support of the
presentation of clinical data and new product information by key physicians,
limited direct-mail campaigns and the development of strategic physician
alliances and utilization of the
9
Company's scientific advisory boards. The Company believes these efforts to
be cost effective in producing awareness of, and loyalty to, the Company's
products.
The Company's Surgical Business products are sold to hospitals and surgeons
worldwide. For the fiscal years ended October 31, 1995, 1994 and 1993,
approximately 17%, 30% and 33% of the Company's Surgical Business net revenue,
respectively, were to international markets. The decrease in the percent of
Surgical Business net revenue attributed to international markets during fiscal
1995 was primarily due to increases of sales of PERI-STRIPS in the United
States. The majority of the Company's Surgical Business international sales are
in Europe.
In the United States, the Company sells its Surgical Business products through a
combination of 13 distributors and independent sales representatives managed by
the Surgical Business' regional sales managers. To further strengthen the direct
relationship between the Company and the end users of its products, the Company
requires distributors to provide the Company with the names and addresses of
such end users and the Company ships products directly to end users for a
limited period of time when there is a new product application. In addition to
strengthening customer relationships, this practice provides the Company with
some protection in the event a distributor is terminated and resists providing
the Company with customer lists.
Internationally, the Company's Surgical Business products are sold through 31
distributors. In some situations, sales in a country may occur through more than
one distributor due to distributors' varying market strengths and focus.
In fiscal 1995, three domestic distributors accounted for the following
percentages of the Surgical Business' gross revenue: Futuretech, Inc., (21%);
Cardio Medical Products, (12%); and Life Systems, Inc., (17%). In fiscal 1994,
the Surgical Business had no single customer or distributor who accounted for
10% or more of the Surgical Business' gross revenue. In fiscal 1993, one
domestic distributor accounted for 11% of the Surgical Business' gross revenue.
The Company currently has written agreements with 19 of its domestic and
international independent sales representatives and distributors. These
agreements generally impose limited geographic exclusivity and minimum purchase
obligations on the Company's independent sales representatives and distributors.
However, significant overlap occurs in many of the Company's international
distribution agreements. These agreements are typically terminable upon breach
of the agreement by the distributor, including breach of the minimum sales
obligations imposed by the agreement, as well as certain extraordinary events.
The Surgical Business' marketing and sales department and its national and
international distribution network is managed by the Vice President of Marketing
and Sales. The Surgical Business' marketing and sales department currently
consists of 15 employees. These employees include domestic and international
sales managers, domestic regional sales managers, product managers and customer
service personnel.
COMPETITION
The Company's Surgical Business competes primarily on the basis of product
performance, service and price. The Company believes that product performance is
the single most important factor in selling any of its products and develops and
produces its products accordingly. The surgical products market in which the
Company competes is characterized by intense competition. This market is
dominated by established manufacturers that have broader product lines, greater
distribution capabilities, substantially greater capital resources and larger
marketing, research and development staffs and facilities than the Company. Many
of these competitors offer broader product lines within the Company's specific
product market, particularly in the Company's surgical tool product markets
and/or in the general field of medical devices and supplies. Broad product lines
give many of the Company's competitors the ability to negotiate exclusive, long-
term medical device supply contracts and, consequently, the ability to offer
comprehensive pricing for their products, including those that compete with the
Company's products. By offering a broader product line in the general field of
medical devices and supplies, competitors may also have a significant advantage
in marketing competing products to group purchasing organizations, health
maintenance organizations and other managed care organizations that increasingly
seek to reduce costs through centralization
10
of purchasing functions.
The Company is not aware of any tissue or synthetic products that are
configured for use with surgical staplers in LVR surgery which compete with
PERI-STRIPS. To the best of the Company's knowledge, the FDA has not cleared
for marketing any staple line reinforcement product, other than PERI-STRIPS,
for use in LVR surgery. To the Company's knowledge, the dural patches that
are currently available and compete with DURA-GUARD are either autologous or
are produced from processed cadaver tissue, including TutoplastTM, a
processed cadaver product manufactured by Biodynamics International, Inc. In
addition to specifically configured patches, there are multi-purpose patches
made from bovine and other types of animal tissue that compete with the
Company's SUPPLE PERI-GUARD, PERI-GUARD, and VASCU-GUARD products, including
bovine pericardium products produced by Medtronic, Inc. and Baxter
International Inc. The Company does not believe that these alternative bovine
pericardium products have specific FDA marketing clearance for use in the
lung, although such products are FDA cleared for pericardial closure and soft
tissue repair. In addition, synthetic multi-purpose patches made out of PTFE
or silicone fabric are currently available. W. L. Gore & Associates, Inc.,
manufacturer of Gore-Tex-Registered Trademark-, is believed to have a
prominent position in the synthetic patch market. Synthetic patches are
generally cheaper to produce and to the extent that comparable synthetic
patches are available and effective in procedures, the Company faces
significant price competition for its Tissue-Guard products. The Company
believes, however, that the collagen characteristics exclusive to tissue, the
special configuration of its Tissue-Guard products and the proprietary
tissue-fixation technology (SUPPLE PERI-GUARD, PERI-STRIPS, DURA-GUARD and
VASCU-GUARD) and patented (PERI-GUARD) tissue-fixation technology employed by
the Company offer significant product performance advantages over competing
products.
Alternative treatments and competitive products to BIOGRAFT include drug
therapies and surgical procedures that use autologous or synthetic grafts.
Once the decision has been made to use surgical intervention, surgeons
generally prefer the patient's own vessels for lower limb vascular
reconstruction. When the patient's own vessels are not available in
sufficient quality or quantity, surgeons choose a prosthesis graft such as
BIOGRAFT or synthetic grafts made from expanded PTFE produced by W. L. Gore &
Associates, Inc., IMPRA, Inc. or other grafts made of bio-synthetic materials.
MANUFACTURING
The Company manufactures all of its Surgical Business products except the
BIO-VASCULAR PROBE at its St. Paul, Minnesota facility. In July 1995, the
Company moved to a new 36,000 square foot facility, which more than doubled
its total space and nearly quadrupled its manufacturing capacity. The Company
acquires bovine pericardium for use in the Tissue-Guard product line from a
private independent contractor who obtains the tissue from local United
States Department of Agriculture inspected meat packing facilities. The
Company acquires human umbilical cords for use in BIOGRAFT from various
hospitals throughout the United States. The Company has not experienced any
product shortages arising from interruptions in the supply of any raw
materials or components, and has identified alternative sources of supply for
such raw materials and components.
The BIO-VASCULAR PROBE is manufactured to the Company's specifications by a
contract manufacturer, with certain final cleaning, packaging and
sterilization testing procedures performed by the Company at its St. Paul
facility. While the Company has not experienced any interruption in supply of
this product to date, it has not identified any alternative source of supply
and any significant interruption in supply of this product in the future
could have an adverse effect on the Company's sales of the BIO-VASCULAR PROBE.
MEDICAL IMAGING SOFTWARE BUSINESS
GENERAL. The Medical Imaging Software Business develops and markets 3-D
volume imaging software products for the visualization and analysis of
imaging data for medical applications. The Medical Imaging Software Business
is conducted through the Company's wholly-owned subsidiary, Vital Images,
which was acquired in May 1994. Prior to its acquisition by the Company,
Vital Images also developed and produced 3-D volume imaging software for use
in geoscience applications. In August 1995, the Company granted an
exclusive, perpetual source code license to CogniSeis for the
-11-
Company's geoscience product which focused the Company exclusively on
medical applications for its software technology. See "Management's
Discussion and Analysis of Results of Operations and Financial
Condition--Overview" on page 28 of this Report.
The Company's Medical Imaging Software Business is continuing development of
VOXELVIEW, the first product developed by Vital Images for medical
applications. VOXELVIEW provides complete and accurate 3-D rendering of data
collected by advanced medical imaging devices such as spiral CT scanners, MRI
imaging devices, PET scanning devices, and ultrasound devices. The 3-D images
rendered by VOXELVIEW are intended to enhance the ability of radiologists,
surgeons and other physicians to screen for specific pathologies, diagnose
pathological conditions and plan surgical procedures.
INDUSTRY BACKGROUND. The use of CT scan, MRI, PET and Ultrasound is
widespread in the U.S. medical community and, to a lesser extent, in other
industrialized countries. CT scan, MRI, PET and Ultrasound capture and record
digital information describing the dimensions and properties of scanned
objects. Historically, these imaging devices produced digital output in a
variety of proprietary formats. The imaging scanner manufacturers have now
adopted an international standard called DICOM3 that greatly simplifies the
process of using a VOXELVIEW-powered workstation in conjunction with the
latest generation of imaging systems. In the United States, the market for
CT and MRI scanners has evolved as scanners with higher resolution and faster
data acquisition have been developed. VOXELVIEW 's value to the end-user
increases with the speed and greater sophistication of the imaging equipment
in use.
While the number of imaging devices used in hospitals and clinics is large,
the use of 3-D rendering of imaging data collected by such devices has been
exploited primarily by leading medical institutions. Until now, the
workstations required to run 3-D volume visualization software were very
expensive, limiting the number of institutions which could afford them.
Additionally, the number of images that was able to be captured was low
enough that diagnosis could be done by viewing only 2-D slices. Recent
enhancements in scanner technology yield a greater number of images in much
more detail, which can only be efficiently "read" when rendered in 3-D. The
Company believes that its volume rendering technology will be more effective
in analyzing data than the mathematically modeled "surface rendering"
approach used by others.
PRODUCTS AND PRODUCT DEVELOPMENT. VOXELVIEW is an interactive, volume
imaging and analysis software system designed to accept large volumes of data
from any medical digital imaging technology, manipulate the data at high
speeds and display it in accurate 3-D images. VOXELVIEW is based upon a high
speed volume renderer, the Voxel Engine, which can image volume data at a
speed which permits "real-time" viewing of data sets. VOXELVIEW has been
designed to enhance the ability of radiologists, surgeons and other
physicians to screen for specific pathologies, diagnose pathological
conditions and plan surgical procedures. The Company has licensed VOXELVIEW
software packages to approximately 80 medical and research institutions as a
research tool. Currently, VOXELVIEW only operates on high-speed
graphics-oriented work stations marketed by Silicon Graphics, Inc. ("Silicon
Graphics").
The Company recently completed development of VOXELVIEW 2.5, an updated and
improved version of VOXELVIEW. The Company is developing VOXELVIEW 2.5 so
that it can be marketed to a broader group of medical institutions. Versions
of VOXELVIEW will (i) improve the product's interface qualities and make it
more user-friendly, and (ii) enable the product to operate on work stations
manufactured by companies other than Silicon Graphics, and be directed
towards specific applications. In December 1995, the Company received notice
of clearance from the Food and Drug Administration ("FDA") to market
VOXELVIEW as a clinical diagnostic and surgical planning device when used in
conjunction with CT and MRI image data. The Company has also adopted the
industry standard graphics language, OpenGL-Registered Trademark-, which
should enable the Company's products to operate on hardware platforms
manufactured by companies such as Hewlett-Packard Company and IBM. There can
be no assurance that the Company will be able to successfully commercialize
VOXELVIEW 2.5.
The Company has also developed a modular enhancement to VOXELVIEW called
VOXEL ANIMATOR, which allows the user to create "fly throughs." A "fly
through," for example, would allow a radiologist to perform virtual
endoscopies by navigating through the 3-D data of patients' blood vessels
and/or organs to detect disease. This technology is designed to assist the
physician in lowering patient risk and diagnostic cost and achieving better
surgical outcomes.
-12-
MARKETS. Having received notice of FDA clearance to market VOXELVIEW in
December 1995, the Company is currently finalizing the marketing plan for
this product. The Company intends initially to target 250 of the largest
academic medical institutions and an additional 300 tertiary care
institutions. As the price of high speed workstations decrease, the
marketing focus will be expanded to a broader audience of medical
institutions.
The Medical Imaging Software Business plans to continue its strategy of
direct marketing within the United States while using distributors and other
marketing partners internationally. The Company also has an OEM agreement
with Precision Therapy, Inc. (""PTI"), a leading supplier of radiation
treatment planning systems, under which the Company has granted PTI an
exclusive license for the use of a portion of VOXELVIEW technology for use as
a tool in radiation planning therapy. To date, revenue from this agreement
has not been material. The Company intends to seek other advantageous OEM
and third party relationships that will increase its ability to reach
attractive markets.
RESEARCH AND DEVELOPMENT. The majority of the Medical Imaging Software
Business' employees are engaged in research and development. The Company also
collaborates with researchers at several universities and maintains close
ties with lead engineering groups at Silicon Graphics. The Company is
currently concentrating its research and development efforts on improving
VOXELVIEW as a medical diagnostic tool, including working on refinements that
will increase clinical applications of VOXELVIEW by improving human interface
qualities, making the product more user-friendly. The Company spent
$1,357,000, $1,255,000 and $719,000 on research and development in the
Medical Imaging Software Business in fiscal 1995, 1994 and 1993,
respectively. In addition, the Company recognized revenues of $115,220,
$105,050 and $122,250 in fiscal 1995, 1994 and 1993 with regard to customer
sponsored research and development. For information about Company-wide
research and development expenses, see the Consolidated Financial Statements
on page 39 of this Report.
COMPETITION. The medical digital imaging market in which the Company
competes is characterized by intense competition. This market is dominated by
established manufacturers of imaging equipment that have broader product
lines, greater distribution capabilities, substantially greater capital
resources and larger marketing, research and development staffs and
facilities than the Company. The Company competes with major imaging
equipment vendors, such as GE Medical Systems, Picker International Inc. and
Siemens AG, who currently offer 3-D rendering or will do so in the near
future. These large equipment vendors have an entrenched position in major
radiology departments and significantly greater marketing resources than the
Company. In addition, the Company competes with other medical imaging
software developers, including ISG, Inc. and Cemax, Inc., which offer
competing after-market software for medical imaging and these competitors
currently have greater marketing and distribution resources and capabilities
than the Company.
The Company competes primarily in two ways. First, the Company specializes in
direct volume rendering technology and has developed a high level of
expertise in the effective implementation of this technology, resulting in
much higher levels of data fidelity than other 3-D methods used in medical
applications. Second, the Company has developed a unique feature of its
imaging software, VOXEL ANIMATOR, allowing a user to conduct "fly through"
examinations similar to a virtual reality environment. The Company believes
that no competitor has developed this "fly through" capability.
GOVERNMENTAL REGULATION
The manufacture and sale of the Company's surgical and medical imaging
products are subject to regulation by numerous governmental authorities,
principally the FDA and corresponding foreign agencies. In the United States,
the FDA administers the Federal Food, Drug and Cosmetics Act and amendments
thereto contained in the Safe Medical Devices Act of 1990. The Company is
subject to the standards and procedures respecting manufacture and marketing
of medical devices contained in the Federal Food, Drug and Cosmetics Act and
the regulations promulgated thereunder and is subject to inspection by the
FDA for compliance with such standards and procedures.
These regulations classify medical devices as either Class I, II or III
devices, which are subject to general controls, special controls or premarket
approval requirements, respectively. All Class I and II devices as well as
some Class III devices marketed prior to the effective date of the Medical
Device Amendments of 1976 can be cleared for marketing pursuant to
-13-
a 510(k) pre-market notification, establishing that the device is
"substantially equivalent" to a device that was legally marketed prior to
May 28, 1976, the date on which the Medical Device Amendments of 1976 became
effective. The 510(k) pre-market notification must be supported by data
establishing the claim of substantial equivalence to the satisfaction of the
FDA. The process of obtaining a 510(k) clearance typically can take several
months to a year or longer. If substantial equivalence cannot be established,
or if the FDA determines that the device or the particular application for
the device requires a more rigorous review, the FDA will require that the
manufacturer submit a PMA application that must be carefully reviewed and
approved by the FDA prior to sale and marketing of the device in the United
States. The PMA application must contain the results of clinical trials, the
results of all relevant prototype tests, laboratory and animal studies, a
complete description of the device and its components, and a detailed
description of the methods, facilities and controls used for manufacturing,
including the method of sterilization and its assurance. In addition, the
submission must include the proposed labeling, advertising literature and
training methods, if applicable. Most Class III devices are subject to the
PMA requirements rather than the 510(k) pre-market notification procedure.
The process of obtaining a PMA can be expensive, uncertain and lengthy,
frequently requiring anywhere from one to several years from the date of FDA
submission, if approval is obtained at all. Moreover, a PMA, if granted, may
include significant limitations on the indicated uses for which a product may
be marketed. FDA enforcement policy strictly prohibits the marketing of
approved medical devices for unapproved uses. In addition, product approvals
can be withdrawn for failure to comply with regulatory standards or the
occurrence of unforeseen problems following initial marketing.
Of the Company's current products, BIOGRAFT and PERI-GUARD (when marketed as
a pericardial patch) are Class III devices. BIOGRAFT received marketing
clearance from the FDA pursuant to a PMA, while PERI-GUARD received clearance
for use as a pericardial patch as the result of a 510(k) submission.
PERI-STRIPS (as marketed in both strip and sleeve configurations),
VASCU-GUARD, DURA-GUARD, PERI-GUARD (when marketed as a patch for soft tissue
deficiency), SUPPLE PERI-GUARD (when marketed as a patch for soft tissue
deficiency and as a pericardial patch) and both the disposable and reusable
FLO-RESTER and the BIO-VASCULAR PROBE have all been classified as Class II
medical devices and have received 510(k) marketing clearance from the FDA.
The Company's Medical Imaging Software VOXELVIEW 2.5 is also a Class II
medical device which received notice of market clearance in December 1995.
Both the United States and Europe have recently focused attention on the
safety of tissue banks, spurred by incidents of the transmission of human
disease during tissue transplantation. In the United States, recent FDA draft
regulations have outlined requirements for tissue banks. The legislation has
specifically excluded medical devices subject to FDA review, including
preserved umbilical cord vein grafts such as BIOGRAFT. As a result, the
Company does not expect BIOGRAFT to be subject to tissue bank regulations in
the United States, including the expensive donor screening and donor testing
procedures. In response to the increased scrutiny of umbilical cord vein
grafts, the Company commissioned an independent virology laboratory to test
BIOGRAFT for viral inactivation. The results of the testing demonstrated that
BIOGRAFT'S chemical manufacturing processes inactivate a variety of viruses,
resulting in a sterile product. The Company has informed the FDA of these
test results and does not anticipate that the FDA will impose additional
regulatory requirements on BIOGRAFT. There can be no assurance, however, that
the FDA will not impose additional regulatory requirements on BIOGRAFT at
some later date or that BIOGRAFT would be able to meet any such new
requirements.
The Company is also subject to regulation in most of the foreign countries in
which it sells its products with regard to product standards, packaging
requirements, labeling requirements, import restrictions, tariff regulations,
duties and tax requirements. Many of the regulations applicable to the
Company's products in such countries are similar to those of the FDA. The
national health or social security organizations of certain of such countries
require the Company's products to be qualified before they can be marketed in
those countries. In Japan, a potentially significant market for the Company's
products, clinical trials of certain of the Company's products are required
before such products can be cleared for sale in the Japanese market. To date,
this has delayed the Company's market entry in some cases, but has not
ultimately prevented sales in Japan of any of the Company's devices sold in
the United States. The Company relies on its independent distributors to
comply with the majority of the foreign regulatory requirements, including
registration of the Company's products with the appropriate governmental
authorities. To date, the Company has been successful in complying with the
regulatory requirements in most foreign countries in which its products are
marketed, although the responsible authorities in France have raised concerns
regarding the Company's products produced from bovine tissue. If France
prohibits sales of Tissue-Guard products, it is not expected
-14-
to have a material adverse effect on the Company. Although the Company does
not anticipate that any other EU countries will prohibit the sale of
Tissue-Guard products, such prohibition by certain EU countries could have a
material adverse effect on the Company's business, financial condition and
results of operation.
The Company is subject to periodic inspections by the FDA, whose primary
purpose is to audit the Company's compliance with good manufacturing
practices ("GMP") established by the FDA and other applicable government
standards. Strict regulatory action may be initiated in response to audit
deficiencies or to product performance problems. The Company believes that
its manufacturing and quality control procedures are in compliance with the
requirements of the FDA regulations.
The Company's new manufacturing facilities and processes are also undergoing
an inspection and audit process by the British Standards Institute ("BSI")
in conjunction with the Company's efforts to achieve compliance with the
requirements of the MDD issued by the EU. The BSI is the "Notified Body"
that the Company has selected to verify that the Company's quality system
conforms with the ISO 9001 international quality standard and that its
products conform with the "essential requirements" set forth by the MDD for
the class of products produced by the Company. Certification by BSI of
conformity with both the ISO 9001 standard and the MDD essential requirements
would enable the Company to prepare a Declaration of Conformity supporting
the placement of the "CE" mark on the Company's products. The CE mark would
enable the Company's products to be marketed, sold and used throughout the
EU, subject to limited "safeguard" powers of member states. Presently, the
CE mark is not required to be affixed to the Company's products (or those of
its competitors) sold in the EU, but may be affixed during a transition
period currently in effect and which began January 1, 1995. This transition
period will end on June 15, 1998, when all of the Company's current products
(and those of its competitors) will be required to comply with the essential
requirements in order to be marketed in the EU. BSI completed a
pre-assessment of certain of the Company's facilities and processes in May
1995, identifying areas requiring a moderate degree of modification to comply
with the essential requirements. A second pre-assessment focusing on other
aspects of the Company's operations was completed in October 1995, and a
final assessment has been tentatively scheduled for April 1996. Authority to
prepare a Declaration of Conformity will require the successful completion of
a final audit by BSI and submission and clearance of a dossier on each of the
Company's products, demonstrating compliance with the essential requirements
of the MDD. The Company believes that these steps will be completed by the
summer of 1996, although there can be no assurance that the Company will be
successful in receiving certification by BSI.
The future regulatory environment for BIOGRAFT in Europe is unclear. The MDD
explicitly excludes from coverage medical devices derived from human tissue;
however, certain European medical device manufacturers are actively lobbying
for the re-inclusion of such devices in the MDD. If this effort is
successful, the earliest date for applying for CE mark approval for BIOGRAFT
is expected to be 1998. In addition, if extensive donor screening and donor
testing requirements are imposed, such requirements could make it
uneconomical to sell BIOGRAFT in Europe even under the CE mark. As a result
of significant problems with their blood supply, France has passed national
laws and regulations requiring extensive donor screening and testing on
products derived from human tissue. Accordingly, BIOGRAFT is not being sold
in France. It is not known whether a CE mark for BIOGRAFT would override such
national requirements or whether other countries in the EU will adopt
regulations similar to those of France. The Company is seeking BIOGRAFT
registration in Germany, but cannot predict when or if it will achieve such
registration. BIOGRAFT is not marketed generally in Germany, but rather is
prescribed by physicians on a prescription-by-prescription basis. If the CE
mark is unavailable for BIOGRAFT or if the requirements for obtaining a CE
mark are too burdensome, the Company will seek country-by-country
registration of the product where such registration requirements exist. The
Company cannot predict when or if it would obtain such registrations.
The financial arrangements through which the Company markets, sells and
distributes its products may be subject to certain federal and state laws and
regulations in the United States with respect to the provision of services or
products to patients who are Medicare or Medicaid beneficiaries. The "fraud
and abuse" laws and regulations prohibit the knowing and willful offer,
payment or receipt of anything of value to induce the referral of Medicare or
Medicaid patients for services or goods. In addition, the physician
anti-referral laws prohibit the referral of Medicare or Medicaid patients for
certain "Designated Health Services" to entities in which the referring
physician has an ownership or compensation interest. Violations of these laws
and regulations may result in civil and criminal penalties, including
substantial fines and imprisonment. In a number
-15-
of states, the scope of fraud and abuse or physician anti-referral laws and
regulations, or both, have been extended to include the provision of services
or products to all patients, regardless of the source of payment, although
there is variation from state to state as to the exact provisions of such
laws or regulations. In other states, and, on a national level, several
health care reform initiatives have been proposed which would have a similar
impact. The Company believes that its operations and its marketing, sales and
distribution practices currently comply in all respects with all current
fraud and abuse and physician anti-referral laws and regulations, to the
extent they are applicable. Although the Company does not believe that it
will need to undertake any significant expense or modification to its
operations or its marketing, sales and distribution practices to comply with
federal and state fraud and abuse and physician anti-referral regulations
currently in effect or proposed, financial arrangements between manufacturers
of medical devices and other health care providers may be subject to
increasing regulation in the future. Compliance with such regulation could
adversely affect the Company's marketing, sales and distribution practices,
and may affect the Company in other respects not presently foreseeable, but
which could have an adverse impact on the Company's business, financial
condition and results of operations.
THIRD PARTY REIMBURSEMENT AND COST CONTAINMENT
The Company's surgical products are purchased primarily by hospitals and
other users which then bill various third-party payors for the services
provided to the patients. These payors, which include Medicare, Medicaid,
private health insurance plans and managed care organizations, reimburse part
or all of the costs and fees associated with the procedures utilizing the
Company's products. Through fiscal 1995, the Company's medical imaging
products have been purchased by a limited number of medical and research
institutions for research applications and have, therefore, not been subject
to reimbursement issues.
The availability and level of reimbursement from third-party payers is
significant to the Company's business. For Medicare carriers, the United
States Healthcare Finance Administration ("HCFA"), an agency of the federal
government, establishes a national coverage policy, including the amount to
be reimbursed, for coverage of claims submitted for reimbursement related to
a specific procedure. Private health insurance plans and managed care
organizations make their own determinations regarding coverage and
reimbursement based either upon ""usual and customary" fees or,
increasingly, upon a similar prospective payment system.
During the past several years, the major third party payers have
substantially revised their reimbursement methodologies in an attempt to
contain their healthcare reimbursement costs. Medicare and Medicaid
reimbursement for inpatient hospital services is based on a fixed amount per
admission based on the patient's specific diagnosis. As a result, any
illness to be treated or procedure to be performed will be reimbursed only at
a prescribed rate set by the government that is known in advance to the
healthcare provider. If the treatment costs less, the provider keeps the
difference. If it costs more, the provider cannot bill the patient for the
rest. Frequently, reimbursement is reduced to reflect the availability of a
new procedure or technique, and as a result hospitals are generally willing
to implement new cost saving technologies before these downward adjustments
take effect. No separate payment is made in most cases for products such as
the Company's when they are furnished or used in connection with inpatient
care. Any amendments to existing rules and regulations which restrict or
terminate the reimbursement eligibility (or the extent or amount of coverage)
of medical procedures using the Company's products or the eligibility (or the
extent or amount of coverage) of the Company's products could have an adverse
impact on the Company's business, financial condition and results of
operations.
In response to the focus of national attention on rising health care costs, a
number of changes to reduce costs have been proposed or have begun to emerge.
There have been, and may continue to be proposals by legislators and
regulators and third-party payors to curb these costs. There has also been a
significant increase in the number of Americans enrolling in some form of
managed care plan, and over 80% of hospitals participate in or have
agreements with HMOs. It has become a typical practice for hospitals to
affiliate themselves with as many managed care plans as possible. Higher
managed care penetration typically drives down the prices of health care
procedures, which in turn places pressure on medical supply prices. This
causes hospitals to implement tighter vendor selection and certification
processes, by reducing the number of vendors used, purchasing more products
from fewer vendors and trading discounts on price for guaranteed higher
volumes
16
to vendors. Hospitals have also sought to control and reduce costs over the
last decade by joining group purchasing organizations or purchasing
alliances. The Company cannot predict what continuing or future impact these
practices, the existing or proposed legislation, or such third-party payor
measures may have on its future business, financial condition or results of
operations.
Because the Company's surgical products are primarily used in thoracic,
cardiac, neuro and vascular surgeries, changes in reimbursement policies and
practices of third party payors with respect to these surgeries could have a
substantial and material impact on sales of the Company's products. The
development or increased use of more cost effective treatments for diseases
requiring these surgeries could cause such payors to decrease or deny
reimbursement for such surgeries or to favor these other treatments over
surgical treatment.
Recent developments concerning reimbursement of LVR surgery are likely to
have a material adverse effect on the Company's business and results of
operations. Generally, Medicare had been reimbursing hospitals and surgeons
for LVR surgery since the procedure was re-introduced in 1994. LVR surgery
uses PERI-STRIPS, the product which has been primarily responsible for the
Company's growth in net revenue and net income in recent periods (see
"Surgical Business--Markets and Medical Need, Lung Volume Reduction Surgery"
on page 3 of this report). Recently, HCFA decided that it did not have enough
patient follow-up data to substantiate the safety and efficacy of LVR
surgery. On that basis, HCFA decided to cease reimbursement of LVR surgery
until its technical assessment committee ("TAC") could complete an evaluation
of the safety and efficacy of the procedure. TAC has set February 13, 1996
as the final date for surgeons to submit patient data. It is reasonably
expected that once the data is received by TAC any decision regarding
reimbursement will take, at a minimum, two months and possibly a year or
more. HCFA's decision to deny reimbursement for LVR surgery is expected to
have a material adverse effect on the Company's net revenue and net income at
a minimum in the first and second quarters of fiscal 1996, and may continue
to have such an effect in future periods. While the Company believes, based
on reported outcomes, that HCFA will eventually approve reimbursement for LVR
surgery, the Company cannot say with any certainty when, or if, the
reimbursement of LVR surgery will be approved. The Company believes that LVR
procedures reimbursed by Medicare constitute over 50% of total LVR
procedures. While the Company understands that private insurance companies
and managed care organizations (which the Company believes have been the
third-party payors responsible for a significant percentage of reimbursed LVR
procedures) are currently reimbursing LVR surgery based on their own
evaluation of the procedure and its outcomes, it is unknown whether these
private payors will change their reimbursement practices in light of HCFA's
decision. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Comparison of the Year Ended October 31, 1995 with
the Year Ended October 31, 1994, Net Revenue" on page 30 of this Report.)
INTELLECTUAL PROPERTY
The Company's success will depend in large part on its ability to preserve
its trade secrets, to obtain patent protection for its products and to
operate without infringing the proprietary rights of third parties. While the
Company has obtained or acquired a license to certain patents and applied for
additional United States and foreign patents covering certain aspects of its
products, no assurance can be given that any additional patents will be
issued, that the scope of any patent protection will exclude competitors or
that any of the Company's rights under such patents will be held valid if
subsequently challenged. The validity and breadth of claims covered in
medical technology patents involve complex legal and factual questions and
therefore may be highly uncertain. Whether or not the Company's patent
applications are granted, others may receive patents which contain claims
having a scope that covers products developed by the Company.
In July 1995, the Company received notice of allowance of a United States
patent which relates to the use of tissue on a removable backing and covers
the sleeve configuration of PERI-STRIPS. In connection with this same
application, the Company has filed divisional patent applications relating to
the combination of tissue with a surgical stapling gun and methods of
performing a surgical procedure to remove diseased tissue. There can be no
assurance that these divisional patent applications will be granted. Other
than the notice of allowance of a patent on the sleeve configuration of
PERI-STRIPS, the Company holds no patents and pays no royalties on SUPPLE
PERI-GUARD or the configurations of SUPPLE PERI-GUARD marketed as DURA-GUARD
or VASCU-GUARD. In December 1994, the Company entered into an agreement with
Surgical Research, Inc., which obligates the Company to pay royalties of
five percent (5%) on net revenue from sales of PERI-STRIPS for the life of
17
any patents, if any are issued, or for seven years. In December 1995, the
Company purchased the patent for PERI-GUARD. Previously, the Company had an
exclusive, worldwide, perpetual license to make, use and sell its PERI-GUARD
product for use in connection with the cardiovascular system. The Company
also has an exclusive, worldwide, perpetual license to make, use and sell its
FLO-RESTER product. The last of the patents related to the Company's
BIOGRAFT product expired in November 1993.
In its Surgical Business, the Company also relies on trade secrets and
proprietary know-how which it seeks to protect, in part, through
confidentiality agreements with employees, consultants and other parties.
SUPPLE PERI-GUARD, which is used in the manufacture of the majority of the
Company's Tissue-Guard products, is protected exclusively by trade secrets.
There can be no assurance that these agreements will not be breached, that
the Company will have adequate remedies for any breach, or that the Company's
trade secrets will not otherwise become known to or independently developed
by competitors.
In its Medical Imaging Software Business, the Company relies on a combination
of license agreements, contracts, confidentiality agreements and trade
secrets to establish and protect its proprietary rights in its technology.
The Company distributes its products under software license agreements that
grant customers licenses to use, rather than ownership of, the software. The
Company also employs encryption technology to prevent the use of its software
on work stations that have not been specifically designated by the Company.
Effective copyright and trade secret protection may be unavailable or limited
in certain foreign countries. In September 1988, the Company acquired the
exclusive perpetual license to use, further develop and market the technology
underlying VOXELVIEW on a worldwide basis.
The surgical products and medical imaging industries are characterized by
frequent and substantial intellectual property litigation, and competitors
may resort to intellectual property litigation as a means of competition. The
surgical products and medical imaging markets are characterized by extensive
patent and other intellectual property claims that can create greater
potential than in less developed markets for possible allegations of
infringement, particularly with respect to newly developed technology.
Intellectual property litigation is complex and expensive, and the outcome of
such litigation is difficult to predict. Any future litigation, regardless of
outcome, could result in substantial expense to the Company and significant
diversion of the efforts of the Company's technical and management personnel.
Litigation may also be necessary to enforce patents issued to and licenses
held by 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 others. An adverse determination in any such proceeding
could subject the Company to significant liabilities to third parties, or
require the Company to seek licenses from third parties or pay royalties that
may be substantial. Furthermore, there can be no assurance that necessary
licenses would be available to the Company on satisfactory terms, if at all.
Accordingly, an adverse determination in a judicial or administrative
proceeding or failure to obtain necessary licenses could prevent the Company
from manufacturing or selling certain of its products which in turn would
have a material adverse effect on the Company's business, financial condition
or results of operations.
The Company has registered United States trademarks, including PERI-STRIPS,
VASCU-GUARD, PERI-GUARD, BIOGRAFT, FLO-RESTER, VOXELVIEW and VOXELGEO.
EMPLOYEES
At January 3, 1996, the Company, including its wholly-owned subsidiary,
employed 123 full-time and two part-time individuals, including 18 in
research and development, 61 in manufacturing, 18 in sales and marketing, 25
in general and administrative functions and three in regulatory affairs. The
Company's employees are not represented by a union, and the Company considers
its relationship with its employees to be good.
(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT
SALES
For information with respect to the Company's revenue attributable to
international markets, see page 52 of this Annual Report on Form 10-K.
18
ITEM 1A - IMPORTANT FACTORS
The following factors are important and should be considered carefully in
connection with any evaluation of the Company's business, financial
condition, results of operations and prospects.
HISTORY OF LOSSES; UNCERTAIN PROFITABILITY PROSPECTS
The Company has experienced a net loss during each of the three years in the
period ended October 31, 1994, although the Surgical Business has had
operating income for each of these years. The imaging business has incurred
losses since 1990, and the Company does not expect that the Medical Imaging
Software Business will be profitable in the near term. While the Company was
profitable in the year ended October 31, 1995, there can be no assurance that
the Company will continue to be profitable in the near term or at any time in
the future. The Company's profitability in the near term and the foreseeable
future will depend upon the continued success of PERI-STRIPS, of which there
can be no assurance. See "Important Factors - Limitations on Third-Party
Reimbursement" below.
LIMITATIONS ON THIRD-PARTY REIMBURSEMENT
The Company's products are purchased primarily by hospitals and other users,
which bill various third-party payors, such as government health programs,
private health insurance plans, managed care organizations and other similar
programs, for the health care goods and services provided to their patients.
Payors may deny reimbursement if they determine that a product used in a
procedure was not used in accordance with established Payor protocol
regarding cost-effective treatment methods or was used for an unapproved
indication.
Third-party payors are also increasingly challenging the prices charged for
medical products and services and, in some instances, have put pressure on
medical device suppliers to lower their prices. The Company is unable to
predict what changes will be made in the reimbursement methods used by
third-party health care payors. There can be no assurance that the surgical
procedures in which the Company's products are used will continue to be
considered cost-effective by third-party payors, that reimbursement for such
surgeries or imaging services will be available or, if available will
continue, or that payors' reimbursement levels will not adversely affect the
Company's ability to sell its products on a profitable basis. The Company's
medical imaging products have been purchased to date by a limited number of
medical and research institutions for research applications. The cost of
health care has risen significantly over the past decade, and there have been
and may continue to be proposals by legislators, regulators and third-party
payors to curb these costs. Failure by hospitals and other users of the
Company's products to obtain reimbursement from third-party payors, changes
in third-party payors' policies towards reimbursement for procedures using
the Company's products or legislative action could have a material adverse
effect on the Company's business, financial condition and results of
operations.
For Medicare carriers, the U.S. Healthcare Finance Administration ("HCFA")
establishes a national coverage policy, including the amount to be
reimbursed, for coverage of claims submitted for reimbursement related to a
specific procedure. Recent developments concerning reimbursement of LVR
surgery are likely to have a material adverse effect on the Company's
business and results of operations. Generally, Medicare had been reimbursing
hospitals and surgeons for LVR surgery since the procedure was re-introduced
in 1994. LVR surgery uses PERI-STRIPS, the product which has been primarily
responsible for the Company's growth in net revenue and net income in recent
periods (see "Surgical Business--Markets and Medical Need, Lung Volume
Reduction Surgery" on page 3 of this report). Recently, HCFA decided that it
did not have enough patient follow-up data to substantiate the safety and
efficacy of LVR surgery. On that basis, HCFA decided to cease reimbursement
of LVR surgery until its technical assessment committee ("TAC") could
complete an evaluation of the safety and efficacy of the procedure. TAC has
set February 13, 1996 as the final date for surgeons to submit patient data.
It is reasonably expected that once the data is received by TAC any decision
regarding reimbursement will take, at a minimum, two months and possibly a
year or more. HCFA's decision to deny reimbursement for LVR surgery is
expected to have a material adverse effect on the Company's net revenue and
net income at a minimum in the first and second quarters of fiscal 1996, and
may continue to have such an effect in future periods. While the Company
believes, based on reported outcomes, that HCFA will eventually approve
19
reimbursement for LVR surgery, the Company cannot say with any certainty
when, or if, the reimbursement of LVR will be approved. The Company believes
that LVR procedures reimbursed by Medicare constitute over 50% of total LVR
procedures. While the Company understands that private insurance companies
and managed care organizations (which the Company believes have been the
third-party payors responsible for a significant percentage of reimbursed LVR
procedures) are currently reimbursing LVR surgery based on their own
evaluation of the procedure and its outcomes, it is unknown whether these
private payors will change their reimbursement practices in light of HCFA's
decision. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Comparison of the Year Ended October 31, 1995 with
the Year Ended October 31, 1994, Net Revenue" on page 30 of this Report and
"Third Party Reimbursement and Cost Containment" on page 16 of this report.
DEPENDENCE ON LUNG VOLUME REDUCTION PROCEDURE
The growth in revenue and profitability of the Company in fiscal 1995 as
compared to fiscal 1994 was primarily due to increased sales of PERI-STRIPS.
PERI-STRIPS accounted for approximately 41% of the Company's net revenue for
the year ended October 31, 1995. The Company believes that sales of
PERI-STRIPS will be the primary factor in revenue growth and profitability in
the foreseeable future. This product is used primarily in lung volume
reduction ("LVR") surgery, a procedure that was abandoned 35 years ago due to
unacceptable mortality and complication rates. The LVR procedure was
re-introduced in 1994, modified and enabled by the use of a surgical stapler
in combination with the Company's PERI-STRIPS product. Due to the recent
re-introduction of the modified procedure, the number of patients who have
undergone the procedure and for whom a clinically acceptable post-operative
period of evaluation has elapsed is still relatively small. Similarly, the
number of physicians performing the procedure and from whom data is available
to the Company is small. Accordingly, there presently does not exist a
statistically meaningful body of clinical data from which to draw conclusions
concerning the efficacy and long-term outcomes associated with the LVR
procedure. The Company believes that patients who have undergone the LVR
procedure may require and additional year or more of follow-up examination
before the procedure can be properly evaluated by the medical community. If
the LVR procedure is ultimately determined to provide only temporary benefits
or otherwise results in unfavorable or unacceptable outcomes, this would
adversely affect sales of the Company's PERI-STRIPS product and have a
material adverse effect on the Company's results of operations. The success
of PERI-STRIPS will also depend on the acceptance of the product by surgeons
performing LVR surgery. The Company estimates that there were approximately
700 surgeons worldwide trained to perform the LVR procedure by the end of
calendar 1995. Although additional surgeons are being trained, the growth in
PERI-STRIPS sales has been and will continue to be closely related to the
number of surgeons trained in the LVR procedure and the willingness of such
surgeons to perform the LVR procedure. If the number of surgeons trained and
effectively performing the LVR procedure does not grow as rapidly as the
Company anticipates, the Company's business, results of operations and
financial condition will be adversely affected. Growth in the number of LVR
procedures performed is also dependent upon the criteria used by surgeons in
selecting patients deemed appropriate candidates for such surgery. If the
selection criteria become too rigorous, the number of LVR procedures
performed and related sales of the PERI-STRIPS product may decrease, which
would have a material adverse effect on the Company's business, results of
operations and financial condition. See "Surgical Business--Markets and
Medical Need" on page 3 of this Report.
HIGHLY COMPETITIVE INDUSTRIES AND RISK OF TECHNOLOGICAL OBSOLESCENCE
The Company faces intense competition in both its Surgical Business and its
Medical Imaging Software Business. The medical product and imaging
industries are highly competitive and characterized by rapid innovation and
technological change. The Company expects technology to continue to develop
rapidly, and the Company's success will depend to a large extent on its
ability to maintain a competitive position with its technology. There can be
no assurance that the Company will be able to compete effectively in the
marketplace or that products developed by its competitors will not render its
products obsolete or non-competitive. Similarily, there can be no assurance
that the Company's competitors will not succeed in developing or marketing
products that are viewed by physicians as providing superior clinical
performance or are less expensive relative to the Company's products
currently marketed or to be developed. Several established companies
manufacture and sell surgical products which compete with all of the
Company's surgical products, other than PERI-STRIPS. The Company believes
that at least two established companies are developing products intended to
compete with PERI-STRIPS. The competition in the imaging industry is also
intense and consists largely of established manufacturers of imaging
20
equipment. The companies with which the Company competes have greater
distribution capabilities, substantially greater capital resources and larger
marketing, research and development staffs and facilities than the Company.
In addition, many of the Company's competitors offer broader product lines
within the Company's specific product markets. Broad product lines may give
the Company's competitors the ability to negotiate exclusive, long-term
medical product supply contracts and the ability to offer comprehensive
pricing for their products, including those that compete with the Company's
products. By offering a broader product line in the general field of medical
products and supplies, competitors may also have a significant advantage in
marketing competing products to group purchasing organizations and managed
care organizations that increasingly seek to reduce costs. There can be no
assurance that the Company will be able to compete effectively with such
manufacturers in either its Surgical Business or its Medical Imaging Software
Business. See "Surgical Business--Competition" and "Medical
Imaging Software Business--Competition" on pages 10 and 13, respectively, of
this Report.
ABILITY TO MANAGE GROWTH
To support the anticipated growth due to sales of its PERI-STRIPS product,
the Company will require additional supply, manufacturing, quality assurance,
inventory management, marketing and sales capabilities. Although the Company
is taking steps to meet these needs, there can be no assurance that the
Company will be able to secure the necessary personnel and systems
capabilities to sustain and support the current rate of growth. See
"Surgical Business--Marketing" and "Manufacturing" on pages 9
and 11, respectively, of this Report.
INTELLECTUAL PROPERTY
The Company protects its technology through trade secrets and proprietary
know-how and through patents, both owned and licensed. The Company seeks to
protect its trade secrets and proprietary know-how through confidentiality
agreements with employees, consultants and other parties. SUPPLE PERI-GUARD,
which is used in the manufacture of the majority of the Company's
Tissue-Guard products, is protected exclusively by trade secrets. There can
be no assurance that the Company's trade secrets or confidentiality
agreements will provide meaningful protection of the Company's proprietary
information or, in the event of a breach of any confidentiality agreement,
that the Company will have adequate remedies. There can be no assurance that
any pending or future patent applications will result in issued patents, or
that any current or future patent, regardless of whether the Company is an
owner or licensee of such patent, will not be challenged, invalidated or
circumvented or that the rights granted thereunder or under its licensing
agreements will provide a competitive advantage to the Company. Furthermore,
there can be no assurance that others will not independently develop similar
technologies or duplicate any technology developed by the Company or that the
Company's technology does not or will not infringe patents or other rights
owned by others.
The medical product industry is characterized by frequent and substantial
intellectual property litigation, and competitors may resort to intellectual
property litigation as a means of competition. Intellectual property
litigation is complex and expensive, and the outcome of such litigation is
difficult to predict. Any future litigation, regardless of the outcome,
could result in substantial expense to the Company and significant diversion
of the efforts of the Company's technical and management personnel.
Litigation may also be necessary to enforce patents issued to the Company and
license agreements entered into by 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 others. An adverse determination in
any such proceeding could subject the Company to significant liabilities to
third parties, or require the Company to seek licenses from third parties or
pay royalties that may be substantial. Furthermore, there can be no
assurance that necessary licenses would be available to the Company on
satisfactory terms, if at all. Accordingly, an adverse determination in a
judicial or administrative proceeding or failure to obtain necessary licenses
could prevent the Company from manufacturing or selling certain of its
products which in turn would have a material adverse effect on the Company's
business, financial condition and results of operations. See "Intellectual
Property" on page 17 of this Report.
21
RISKS ASSOCIATED WITH HUMAN TISSUE PRODUCTS
Both the United States and Europe have recently focused attention on the
safety of tissue banks, spurred by incidents of the transmission of human
disease during tissue transplantation. In the United States, recent
regulations drafted by the U.S. Food and Drug Administration (the "FDA")
have outlined requirements for tissue banks. The regulations have
specifically excluded from regulation medical devices subject to FDA review,
including preserved umbilical cord vein grafts such as BIOGRAFT. As a
result, the Company does not expect BIOGRAFT to be subject to tissue bank
regulations in the United States and the related expensive donor screening
and donor testing procedures. There can be no assurance, however, that the
FDA will not impose additional regulatory requirements on BIOGRAFT at some
later date or that BIOGRAFT would be able to meet any such new requirements.
The future regulatory environment for BIOGRAFT in Europe is unclear. While
the Medical Device Directive ("MDD") issued by the European Union ("EU")
explicitly excludes medical devices derived from human tissue from
regulation, certain European medical device manufacturers are actively
lobbying for the re-inclusion of such devices in the MDD. If this effort is
successful, the earliest date for applying for CE mark approval for BIOGRAFT
is expected to be 1998. In addition, if extensive donor screening and donor
testing requirements are imposed, such requirements could make it
uneconomical to sell BIOGRAFT in Europe even under the CE mark. BIOGRAFT
accounted for 11% and 30% of the Company's net revenue and international net
revenue, respectively, for the year ended October 31, 1995.
EARLY STAGE OF THE MEDICAL IMAGING SOFTWARE BUSINESS
The Company's imaging business incurred operating losses of $790,000,
$1,183,000 in fiscal 1993 and 1994, respectively, and had operating income
of $252,000 for the year ended October 31, 1995, entirely due to the
$1,500,000 one-time source code license fee for VOXELGEO, its imaging
technology for geoscience applications, which contributed $1,322,000 to
operating income (See "Managements' Discussion and Analysis of Financial
Condition and Results of Operations --Effect of One-Time Source Code
License" on page 32 of this Report). The grant of this perpetual, exclusive
license to VOXELGEO allows the Medical Imaging Software Business to focus
exclusively on medical applications of its imaging technology. With this
exclusive license, the Company will no longer be receiving revenue from
sales for these geoscience applications. The Company does not anticipate
that expenses of the Imaging Business will decrease proportionally to this
decrease in revenue. As a result, the Imaging Business will likely incur
operating losses in the near term. Although the Company has received FDA
510(k) clearance to market its VOXELVIEW product as a medical product, it
does not anticipate significant revenues from its medical imaging products in
the near term as it develops its business plan for this new clinical product.
The Company expects to continue to invest significant resources in the
research and development of VOXELVIEW. The Company believes that successful
commercialization of VOXELVIEW primarily depends upon the development of an
improved and application specific user interface. In addition, VOXELVIEW
currently can only be used on hardware manufactured by a single manufacturer,
and therefore the VOXELVIEW product will be affected in the short-term by the
success or failure of this hardware manufacturer. Furthermore, the success of
the VOXELVIEW software currently under development will depend upon the
ability and willingness of physicians to use such 3-D software in clinical
diagnosis, surgical planning and patient screening, of which there can be no
assurance. See "Medical Imaging Software Business--Products and Product
Development" on page 12 of this Report.
GOVERNMENTAL REGULATION
The Company's products, development activities and manufacturing processes are
subject to extensive and rigorous regulation by the FDA and by comparable
agencies in foreign countries. In the United States, the FDA regulates the
introduction, manufacturing, labeling and record keeping procedures for medical
devices, including medical imaging software. The process of obtaining marketing
clearance from the FDA for new products and new applications for existing
products can be time-consuming and expensive, and there is no assurance that
such clearances will be granted or that FDA review will not involve delays that
would adversely affect the Company's ability to commercialize additional
products or
22
additional applications for existing products. In addition, certain of the
Company's surgical products that are in the research and development stage
may be subject to a lengthy and expensive pre-market approval ("PMA")
process with the FDA. Even if regulatory approvals to market a product are
obtained from the FDA, these approvals may entail limitations on the
indicated uses of the product. Product approvals by the FDA can also be
withdrawn due to failure to comply with regulatory standards or the
occurrence of unforeseen problems following initial approval. The FDA could
also limit or prevent the manufacture or distribution of the Company's
products and has the power to require the recall of such products. FDA
regulations depend heavily on administrative interpretation, and there can be
no assurance that future interpretations made by the FDA or other regulatory
bodies, with possible retroactive effect, will not adversely affect the
Company. The FDA, various state agencies and foreign regulatory agencies
inspect the Company and its facilities from time to time to determine whether
the Company is in compliance with various regulations relating to
manufacturing practices, validation, testing, quality control and product
labeling. A determination that the Company is in violation of such
regulations could lead to imposition of civil penalties, including fines,
product recalls or product seizures and, in extreme cases, criminal sanctions.
Approximately 17% of the Company's net revenue in fiscal 1995 resulted from
sales of its products outside the United States through independent
distributors. International regulatory bodies have established varying
regulations governing product standards, packaging requirements, labeling
requirements, import restrictions, tariff regulations, duties and tax
requirements. The Company relies on independent distributors to comply with
these foreign regulatory requirements and communication between foreign
regulatory agencies and the Company is indirect and occurs through the
foreign distributor. The inability or failure of independent distributors to
comply with the varying regulations or the imposition of new regulations
could restrict such distributors' ability to sell the Company's products
internationally and thereby adversely affect the Company's business,
financial condition and results of operations.
The new registration scheme in the EU requires that the Company's quality
system conform with the ISO 9001 international quality standard and that its
products conform with the "essential requirements" set forth by the MDD for
the class of products produced by the Company. Compliance with these
requirements will allow the Company to issue a "Declaration of Conformity"
and apply the "CE" mark to products, allowing free sale in the EU. While
the Company is currently undergoing a review procedure to verify compliance
with the ISO 9001 standard and the essential requirements, there can be no
assurance that the Company will obtain the CE mark in a timely manner, or at
all. Failure to obtain the CE mark by 1998 would limit the Company's ability
to sell its products in Europe and would have a material adverse effect on
the Company's business, financial condition and results of operations. See
"Governmental Regulation" on page 13 of this report.
EXPOSURE TO PRODUCT LIABILITY CLAIMS; RISK OF PRODUCT RECALL
The medical product industry historically has been litigious, and the
manufacture and sale of the Company's products inherently entails a risk of
product liability claims. Since the Company's principal products are
designed to be permanently placed in the human body, production errors could
result in an unsafe product and injury to the patient. Although the Company
maintains product liability insurance in amounts believed to be adequate
based upon the nature and risks of its business in general and its actual
experience to date, there can be no assurance that one or more liability
claims will not exceed the coverage limits of such policies or that such
insurance will continue to be available on commercially reasonable terms, if
at all. Furthermore, the Company does not expect to be able to obtain
insurance covering its costs and losses as the result of any recall of its
products due to alleged defects, whether such a recall is instituted by the
Company or required by a regulatory agency. On one occasion in 1992, the
Company initiated a product recall to correct the mislabeling on a small
number of one of its surgical tool products. The mislabeling did not result
in injury to any patient and did not have an adverse effect on the Company's
business, financial condition or results of operations. A product liability
claim, recall or other claim with respect to uninsured liabilities or in
excess of insured liabilities could have a material adverse effect on the
business, financial condition and results of operations of the Company.
23
DEPENDENCE ON DISTRIBUTOR SALES
Sales to distributors constitute a significant portion of the Company's
current business. In the year ended October 31, 1995, three domestic
distributors accounted for an aggregate of 39% of the Surgical Business'
gross revenue, with each of such distributors accounting for in excess of 10%
of the Company's gross revenue for the period. There can be no assurance
that the Company will be able to maintain its relationships with these
significant distributors, or, in the event of termination of any of such
relationships, that a new replacement distributor will be found. The loss of
a significant distributor could materially adversely affect the Company's
business, financial condition and results of operations if a new distributor
or other suitable sales organization could not be found on a timely basis in
the relevant geographic market. See "Surgical Business--Marketing" on
page 9 of this Report.
ITEM 2 - PROPERTIES
The Company leases approximately 36,000 square feet of office and
manufacturing space at 2575 University Avenue, St. Paul, Minnesota for use in
its Surgical Business. The base rent of this lease, which commenced August 1,
1995 and expires July 31, 2005, is approximately $255,000 annually. The
Company also pays apportioned real estate taxes and common costs on this
lease.
Additionally, the Company leases approximately 8,800 square feet located in
Fairfield, Iowa for use in its Medical Imaging Software Business, under a
non-cancelable operating lease which expires on June 1, 1997 and includes an
option to renew for one four-year period. The base rent for this facility is
approximately $75,000 annually.
The Company believes that its current space is adequate for the foreseeable
future.
ITEM 3 - LEGAL PROCEEDINGS
The Company is not currently involved in any material legal proceedings.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this Report.
ITEM 4A - EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's executive officers, their ages, and their offices held as of
January 3, 1996 are as follows:
NAME AGE TITLE
- ---- --- -----
John T. Karcanes ............. 49 President, Chief Executive Officer and
Director
Andrew M. Weiss .............. 38 President, Vital Images, Incorporated
Vice President of Bio-Vascular, Inc.
24
Vincent Argiro, Ph.D ......... 39 Vice President of the Company,
Executive Vice President and Chief
Technology Officer of Vital Images,
Incorporated and Director
M. Karen Gilles .............. 53 Vice President of Finance, Chief
Financial Officer, and Corporate
Secretary
Bruce A. MacFarlane, Ph.D. ... 43 Vice President of Regulatory Affairs
and Quality Assurance
Robert P. Nelson ............. 50 Vice President of Operations
Kemal Schankereli ............ 43 Vice President of Research and
Development
Frank A. Stephenson .......... 42 Vice President of Marketing and Sales
JOHN T. KARCANES. Mr. Karcanes has served as President, Chief Operating
Officer and a director of the Company since April 1994 and as Chief Executive
Officer of the Company since November 1994. From June 1992 to April 1994, Mr.
Karcanes acted as an independent consultant and an interim executive officer,
working primarily with early-stage technology companies. From 1987 to June
1992, Mr. Karcanes served as President and Chief Executive Officer of
Crosfield Lightspeed, Inc., a technology company serving the publishing
industry. Mr. Karcanes served as President of Palladian Software, Inc., a
software development company, from 1984 to 1986, and from 1981 to 1984, he
served in a number of executive positions in international operations and
sales and marketing with Cullinet Software, Inc., a database and application
software company, and Computer Pictures Corporation, a software company
specializing in executive information systems.
ANDREW M. WEISS. Mr. Weiss was appointed President of Vital Images and a
Vice President of the Company in October 1995. From July 1994 until October
1995, Mr. Weiss served as Vice President of Sales and Marketing for Marquette
Electronics, a medical device manufacturer. From January 1986 through June
1994, Mr. Weiss was employed by General Electric Corporation, a
multi-national corporation with operations including medical device and
medical imaging equipment manufacturing, serving as Marketing Manager of GE
Capital Vendor Financial Services from January 1994 through June 1994, as
Marketing Programs Manager for GE Medical Systems - Americas from April 1992
through December 1993 and as Marketing Programs Manager for GE Medical
Systems - Europe from January 1990 through March 1992.
VINCENT ARGIRO. Dr. Argiro was appointed Executive Vice President and
Chief Technology Officer of Vital Images in October 1995 and serves as a Vice
President and Director of the Company. Dr. Argiro was elected a Vice
President and Director of the Company in May 1994 in connection with the
acquisition of Vital Images. Following the acquisition, Dr. Argiro served as
President of Vital Images from May 1994 to October 1995. Dr. Argiro, the
founder of Vital Images, served as Chairman of the Board of Vital Images from
1988 until May 1994. From 1988 to 1990 and from September 1991 to June 1992,
Dr. Argiro also served as President of Vital Images. In September 1991, Dr.
Argiro became Chief Executive Officer of Vital Images. From 1984 to June
1992, Dr. Argiro served as an Associate Professor of Physiology at Maharishi
International University where he conducted research in neuroscience and cell
biology.
M. KAREN GILLES. Ms. Gilles has served as Chief Financial Officer of the
Company since December 1990, Vice President of Finance since 1989, and
Secretary of the Company since November 1991 after serving as the Director of
Finance and Administration from April 1989 to December 1989. From 1985 to
1989, Ms. Gilles served as Controller for VEE Corporation, a production
company, and Colin Companies, a related concession company. From 1983 to
1985, Ms. Gilles was an accountant with McGladrey & Pullen, a public
accounting firm.
25
BRUCE A. MACFARLANE. Dr. MacFarlane has served as Vice President of
Regulatory Affairs and Quality Assurance since June 1995 after serving as
Director of Regulatory Affairs from November 1991 to June 1995. From 1985 to
October 1991, Dr. MacFarlane served as Director of New Product Development
and Regulatory Affairs at Medical Devices, Inc., a medical device company
which manufactures electromedical devices.
ROBERT P. NELSON. Mr. Nelson has served as Vice President of Operations
since September 1991. From 1988 until August 1991, Mr. Nelson served as
Director of Operations for Rexton, Inc., a hearing aid manufacturer. From
1977 through 1987, he served as Director of Operations for heart valve
manufacturing at Medtronic, Inc., a medical device company.
KEMAL SCHANKERELI. Mr. Schankereli has served as Vice President of
Research and Development since December 1993 after serving as Director of
Research and Development from January 1993 to December 1993. From 1991 to
December 1992, Mr. Schankereli served as a private consultant to the
bio-medical device industry. From 1983 to 1991, Mr. Schankereli held the
position of Manager of Vascular Product Research at St. Jude Medical, Inc., a
medical device company. From 1978 to 1983, Mr. Schankereli served as a Senior
Research Scientist at Meadox Medicals, Inc., a medical device company.
FRANK A. STEPHENSON. Mr. Stephenson has served as Vice President of
Marketing and Sales since December 1994. From 1989 to August 1994, Mr.
Stephenson served as Vice President of Marketing and Sales for Spectranetics
Corporation, a medical laser company. From 1985 to 1989, Mr. Stephenson held
a series of marketing management positions with Boston Scientific, Inc., a
manufacturer of medical devices, and served as a senior sales representative
and trainer from 1982 to 1985 with Codman & Shurtleff, a distributor of
neurosurgical products, which is a division of Johnson and Johnson, Inc.
PART II
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is currently traded on the Nasdaq National Market
under the symbol "BVAS". Prior to September 21, 1995, the Company's common
stock was quoted on the Nasdaq SmallCap Market. The following table sets forth,
for each of the fiscal periods indicated, the range of high and low bid
quotations per share of Common Stock as reported on the Nasdaq SmallCap Market
through September 20, 1995, and the range of high and low closing sale prices
per share since