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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, 1996
or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act o 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
Common Stock Purchase Rights
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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
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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 2, 1997, 9,486,270 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 $64,024,223.
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 19, 1997 (the "1997 Proxy Statement").
Tissue-Guard(TM), Supple Tissue-Guard(TM), Peri-Strips(R), Dura-Guard(R), Vascu-
Guard(R), Supple Peri-Guard(R), Peri-Guard(R), Biograft(R), Flo-Rester(R), and
Bio-Vascular Probe(R), are trademarks of the Company. VoxelView(R),
VoxelGeo(R), Voxel Animator(TM), and Vitrea(TM) are trademarks of Vital Images
Incorporated ("Vital Images").
Forward-Looking Statements
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This Annual Report on Form 10-K contains certain forward-looking statements.
For this purpose, any statements contained in this Form 10-K that are not
statements of historical fact may be deemed to be forward-looking statements.
Without limiting the foregoing, words such as "may," "will," "expect,"
"believe," "anticipate," "estimate" or "continue" or the negative or other
variations thereof or comparable terminology are intended to identify forward-
looking statements. These statements by their nature involve substantial risks
and uncertainties, and actual results may differ materially depending on a
variety of factors, including those set forth in the section below entitled
"Important Factors."
PART I
ITEM 1 - Business
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Bio-Vascular, Inc. ("Bio-Vascular" or "the Company") was incorporated in
Minnesota in July 1985. 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.
Discontinued Operations
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On October 28, 1996, the Bio-Vascular Board of Directors approved the spin-off
of its wholly owned subsidiary, Vital Images, to the Company's shareholders
through a pro rata distribution of all of the issued and outstanding shares of
capital stock. The spin-off is expected to occur around March 31, 1997,
following review of the appropriate filings by the Securities and Exchange
Commission, at which time Vital Images will trade as an independent public
company. The Company has attempted to structure the transaction as tax-free,
but since no advance ruling will be sought from the Internal Revenue Service, no
assurance can be made about the final tax treatment of the transaction. In
connection with the distribution, the Company will mail to shareholders, prior
to the distribution date, an Information Statement containing information
regarding Vital Images, its business and operations, and the distribution.
Vital Images is a leading developer of 3-D volume rendering software for medical
research, clinical diagnosis and screening, and surgical planning. Its
products, which are sold worldwide to hospitals, medical imaging centers,
surgery centers and oncology centers, are intended to reduce invasiveness,
enhance visual information and produce fast results.
In November 1996 Vital Images received clearance from the U.S. Food and Drug
Administration ("FDA") to market its new Vitrea(TM) 3-D medical visualization
system. The Vitrea system permits the user to visualize radiological images in
two or three dimensions, and navigate or "fly through" them interactively.
Vitrea will automatically set all visualization parameters using adaptive
clinical protocols. The Vitrea system, which consists of proprietary software
from Vital Images, operates on the new Silicon Graphics 0/2/(TM) computer and
will be marketed as an integrated visualization system. The Vitrea system
incorporates two features that make it easy to use: the built in clinical
workflow and the clinical protocols. The Vitrea workflow allows the user in five
minutes or less to: retrieve CT or MR data over the hospital's network; select a
starting image from a gallery of 2-D or 3-D views; "fly" through or around the
selected 3-D view; take a snapshot of selected images and create a multimedia
report; print the report to standard film or paper printers; and post the report
to an intranet server for instant secure access to the referring physician using
PC-based web browser technology.
Vital Images will market the Vitrea system through a direct sales channel in the
United States and through dealers in Europe and Asia, pending the appropriate
regulatory clearances in those countries. In addition, Vital Images is pursuing
development and sourcing relationships with major diagnostic imaging
manufacturers.
2
Vital Images' offices are located at 2575 University Avenue, St. Paul, MN 55114-
1024 and at 505 North Fourth Street, Fairfield, Iowa 52556. Its telephone number
in St. Paul is (612) 603-3800 and in Fairfield is (515) 472-7726.
As a result of the plan to spin-off Vital Images, the Company's financial
statements and notes thereto contained elsewhere in this Annual Report on Form
10-K report the business of Vital Images as discontinued operations.
General Development of Business
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Bio-Vascular, Inc. develops, manufactures and markets proprietary specialty
medical products for use in thoracic, cardiac, neuro and vascular surgery. The
Company's products include the Tissue-Guard product line and the Biograft
peripheral vascular graft. The Tissue-Guard product line includes Peri-Strips,
Dura-Guard, Vascu-Guard, Supple Peri-Guard, Peri-Guard, Tissue-Guard and Supple
Tissue-Guard. Tissue-Guard products are made from bovine pericardium (the thin
membrane surrounding the heart of cattle) processed using the Company's
proprietary tissue-fixation technologies. The Tissue-Guard products, made in
various configurations, 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 Company also
markets and sells two surgical tools used in cardiac and vascular surgery, Flo-
Rester vessel occluders and the Bio-Vascular Probe, both of which are used in
bypass surgeries.
Peri-Strips was cleared to market by the Food and Drug Administration ("FDA") in
April of 1994. Peri-Strips are used primarily in lung volume reduction surgery
("LVRS") and other surgical procedures on the lung. LVRS is performed
principally on patients with late-stage emphysema who have significantly reduced
respiratory function. During a bilateral 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 LVRS. While there is considerable
evidence that LVRS can significantly improve patients' breathing capacity,
exercise tolerance and quality of life, there does not presently exist, however,
a statistically significant body of clinical data from which to draw conclusions
concerning long-term outcomes associated with LVRS, as the procedure was first
performed less than four years ago.
Dura-Guard, which was cleared to market by the FDA in June of 1995, is a dural
patch used in cranial surgery designed to reduce post-surgical adhesions and
fluid leakage. Vascu-Guard, which was cleared to market by the FDA in June of
1995, is a vascular patch used primarily in carotid endarterectomy procedures
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.
The Company entered a period of significant growth in late 1994 and fiscal 1995.
Net revenue ("revenue") increased by 110%, fueled by sales of its Peri-Strips
product. Revenue from the sales of Peri-Strips was $685,000 in fiscal 1994 and
had increased to $5,550,000 in fiscal 1995. In January of 1996, the Healthcare
Financing Administration ("HCFA"), the agency of the federal government that
administers Medicare, made a national policy decision not to reimburse LVRS
("the HCFA decision"). These surgeries had been reimbursed nationwide on a
regional basis during fiscal 1994 and 1995. The Company estimates that
approximately 70% of the patients undergoing LVRS in fiscal 1995 were Medicare
patients. In April of 1996, the National Institute of Health ("NIH") announced a
collaborative study of LVRS with HCFA. The study, as it is currently structured,
is estimated to take seven years if it goes to completion and will include 2,580
Medicare patients, with a little more than half of those receiving LVRS done
bilaterally by open median sternotomy or thoracoscopic. This represents less
than 2% of those currently estimated to benefit from LVRS. The HCFA decision
materially and adversely affected the Company's financial results. In fiscal
1996 revenue from the sale of Peri-Strips decreased $1,214,000 to $4,336,000.
The Company understands that private insurance companies and managed care
organization are currently reimbursing LVRS based on their own evaluation of the
procedure and its outcomes. It is unknown whether these private payers will
change their reimbursement practices in the future. If these private payers
change their reimbursement practices, it could have an adverse impact on the
Company's business, financial condition and results of operations. (See
Business -Third Party Reimbursement and Cost Containment on Pages 15 and 16 of
this Report.)
3
Members of Congress have been focusing their attention on the concerns raised by
HCFA's decision not to reimburse LVRS. The federal government's fiscal year
1997 appropriations bill, which was signed into law in the Fall of 1996,
included language requiring HCFA to review all available studies and research
data on the treatment of end-stage emphysema by LVRS and make a recommendation
to Congress as to the appropriateness of Medicare coverage by January 1, 1997.
The legislative history accompanying the law and interpreting this bill language
calls for HCFA's report to describe "a method and schedule for restoring
Medicare coverage of lung volume reduction surgery." As of January 24, 1997,
HCFA has not complied with this mandate and no information regarding the report
is available at this time. In addition, in late December 1996, a dozen members
of Congress submitted a written request to the House Ways and Means Committee
that it hold a hearing early in 1997 regarding LVRS because "such important
ethical and quality of care concerns have been raised." The hearing request
letter also states, "because many in the medical community believe LVRS is a
safe and effective treatment for certain patients with end-stage emphysema, we
are concerned that the decision not to extend Medicare coverage for the
procedure could negatively affect the lives of thousands of older Americans who
suffer from this disease." Despite the interest and action of Congress, no
assumptions can be made that any changes will occur to alter the study as it is
currently designed or to change the reimbursement decision before the study is
complete.
Financial Information About Industry Segments
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In connection with the spin-off of Vital Images and the Company's reporting of
the Vital Images business as discontinued operations in the financial statements
and notes thereto contained elsewhere in this Report, the Company's revenues,
operations and assets reported herein represent the Company's sole continuing
industry segment of developing, manufacturing and marketing proprietary
specialty medical products.
Narrative Description of Business
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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 81% and 82% of the Company's net revenue in
fiscal 1996 and 1995,
4
respectively.
Lung Volume Reduction Surgery ("LVRS"). 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 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 just the cost of medication and oxygen supplements for late-stage
emphysema patients can range from $5,000 to $8,000 annually. In addition,
visits to the doctor, in-home health care and equipment, and the need for
periodic emergency room care for persons suffering the effects of late-stage
emphysema, 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 LVRS 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 LVRS more quickly, a particularly
important consideration in light of the debilitated condition of the patients
requiring the surgery. Despite many advances in LVRS, 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 LVRS using strips of Supple Peri-Guard to reinforce the staple line to
prevent air leakage around the staples.
During LVRS, 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 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 and
state. The Company estimates that the current cost of LVRS ranges from $25,000
to $45,000 per procedure.
The American Lung Association estimates that in 1992 there were approximately
1.9 million Americans suffering from emphysema. LVRS, 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 LVRS candidate be less than 75 years
old, quit smoking at least six months prior to LVRS, have no documented history
of heart disease or previous lung surgery and have no other major diseases. In
addition, most surgeons performing LVRS 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 LVRS and as long-term clinical
results become available.
5
While LVRS 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
shortness of breath, improved exercise tolerance and improved quality of life.
However, LVRS was only re-introduced into the United States in late calendar
1993. While it is estimated that over 2,300 surgeons have been trained and over
4,500 procedures have been performed, not enough time has elapsed to provide a
statistically significant body of clinical data from which to draw conclusions
concerning the long-term efficacy and long-term outcomes associated with LVRS.
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. The primary patching materials include autologous tissue, synthetic
patches, 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 125,000 cranial
operations were performed in 1995. 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 110,000
carotid endarterectomy procedures were performed in 1995, 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.
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
6
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 1995.
Products
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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 Application Representative Procedure Clearance
Product Line ------------ ------------------------- --------------------------- -----------
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Tissue-Guard
Peri-Strips Soft tissue stapling Lung volume reduction/lung
buttress resection 510(k)
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
7
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 1996 1995 1994
------------ ---- ---- ----
(In thousands)
Peri-Strips...................... $4,336 $5,550 $ 685
Tissue-Guard Product (excluding
Peri-Strips).................... 2,944 1,845 990
Biograft......................... 938 1,198 1,525
Surgical Productivity Tools...... 1,902 1,825 1,700
Tissue-Guard Product Line. The Company's Tissue-Guard products are all produced
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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 and patented
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. 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. Tissue-
Guard has a 15 year history of successful clinical performance as a surgical
patch in a wide variety of clinical applications.
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, soft tissue stapling buttress, are currently used
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primarily in LVRS 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:
8
. 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 LVRS.
. 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 LVRS to be approximately $1,500.
Dura-Guard. Dura-Guard, a dural repair patch, is primarily used in craniotomy
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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. 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. Studies have shown 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 for easier handling and
promotes tissue integration for strength and stability.
9
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: research and development supports current products
through training of Company personnel and writing and publishing research papers
on existing products; they develop product line extensions by improving current
products or developing new applications for current products; and they develop
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 research and development staff currently consists of three
scientists and two technicians. The Company 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 $909,000, $643,000 and $414,000 on research and
development in fiscal 1996, 1995 and 1994, respectively.
Marketing
The sales and marketing strategy of the Company includes developing and
maintaining a close working relationship with the hospitals and surgeons who
purchase and use the Company's products in order to assess and satisfy their
needs. For the past two years, the Company has focused marketing efforts toward
assisting in the education of surgeons in the use of Peri-Strips in LVRS through
sponsorship of workshops and training programs. These workshops and training
sessions have been conducted in the United States, Canada and certain European
and Far Eastern countries. The Company estimates that approximately 2,350
surgeons have been trained in LVRS as of the end of fiscal 1996. The Company
has also sponsored "focus group" meetings as a forum for discussion and the
exchange of information for surgeons performing LVRS. In addition, the Company
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 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.
10
The Company's products are sold to hospitals and surgeons worldwide. For the
fiscal years ended October 31, 1996, 1995 and 1994, approximately 22%, 17%, and
30% of the Company's revenue, respectively, were from sales in international
markets. The decrease in the percent of 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 international sales
are in Europe.
In the United States, the Company sells its products through a combination of 12
distributors and independent sales representatives managed by 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. The Company also 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 products are sold through 35 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 1996, three domestic distributors accounted for the following
percentages of the Company's gross revenue: Futuretech, Inc., (18%); Life
Systems, Inc., (15%); and Cardio Medical Products, (12%). In fiscal 1995, the
same three domestic distributors each accounted for more than 10% gross revenue,
while in fiscal 1994 Futuretech and Life Systems accounted for more than 10% of
gross revenue.
The Company currently has written agreements with 29 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 Company's marketing and sales department and its national and international
distribution network is managed by the Vice President of Marketing and Sales.
The Company's marketing and sales department currently consists of 13 employees.
These employees include domestic and international sales managers, domestic
regional sales managers, product managers, administrative and customer service
personnel.
Competition
The Company 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 of purchasing functions.
In 1996 the FDA cleared for marketing a synthetic product made from PTFE,
configured for use with surgical staplers
11
in LVRS, and intended to compete with Peri-Strips. Pictures taken with electron
microscopes indicate that PTFE , unlike Peri-Strips, does not fully
reapproximate around surgical staplers. Additionally, the Company is aware of
two tissue products that appear to intend to compete with Peri-Strips. The
Company, however, has three patents related to the use of Peri-Strips as a soft
tissue stapling buttress (see Intellectual Property on page 16) which the
Company intends to vigorously enforce. To the Company's knowledge, there are
dural patches currently available that compete with Dura-Guard. These are either
autologous tissue or processed cadaver tissue, including Tutoplast(TM), a
processed cadaver product manufactured by Biodynamics International, Inc., and
synthetic patches. 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(R), 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.
There can be no assurance that products which compete with the Company's
products will not achieve greater acceptance than the Company's products or that
future products developed by competitors will not offer similar or enhanced
performance advantages relative to the Company's product.
Manufacturing
The Company manufactures all of its products except the Bio-Vascular Probe at
its St. Paul, Minnesota facility. In late fiscal 1996, the Company acquired the
equipment and technology necessary to manufacture the Bio-Vascular Probe and
expects to begin the manufacture early in calendar 1997. Until that time, the
Bio-Vascular Probe will continue to be 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. Since July of 1995, the Company has occupied a 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 ("USDA") 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.
Governmental Regulation
The manufacture and sale of the Company's 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. 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
12
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 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.
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
13
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.
Bovine Spongiform Encephalopathy ("BSE") is endemic in cattle in the United
Kingdom (UK) and has received much publicity in Europe regarding beef for
dietary consumption. Under the direction of the USDA, the U.S. government has
had an active program of surveillance and import controls since the late 1980's,
designed to prevent the introduction of BSE into U.S. cattle. To date all
evidence indicates that U.S. cattle are free of BSE. The Company obtains all of
its raw pericardium from USDA slaughterhouses. To date BSE has not impeded sale
of the Company's products worldwide. The Company's Notified Body, the British
Standards Institute ("BSI"), and French authorities have specifically reviewed
Tissue-Guard sourcing and manufacturing processes and have then accepted the
Company's bovine pericardium products. The Company cannot predict whether or not
a case of BSE may someday be reported in the U.S. If a case of BSE were reported
in the U.S. cattle, it could have a material adverse effect on the Company's
business, financial condition and results of operations. Although the Company
does not anticipate that any countries will prohibit the sale of Tissue-Guard
products as a result of concerns related to BSE, such prohibition by certain
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 were inspected and
audited by the BSI to verify the Company's compliance with the requirements of
the Medical Device Directive ("MDD") issued by the European Union ("EU"). They
have also verified 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. In June of 1996, BSI certified the Company's conformity with both the
ISO 9001 standard and the MDD essential requirements, entitling the Company to
place the "CE" mark on the Company's Tissue-Guard products. The CE mark enables
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.
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 only. If the CE mark is unavailable for Biograft or if the
requirements for obtaining a CE mark are too burdensome, the Company intends to
seek country-by-country registration of the product where such registration
requirements exist for as long as it continues to market the Biograft. 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
14
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 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 products are purchased primarily by hospitals and other users
which then bill various third-party payers for the services provided to the
patients. These payers, 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.
The availability and level of reimbursement from third-party payers is
significant to the Company's business. For Medicare carriers, HCFA may establish
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 payers 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
15
guaranteed higher volumes 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 payers 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 payers to decrease or deny reimbursement for such surgeries or
to favor these other treatments over surgical treatment.
In January of 1996, HCFA made a national policy decision not to reimburse LVRS
("the HCFA decision"), which had been reimbursed nationwide on a regional basis
during fiscal 1994 and 1995. The Company estimates that approximately 70% of the
patients undergoing LVRS in fiscal 1995 were Medicare patients. In April of
1996, the National Institute of Health ("NIH") announced a collaborative study
of LVRS with HCFA. The study, as it is currently structured, is estimated to
take seven years if it goes to completion and will include 2,580 Medicare
patients, with a little more than half of those receiving bilateral open median
sternotomy or thoracoscopic LVRS. This represents less than 2% of those
currently estimated to benefit from LVRS. The HCFA decision materially and
adversely affected the Company's financial results. In fiscal 1996 revenue from
the sale of Peri-Strips decreased $1,214,000 to $4,336,000. The Company
understands that some private insurance companies and managed care organizations
are currently reimbursing LVRS based on their own evaluation of the procedure
and its outcomes. It is unknown whether these private payers will change their
reimbursement practices in the future.
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.
The Company has been granted three United States patents relating to the use of
tissue on a removable backing which cover the sleeve configuration of Peri-
Strips, the combination of tissue with a surgical stapling gun, and methods of
performing a surgical procedure to remove diseased tissue. 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 revenue from sales of Peri-
Strips for the life of the patents. 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.
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.
16
The surgical products industry is characterized by frequent and substantial
intellectual property litigation, and competitors may resort to intellectual
property litigation as a means of competition. The surgical products 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. It is the Company's intention to vigorously
enforce and defend these intellectual property rights. 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(R),
Dura-Guard(R), Vascu-Guard(R), Supple Peri-Guard(R), Peri-Guard(R), Biograft(R),
Flo-Rester(R) and Bio-Vascular Probe(R).
Employees
At January 2, 1997, the Company's continuing operations employed 64 full-time
and two part-time individuals, including 5 in research and development, 26 in
manufacturing, 13 in sales and marketing, 19 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.
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 47 of this Annual Report on Form 10-K.
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.
Limitations on Third-Party Reimbursement
The Company's products are purchased primarily by hospitals and other users,
which bill various third-party payers, 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.
Payers 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 payers 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 payers. 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 payers, that reimbursement for such surgeries or
imaging services will be available or, if available will continue, or that
payers' reimbursement levels will not adversely affect the Company's ability to
sell its products on a
17
profitable basis. 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 payers to curb these costs. Failure by hospitals and
other users of the Company's products to obtain reimbursement from third-party
payers, changes in third-party payers' 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.
In January of 1996, HCFA made a national policy decision not to reimburse LVRS
("the HCFA decision"), which had been reimbursed nationwide on a regional basis
during fiscal 1994 and 1995. The Company estimates that approximately 70% of the
patients undergoing LVRS in fiscal 1995 were Medicare patients. In April of
1996, the National Institute of Health ("NIH") announced a collaborative study
of LVRS with HCFA. The study, as it is currently structured, is estimated to
take seven years if it goes to completion and will include 2,580 Medicare
patients, with a little more than half of those receiving bilateral open median
sternotomy or thoracoscopic LVRS. This represents less than 2% of those
currently estimated to benefit from LVRS. The HCFA decision materially and
adversely affected the Company's financial results. In fiscal 1996 revenue from
the sale of Peri-Strips decreased $1,214,000 to $4,336,000. The Company
understands that some private insurance companies and managed care organizations
are currently reimbursing LVRS based on their own evaluation of the procedure
and its outcomes. It is unknown whether these private payers will change their
reimbursement practices in the future.
Highly Competitive Industries and Risk of Technological Obsolescence
The Company faces intense competitions. The medical products industry is 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. Similarly,
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. 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.
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.
18
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 16 of this Report.
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 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
MDD issued by the 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 9% and 11% of the Company's net revenue and international net
revenue, respectively, for the year ended October 31, 1996.
Bovine Spongiform Encephalopathy ("BSE") is endemic in cattle in the United
Kingdom (UK) and has received much publicity in Europe regarding beef for
dietary consumption. Under the direction of the USDA, the U.S. government has
had an active program of surveillance and import controls since the late 1980's,
designed to prevent the introduction of BSE into U.S. cattle. To date all
evidence indicates that U.S. cattle are free of BSE. The Company obtains all of
its raw pericardium from USDA slaughterhouses. To date BSE has not impeded sale
of the Company's products worldwide. The Company's Notified Body, the British
Standards Institute ("BSI"), and French authorities have specifically reviewed
Tissue-Guard sourcing and manufacturing processes and have then accepted the
Company's bovine pericardium products. The Company cannot predict whether or
not a case of BSE may someday be reported in the U.S. If a case of BSE were
reported in the U.S. cattle, it could have a material adverse effect on the
Company's business, financial condition and results of operations. Although the
Company does not anticipate that any countries will prohibit the sale of Tissue-
Guard products as a result of concerns related to BSE, such prohibition by
certain countries could have a material adverse effect on the Company's
business, financial condition and results of operation.
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.
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
19
would adversely affect the Company's ability to commercialize additional
products or additional applications for existing products. In addition, certain
of the Company's 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 22% of the Company's revenue in fiscal 1996 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 has obtained the "CE"
mark for its Tissue-Guard products, there can be no assurance that the Company
will be able to maintain compliance with the regulations to retain the CE mark.
In addition, it is uncertain whether the Company will be successful in obtaining
the CE mark for its other products or new product introductions. 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 12 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.
In September 1996 the Company voluntarily issued a Safety Alert regarding the
usage of its bovine pericardium as a urethral sling and removed "urethral sling"
from the "indications" statement in its instructions for use. The Company
issued the safety alert as a prudent course of action. The deletion of
"urethral sling" from the labeling caused the action to fall into the category
of a "field correction". In November 1996 the FDA acknowledged this field
correction and reported it in the "FDA Weekly Enforcement Report" of November
11, 1996 as a "recall", as the definition of a recall encompasses field
corrections. No product units were physically recalled and none were returned
to the Company.
20
Although Peri-Guard and Supple Peri-Guard have included the urethral sling
indication in their labeling for several years, the products were rarely used in
this application until late 1995. At that time a handful of urological surgeons
began using the products in place of autologous fascia slings to treat female
urinary incontinence. Approximately 65 transvaginal implants were done,
resulting in 16 explants due to vaginal discharge, opening of the vaginal
incision, and localized inflammation without fever. These results were similar
to those which have been reported for synthetic urethral slings.
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.
Dependence on Distributor Sales
Sales to distributors constitute a significant portion of the Company's current
business. In the year ended October 31, 1996, three domestic distributors
accounted for an aggregate of 44% of 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 Business - "Marketing" on
page 10 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. 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. The Company believes that its current
space is adequate for the foreseeable future.
ITEM 3 - Legal Proceedings
- --------------------------
During the first quarter of fiscal 1997, the Company received notice of a suit
brought against it in Tokyo District Court in Japan by Jostra, Japan, K.K., a
former Japanese distributor, claiming wrongful termination and economic damage
of $500,000. The Company believes the claim to be completely without merit and
intends to pursue this matter vigorously.
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, 1997 are as follows:
Name Age Title
---- --- -----
John T. Karcanes...... 50 President, Chief Executive Officer and
Director
Andrew M. Weiss*...... 39 President, Vital Images, Incorporated
Vice President of Bio-Vascular, Inc.
21
Name Age Title
---- --- -----
Vincent Argiro, Ph.D*............. 40 Vice President of the Company, Executive
Vice President and Chief Technology Officer
of Vital Images, Incorporated and Director
M. Karen Gilles................... 54 Vice President of Finance, Chief Financial
Officer, and Corporate Secretary
Bruce A. MacFarlane,.............. 44 Vice President of Regulatory Affairs and
Ph.D. Quality Assurance
Robert P. Nelson.................. 51 Vice President of Operations
Kemal Schankereli................. 44 Vice President of Research and Development
Frank A. Stephenson............... 43 Vice President of Marketing and Sales
*Will cease to be an officer of Bio-Vascular concurrent with the spin-off
of Vital Images.
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
22
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.
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 September 21, 1995 as reported by the Nasdaq National Market.
These prices do not include adjustments for retail mark-ups, mark-downs or
commissions, and prior to September 21, 1995, represent inter-dealer quotations
and do not necessarily represent actual transactions).
High Low
------- -------
Fiscal 1996
First Quarter............ $15.000 $ 7.500
Second Quarter........... 13.125 8.000
Third Quarter............ 9.875 6.125
Fourth Quarter........... 8.375 5.250
Fiscal 1995
First Quarter............ $ 5.750 $ 4.625
Second Quarter........... 7.375 5.250
Third Quarter.............. 14.650 6.875
Fourth Quarter............. 18.000 11.625
23
The Company has not declared or paid any cash dividends on its Common Stock
since its inception, and the Board of Directors presently intends to retain all
earnings for use in the business for the foreseeable future. As of January 2,
1997 there were approximately 6,900 beneficial owners of the Company's Common
Stock.
24
ITEM 6 - Selected Financial Data
--------------------------------
For the Year Ended October 31: 1996 1995 1994 1993 1992
===========================================================================================================
Net revenue $10,124,709 $10,426,076 $ 4,951,743 $4,422,775 $4,185,110
Gross margin 6,681,611 6,964,259 3,027,708 2,586,354 2,519,324
Operating income (loss) 571,013 2,121,096 (255,951) 333,058 399,046
Income (loss) from continuing
operations 1,218,501 1,659,162 (697,025) 650,634 555,483
Discontinued operations,
net of taxes (2,396,142) 527,304 (1,182,497) (808,778) (714,201)
Net income (loss) $(1,177,641) $ 2,186,466 $(1,879,522) $ (158,144) $ (158,718)
--------------- ------------ ------------ ----------- -----------
Per share amounts:
Income (loss) from continuing .13 .20 (.10) .09 .08
operations
Net income (loss) per share $ (0.12) $ 0.27 $ (0.26) $ (.02) $ (.02)
Weighted average shares
outstanding 9,433,000 8,172,000 7,277,000 7,055,000 6,743,000
At October 31: 1996 1995 1994 1993 1992
==========================================================================================================
Working capital /1/ 22,106,990 24,059,746 6,261,521 6,636,651 5,491,466
Total assets /1/ 37,881,279 37,303,375 7,431,793 8,807,445 7,974,050
Long-term debt -- -- -- 40,016 70,173
Shareholders' equity /2/ 35,220,535 35,355,336 6,785,539 8,476,742 7,643,046
/1/ In connection with the spin-off of Vital Images Incorporated the Company
will eliminate Vital Images' intercompany debt and contribute $10,000,000 in
cash, cash equivalents and/or marketable securities effective November 1, 1996,
which Vital Images will use for working capital purposes from that date forward.
/2/ On the distribution date, Shareholders' Equity will be reduced by an amount
approximating the $10,000,000 working capital contribution, net of the losses of
Vital Images through the distribution date which are estimated to be $1,348,000.
25
ITEM 7 - Management's Discussion and Analysis of Financial Condition and Results
- --------------------------------------------------------------------------------
of Operations
- -------------
Overview
On October 28, 1996, the Bio-Vascular Board of Directors approved the spin-off
of its wholly owned subsidiary, Vital Images, to the Company's shareholders
through a pro-rata distribution of all of the issued and outstanding shares of
capital stock. The spin-off is expected to occur around March 31, 1997,
following review of the appropriate filings by the Securities and Exchange
Commission, at which time Vital Images will trade as an independent public
company. The Company has attempted to structure the transaction as tax-free,
but since no advance ruling will be sought from the Internal Revenue Service, no
assurance can be made about the final tax treatment of the transaction.
It is expected that one share of Vital Images common stock will be distributed
in the spin-off for every two Bio-Vascular shares held. In connection with the
spin-off of Vital Images Incorporated, the Company will eliminate Vital Images'
intercompany debt and contribute $10,000,000 in cash, cash equivalents and/or
marketable securities effective November 1, 1996, which Vital Images will use
for working capital purposes from that date forward. On the distribution date,
Shareholders' Equity will be reduced by an amount approximating the $10,000,000
working capital contribution, net of the losses of Vital Images through the
distribution date which are estimated to be $1,348,000. Cash, cash equivalents
and marketable securities retained by Bio-Vascular will be approximately
$19,500,000.
The Company believes that strategically and financially, the timing and
circumstances are right to separate the Company's Surgical and Imaging
Businesses for the long-term benefit of the shareholders. Both organizations,
it is believed, will benefit from a tighter focus on their respective markets,
will be able to invest in research and development at levels appropriate to
their respective stages of development and will be able to evolve unique
organizational and marketing structures to better serve their substantially
different markets. Vital Images became a wholly-owned subsidiary of the Company
on May 24, 1994 in a business combination accounted for as a "pooling-of-
interests".
Vital Images, Incorporated, the new public company that results from the spin-
off, is a leading developer of 3-D volume rendering software for medical
research, clinical diagnosis and screening, and surgical planning. Its
products, which are sold worldwide, are intended to reduce invasiveness,
enhance visual information and produce fast results. As a result of the plan to
spin-off Vital Images, Bio-Vascular's discussion and analysis of financial
results, financial statements and notes to financial statements report Vital
Images as discontinued operations. (See Footnote 2 of Notes to the Financial
Statements on page 40 of this Report.) Prior years' consolidated financial
statements and notes have been restated accordingly. In addition, the Company
accrued the estimated losses of Vital Images through the anticipated date of
distribution, March 31, 1997. These estimated losses are reported as the loss
on disposal. All of the discussion which follows addresses the Company's
continuing operations.
The Company's continuing business develops, manufactures and markets proprietary
specialty medical products for use in thoracic, cardiac, neuro and vascular
surgery. The Company entered a period of significant growth in late 1994 and
during fiscal 1995. Net revenue ("revenue") increased by 110%, fueled by sales
of its Peri-Strips product. Peri-Strips are used in conjunction with lung
volume reduction surgery ("LVRS"), a surgical treatment for late-stage (also
referred to as end-stage) emphysema patients. Peri-Strips was cleared to
market by the Food and Drug Administration in April of 1994. Revenue from the
sales of Peri-Strips was $685,000 in fiscal 1994 and had increased to $5,550,000
in fiscal 1995. In January 1996, the Healthcare Financing Administration
("HCFA"), the agency of the federal government that administers Medicare, made a
national policy decision not to reimburse LVRS ("the HCFA decision"), these
surgeries had been reimbursed nationwide on a regional basis during fiscal 1994
and 1995. The Company estimates that approximately 70% of the patients
undergoing LVRS in fiscal 1995 were Medicare patients. In April of 1996, HICFA
announced a collaborative study of LVRS with the National Institute of Health
("NIH"). The study, as it is currently structured, is estimated to take seven
years if it goes to completion and will include 2,580 Medicare patients, with a
little more than half of those receiving bilateral open median sternotomy or
thoracoscopic LVRS. This represents less than 2% of those currently estimated
to benefit from LVRS. The HCFA decision materially and adversely affected the
26
Company's financial results. In fiscal 1996, revenue from the sale of Peri-
Strips decreased $1,214,000 to $4,336,000. The Company understands that some
private insurance companies and managed care organizations are currently
reimbursing LVRS based on their own evaluation of the procedure and its
outcomes. It is unknown whether these private payers will change their
reimbursement practices in the future. If these private payers change their
reimbursement practices, it could have an adverse impact on the Company's
business, financial condition and results of operations. (See Business - Third
Party Reimbursement and Cost Containment on Pages 15 and 16 of this Report.)
Members of Congress have been focusing their attention on the concerns raised by
HCFA's decision not to reimburse LVRS. The federal government's fiscal year 1997
appropriations bill was signed into law in the Fall of 1996 which included
language requiring HCFA to review all available studies and research data on the
treatment of end-stage emphysema by LVRS and make a recommendation to Congress
as to the appropriateness of Medicare coverage by January 1, 1997. The
legislative history accompanying the law and interpreting this bill language
calls for HCFA's report to describe "a method and schedule for restoring
Medicare coverage of lung volume reduction surgery." As of January 24, 1997,
HCFA has not complied with this mandate and no information regarding the report
is available at this time. In addition, in late December 1996, a dozen members
of Congress submitted a written request to the House Ways and Means Committee
that it hold a hearing early in 1997 regarding LVRS because "such important
ethical and quality of care concerns have been raised." The hearing request
letter also states, "because many in the medical community believe LVRS is a
safe and effective treatment for certain patients with end-stage emphysema, we
are concerned that the decision not to extend Medicare coverage for the
procedure could negatively affect the lives of thousands of older Americans who
suffer from this disease." Despite the interest and action of Congress, no
assumptions can be made that any changes will occur to alter the study as it is
currently designed or to change the reimbursement decision before the study is
complete.
Results of Continuing Operations
Comparison of the Year Ended October 31, 1996 with the Year Ended October 31,
1995
Revenue decreased to $10,125,000 from $10,426,000, primarily due to the decrease
in Peri-Strips revenue resulting from the HCFA decision, offset substantially by
an increase in revenue from sales of other Tissue Guard products. Peri-Strips
revenue decreased $1,214,000 to $4,336,000 from $5,550,000. Revenue from sales
of other Tissue-Guard products, Dura-Guard, Vascu-Guard, Supple Peri-Guard and
Peri-Guard, increased by $1,099,000 to $2,944,000 from $1,845,000, primarily due
to the increase in revenue from Dura-Guard, which was cleared to market by the
FDA in June 1