NOTES
TO UNAUDITED CONDENSED FINANCIAL STATEMENTS
September
30, 2007
OVERVIEW
OF BUSINESS
Description
of the business
OrthoLogic
is a biotechnology company committed to developing a pipeline of novel peptides
and other molecules aimed at helping patients with under-served
conditions. The Company is focused on development and
commercialization of two product platforms: Chrysalin® (TP508) and
AZX100.
Chrysalin
(TP508), is a novel synthetic 23-amino acid peptide, is believed to produce
angiogenic and other tissue repair effects by activating or upregulating nitric
oxide synthase (NOS) and the production of nitric oxide in endothelial cells,
and if so, it may have potential therapeutic value in tissues and diseases
exhibiting endothelial dysfunction. We have primarily investigated
Chrysalin in two indications, fracture repair and diabetic foot ulcer healing
and we are initiating study of other potential vascular
indications. The Company owns exclusive worldwide rights to
Chrysalin.
AZX100 is
a novel synthetic pre-clinical 24-amino acid peptide and is believed to have
smooth muscle relaxation and anti-fibrotic properties. AZX100 is currently
being
evaluated for medically and commercially significant applications, such as
prevention of dermal scarring, pulmonary fibrosis, the treatment of asthma,
and
vascular intimal hyperplasia. OrthoLogic has an exclusive worldwide
license to AZX100.
We
continue to explore other biopharmaceutical compounds that can complement our
research activity internally and broaden our potential pipeline for successful
products.
Company
History
Prior
to
November 26, 2003, we developed, manufactured and marketed proprietary,
technologically advanced orthopedic products designed to promote the healing
of
musculoskeletal bone and tissue, with particular emphasis on fracture healing
and spine repair. Our product lines included bone growth stimulation
and fracture fixation devices including the OL1000 product line, SpinaLogic® and
OrthoFrame/Mayo, which we sometimes refer to as our “Bone Device
Business.”
On
November 26, 2003, we sold our Bone Device Business. Our principal
business remains focused on tissue repair, although through biopharmaceutical
approaches rather than through the use of medical devices.
On
August
5, 2004, we purchased substantially all of the assets and intellectual property
of Chrysalis Biotechnology, Inc. (“CBI”), including its exclusive worldwide
license for Chrysalin for all medical indications, for $2.5 million in cash
and
$25.0 million in OrthoLogic common stock, with an additional $7.0 million
in OrthoLogic common stock due should certain triggering events
occur. We became a development stage company commensurate with the
acquisition. Subsequently, our efforts were focused on
research and development of our Chrysalin Product Platform, with the goal of
commercializing our products.
On
February 27, 2006, the Company purchased certain assets and assumed certain
liabilities of AzERx, Inc. Under the terms of the transaction, OrthoLogic
acquired an exclusive license for the core intellectual property relating to
AZX100.
Our
development activities for the Chrysalin Product Platform and AZX100 represent
a
single operating segment as they share the same product development path and
utilize the same Company resources. As a result, we have determined
that it is appropriate to reflect our operations as one reportable segment.
Through September 30, 2007, we have incurred $99 million in net losses as a
development stage company.
In
these
notes, references to “we”, “our” and the “Company” refer to OrthoLogic
Corp. References to our Bone Device Business refer to our former
business line of bone growth stimulation and fracture fixation devices,
including the OL1000 product line, SpinaLogic®, OrthoFrame® and
OrthoFrame/Mayo.
Financial
Statement Presentation
In
the
opinion of management, the unaudited condensed interim financial statements
include all adjustments necessary for the fair presentation of our financial
position, results of operations, and cash flows. The results of
operations for the interim periods are not necessarily indicative of the results
to be expected for the complete fiscal year.
Use
of
estimates: The preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America requires that
management make a number of assumptions and estimates that affect the reported
amounts of assets, liabilities, and expenses in our financial statements and
accompanying notes. Management bases its estimates on historical
experience and various other assumptions believed to be
reasonable. Although these estimates are based on management’s
assumptions regarding current events and actions that may impact the Company
in
the future, actual results may differ from these estimates and
assumptions. Our critical accounting policies are those that affect,
or could affect our financial statements materially and involve a significant
level of judgment by management. The accounting policies and related risks
described in our Annual Report for the year ended December 31, 2006 are those
that depend most heavily on these judgments and estimates. As of
September 30, 2007, there have been no material changes to any of the critical
accounting policies contained therein.
Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to Securities and Exchange Commission rules and
regulations, although the Company believes that the disclosures herein are
adequate to make the information presented not misleading. It is
suggested that these unaudited condensed financial statements be read in
conjunction with the financial statements and the notes thereto included in
the
Company’s Annual Report for the year ended December 31,
2006. Information presented as of December 31, 2006 is derived from
audited statements.
New
Accounting Pronouncement: We adopted the provisions of Financial
Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for
Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN
48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise’s financial statements in accordance
with FASB Statement 109, “Accounting for Income Taxes”, and prescribes a
recognition threshold and measurement process for financial statement
recognition and measurement of a tax position taken or expected to be taken
in a
tax return. FIN 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and
transition.
Based
on
our evaluation, we have concluded that there are no significant uncertain tax
positions requiring recognition in our financial statements or adjustments
to
our deferred tax assets and related valuation allowance. Our evaluation was
performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the
tax years which remain subject to examination by major tax jurisdictions as
of
September 30, 2007.
We
may
from time to time be assessed interest or penalties by major tax jurisdictions,
although any such assessments historically have been minimal and immaterial
to
our financial results. In the event we have received an assessment for interest
and/or penalties, it has been classified in the financial statements as selling,
general and administrative expense.
A. STOCK
BASED COMPENSATION
Effective
January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment”,
(SFAS 123(R)). SFAS 123(R) requires all share-based payments,
including grants of stock options, restricted stock units and employee stock
purchase rights, to be recognized in our financial statements based on their
respective grant date fair values. Under this standard, the fair value of each
employee stock option and employee stock purchase right is estimated on the
date
of grant using an option pricing model that meets certain
requirements. We currently use the Black-Scholes option pricing model
to estimate the fair value of our share-based payments. The
determination of the fair value of share-based payment awards utilizing the
Black-Scholes model is affected by our stock price and a number of assumptions,
including expected volatility, expected life, risk-free interest rate and
expected dividends. We use historical volatility adjusted for future
expectations. The expected life of stock options is based on historical data
and
future expectations. The risk-free interest rate assumption is based
on observed interest rates appropriate for the terms of our stock options and
stock purchase rights. The dividend yield assumption is based on our
history and expectation of dividend payouts. The fair value of our
restricted stock units is based on the fair market value of our common stock
on
the date of grant. Stock-based compensation expense recognized in our
financial statements in 2006 and thereafter is based on awards that are
ultimately expected to vest. We recognize compensation cost for an
award with only service conditions that has a graded vesting schedule on a
straight line basis over the requisite service period as if the award was,
in-substance, a multiple award. However, the amount of compensation
cost recognized at any date must at least equal the portion of grant-date fair
value of the award that is vested at that date. The amount of stock-based
compensation expense in 2006 and thereafter will be reduced for estimated
forfeitures. Forfeitures are required to be estimated at the time of
grant and revised, if necessary, in subsequent periods if actual forfeitures
differ from those estimates. We evaluate the assumptions used to
value stock awards on a quarterly basis. If factors change and we
employ different assumptions, stock-based compensation expense may differ
significantly from what we have recorded in the past. The Company
chose the modified-prospective transition alternatives in adopting SFAS
123(R). Under the modified-prospective transition method,
compensation cost is recognized in financial statements issued subsequent to
the
date of adoption for all stock-based payments granted, modified or settled
after
the date of adoption, as well as for any unvested awards that were granted
prior
to the date of adoption. Because the Company previously adopted only
the pro forma disclosure provisions of SFAS 123, we recognize compensation
cost
relating to the unvested portion of awards granted prior to January 1, 2006,
the
date of adoption, using the same estimate of the grant-date fair value and
the
same attribution method used to determine the pro forma disclosure under SFAS
123, except that a forfeiture rate has been estimated for all options, as
required by SFAS 123(R).
Stock
Options issued prior to December 31, 2005
Unrecognized
non-cash stock compensation expense related to unvested options outstanding
as
of December 31, 2005 was approximately $1 million (includes 328,124 shares
valued at $500,000 unvested and cancelled on April 5, 2006 upon the resignation
of James M. Pusey, MD). Because of the significant expected forfeiture rate
(54%) caused by the options cancelled at the time of Dr. Pusey’s resignation,
the expected compensation cost for unvested options at December 31, 2005, was
approximately $388,000. At September 30, 2007, the
remaining compensation cost related to unvested options outstanding at December
31, 2005, is approximately $26,000, which will be recognized over the remaining
vesting period of approximately two years, with an estimated weighted average
period of one year.
2006
Stock Options
Using
an
estimated forfeiture rate of 12%, compensation cost recorded for the nine months
ended September 30, 2007, for options issued in 2006 was $299,000. The
options granted generally vest over a two to four-year period from the date
of
grant and, accordingly, the remaining unamortized cost at September 30, 2007
of
approximately $365,000 will be amortized ratably over the period ending December
31, 2009, with an estimated weighted average period of one year.
2007
Stock Options
On
January 1, 2007, the Board of Directors granted each Director a fully vested
option to purchase 10,000 shares of the Company’s common stock at an exercise
price of $1.43. Additionally, during the three months ended March 31,
2007, the Company granted a fully vested option to purchase 13,889 shares of
the
Company’s common stock to a consultant at an exercise price of $1.44 and an
option to purchase 5,000 shares that vests over a four-year period, to an
employee, at an exercise price of $1.45. On May 21, 2007, the Company
granted an option to Dr. Steer to purchase 50,000 shares of the Company’s common
stock at $1.53, which vests pro-rata over a two-year period.
During
the three months ended September 30, 2007, the Company granted options to
purchase 86,000 shares of the Company’s common stock to the members of its
Scientific Advisory Board at an average exercise price of $1.43 per
share. The options vested 25% on the date of grant, with the
remaining options vesting pro-rata over a three year period.
The
Company used the Black-Scholes model with the following assumptions, to
determine the total fair value of $52,000 for options to purchase 78,889 shares
of the Company’s common stock issued during the three months ended March 31,
2007, the fair value of $33,000 for options to purchase 50,000 shares of the
Company’s common stock issued during the three months ended June 30, 2007, and
the fair value of $87,000 for options to purchase 86,000 shares of the Company’s
common stock issued during the three months ended September 30,
2007.
|
Three
months ended
|
Three
months ended
|
Three
months ended
|
|
March 31,
2007
|
June 30,
2007
|
September 30,
2007
|
Risk
free interest rate
|
4.6%
|
4.87%
|
4.24%
|
Volatility
|
66%
|
61%
|
59%
|
Expected
term from vesting
|
2.8
Years
|
2.8
Years
|
2.9
Years
|
Dividend
yield
|
0%
|
0%
|
0%
|
Using
an
estimated forfeiture rate of 20%, compensation cost recorded for the nine months
ended September 30, 2007, for options issued in 2007, was
$99,000. The options granted, that did not vest on the grant date,
vest over two to four-year periods from the date of grant and, accordingly,
the
remaining unamortized cost at September 30, 2007 of approximately $34,000 will
be amortized ratably over the period ending December 31, 2010, with an estimated
weighted average period of one year.
2007 Awards
of Shares of Common Stock
On
January 1, 2007, the Board of Directors of the Company awarded 104,898 shares
of
restricted stock (17,843 shares to each director), which vest on January 1,
2008. The total fair value of the grants, determined using the
closing price of the Company’s common stock on the date of grant, was $150,000,
which included $25,000 (17,843 shares) that were subsequently forfeited due
to
Mr. Casey’s decision to not seek re-election to the Board of Directors on May
10, 2007. Of the net fair value of the awards of $125,000, $89,000
has been recognized as compensation cost in the nine months ended September
30,
2007.
On
May
10, 2007, the Board of Directors of the Company awarded total compensation
of
$115,000 to various executives, to be paid through the issuance of shares of
the
Company’s common stock. The total number of shares of stock issued
was 76,159.
Summary
Non-cash
stock compensation cost for the nine months ended September 30, 2007, totaled
$591,000. In the condensed Statements of Operations for the nine
months ended September 30, 2007, non-cash stock compensation expense of $394,000
was recorded as a general and administrative expense and $197,000 was recorded
as research and development expense.
Non-cash
stock compensation cost for the nine months ended September 30, 2006, totaled
$2,252,000 of which $607,000 related to stock awards. In the
condensed Statements of Operations for the nine months ended September 30,
2006,
non-cash stock compensation expense of $1,649,000 was recorded as a general
and
administrative expense and $603,000 was recorded as a research and development
expense.
During
the nine months ended September 30, 2006, options to purchase 670,400 shares
of
the Company’s common stock were exercised resulting in the receipt by the
Company of net cash proceeds of $2,962,000. The intrinsic value of
options exercised during the nine months ended September 30, 2006 was
$689,000. No options were exercised in the nine months ended
September 30, 2007.
A
summary
of option activity under our stock option plans for the nine months ended
September 30, 2007, is as follows:
|
|
Number
of Options
|
|
|
Weighted
average exercise price
|
|
|
Weighted
average remaining contractual term
(years)
|
|
Options
outstanding December 31, 2006
|
|
|
3,438,126
|
|
|
$
|
3.69
|
|
|
|
|
Plus: Options
granted
|
|
|
214,889
|
|
|
|
1.45
|
|
|
|
|
Less:
|
|
|
|
|
|
|
|
|
|
|
|
Options
exercised
|
|
|
-
|
|
|
|
|
|
|
|
|
Options
expired/forfeited
|
|
|
(328,390
|
)
|
|
|
4.60
|
|
|
|
|
Options
outstanding at September 30, 2007
|
|
|
3,324,625
|
|
|
|
3.46
|
|
|
|
6.50
|
|
Options
exercisable at September 30, 2007
|
|
|
2,520,621
|
|
|
|
3.66
|
|
|
|
5.82
|
|
Options
vested and expected to vest at September 30, 2007
|
|
|
3,093,494
|
|
|
|
3.48
|
|
|
|
6.34
|
|
A
summary
of the status of the Company’s unvested shares as of September 30, 2007, and
changes during the nine months ended September 30, 2007, is presented
below:
|
|
|
|
|
Weighted
|
|
|
|
|
|
|
average
|
|
|
|
Number
of
|
|
|
Grant
date
|
|
Unvested
Shares
|
|
Options
|
|
|
Fair
Value
|
|
Unvested
shares at December 31, 2006
|
|
|
-
|
|
|
$
|
-
|
|
Granted
|
|
|
181,057
|
|
|
$
|
1.46
|
|
Vested
|
|
|
(76,159
|
)
|
|
$
|
1.51
|
|
Canceled/forfeited
|
|
|
(17,483
|
)
|
|
$
|
1.43
|
|
Unvested
shares at September 30, 2007
|
|
|
87,415
|
|
|
$
|
1.43
|
|
It
is the
Company’s policy to issue options from shareholder approved incentive plans.
However, if the options are issued as an inducement for an individual to join
the Company, the Company may issue stock options outside of shareholder approved
plans. The options granted under shareholder approved incentive plans
have a ten-year term and vest over a two to four-year period of
service. All options and stock purchase rights are granted with an
exercise price equal to the current market value on the date of grant and,
accordingly, options or stock purchase rights have no intrinsic value on the
date of grant. Based on the closing market price of the Company’s
common stock at September 30, 2007, of $1.41, stock options exercisable or
expected to vest at September 30, 2007 have no intrinsic value. At September
30,
2007, 436,026 shares remain available to grant under the Company’s 2005 Equity
Incentive Plan.
Warrants
At
September 30, 2007, the Company has warrants outstanding to purchase 46,706
shares of the Company’s common stock with an exercise price of $6.39 per share
which expire in February 2016, and warrants outstanding to purchase 117,423
shares of the Company’s common stock with an exercise price of $1.91 per share
which expire in July 2016.
Additionally,
(as described in Note 15 to our Annual Report on Form 10-K for the year ended
December 31, 2006), performance based warrants to purchase 240,000 shares of
the
Company’s common stock with an exercise price of $1.91, which expire in February
2016, are outstanding but unvested at September 30, 2007. The total
cost of the performance based warrants will be charged to expense over the
period of performance. The costs will be determined based on the fair value
of
the warrants determined by using the Black-Scholes model, revalued at each
Company reporting date until fully vested. The fair value of the
performance based warrants using the Black-Scholes model, 59% volatility, 0%
dividend yield, expected term of 8.4 years, and 4.24% interest rate was $209,000
at September 30, 2007. No costs were charged to expense at September
30, 2007 as it is not yet probable that any performance based warrants will
vest.