UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-Q
x
QUARTERLY
REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
FOR
THE
QUARTERLY PERIOD ENDED
SEPTEMBER
30, 2008
p
TRANSITION
REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
FOR
THE
TRANSITION PERIOD FROM ________________
TO
_____________
Commission
file number
001-33874
XCORPOREAL,
INC.
(Exact
name of small business issuer as specified in its charter)
Delaware
|
|
75-2242792
|
(State
or other jurisdiction of
incorporation
or organization)
|
|
(IRS
Employer Identification Number)
|
12121
Wilshire Blvd., Suite 350, Los Angeles, California 90025
(Address
of principal executive offices)
(310)
923-9990
(Issuer’s
telephone number)
Check
whether the issuer (1) filed all reports required to be filed by Section 13
or
15(d) of the Exchange Act during the past 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days. Yes
x
No
¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.
¨
Large accelerated filer
|
|
¨
Accelerated filer
|
|
|
|
¨
Non-accelerated filer
|
|
x
Smaller reporting company
|
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).Yes
o
No
x
State
the
number of shares outstanding of each of the issuer’s classes of common equity,
as of the latest practicable date.
Class
|
|
Outstanding
as of November 17, 2008
|
Common
Stock, $0.0001 par value
|
|
14,704,687
shares
|
INDEX
PART
I — FINANCIAL INFORMATION
|
2
|
|
|
Item
1. Interim Financial Statements
|
2
|
|
|
Balance
Sheets at September 30, 2008 (unaudited) and December 31,
2007
|
2
|
|
|
Statements
of Operations (unaudited) for the three and nine months ended
September
30, 2008 and September 30, 2007 and the period from inception
(May 4,
2001) to September 30, 2008
|
3
|
|
|
Statements
of Cash Flows (unaudited) for the nine months ended September
30, 2008 and
September 30, 2007 and the period from inception (May 4, 2001)
to
September 30, 2008
|
4
|
|
|
Statement
of Stockholders Equity (Deficit) for the nine months ended September
30,
2008 and the period from inception (May 4, 2001) to September
30, 2008
(unaudited)
|
5
|
|
|
Notes
to the Interim Financial Statements
|
6
|
|
|
Item
2. Management’s Discussion and Analysis of Financial Condition and Results
of Operations
|
15
|
|
|
Item
3. Quantitative and Qualitative Disclosures about Market
Risk
|
19
|
|
|
Item
4. Controls and Procedures
|
19
|
|
|
PART
II — OTHER INFORMATION
|
21
|
|
|
Item
1. Legal Proceedings
|
21
|
|
|
Item
1A. Risk Factors
|
22
|
|
|
Item
2. Unregistered Sales of Equity Securities ; Use of Proceeds
from
Registered Securities
|
23
|
|
|
Item
6. Exhibits
|
24
|
|
|
Signatures
|
25
|
PART
I — FINANCIAL INFORMATION
ITEM
1. Financial Statements
XCORPOREAL,
INC.
(a
Development Stage Company)
BALANCE
SHEETS
(Unaudited)
|
|
September 30,
|
|
December 31,
|
|
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
ASSETS
|
|
|
|
|
|
Current
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
253,042
|
|
$
|
106,495
|
|
Marketable
securities, at fair value
|
|
|
5,756,685
|
|
|
16,401,898
|
|
Restricted
cash
|
|
|
67,788
|
|
|
68,016
|
|
Prepaid
Expenses & Other Current Assets
|
|
|
300,473
|
|
|
408,303
|
|
Total
current assets
|
|
|
6,377,988
|
|
|
16,984,712
|
|
|
|
|
|
|
|
|
|
Property
and equipment, net
|
|
|
304,749
|
|
|
266,912
|
|
|
|
|
|
|
|
|
|
Other
assets
|
|
|
877
|
|
|
922
|
|
|
|
|
|
|
|
|
|
Total
Assets
|
|
$
|
6,683,614
|
|
$
|
17,252,546
|
|
|
|
|
|
|
|
|
|
LIABILITIES
|
|
|
|
|
|
|
|
Current
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
1,180,138
|
|
$
|
1,125,239
|
|
Accrued
professional fees
|
|
|
3,049,015
|
|
|
425,228
|
|
Accrued
royalties
|
|
|
270,833
|
|
|
83,333
|
|
Accrued
compensation
|
|
|
139,564
|
|
|
196,541
|
|
Accrued
other liabilities
|
|
|
120,330
|
|
|
68,946
|
|
Payroll
liabilities
|
|
|
10,955
|
|
|
11,926
|
|
Deferred
rent
|
|
|
40,929
|
|
|
-
|
|
Other
current liabilities
|
|
|
115,400
|
|
|
115,400
|
|
Total
Current Liabilities
|
|
|
4,927,164
|
|
|
2,026,613
|
|
|
|
|
|
|
|
|
|
Shares
issuable
|
|
|
4,615,000
|
|
|
-
|
|
|
|
|
|
|
|
|
|
COMMITMENTS
& CONTINGENCIES
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
STOCKHOLDERS'
EQUITY
|
|
|
|
|
|
|
|
Preferred
Stock, $0.0001 par value, 10,000,000 shares authorized, none
outstanding
|
|
|
-
|
|
|
-
|
|
Common
Stock, $0.0001 par value, 40,000,000 shares authorized, 14,704,687
and
14,372,472 outstanding on September 30, 2008 and December 31, 2007,
respectively
|
|
|
1,470
|
|
|
1,437
|
|
Additional
paid-in capital
|
|
|
41,526,283
|
|
|
36,822,316
|
|
Deficit
accumulated during the development stage
|
|
|
(44,386,303
|
)
|
|
(21,597,820
|
)
|
Total
Stockholders' (Deficit) Equity
|
|
|
(2,858,550
|
)
|
|
15,225,933
|
|
Total
Liabilities & Stockholders' (Deficit) Equity
|
|
$
|
6,683,614
|
|
$
|
17,252,546
|
|
See
accompanying notes to interim financial statements.
XCORPOREAL,
INC.
(a
Development Stage Company)
STATEMENTS
OF OPERATIONS
(Unaudited)
|
|
|
|
|
|
|
|
|
|
May 4, 2001 (Date
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
of Inception) to
|
|
|
|
September 30,
|
|
September 30,
|
|
September 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
2008
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
Expenses:
|
|
|
|
|
|
|
|
|
|
|
|
Selling,
general and administrative
|
|
$
|
2,111,578
|
|
$
|
2,664,405
|
|
$
|
7,756,230
|
|
$
|
8,254,693
|
|
$
|
22,158,922
|
|
Research
and development
|
|
|
12,694,055
|
|
|
2,087,753
|
|
|
18,900,027
|
|
|
4,775,887
|
|
|
27,328,519
|
|
Other
expenses
|
|
|
1,871,430
|
|
|
-
|
|
|
1,871,430
|
|
|
-
|
|
|
1,871,430
|
|
Depreciation
and amortization
|
|
|
27,253
|
|
|
9,243
|
|
|
75,837
|
|
|
14,626
|
|
|
108,103
|
|
Loss
before other income, income taxes, and other expenses
|
|
|
(16,704,316
|
)
|
|
(4,761,401
|
)
|
|
(28,603,524
|
)
|
|
(13,045,206
|
)
|
|
(51,466,974
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
and other income
|
|
|
44,871
|
|
|
290,677
|
|
|
278,941
|
|
|
910,603
|
|
|
1,546,171
|
|
Change
in fair value of shares issuable
|
|
|
5,538,000
|
|
|
-
|
|
|
5,538,000
|
|
|
-
|
|
|
5,538,000
|
|
Loss
before income taxes and other expenses
|
|
|
(11,121,445
|
)
|
|
(4,470,724
|
)
|
|
(22,786,583
|
)
|
|
(12,134,603
|
)
|
|
(44,382,803
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
taxes
|
|
|
300
|
|
|
-
|
|
|
1,900
|
|
|
-
|
|
|
3,500
|
|
Net
Loss
|
|
$
|
(11,121,745
|
)
|
$
|
(4,470,724
|
)
|
$
|
(22,788,483
|
)
|
$
|
(12,134,603
|
)
|
$
|
(44,386,303
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
and diluted loss per share
|
|
$
|
(0.76
|
)
|
$
|
(0.32
|
)
|
$
|
(1.57
|
)
|
$
|
(0.86
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average number of shares outstanding
|
|
|
14,704,687
|
|
|
14,089,180
|
|
|
14,561,070
|
|
|
14,162,687
|
|
|
|
|
See
accompanying notes to interim financial statements.
XCORPOREAL,
INC.
(a
Development Stage Company)
STATEMENTS
OF CASH FLOWS
(Unaudited)
|
|
|
|
|
|
May 4, 2001 (Date
|
|
|
|
Nine Months Ended
|
|
of Inception) to
|
|
|
|
September 30,
|
|
September 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
Cash flows used in operating activities
|
|
|
|
|
|
|
|
Net
Loss for the Period
|
|
$
|
(22,788,483
|
)
|
$
|
(12,134,603
|
)
|
$
|
(44,386,303
|
)
|
|
|
|
|
|
|
|
|
|
|
|
Adjustments
to reconcile net loss to net cash (used in) operating
activities:
|
|
|
|
|
|
|
|
|
|
|
Stock
Based Compensation
|
|
|
3,813,158
|
|
|
2,233,238
|
|
|
7,798,894
|
|
Non-employee
Stock Based Compensation
|
|
|
92,842
|
|
|
2,923,344
|
|
|
5,172,762
|
|
Common
Stock Issuance for consulting services rendered
|
|
|
798,000
|
|
|
-
|
|
|
896,000
|
|
Increase
in shares issuable
|
|
|
10,153,000
|
|
|
-
|
|
|
10,153,000
|
|
Mark
to market of shares issuable
|
|
|
(5,538,000
|
)
|
|
-
|
|
|
(5,538,000
|
)
|
Depreciation
|
|
|
75,792
|
|
|
14,562
|
|
|
107,980
|
|
Net
Change in assets and liabilities:
|
|
|
|
|
|
|
|
|
|
|
Decrease
(increase) in Prepaid Expenses & Other Current Assets
|
|
|
107,830
|
|
|
(223,935
|
)
|
|
(300,473
|
)
|
Decrease
(increase) in Other Assets
|
|
|
45
|
|
|
64
|
|
|
(877
|
)
|
Increase
in Accounts Payable and Accrued Liabilities
|
|
|
2,859,622
|
|
|
323,248
|
|
|
4,733,464
|
|
Increase
in Deferred Rent
|
|
|
40,929
|
|
|
-
|
|
|
40,929
|
|
Increase
in Other Current Liabilities
|
|
|
-
|
|
|
-
|
|
|
115,400
|
|
Net
Cash Used in Operating Activities
|
|
|
(10,385,265
|
)
|
|
(6,864,082
|
)
|
|
(21,207,224
|
)
|
|
|
|
|
|
|
|
|
|
|
|
Cash
Flows from Investing Activities
|
|
|
|
|
|
|
|
|
|
|
Capital
Expenditures
|
|
|
(113,629
|
)
|
|
(207,321
|
)
|
|
(412,729
|
)
|
Restricted
Cash
|
|
|
228
|
|
|
(87,996
|
)
|
|
(67,788
|
)
|
Purchase
of marketable securities
|
|
|
(8,598,102
|
)
|
|
(21,932,739
|
)
|
|
(33,598,102
|
)
|
Sale
of marketable securities
|
|
|
19,243,315
|
|
|
2,323,422
|
|
|
27,841,417
|
|
Net
Cash Provided by (Used in) Investing Activities
|
|
|
10,531,812
|
|
|
(19,904,634
|
)
|
|
(6,237,202
|
)
|
|
|
|
|
|
|
|
|
|
|
|
Cash
Flows from Financing Activities
|
|
|
|
|
|
|
|
|
|
|
Capital
Stock issued
|
|
|
-
|
|
|
-
|
|
|
27,434,348
|
|
Advances
from related party
|
|
|
-
|
|
|
-
|
|
|
64,620
|
|
Additional
Proceeds from the Sale of Common Stock in 2006
|
|
|
-
|
|
|
-
|
|
|
198,500
|
|
Net
Cash Provided by Financing Activities
|
|
|
-
|
|
|
-
|
|
|
27,697,468
|
|
|
|
|
|
|
|
|
|
|
|
|
Increase/(decrease)
in cash during the period
|
|
|
146,547
|
|
|
(26,768,716
|
)
|
|
253,042
|
|
Cash,
beginning of the period
|
|
|
106,495
|
|
|
27,440,987
|
|
|
-
|
|
Cash,
end of the period
|
|
$
|
253,042
|
|
$
|
672,271
|
|
$
|
253,042
|
|
|
|
|
|
|
|
|
|
|
|
|
Supplemental
disclosure of cash flow information; cash paid for:
|
|
|
|
|
|
|
|
|
|
|
Interest
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
Income
taxes
|
|
$
|
1,900
|
|
$
|
-
|
|
$
|
3,500
|
|
See
accompanying notes to interim financial statements.
XCORPOREAL,
INC.
(a
Development Stage Company)
STATEMENTS
OF STOCKHOLDERS’ EQUITY (DEFICIT)
For
the Period May 4, 2001 (Inception) to September 30, 2008
(Unaudited)
|
|
|
|
|
|
|
|
Deficit
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated
|
|
|
|
|
|
|
|
|
|
Additional
|
|
During
|
|
|
|
|
|
Common Stock
|
|
Paid-in
|
|
Development
|
|
|
|
|
|
Shares
|
|
Amount
|
|
Capital
|
|
Stage
|
|
Total
|
|
Common
stock issued for cash at $0.01 per share
|
|
|
2,500,000
|
|
$
|
250
|
|
$
|
24,750
|
|
|
|
|
$
|
25,000
|
|
Net
Loss for the year ended December 31, 2001
|
|
|
|
|
|
|
|
|
|
|
$
|
(40,255
|
)
|
|
(40,255
|
)
|
Balance
as of December 31, 2001
|
|
|
2,500,000
|
|
|
250
|
|
|
24,750
|
|
|
(40,255
|
)
|
|
(15,255
|
)
|
Common
stock issued for cash at $0.05 per share
|
|
|
1,320,000
|
|
|
132
|
|
|
65,868
|
|
|
|
|
|
66,000
|
|
Net
Loss for the year ended December 31, 2002
|
|
|
|
|
|
|
|
|
|
|
|
(31,249
|
)
|
|
(31,249
|
)
|
Balance
as of December 31, 2002
|
|
|
3,820,000
|
|
|
382
|
|
|
90,618
|
|
|
(71,504
|
)
|
|
19,496
|
|
Net
Loss for the year ended December 31, 2003
|
|
|
|
|
|
|
|
|
|
|
|
(12,962
|
)
|
|
(12,962
|
)
|
Balance
as of December 31, 2003
|
|
|
3,820,000
|
|
|
382
|
|
|
90,618
|
|
|
(84,466
|
)
|
|
6,534
|
|
Net
Loss for the year ended December 31, 2004
|
|
|
|
|
|
|
|
|
|
|
|
(23,338
|
)
|
|
(23,338
|
)
|
Balance
as of December 31, 2004
|
|
|
3,820,000
|
|
|
382
|
|
|
90,618
|
|
|
(107,804
|
)
|
|
(16,804
|
)
|
Net
Loss for the year ended December 31, 2005
|
|
|
|
|
|
|
|
|
|
|
|
(35,753
|
)
|
|
(35,753
|
)
|
Balance
as of December 31, 2005
|
|
|
3,820,000
|
|
|
382
|
|
|
90,618
|
|
|
(143,557
|
)
|
|
(52,557
|
)
|
Common
stock issued for a license rights at $0.0001 per share
|
|
|
9,600,000
|
|
|
960
|
|
|
40
|
|
|
|
|
|
1,000
|
|
Capital
stock cancelled
|
|
|
(3,420,000
|
)
|
|
(342
|
)
|
|
342
|
|
|
|
|
|
-
|
|
Warrants
granted for consulting fees
|
|
|
|
|
|
|
|
|
2,162,611
|
|
|
|
|
|
2,162,611
|
|
Forgiveness
of related party debt
|
|
|
|
|
|
|
|
|
64,620
|
|
|
|
|
|
64,620
|
|
Common
stock issued for cash at $7.00, net of placement fees of
$2,058,024
|
|
|
4,200,050
|
|
|
420
|
|
|
27,341,928
|
|
|
|
|
|
27,342,348
|
|
Stock-based
compensation expense
|
|
|
|
|
|
|
|
|
264,251
|
|
|
|
|
|
264,251
|
|
Net
loss for the period
|
|
|
|
|
|
|
|
|
|
|
|
(4,380,212
|
)
|
|
(4,380,212
|
)
|
Balance
as of December 31, 2006
|
|
|
14,200,050
|
|
|
1,420
|
|
|
29,924,410
|
|
|
(4,523,769
|
)
|
|
25,402,061
|
|
Capital
stock cancelled
|
|
|
(200,000
|
)
|
|
(20
|
)
|
|
20
|
|
|
|
|
|
-
|
|
Common
stock issued pursuant to consulting agreement at $4.90 per
share
|
|
|
20,000
|
|
|
2
|
|
|
97,998
|
|
|
|
|
|
98,000
|
|
Recapitalization
pursuant to merger
|
|
|
352,422
|
|
|
35
|
|
|
(37,406
|
)
|
|
|
|
|
(37,371
|
)
|
Warrants
granted for consulting services
|
|
|
|
|
|
|
|
|
2,917,309
|
|
|
|
|
|
2,917,309
|
|
Stock-based
compensation expense
|
|
|
|
|
|
|
|
|
3,721,485
|
|
|
|
|
|
3,721,485
|
|
Additional
Proceeds from the Sale of Common Stock in 2006
|
|
|
|
|
|
|
|
|
198,500
|
|
|
|
|
|
198,500
|
|
Net
loss for the period
|
|
|
|
|
|
|
|
|
|
|
|
(17,074,051
|
)
|
|
(17,074,051
|
)
|
Balance
as of December 31, 2007
|
|
|
14,372,472
|
|
|
1,437
|
|
|
36,822,316
|
|
|
(21,597,820
|
)
|
|
15,225,933
|
|
Common
stock issued as compensation for consulting services at $3.61 per
share
|
|
|
200,000
|
|
|
20
|
|
|
721,980
|
|
|
|
|
|
722,000
|
|
Warrants
granted for consulting services
|
|
|
|
|
|
|
|
|
75,489
|
|
|
|
|
|
75,489
|
|
Stock-based
compensation expense
|
|
|
|
|
|
|
|
|
1,121,118
|
|
|
|
|
|
1,121,118
|
|
Net
loss for the period
|
|
|
|
|
|
|
|
|
|
|
|
(6,350,365
|
)
|
|
(6,350,365
|
)
|
Balance
as of March 31, 2008
|
|
|
14,572,472
|
|
|
1,457
|
|
|
38,740,903
|
|
|
(27,948,185
|
)
|
|
10,794,175
|
|
Common
stock issued as compensation for consulting services at $3.80 per
share
|
|
|
20,000
|
|
|
2
|
|
|
75,998
|
|
|
|
|
|
76,000
|
|
Cashless
exercise of warrants
|
|
|
112,215
|
|
|
11
|
|
|
(11
|
)
|
|
|
|
|
0
|
|
Warrants
granted for consulting services
|
|
|
|
|
|
|
|
|
9,256
|
|
|
|
|
|
9,256
|
|
Stock-based
compensation expense
|
|
|
|
|
|
|
|
|
960,840
|
|
|
|
|
|
960,840
|
|
Net
loss for the period
|
|
|
|
|
|
|
|
|
|
|
|
(5,316,373
|
)
|
|
(5,316,373
|
)
|
Balance
as of June 30, 2008
|
|
|
14,704,687
|
|
|
1,470
|
|
|
39,786,986
|
|
|
(33,264,558
|
)
|
|
6,523,898
|
|
Stock-based
compensation expense
|
|
|
|
|
|
|
|
|
1,739,297
|
|
|
|
|
|
1,739,297
|
|
Net
loss for the period
|
|
|
|
|
|
|
|
|
|
|
|
(11,121,745
|
)
|
|
(11,121,745
|
)
|
Balance
as of September 30, 2008
|
|
|
14,704,687
|
|
$
|
1,470
|
|
$
|
41,526,283
|
|
$
|
(44,386,303
|
)
|
$
|
(2,858,550
|
)
|
See
accompanying notes to interim financial statements.
XCORPOREAL,
INC.
(a
Development Stage Company)
NOTES
TO INTERIM FINANCIAL STATEMENTS
September
30, 2008
(Unaudited)
Note
1 — Interim Reporting
While
information presented in the accompanying interim financial statements is
unaudited, it includes all adjustments, which are, in the opinion of management,
necessary to present fairly the financial position, results of operations,
and
cash flows for the interim period presented.
The
results of operations for the period ended September 30, 2008 are not
necessarily indicative of the results that can be expected for the year ended
December 31, 2008.
Note
2 — Nature of Operations
and
Going Concern Uncertainty
On
October 12, 2007, pursuant to a merger agreement with Xcorporeal, Inc. (referred
to hereinafter as Operations), our newly-formed wholly-owned merger subsidiary,
merged with and into Operations, which became our wholly-owned subsidiary and
changed its name to “Xcorporeal Operations, Inc.” We changed our name from CT
Holdings Enterprises, Inc. (CTHE) to “Xcorporeal, Inc.” and amended our
certificate of incorporation and bylaws to read substantially as Operations.
As
a result, our authorized common stock changed from 60,000,000 shares to
40,000,000 common shares, and our authorized preferred stock changed from
1,000,000 shares to 10,000,000 shares, resulting in total authorized capital
stock of 50,000,000 shares.
Immediately
prior to the merger, we caused a one-for-8.27 reverse split of our common stock.
Each share of Operations common stock was then converted into one share of
our
common stock. In addition, we assumed all outstanding Operations options and
warrants to purchase Operations common stock.
In
this
merger, CTHE is considered to be the legal acquirer and Xcorporeal to be the
accounting acquirer. As the former shareholders of Operations owned over 97%
of
the outstanding voting common stock of CTHE immediately after the merger and
CTHE was a public shell company, Operations is considered the accounting
acquirer and the transaction is considered to be a recapitalization of
Operations.
Historical
financial statements prior to the merger were restated to be those of
Operations. The merger is accounted for as if it were an issuance of the common
stock of Operations to acquire our net assets, accompanied by a
recapitalization. Historical stockholders’ equity of Operations is retroactively
restated for the equivalent number of shares received in the merger, after
giving effect to the difference in par value with an offset to paid-in capital.
The assets and liabilities of Operations are carried forward at their
predecessor carrying amounts. Retained deficiency of Operations is carried
forward after the merger. Operations prior to the merger are those of
Operations. Earnings per share for periods prior to the merger are restated
to
reflect the number of equivalent shares received by Operations’s stockholders.
The costs of the transaction will be expensed to the extent they exceed cash
received from CTHE. References to "we," "us, "our" and the "company" after
consummation of the merger include CTHE and Operations.
As
a
result of the merger, we transitioned to a development stage company focused
on
researching, developing, and commercializing technology and products related
to
the treatment of kidney failure.
We
expect
to incur negative cash flows and net losses for the foreseeable future. Based
upon our current plans, we believe that our existing cash reserves will not
be
sufficient to meet our operating expenses and capital requirements before we
achieve profitability. Accordingly, we may seek to raise additional funds
through public or private placement of shares of preferred or common stock
or
through public or private financing. Our ability to meet our cash obligations
as
they become due and payable will depend on our ability to sell securities,
borrow funds, reduce operating costs, or some combination thereof. We may not
be
successful in raising necessary funds on acceptable terms, or at all. As a
result of these conditions, there is substantial doubt about our ability to
continue as a going concern. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
Upon
receipt of the approximate $27.3 million raised through a private placement
which closed in the fourth quarter of 2006, we strategically began our operating
activities and research and development efforts which resulted in a net loss
of
$17.1 million in 2007, and $22.8 million in the nine months ended September
30,
2008 including a net $4.6 million fair value accrual of a potential 9.23 million
shares issuance discussed in Note 4-Legal Proceedings below. In addition, we
invested $25.0 million in high grade money market funds and marketable
securities of which we sold $19.2 million of the investments, leaving a balance
of $5.8 million as of September 30, 2008.
We
are a
medical device company developing an innovative
extra-corporeal
platform
technology to be used in devices to replace the function of various human
organs. The platform leads to three initial products: (i) a Portable Artificial
Kidney (PAK) for hospital Renal Replacement Therapy, (ii) a PAK for home
hemodialysis and (iii) a Wearable Artificial Kidney (WAK) for continuous
ambulatory hemodialysis. Our rights to the WAK derive in part from a License
Agreement dated September 1, 2006, between Operations and National Quality
Care,
Inc. ("NQCI") pursuant to which we obtained the exclusive rights to the
technology designated therein (the "License Agreement"). See Note 4-Legal
Proceedings below
.
We
have
focused much of our efforts on development of the PAK, which has not been
derived from the technology covered by the License Agreement. Through the
productive research and development efforts of the PAK, we have completed
functional prototypes of our hospital and home PAKs that we plan to
commercialize after 510(k) notification clearance from the Food and Drug
Administration (FDA) which we plan to seek by next year. Prior to the 510(k)
submission to the FDA for clinical use under direct medical supervision, the
units will undergo final verification and validation. It generally takes 4
to 12
months from the date of a 510(k) submission to obtain clearance from the FDA,
although it may take longer. As we begin to shift out of the phase of
development and build of the prototype equipment, reducing the related spending
on research and development costs as well as consulting and material costs,
see
Note 16-Product Development Agreement, we expect that our monthly expenditures
will remain somewhat constant. With this transition, there will be a shift
of
resources towards verification and validation of our devices along with
developing a marketing plan for the PAK.
In
addition, we have used some of our resources for the development of the WAK
which we have demonstrated a feasibility prototype. Commercialization of the
WAK
will require development of a functional prototype and likely a full pre-market
approval by the FDA, which could take several years. Once the Technology
Transaction has closed and the results of the arbitration proceeding described
in Note 4-Legal Proceedings are final, we will determine whether to devote
additional resources to development of the WAK.
Because
neither the PAK nor the WAK is yet at a stage where it can be marketed
commercially, we are not able to predict the portion of our future business
which will be derived from each.
Note
3 — Development Stage Company
We
are a
development stage company, devoting substantially all of our efforts to the
research, development, and commercialization of kidney failure treatment
technologies.
Risks
and Uncertainties—
We
operate in an industry that is subject to intense competition, government
regulation, and rapid technological change. Our operations are subject to
significant risk and uncertainties including financial, operational,
technological, legal, regulatory, and other risks associated with a development
stage company, including the potential risk of business failure.
Note
4 – Legal Proceedings
On
December 1, 2006, Operations initiated arbitration against National Quality
Care, Inc. (NQCI) for NQCI's failure to fully perform its obligations under
the
License Agreement dated September 1, 2006. On September 1, 2006, Operations
also
entered into a Merger Agreement with NQCI which contemplated that Operations
would acquire NQCI as a wholly owned subsidiary pursuant to a triangular merger,
or would issue to NQCI shares of common stock in consideration of the assignment
of the technology relating to the WAK and other medical devices which, as listed
under “Technology” on the License Agreement, are “all existing and hereafter
developed Intellectual Property, Know-How, Licensor Patents, Licensor Patent
Applications, Derivative Works and any other technology, invented, improved
or
developed by Licensor, or as to which Licensor owns or holds any rights, arising
out of or relating to the research, development, design, manufacture or use
of
(a) any medical device, treatment or method as of the date of this Agreement,
(b) any portable or continuous dialysis methods or devices , specifically
including any wearable artificial kidney, or Wearable Artificial Kidney, and
related devices, (c) any device, methods or treatments for congestive heart
failure, and (d) any artificial heart or coronary device” (the “Technology
Transaction”). The merger was not consummated.
On
January 3, 2008, the arbitrator issued an order denying NQCI’s motion to amend
its counterclaim to add us as a successor company following the merger. However,
in the Second Interim Award, the arbitrator found that we are the successor
to
Operations as a result of the merger, even though we are not a party to any
of
the agreements or the arbitration, and ordered that our shares should be issued
to NQCI rather than shares of Operations.
On
June
9, 2008, the arbitrator issued an Interim Award granting specific performance
of
the Technology Transaction. The Interim Award stated that the total aggregate
shares of stock to be received by NQCI at the Closing should equal 48% of all
Operations shares outstanding as of the date of the Merger Agreement. On
September 1, 2006, there were 10,000,000 shares of Operations common stock
outstanding. Copies of the License Agreement and Merger Agreement are attached
as exhibits to our amended current report on Form 8-K/A filed with the
Securities and Exchange Commission on June 11, 2008.
On
August
4, 2008, the arbitrator issued a Second Interim Award, stating that 9,230,000
shares of our common stock should be issued to NQCI to effectuate the Technology
Transaction. As of November 17, 2008, there were 14,704,687 shares of our common
stock issued and outstanding. Accordingly, following Closing of the Technology
Transaction, NQCI would be our largest stockholder and would own approximately
39% of our total outstanding shares.
The
arbitrator has not ordered us to close the Technology Transaction. However,
the
arbitrator found that, with the exception of shareholder approval, virtually
all
conditions to Closing the Technology Transaction have been waived. The award
further states that, if we or our stockholders do not approve the issuance
of
our stock to effectuate the Technology Transaction, all of the Technology
covered by the License will be declared the sole and exclusive property of
NQCI,
and the arbitrator will schedule additional hearings to address whether the
PAK
technology is included within that Technology, and whether NQCI is entitled
to
compensatory damages and the amount of damages, if any, under these
circumstances. Upon closing of the Technology Transaction, the License Agreement
will terminate, and we will own all of the Technology.
The
Second Interim Award also states that the License Agreement will remain in
full
force and effect until the Technology Transaction closes or the arbitrator
determines that it will never close. NQCI has made a claim for reimbursement
of
approximately $690,000 in alleged expenses, Licensor Expenses, under the License
Agreement which were accrued under “Accrued professional fees” as of September
30, 2008. The Licensor Expenses was accrued in the three months ended June
30,
2008 with the expenditure recorded as Licensing Expense within research and
development operating expenses. To date, we have not received any supporting
backup of these alleged Licensor Expenses.
On
August
15, 2008, the arbitrator awarded NQCI $1.87 million to settle over $4 million
NQCI claimed in attorneys’ fees and costs, stating that NQCI’s lack of success
and other factors warranted a substantial reduction in the sums claimed.
The
arbitrator stated in pertinent part: “National’s success in the arbitration has
been only partial and this is directly relevant to the question of the quantum
of attorneys’ fees which should be awarded. … National sought eight or nine
figure damages, but was awarded none. … Further, National asserted claims for
fraud, interference with contract, and other torts, all of which were rejected.
This lack of success warrants a substantial reduction in the sums claimed.” NQCI
asked for a total of $4.04 million in attorneys’ fees and costs. The arbitrator
awarded NQCI a total of $1.87 million which have been accrued under “Accrued
professional fees” as of September 30, 2008. The interim settlement of legal
fees was accrued in the three and nine months ended September 30, 2008 with
the
expenditure recognized as “Other expenses” and payment pending to
date.
In
an
August 29, 2008 Order Re Issuance of Xcorporeal Shares, the arbitrator stated
that the shares should be issued directly to NQCI’s stockholders. However, on
September 4, 2008, the arbitrator issued an order that we should issue and
deliver the 9,230,000 shares directly to NQCI, rather than directly to NQCI
stockholders, if we obtain stockholder approval and elect to proceed with the
Technology Transaction.
The
Second Interim Award requires that we file a registration statement under the
Securities Act to register for resale the shares to be issued to NQCI within
30
days after the closing of the Technology Transaction. The arbitrator
acknowledged that our obligation is to file the registration statement and
to
use reasonable efforts to have the shares registered and not to guarantee
registration and resultant actual public tradability. However, the arbitrator
nevertheless ordered that the registration statement must be declared effective
within 90 days. We have no control over whether the registration statement
will
be declared effective by the Securities and Exchange Commission (SEC), and
no
way to predict what further action, if any, the arbitrator may order if it
is
not declared effective.
The
Technology Transaction will be accounted for as a purchase of the Technology
in
exchange for shares of our common stock.
In
accordance with FASB Concepts Statement No. 7,
Using Cash Flow Information
and Present Value in Accounting Measurements
, t
he
Technology Transaction will be measured based on the fair value of the shares
surrendered on the date of issuance, which is clearly more evident than the
fair
value of the intellectual property. Through the evaluation of the components
of
the intellectual property and information pursuant to the arbitration suggesting
it may not be proprietary, we have determined the intellectual property is
not
economically viable. However, continuing research on the technology will be
useful in developing the prototype of our Wearable Artificial Kidney. In
accordance with FASB 2,
Accounting for Research and Development Costs
,
and its
related interpretations, we will expense the value of the intellectual property,
determined in process research and development, at the date of
acquisition.
Pursuant
to the Second Interim Award,
stating
that, if the Technology Transaction is submitted to and approved by our
stockholders, 9,230,000 shares of our common stock should be issued to NQCI
to
effectuate the transaction, we accrued for the 9.23 million shares of our common
stock. As the Second Interim Award states that a registration statement for
any
issued shares must be declared effective within 90 days, and such contingency
is
not within our control, we have recorded the issuance as a liability, rather
than as equity. The fair value of the 9.23 million shares was measured using
the
closing price of our common stock on August 4, 2008, the date of the Second
Interim Award, and revalued, marked to market, as of the end of this interim
reporting period, September 30, 2008. The fair value of the accrued shares
on
August 4, 2008, was $10,153,000 which was revalued at $4,615,000 as of September
30, 2008, resulting in a $5,538,000 non-operating gain to the statement of
operations for the three and nine months ended September 30, 2008. The net
fair
value of $4,615,000 was accrued under “Shares issuable” as of September 30,
2008. Stockholders’ approval and issuance of the shares are pending to
date.
Although
we may seek stockholder approval for the issuance of the 9.23 million shares
of
our common stock to effectuate the Technology Transaction, we are uncertain
whether the SEC will approve a form of proxy to solicit stockholder approval
of
the transaction, our stockholders will vote to approve the transaction, shares
will be issued to NQCI, or the SEC will declare effective a registration
statement to register the shares for resale. If the Technology Transaction
does
not close, the arbitrator may issue alternative relief. In the event of an
alternate award, the above accrual may be adjusted and the accrual or the actual
settlement will be recorded to coincide with the alternate award.
If
the
9.23 million shares contemplated by the Second Interim Award are issuable
pursuant to a shareholder vote and the shares are issued pursuant to either
a
registration of such shares or the waiver of the registration proposal by the
arbitrator, then the $4.6 million contingent liability record on our balance
sheet becomes an addition of 9.23 million shares to our outstanding common
shares and increases stockholders’ equity by the 9.23 million shares multiplied
by the trading price of our shares on that day.
The
arbitrator has stated that he has not yet issued a final award that may be
confirmed or challenged in a court of competent jurisdiction. A party to the
arbitration could challenge the interim award in court, even after stockholders
approve the transaction. In addition, the arbitrator could again change the
award by granting different or additional remedies, even after stockholders
approve the transaction. We cannot guarantee that the arbitrator would order
that stockholders be given another opportunity to vote on the transaction,
even
if such changes are material. Arbitrators have broad equitable powers, and
arbitration awards are difficult to challenge in court, even if the arbitrator
makes rulings that are inconsistent or not in accordance with the law or the
evidence.
The
above
legal proceedings are discussed in further detail below in Part II-Other
Information, Item 1. Legal Proceedings.
Note
5 — Cash Equivalents and Marketable Securities
We
invest
available cash in short-term commercial paper, certificates of deposit, money
market funds, and high grade marketable securities. We consider any liquid
investment with an original maturity of three months or less when purchased
to
be cash equivalents. Investments, including certificates of deposit with
maturity dates greater than three months when purchased and which have readily
determined fair values, are classified as available-for-sale investments and
reflected in current assets as marketable securities at fair market value.
Our
investment policy requires that all investments be investment grade quality
and
no more than ten percent of our portfolio may be invested in any one security
or
with one institution. At September 30, 2008, all of our cash was held in high
grade money market funds and marketable securities.
Restricted
cash represents deposits secured as collateral for a bank credit card
program.
Note
6 — Fair Value Measurements
Effective
January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements,” (“SFAS
157”). SFAS 157 defines fair value, establishes a framework for measuring fair
value, and expands disclosures about fair value measurements. This statement
does not require any new fair value measurements; rather, it applies to other
accounting pronouncements that require or permit fair value measurements. In
February 2008, FSP FAS 157-2, “Effective Date of FASB Statement
No. 157”, was issued, which delays the effective date of SFAS 157 to
fiscal years and interim periods within those fiscal years beginning after
November 15, 2008 for non-financial assets and non-financial liabilities,
except for items that are recognized or disclosed at fair value in the financial
statements on a recurring basis (at least annually). We elected to defer the
adoption of the standard for these non-financial assets and
liabilities.
Fair
value is defined under SFAS 157 as the price that would be received to sell
an
asset or paid to transfer a liability in the principal or most advantageous
market in an orderly transaction between market participants on the measurement
date. SFAS 157 also establishes a three-level hierarchy, which requires an
entity to maximize the use of observable inputs and minimize the use of
unobservable inputs when measuring fair value.
Beginning
January 1, 2008, assets and liabilities recorded at fair value in the balance
sheet are categorized based upon the level of judgment associated with the
inputs used to measure their fair value. Level inputs, as defined by SFAS 157,
are as follows:
|
·
|
Level
I - inputs are unadjusted, quoted prices for identical assets or
liabilities in active markets at the measurement
date.
|
|
·
|
Level
II - inputs, other than quoted prices included in Level I, that
are
observable for the asset or liability through corroboration with
market
data at the measurement date.
|
|
·
|
Level
III - unobservable inputs that reflect management’s best estimate of what
market participants would use in pricing he asset or liability
at the
measurement date.
|
The
following tables summarize fair value measurements by level at September 30,
2008 for assets and liabilities measured at fair value on a recurring
basis:
|
|
Level
I
|
|
Level
II
|
|
Level
III
|
|
Total
|
|
Cash
and cash equivalents
|
|
$
|
253,042
|
|
$
|
-
|
|
$
|
-
|
|
$
|
253,042
|
|
Marketable
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
paper
|
|
|
3,708,821
|
|
|
-
|
|
|
-
|
|
|
3,708,821
|
|
Corporate
securities fixed rate
|
|
|
651,811
|
|
|
-
|
|
|
-
|
|
|
651,811
|
|
Money
market fund
|
|
|
1,396,053
|
|
|
-
|
|
|
-
|
|
|
1,396,053
|
|
Restricted
cash
|
|
|
67,788
|
|
|
-
|
|
|
-
|
|
|
67,788
|
|
Total
assets
|
|
$
|
6,077,515
|
|
$
|
-
|
|
$
|
-
|
|
$
|
6,077,515
|
|
Short-term
investments classified as available-for-sale were as follows:
|
|
September 30, 2008
|
|
|
|
Aggregate Fair
Value
|
|
Gross Unrealized
Gains / (Losses)
|
|
Estimated Fair
Value
|
|
Commercial
paper
|
|
$
|
3,708,821
|
|
$
|
-
|
|
$
|
3,708,821
|
|
Corporate
securities fixed rate
|
|
|
651,811
|
|
|
-
|
|
|
651,811
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
4,360,632
|
|
$
|
-
|
|
$
|
4,360,632
|
|
Xcorporeal
reviews impairments associated with the above in accordance with SFAS No. 115,
“Accounting for Certain Investments in Debt and Equity Securities,” and FASB
Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments,” to determine the
classification of the impairment as temporary or other-than-temporary.
Xcorporeal considers these investments not to be temporarily impaired as of
September 30, 2008.
There
were no gross unrealized gains or losses as of September 30, 2008.
Note
7 - Property and Equipment
Property
and equipment consist of the following at September 30, 2008:
Property
and equipment
|
|
$
|
412,729
|
|
Accumulated
depreciation
|
|
|
(107,980
|
)
|
Property
and equipment, net
|
|
$
|
304,749
|
|
Depreciation
expense for the three and nine months ended September 30, 2008 and 2007 was
$27,238 and $75,792, and $9,229 and $14,562, respectively.
Note
8 – Shares Issuable
Pursuant
to the August 4, 2008, Second Interim Award, stating that, if the Technology
Transaction is submitted to and approved by our stockholders, 9,230,000 shares
of our common stock should be issued to NQCI to effectuate the transaction,
, we
accrued for the 9,230,000 shares of our common stock. As the Second Interim
Award states that a registration statement for any issued shares must be
declared effective within 90 days, and such contingency is not within out
control,we have recorded the issuance as a liability, rather than as equity.
Until issuance, the shares issuable will be recorded at fair value in accordance
with EITF 00-19, with subsequent changes in fair value recorded as non-operating
gain or loss to our statement of operations. The fair value of the shares will
be measured using the closing price of our common stock on the reporting date.
The measured fair value of $10,153,000 for the accrued 9.23 million shares
on
August 4, 2008, the date of the Second Interim Award, was accrued under “Shares
issuable” and expensed to “Research and development”. From marking to market,
the fair value of the shares issuable was revalued at $4,615,000 as of September
30, 2008. The resulting non-operating gain of $5,538,000 to the statement of
operations for the three and nine months ended September 30, 2008 was recognized
as “Change in fair value of shares issuable”. Stockholder approval and issuance
of the shares are pending to date.
Although
we may seek stockholders’ approval for the issuance of 9.23 million shares of
our common stock to effectuate the Technology Transaction, we are uncertain
whether the SEC will approve the form of proxy to solicit stockholder approval
of the transaction, our stockholders will vote to approve the transaction,
shares will be issued to NQCI, or the SEC will declare effective the
registration statement to register the shares for resale. If the Technology
Transaction does not close, the arbitrator may issue alternative relief. In
the
event of an alternate award, the above accrual may be adjusted and the accrual
or the actual settlement will be recorded to coincide with the alternate award.
Note
9 - Leases
As
of
February 22, 2008, we entered into a 5 year lease agreement and relocated our
corporate office to a location in Los Angeles, CA. The total lease payments
will
be $1,096,878 over a 5 year period. As of September 30, 2008, our remaining
total lease payments are $1,009,838.
The
following is a schedule by years of future minimum lease payments required
under
the 5-year corporate office lease as of September 30, 2008:
Year
ending December 31:
|
|
|
|
2008
|
|
$
|
52,224
|
(
1 )
|
2009
|
|
|
215,859
|
|
2010
|
|
|
224,650
|
|
2011
|
|
|
233,528
|
|
2012
|
|
|
242,842
|
|
2013
|
|
|
40,735
|
(
2 )
|
|
|
|
|
|
Total
minimum payments required
|
|
$
|
1,009,838
|
|
|
(
1
)
|
excludes
lease payments made through September 30,
2008
|
|
(
2
)
|
initial
term of the lease agreement ends February
2013
|
On
May
15, 2008, we executed the second amendment to the sublease agreement for office
and warehouse space from Aubrey Group, Inc. (Aubrey). Pursuant to the amendment,
we acquired additional office and warehouse space. In addition, our monthly
sublease rent increased to $8,715 through December 31, 2008. As of September
30,
2008, our remaining total sublease payments are $17,429 for the remaining time
we will occupy the subleased space from Aubrey which we have given notice to
vacate by the end of November 2008.
Note
10 — Interest Income
Interest
income of $44,871 and $278,941, and $290,677 and $910,603 was reported for
the
three and nine months ended September 30, 2008 and 2007,
respectively.
Note
11 – Other Expenses
On
August
15, 2008, the arbitrator in the NQCI arbitration issued another interim award,
awarding NQCI a total of $1,871,430 in attorney’s fees and costs. Pursuant to
the award, we accrued the liability under “Accrued professional fees” and
captured the expenditure in “Other expenses” in the three and nine months ended
September 30, 2008.
Note
12 — Related Party Transactions
In
connection with the contribution of the assets to our company, on August 31,
2006
we
issued
to Consolidated National, LLC (CNL), of which Terren Peizer, who beneficially
owns 42.4% of our outstanding common stock, is the sole managing member and
beneficial owner, an aggregate of 9,600,000 shares of common stock of which
6,232,596 shares are still held by CNL.
The
Chief
Medical and Scientific Officer of our Company, Dr. Victor Gura, owns 15,497,250
shares of common stock of NQCI (or approximately 20.9% of NQCI's common stock
outstanding as of October 17, 2008 with whom we entered into the License
Agreement. Such shares include 800,000 shares owned by Medipace Medical Group,
Inc., an affiliate of Dr. Gura, and 250,000 shares subject to warrants held
by
Dr. Gura which are currently exercisable.
Pursuant
to a consulting agreement effective December 1, 2007, Daniel S. Goldberger,
then
a director, provided consulting services as interim Chief Executive Officer.
In
consideration of the services, we paid Mr. Goldberger $15,000 per month during
the first two months and $12,500 per month thereafter during the term of the
consulting agreement. From execution through September 30, 2008, Mr. Goldberger
was compensated $130,000 for his services. Mr. Goldberger resigned as interim
Chief Executive Officer on October 6, 2008, and as a director on October 7,
2008, and remains a strategic consultant to the Company thru the end of 2008.
Mr. Goldberger will receive an additional $22,500 in compensation for such
services.
Dr.
Gura
maintains an office located in Beverly Hills, California. Pursuant to a
reimbursement agreement effective January 29, 2008, we reimburse 50% of the
rental and 50% of his monthly parking. The term of the agreement commenced
on
April 23, 2007, the date of the office lease agreement, and continue until
the
date on which he ceases to use the remote office to perform his duties as our
Chief Medical and Scientific Officer. From commencement through September 30,
2008, we reimbursed our Chief Medical and Scientific Officer $1,507 and $31,187
for 50% of the monthly parking and rental, respectively.
Note
13 — License Agreement
On
August
31, 2006, we entered into a Contribution Agreement with a company whose sole
managing member, Terren Peizer, who beneficially owns 42.4% of our outstanding
common stock. We issued 9,600,000 shares of common stock in exchange for (a)
the
right, title, and interest to the name “Xcorporeal” and related trademarks and
domain names, and (b) the right to enter into a License Agreement with National
Quality Care, Inc. (NQCI) dated September 1, 2006 pursuant to which we obtained
the exclusive rights to the technology relating to our kidney failure treatment
and other medical devices which, as listed under “Technology” on the License
Agreement, are “all existing and hereafter developed Intellectual Property,
Know-How, Licensor Patents, Licensor Patent Applications, Derivative Works
and
any other technology, invented, improved or developed by Licensor, or as to
which Licensor owns or holds any rights, arising out of or relating to the
research, development, design, manufacture or use of (a) any medical device,
treatment or method as of the date of this Agreement, (b) any portable or
continuous dialysis methods or devices , specifically including any wearable
artificial kidney, or Wearable Artificial Kidney, and related devices, (c)
any
device, methods or treatments for congestive heart failure, and (d) any
artificial heart or coronary device.” Operations was a shell corporation prior
to the transaction. We valued the License Agreement at the carry-over basis
of
$1,000. As consideration for being granted the License, we agreed to pay to
NQCI
a minimum annual royalty of $250,000, or 7% of net sales. We recorded $520,833
in royalty expenses covering the minimum royalties from commencement of the
License Agreement through September 30, 2008. The License Agreement expires
in
2105. As of September 30, 2008, we had made one payment of the minimum annual
royalty of $250,000 in November 2008.
The
License Agreement also stipulates the reimbursement of reasonable and necessary
expenses incurred in the ordinary course of business consistent with past
practices (“Licensor Expenses”) until the Closing or the termination of the
Merger Agreement. The Second Interim Award from the arbitration with NQCI states
that the License Agreement will remain in full force and effect until the
Technology Transaction closes or the arbitrator determines that it will never
close. As such, NQCI has made a claim for reimbursement of approximately
$690,000 in alleged expenses under the License Agreement which were accrued
under “Accrued professional fees” as of September 30, 2008.
To
date,
we have not received any supporting backup of this alleged Licensor
Expenses.
See Note
4-Legal Proceedings for further additional information related to this License
Agreement.
Note
14 — Stock Options and Warrants
Incentive
Compensation Plan
On
October 12, 2007, we adopted the Xcorporeal, Inc. 2007 Incentive Compensation
Plan and the related form of option agreement that are substantially identical
to the 2006 Incentive Compensation Plan in effect at Operations immediately
prior to the merger.
The
plan
authorizes the grant of stock options, restricted stock, restricted stock units,
and stock appreciation rights. Effective February 28, 2007, there are 3,900,000
shares of common stock reserved for issuance pursuant to the plan (subject
to
adjustment in accordance with the provisions of the plan). The plan will
continue in effect for a term of up to ten years.
On
October 12, 2007, we also assumed options to purchase up to 3,880,000 shares
of
common stock, net 980,000 of which have since been forfeited, canceled, or
expired, that were granted by Operations under its 2006 Incentive Compensation
Plan.
As
of
September 30, 2008, there were 129,500 optioned shares outstanding and 3,770,500
shares available under the 2007 Incentive Compensation Plan.
Stock
Options to Employees, Officer and Directors
The
Compensation Committee of our Board of Directors determines the terms of the
options granted, including the exercise price, the number of shares subject
to
option, and the vesting period. Options generally vest over five years and
have
a maximum life of ten years.
In
the
three months ended September 30, 2008, an aggregate of 338,000 options were
forfeited as a result of employee terminations and resignations. In addition,
200,000 options were cancelled pursuant to a Director’s voluntary forfeiture
with no other concurrent replacement award or other valuable consideration
as
his services as a Director remained and continued on the date of his voluntary
forfeiture.
We
reported $1,731,200 and $3,813,158 in stock-based compensation expense for
employees, officers, and directors for the three and nine months ended September
30, 2008, respectively. For the three and nine months ended September 30, 2007,
we reported $749,774 and $2,233,238 in stock-based compensation expense for
employees, officers, and directors, respectively.
All
compensation expense for stock options granted has been determined under the
fair value method using the Black-Scholes option-pricing model with the
following assumptions:
|
|
For the nine months ended
|
|
|
|
September 30, 2008
|
|
Expected dividend yields
|
|
|
zero
|
|
Expected
volatility
|
|
|
136
|
%
|
Risk-free
interest rate
|
|
|
3.53-3.81
|
%
|
Expected
terms in years
|
|
|
3.12-8.88
years
|
|
Warrants
and Stock Options to Non-Employees
During
the nine months ended September 30, 2008, there was no issuance of warrants.
However, there were cashless exercises of warrants during the three months
ended
June 30, 2008.
We
reported $8,097 and $92,842 in stock-based compensation expense for consultants
for the three and nine months ended September 30, 2008, respectively. We
reported $128,220 and $2,923,344 in stock-based compensation expense for
consultants for the three and nine months ended September 30, 2007,
respectively.
Compensation
for options granted to non-employees has been determined in accordance with
SFAS
No. 123R, EITF 96-18, and EITF 00-18, “Accounting for Equity Instruments that
are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services.” Accordingly, compensation is determined using the
fair value of the consideration received or the fair value of the equity
instruments issued, whichever is more reliably measured.
For
options and warrants issued as compensation to non-employees for services that
are fully vested and non-forfeitable at the time of issuance, the estimated
value is recorded in equity and expensed when the services are performed and
benefit is received as provided by Financial Accounting and Standards Board
(“FASB”) Emerging Issues Task Force No. 96-18 “Accounting For Equity Instruments
That Are Issued To Other Than Employees For Acquiring or In Conjunction With
Selling Goods Or Services.”
All
charges for warrants granted have been determined under the fair value method
using the Black-Scholes option-pricing model with the following
assumptions:
|
|
For the nine months ended
|
|
|
|
September 30, 2008
|
|
Expected
dividend yields
|
|
zero
|
|
Expected
volatility
|
|
|
136
|
%
|
Risk-free
interest rate
|
|
|
2.36-4.69
|
%
|
Expected
terms in years
|
|
|
1.14-4.05
years
|
|
The
following table shows the change in unamortized compensation expense for stock
options and warrants issued to employees, officers, directors and non-employees
during the nine months ended September 30, 2008:
|
|
Stock Options and
Warrants
Outstanding
|
|
Unamortized Compensation
Expense
|
|
|
|
|
|
|
|
January
1, 2008
|
|
|
4,674,221
|
|
$
|
18,228,742
|
|
|
|
|
|
|
|
|
|
Granted
in the period
|
|
|
55,000
|
|
|
207,448
|
|
|
|
|
|
|
|
|
|
Forfeited
& Cancelled in the period
|
|
|
(823,000)
|
(1)
|
|
(2,386,795
|
)
|
|
|
|
|
|
|
|
|
Expensed
in the period
|
|
|
-
|
|
|
(5,353,382
|
)
|
|
|
|
|
|
|
|
|
Exercised
in the period
|
|
|
(325,000)
|
(2)
|
|
-
|
|
September
30, 2008
|
|
|
3,581,221
|
|
$
|
10,696,013
|
|
(1)
One
of our Directors voluntarily forfeited his 200,000 options on September 8,
2008.
Due to his continued services as a Director on the date of his voluntary
forfeiture, this was treated as a cancellation and all unamortized expense
of
$924,021 was fully recognized in the period.
(2)
The
cashless exercises of the granted 325,000 warrant shares resulted in the
issuance of an aggregate of 112,215 shares of our common stock.
|
|
Number of
Options and
Warrants
|
|
Weighted
Average
Exercise
Price
|
|
Stock Options and Warrants
|
|
|
|
|
|
Balance
at January 1, 2008
|
|
|
4,674,221
|
|
$
|
6.01
|
|
Granted
|
|
|
55,000
|
|
|
7.00
|
|
Exercised
|
|
|
(325,000
|
)
|
|
1.00
|
|
Forfeited
& Cancelled
|
|
|
(823,000
|
)
|
|
6.51
|
|
Balance
at September 30, 2008
|
|
|
3,581,221
|
|
$
|
6.37
|
|
Note
15 — Stockholders’ (Deficit) Equity
In
response to the NQCI arbitration interim award associated to the Technology
Transaction, we are planning to seek stockholders approval to issue 9,230,000
shares of our common stock directly to NQCI to effectuate the transaction.
Upon
issuance and delivery of the proposed shares, NQCI will be our largest
stockholder, owning approximately 39% of our total outstanding
shares.
As
a
result of the accrual for 9.23 million shares, discussed further in Note 4-Legal
Proceedings and Note 8-Shares Issuable above, “Total Stockholders’ (Deficit)
Equity” has a negative balance with our deficit accumulated during the
development stage being greater than our additional paid in capital as of
September 30, 2008.
Note
16 — Product Development Agreement
In
July
2007, we entered into an agreement with Aubrey Group, Inc., an FDA-registered
third-party contract developer and manufacturer of medical devices for the
design and development of a Portable Artificial Kidney ("PAK"). The PAK will
be
designed for use as an Intermittent as well as a Continuous Renal Replacement
Therapy (CRRT) in the hospital with medical supervision. The development is
expected to be completed by the end of 2008 and projected labor and material
costs were estimated at approximately $5.1 million at the inception of the
agreement and over the term. The agreement can be terminated at any time with
30
business days notice. From commencement through September 30, 2008, we incurred
$3,063,798 in expense for the services rendered under this agreement and
anticipate incurring approximately $200,000 for the remainder of
2008.
Note
17 — Subsequent Events
On
October 2, 2008, Kelly J. McCrann was unanimously appointed Chairman of the
Board of Directors and Chief Executive Officer. With his new role, Mr. McCrann
resigned from the Audit Committee and Compensation Committee with Dr. Hans
Polaschegg taking his place on the Compensation Committee. On October 6, 2008,
effective October 2, 2008, we entered into an employment agreement with Mr.
McCrann for a term of two years at an initial annual base salary of $325,000.
He
is eligible to receive discretionary bonuses based on achieving designated
goals
and milestones, and overall performance and profitability. Additionally, Mr.
McCrann was granted 700,000 stock options at an exercise price of $1.50 per
share under our 2007 Incentive Compensation Plan, which vest 25% on each of
the
first, second, third, and fourth anniversaries of the grant date, with
anti-dilution protections. Further, if we issue shares to NQCI pursuant to
the
arbitration with NQCI, Mr. McCrann, shall, upon the date of such issuance to
NQCI, be granted an additional option, number of shares to be determined, under
the 2007 Incentive Compensation Plan to purchase such shares of our common
stock, at an exercise price equal to the greater of (a) $1.50 per share or
(b)
the fair market value of a share of our common stock on the grant date,
necessary to preserve Mr. McCrann’s ownership percentage of the company on a
fully diluted basis, based upon the ownership percentage determined as of the
date of initial grant. If Mr. McCrann is terminated without good cause or
resigns for good reason, as defined in the employment agreement, we will
obligated to pay Mr. McCrann twelve months' base salary. A copy of Mr. McCrann’s
employment agreement is attached as an exhibit to our current report on Form
8-K
filed with the Securities and Exchange Commission on October 8,
2008.
To
comply
with the American Stock Exchange rule requiring that a majority of our directors
be independent, Daniel Goldberger and Dr. Victor Gura resigned as members of
our
board of directors on October 7, 2008.
In
lieu
of Mr. Goldberger’s resignation as our interim CEO on October 6, 2008, we
amended his consulting agreement. Pursuant to the amendment, Mr. Goldberger
will
provide the company with his services through year end. As consideration for
his
services, he will be paid $12,500 for October 2008 and $5,000 per month for
each
of November and December.
On
October 6, 2008, with modification to the lease agreement on October 23, 2008,
we entered into a 5 year lease agreement, commencing November 27, 2008 through
November 26, 2013 with early possession on October 27, 2008, for our new
operating facility in Lake Forest, CA. The monthly base rent will start at
$23,540 per month and increase annually by approximately 3%. The total minimum
lease, base rent, payments will be $1,515,120 over a 5 year period. As required
by the agreement, we issued an 18 month, $300,000, letter of credit secured
by a
new CD account as collateral. Upon execution of the lease agreement, we notified
Aubrey of our intent to vacate our current subleased space by the end of
November 2008. A copy of the lease agreement is attached as Exhibit 10.1 to
this
quarterly report on Form 10-Q.
On
August
10, 2007, Terren S. Peizer entered into an Executive Chairman Agreement with
Operations for an initial term of three years with automatic one-year renewals,
which Executive Chairman Agreement was assumed by us. His base compensation
is
$450,000 per annum as of July 1, 2007, with a signing bonus of $225,000. Mr.
Peizer will be entitled to receive an annual bonus at the discretion of the
board based on performance goals and targeted at 100% of his base compensation.
He is also eligible to participate in any equity incentive plans adopted by
us.
In the event Mr. Peizer’s position is terminated without good cause or he
resigns for good reason, we will be obligated to pay Mr. Peizer in a lump sum
an
amount equal to three years’ base compensation bonus plus 100% of the targeted
bonus. At the request of Mr. Peizer, we stopped making payments to him under
the
agreement in August 2008 and Mr. Peizer voluntarily relinquished his role as
Executive Chairman in October 2008.
ITEM
2. Management’s Discussion and Analysis or Plan of
Operation.
The
following discussion of our financial condition and results of operations should
be read in conjunction with our financial statements and the related notes,
and
the other financial information included in this report.
Forward-Looking
Statements
This
report contains “forward-looking statements” within the meaning of the Private
Securities Litigation Reform Act of 1995 with respect to the financial
condition, results of operations, business strategies, operating efficiencies
or
synergies, competitive positions, growth opportunities for existing products,
plans and objectives of management, markets for stock of Xcorporeal, and other
matters. Statements in this report that are not historical facts are
“forward-looking statements” for the purpose of the safe harbor provided by
Section 21E of the Exchange Act and Section 27A of the Securities Act. Such
forward-looking statements, including, without limitation, those relating to
the
future business prospects, revenues, and income of Xcorporeal, wherever they
occur, are necessarily estimates reflecting the best judgment of the senior
management of Xcorporeal on the date on which they were made, or if no date
is
stated, as of the date of this report. These forward-looking statements are
subject to risks, uncertainties and assumptions, including those described
in
the “Risk Factors” described below, that may affect the operations, performance,
development, and results of our business. Because the factors discussed in
this
report could cause actual results or outcomes to differ materially from those
expressed in any forward-looking statements made by us or on our behalf, you
should not place undue reliance on any such forward-looking statements. New
factors emerge from time to time, and it is not possible for us to predict
which
factors will arise. In addition, we cannot assess the impact of each factor
on
our business or the extent to which any factor, or combination of factors,
may
cause actual results to differ materially from those contained in any
forward-looking statements.
Overview
We
are a
medical device company developing an innovative
extra-corporeal
platform
technology to be used in devices to replace the function of various human
organs. These devices will seek to provide patients with improved, efficient
and
cost effective therapy. The platform leads to three initial
products:
|
•
|
A
PAK for hospital Renal Replacement Therapy
(RRT);
|
|
•
|
A
PAK for home hemodialysis; and
|
|
•
|
A
Wearable Artificial Kidney (WAK) for continuous ambulatory
hemodialysis.
|
For
the
hospital market, we are developing a portable, multifunctional renal replacement
device that will offer cost-effective therapy for those patients suffering
from
Acute Renal Failure (ARF) causing a rapid decline in kidney function. We have
completed our functional prototype of the product, which is currently undergoing
bench testing, and will submit a 510(k) filing with the FDA next year. We plan
to commercialize the product after receiving clearance from the FDA. Timing
of
FDA clearance is uncertain at this time.
We
also
plan to commercialize a home hemodialysis device for the End Stage Renal Disease
(ESRD) market, comprised of patients in whom the kidneys have ceased to
function. We have also completed our functional prototype of the product, which
is currently undergoing bench testing, and we will submit a 510(k) with the
FDA
during 2009. Clinical trials are anticipated to commence as soon as FDA
clearance is received.
Our
WAK
is a device for the chronic treatment of ESRD. We have successfully demonstrated
a prototype system that weighs less than 6 kg., is battery operated, and can
be
worn by an ambulatory patient. Provided that the Technology Transaction
described in Part II, Item 1 – Legal Proceedings below closes, we will evaluate
the feasibility of furthering our development of this product over the next
12
months
.
We
are a
development stage company, have been unprofitable since our inception, and
will
incur substantial additional operating losses for at least the next twelve
months as we continue to implement commercial operations and allocate
significant and increasing resources to research, development, clinical trials,
and other activities. Accordingly, our historical operations and financial
information are not indicative of our future operating results, financial
condition, or ability to operate profitably as a commercial
enterprise.
Research
and Development
R&D
Team
We
have
recruited and currently employ a talented interdisciplinary team of scientists
and engineers who are developing our products. The team includes engineering
leaders from within the dialysis field who provide state of the art as well
as
historical insights into dialysis equipment. The team also includes seasoned
engineers from related medical fields providing us with cutting edge technology
in the areas of fluidics, sensors, and electronics. In addition, we have
retained a medical device consulting firm, The Aubrey Group, Inc., an
FDA-registered third-party contract developer and manufacturer of medical
devices, to provide engineering support in the development and build of the
PAK
thru the end of 2008. In 2009, we will transition into verification and
validation of the PAK utilizing our scientists and engineers as well as outside
consultants.
We
incurred $12.7 million and $18.9 million in research and development costs
in
the three and nine months ended September 30, 2008, respectively, including
the
August 4, 2008, $10.2 million fair value accrual for a potential 9.23 million
shares issuance to effectuate the Technology Transaction in accordance to the
Second Interim Award. Less the accrual for shares issuable, we incurred $2.5
million and $8.7 million in research and development costs in the three and
nine
months ended September 30, 2008, respectively. This compares to $2.1 million
and
$4.8 million incurred in the three and nine months ended September 30,
2007.
Third-party
Arrangements
In
July
2007, we entered into an agreement with Aubrey for the design and development
of
subsystems of the PAK. The PAK will be designed for intermittent hemodialysis
or
CRRT in a clinical setting as well as for treatments in a home setting. The
development is expected to be complete by the end of 2008. At the inception
of
the agreement, total labor and material costs over the term of the Aubrey
agreement was budgeted at approximately $5.1 million which we anticipate to
be
under budget at completion. We can terminate the agreement at any time with
30
business days notice.
We
also
contract with other third parties to assist in our research and development
efforts and to supplement our internal resources while we continue to grow
our
organization.
Management’s
Discussion and Analysis
Results
of Operations for the three and nine months ended September 30,
2008.
We
have
not generated any revenues since inception. We incurred a net loss of $11.1
million and $22.8 million for the three and nine months ended September 30,
2008, respectively, compared to a net loss of $4.5 million and $12.1 million
for
the three and nine months ended September 30, 2007, respectively. The increase
in net loss was primarily due to (i) research, development and other expenses
related to advancing our kidney failure treatment technologies, (ii) stock
compensation expense related to options and warrants granted to directors,
officers, employees, and consultants, (iii) legal fees, (iv) common stock
issuances as compensation for consulting services, (v) accruals for alleged
licensor expenses and interim awards issued in the arbitration with NQCI, and
(vi) increased company personnel. At September 30, 2008, we had positive working
capital of $1.4 million compared to positive working capital of $15.0 million
at
the beginning of the year.
Liquidity
and Capital Resources
We
expect
to incur operating losses and negative cash flows for the foreseeable future.
During the fourth quarter 2006, we raised approximately $27.3 million (net
of
placement fees of $2.1 million) through a private placement. Our ability to
execute on our current business plan is dependent upon our ability to develop
and market our products, and, ultimately, to generate revenue.
As
of
September 30, 2008, we had cash, cash equivalents and marketable securities
of
approximately $6.0 million. We are currently expending cash at a rate of
approximately $1.1 million per month. In addition, we may become obligated
to
pay damages, costs or legal fees in connection with the ongoing arbitration
described under Part II, Item 1-Legal Proceedings below, in an interim amount
of
$1.87 million.
At
present rates, we will have to raise additional funds during the next several
months. We may not be successful in doing so on terms acceptable to us, and
the
inability to raise capital could require us to curtail our current plans in
order to decrease spending, which could have a material adverse effect on our
plan of operation. Our ability to execute on our current business plan is
dependent upon our ability to obtain equity financing, develop and market our
products, and, ultimately, to generate revenue.
We
expect
to incur negative cash flows and net losses for the foreseeable future. Based
upon our current plans, we believe that our existing cash reserves will not
be
sufficient to meet our operating expenses and capital requirements before we
achieve profitability. Accordingly, we may seek to raise additional funds
through public or private placement of shares of preferred or common stock
or
through public or private financing. Our ability to meet our cash obligations
as
they become due and payable will depend on our ability to sell securities,
borrow funds, reduce operating costs, or some combination thereof. We may not
be
successful in raising necessary funds on acceptable terms, or at all. As a
result of these conditions, there is substantial doubt about our ability to
continue as a going concern. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
Upon
receipt of the approximate $27.3 million raised through private placement in
the
fourth quarter of 2006, we strategically began our operating activities and
research and development efforts which resulted in a net loss of $17.1 million
in 2007 and $18.2 million in the nine months ended September 30, 2008. In
addition, we invested $25.0 million in high grade money market funds and
marketable securities of which we sold $19.2 million of the investments, leaving
a balance of $5.8 million as of September 30, 2008.
We
have
focused much of our efforts on development of the PAK, which has not been
derived from the technology covered by the License Agreement. Through the
productive research and development efforts of the PAK, we have completed
functional prototypes of our hospital and home PAKs that we plan to
commercialize after 510(k) clearance from the Food and Drug Administration
(FDA)
which we plan 510(k) submission by next year. Prior to the 510(k) submission
to
the FDA for clinical use under direct medical supervision, the units will
undergo final verification and validation. It generally takes 4 to 12 months
from the date of a 510(k) submission to obtain clearance from the FDA, although
it may take longer. We expect that our monthly expenditures will increase as
we
shift resources towards developing a marketing plan for the PAK.
We
have
used some of our resources for the development of the WAK which we have
demonstrated a feasibility prototype. Commercialization of the WAK will require
development of a functional prototype and likely a full pre-market approval
by
the FDA, which could take several years. Our rights to the WAK derive in part
from a License Agreement dated September 1, 2006 between Operations and National
Quality Care, Inc, pursuant to which we obtained the exclusive rights to the
technology designated therein. Once the Technology Transaction has closed and
the results of the arbitration proceeding are final, we will determine whether
to devote additional resources to development of the WAK.
If
we
ever become obligated to pay all or a substantial portion of the $690,000 in
alleged expenses related to the License Agreement and the interim award of
$1.87
million in attorneys’ fees pursuant to the NQCI arbitration, doing so could have
a material adverse effect on our liquidity and financial ability to continue
with ongoing operations as currently planned.
Because
neither the PAK nor the WAK is yet at a stage where it can be marketed
commercially, we are not able to predict the portion of our future business
which will be derived from each.
Research
and Development
We
employ
an interdisciplinary team of scientists and engineers who are developing the
PAK
and a separate, interdisciplinary team developing the WAK. In addition, we
have
retained Aubrey to assist with the engineering of the PAK. The PAK will be
engineered to perform both hemodialysis, hemofiltration and ultrafiltration
under direct medical supervision. A variation of this device will be developed
for chronic home hemodialysis. An initial laboratory prototype of the PAK,
capable of performing the functions of a hemodialysis machine, and demonstrating
our unique new fluidics circuit, was completed at the end of 2007. The first
physical prototype including industrial design of the PAK was completed in
October 2008. Further refinements to this prototype are now in progress. The
final product design of the PAK will be completed shortly and units will undergo
final verification and validation prior to a 510(k) submission for clinical
use
under direct medical supervision. A clinical study is not required for this
submission.
In
a
clinical feasibility study conducted in London in March 2007, a research
prototype of the WAK was successfully demonstrated in eight patients with
end-stage renal disease. Patients were successfully treated for up to 8 hours
with adequate clearances of urea and creatinine. The device was well tolerated
and patients were able to conduct activities of normal daily living including
walking and sleeping. There were no serious adverse events although clotting
of
the dialyzer occurred in two patients. To our knowledge, this is the first
successful demonstration of a wearable artificial kidney in man. Provided that
the Technology Transaction closes, we will be making substantial improvements
to
the WAK. This work will result in a WAK Generation 2.0. Pending the FDA approval
of an investigational Device Exemption (IDE), additional clinical studies will
be conducted upon completion of the Generation 2.0 WAK prototype.
We
incurred $12.7 million and $18.9 million in research and development costs
in
the three and nine months ended September 30, 2008, respectively, including
the
August 4, 2008, $10.2 million fair value accrual for a potential 9.23 million
shares issuance to effectuate the Technology Transaction in accordance to the
Second Interim Award. As such, less the accrual for the shares issuable, we
incurred $2.5 million and $8.7 million in research and development costs in
the
three and nine months ended September 30, 2008, respectively. This compares
to
$2.1 million and $4.8 million incurred in the three and nine months ended
September 30, 2007.
Contractual
Obligations and Commercial Commitments
Contractual
Obligations:
|
|
Total
|
|
Less than 1
year
|
|
1 - 3 years
|
|
3 - 5 years
|
|
More than 5
years
|
|
Capital
Lease Obligations
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
$
|
-
|
|
Operating
Lease Obligations (1)
|
|
|
1,176,889
|
|
|
107,113
|
|
|
786,199
|
|
|
283,576
|
|
|
-
|
|
Research
& Development Contractual Commitments
|
|
|
77,996
|
|
|
77,996
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Other
Liabilities
|
|
|
12,167
|
|
|
12,167
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
|
$
|
1,267,051
|
|
$
|
197,276
|
|
$
|
786,199
|
|
$
|
283,576
|
|
$
|
-
|
|
(1)
Operating lease commitments for our corporate office facility, product
development facility, Dr. Gura’s office which is a related party transaction,
and two corporate apartments as well as for copiers and T1 access.
The
table
excludes the agreement with Aubrey in relation to the PAK development which
can
be terminated at any time with 30 business days notice. Due to development
efficiencies not anticipated at the inception of the Aubrey agreement, we will
incur less actual costs and expenses than the $5.1 million budgeted amount.
With
the expected completion by end of 2008, we estimate we will incur a total cost
of $3.3 million under this agreement.
Off-Balance
Sheet Arrangements
As
of
September 30, 2008, we had no off-balance sheet arrangements that have or are
reasonably likely to have a current or future effect on our financial condition,
results of operations or cash flows.
Critical
Accounting Policies and Estimates
The
discussion and analysis of our financial condition and results of operations
is
based upon our financial statements, which have been prepared in accordance
with
accounting principles generally accepted in the United States. Generally
accepted accounting principles require management to make estimates, judgments
and assumptions that affect the reported amounts of assets, liabilities,
revenues and expenses, and the disclosure of contingent assets and liabilities.
We base our estimates on experience and on various other assumptions that we
believe to be reasonable under the circumstances, the results of which form
the
basis for making judgments about the carrying values of assets and liabilities
that may not be readily apparent from other sources. Our actual results may
differ from those estimates.
We
consider our critical accounting policies to be those that involve significant
uncertainties, require judgments or estimates that are more difficult for
management to determine or that may produce materially different results when
using different assumptions. We consider the following accounting policies
to be
critical:
Marketable
Securities
We
classify investments with maturity dates greater than three months when
purchased as marketable securities. Investments, including certificates of
deposit with maturity dates greater than three months when purchased and which
have readily determined fair values, are classified as available-for-sale
investments and reflected in current assets as marketable securities at fair
market value. Our investment policy requires that all investments be investment
grade quality and no more than ten percent of our portfolio may be invested
in
any one security or with one institution.
Short-term
investments classified as available-for-sale were as follows:
|
|
September 30, 2008
|
|
|
|
Aggregate Fair
Value
|
|
Gross Unrealized
Gains / (Losses)
|
|
Estimated Fair
Value
|
|
Commercial
paper
|
|
$
|
3,708,821
|
|
$
|
-
|
|
$
|
3,708,821
|
|
Corporate
securities fixed rate
|
|
|
651,811
|
|
|
-
|
|
|
651,811
|
|
Total
|
|
$
|
4,360,632
|
|
$
|
-
|
|
$
|
4,360,632
|
|
Xcorporeal
reviews impairments associated with the above in accordance with SFAS No. 115,
“Accounting for Certain Investments in Debt and Equity Securities,” and FASB
Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments,” to determine the
classification of the impairment as temporary or other-than-temporary.
Xcorporeal considers these investments not to be impaired as of September 30,
2008.
There
were no gross unrealized gains or losses as of September 30, 2008.
Shares
Issuable
Pursuant
to the Second Interim Award, stating that, if the Technology Transaction is
submitted to and approved by our stockholders, 9,230,000 shares of our common
stock should be issued to NQCI to effectuate the transaction, we accrued for
the
9.23 million shares of our common stock. As the Second Interim Award states
that
a registration statement for any issued shares must be declared effective within
90 days, and such contingency is not within our control, we have recorded the
issuance as a liability, rather than as equity. The fair value of the 9.23
million shares was measured using the closing price of our common stock on
August 4, 2008, the date of the Second Interim Award, and revalued, marked
to
market, as of the end of this interim reporting period, September 30, 2008.
The
fair value of the accrued shares on August 4, 2008, was $10,153,000 which was
revalued at $4,615,000 as of September 30, 2008, resulting in a $5,538,000
non-operating gain to the statement of operations for the three and nine months
ended September 30, 2008. The net fair value of $4,615,000 was accrued under
“Shares issuable” as of September 30, 2008. Stockholders’ approval and issuance
of the shares are pending to date.
The
shares issuable liability will be marked to market until a determination is
made
that the Technology Transaction will not be submitted to our stockholders,
the
stockholders vote not to approve the transaction, or they vote to approve the
transaction and the shares are issued and registered. The price of our stock
has
declined since September 30, 2008, and as of November 18, 2008, the closing
price was $0.27 per share, reducing the shares issuable liability from $4.6
million to approximately $2.5 million as of that date. We anticipate that we
will continue to incur losses, which will continue to increase the
shareholder deficit.
Although
we may seek stockholder approval for the issuance of the 9.23 million shares
of
our common stock to effectuate the Technology Transaction, we are uncertain
whether the SEC will approve a form of proxy to solicit stockholder approval
of
the transaction, our stockholders will vote to approve the transaction, shares
will be issued to NQCI, or the SEC will declare effective a registration
statement to register the shares for resale. If the Technology Transaction
does
not close, the arbitrator may issue alternative relief. In the event of an
alternate award, the above accrual may be adjusted and the accrual or the actual
settlement will be recorded to coincide with the alternate award.
If
the
Technology Transaction is approved and the shares are issued and registered
or
the registration requirement is eliminated or waived, that would eliminate
the
s
hares
issuable liability, and increase stockholders equity by the amount of the
liability.
Stock-Based
Compensation
Statements
of Financial Accounting Standards (SFAS) No. 123 (revised 2004),
Share-Based
Payment
, (SFAS
123(R)) and Securities and Exchange Commission issued Staff Accounting Bulletin
(SAB) No. 107 (SAB 107) require the measurement and recognition of compensation
expense for all share-based payment awards made to employees and directors
based
on estimated fair values. We have applied the provisions of SAB 107 in our
adoption of SFAS 123(R).
In
determining stock based compensation, we consider various factors in our
calculation of fair value using a Black-Scholes pricing model. These factors
include volatility, expected term of the options, and forfeiture rates. A change
in these factors could result in differences in the stock based compensation
expense.
ITEM
3. Quantitative and Qualitative Disclosures about Market
Risk
We
invest
our cash in short term high grade commercial paper, certificates of deposit,
money market accounts, and marketable securities. We consider any liquid
investment with an original maturity of three months or less when purchased
to
be cash equivalents. We classify investments with maturity dates greater than
three months when purchased as marketable securities, which have readily
determined fair values and are classified as available-for-sale securities.
Our
investment policy requires that all investments be investment grade quality
and
no more than ten percent of our portfolio may be invested in any one security
or
with one institution.
Investments
in both fixed rate and floating rate interest earning instruments carry a degree
of interest rate risk arising from changes in the level or volatility of
interest rates; however, interest rate movements do not materially affect the
market value of our portfolio because of the short-term nature of these
investments. A reduction in the overall level of interest rates may produce
less interest income from our investment portfolio. The market risk associated
with our investments in debt securities is substantially mitigated by the
frequent turnover of our portfolio.
ITEM
4. Controls and Procedures
Disclosure
Controls and Procedures
Our
management, with the participation of our Chief Executive Officer and our Chief
Financial Officer, conducted an evaluation of the effectiveness of our
disclosure controls and procedures as of the end of the period covered by this
report (September 30, 2008), as is defined in Rule 13a-15(e) promulgated under
the Securities Exchange Act of 1934, as amended. Our disclosure controls and
procedures are intended to ensure that the information we are required to
disclose in the reports that we file or submit under the Securities Exchange
Act
of 1934 is (i) recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission’s rules and forms
and (ii) accumulated and communicated to our management, including the Chief
Executive Officer and Chief Financial Officer, as the principal executive and
financial officer, to allow timely decisions regarding required disclosures.
Based
on
that evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that, as of the end of the period covered by this report, our
disclosure controls and procedures were effective. Our management has concluded
that the financial statements included in this report present fairly, in all
material respects our financial position, results of operations and cash flows
for the periods presented in conformity with generally accepted accounting
principles.
It
should
be noted that any system of controls, however well designed and operated, can
provide only reasonable, and not absolute, assurance that the objectives of
the
system will be met. In addition, the design of any control system is based
in
part upon certain assumptions about the likelihood of future events.
Changes
in Internal Control
There
have been no changes in our internal control over financial reporting, as
defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, during
our
most recent fiscal quarter that have materially affected, or are reasonably
likely to materially affect our internal control over financial
reporting.
PART
II — OTHER INFORMATION
ITEM
1. Legal Proceedings.
On
September 1, 2006, Operations entered into a Merger Agreement with NQCI which
contemplated that we would acquire NQCI as a wholly owned subsidiary pursuant
to
a triangular merger, or we would issue shares of our common stock to NQCI
stockholders in consideration of the assignment of the technology relating
to
our WAK and other medical devices which, as listed under “Technology” on the
License Agreement, are “all existing and hereafter developed Intellectual
Property, Know-How, Licensor Patents, Licensor Patent Applications, Derivative
Works and any other technology, invented, improved or developed by Licensor,
or
as to which Licensor owns or holds any rights, arising out of or relating to
the
research, development, design, manufacture or use of (a) any medical device,
treatment or method as of the date of this Agreement, (b) any portable or
continuous dialysis methods or devices , specifically including any wearable
artificial kidney, or Wearable Artificial Kidney, and related devices, (c)
any
device, methods or treatments for congestive heart failure, and (d) any
artificial heart or coronary device” (the “Technology Transaction”). The
agreement provided that Operations had no obligation to issue or deliver any
shares after December 31, 2006, unless the Parties mutually agreed to extend
such date, which they did not. In addition, on December 29, 2006, NQCI served
us
with written notice that it was terminating the Merger Agreement, which we
accepted. Accordingly, the merger was not consummated. Copies of the License
Agreement and the Merger Agreement are attached as Appendix B and Appendix
C,
respectively, to the preliminary proxy statement filed October 31, 2008, with
the Securities and Exchange Commission.
On
December 1, 2006, Operations initiated arbitration proceedings against NQCI
for
its breach of the License Agreement, which remains pending. NQCI claimed the
License Agreement was terminated, and we sought a declaration that the License
Agreement remained in effect until the Closing of the Merger or Technology
Transaction. We later amended our claims to seek damages for NQCI’s failure to
perform its obligations under the License Agreement. NQCI filed counterclaims
seeking to invalidate the License Agreement and claiming monetary damages
against us. NQCI also filed claims against Dr. Gura, claiming he breached his
obligations to NQCI by agreeing to serve on our board of directors. Following
a
hearing and extensive briefing, the arbitrator denied both parties’ claims for
damages. Although NQCI never filed an amendment to its counterclaims to seek
specific performance, on June 9, 2008, the arbitrator issued an Interim Award
granting specific performance of the Technology Transaction.
The
Interim Award stated that the total aggregate shares of stock to be received
by
NQCI stockholders at the Closing should equal 48% of all Operations shares
outstanding as of the date of the Merger Agreement. On September 1, 2006, there
were 10,000,000 shares of Operations common stock outstanding. NQCI proposed
four possible share interest awards, arguing that it was entitled to between
9,600,000 and 17,130,293 shares, representing a 48% or 54% interest based on
Operations shares outstanding at the time of the Merger Agreement or our present
number of outstanding shares.
On
August
4, 2008, the arbitrator issued a Second Interim Award, modifying the initial
Interim Award, stating that, if we desire to close the Technology Transaction,
we must obtain approval from a majority of our stockholders and issue 9,230,000
shares of our common stock. Although the first Interim Award stated that 48%
of
the outstanding shares should be issued, the Second Interim Award states that
the number of shares issued should be 48% of 19,230,000 shares, the total number
of shares necessary to put our 52% interest at 10,000,000 shares. As of October
31, 2008, there were 14,704,687 shares of our common stock issued and
outstanding. Accordingly, following Closing of the Technology Transaction,
NQCI
stockholders would own approximately 39% of our total outstanding shares, making
NQCI our largest stockholder. The arbitrator found that, with the exception
of
shareholder approval, virtually all conditions to Closing the Technology
Transaction have been waived, including virtually all of NQCI’s representations
and warranties concerning the Technology. Upon Closing of the Technology
Transaction, all of the Technology will be our sole and exclusive
property.
The
Second Interim Award also states that, contrary to the assertions made by NQCI,
the License Agreement will remain in full force and effect until the Technology
Transaction closes or the arbitrator determines that it will never close. Upon
Closing of the Technology Transaction, the License Agreement will terminate,
and
we will own all of the Technology.
On
January 3, 2008, the arbitrator issued an order denying NQCI’s motion to amend
its counterclaim to add us as a successor company following the merger. However,
in the Second Interim Award, the arbitrator found that we are the successor
to
Operations as a result of the merger, even though we are not a party to any
of
the agreements or the arbitration, and ordered that our shares should be issued
to NQCI rather than shares of Operations.
The
arbitrator has not ordered us to close the Technology Transaction. However,
the
Second Interim Award states that, if our stockholders fail to approve the
issuance of stock to effectuate the Technology Transaction, all of the
Technology covered by the License shall be declared the sole and exclusive
property of NQCI, and the arbitrator shall schedule additional hearings to
address two questions: whether the PAK technology is included within that
Technology, and whether NQCI is entitled to compensatory damages and the amount
of damages under these circumstances. During the arbitration, NQCI took the
position that we had misappropriated trade secrets regarding the WAK and used
them to create the PAK. The arbitrator found that we had not misappropriated
NQCI’s trade secrets. However, should the Technology Transaction not close for
any reason, and the arbitrator rules that the licensed Technology must be
returned to NQCI, the arbitrator could find that the PAK is derived in whole
or
in part from the licensed Technology, and could rule that Operations must
“return” the PAK technology to NQCI or that NQCI is entitled to compensatory
damages or both.
On
August
15, 2008, the arbitrator awarded NQCI $1.87 million of over $4 million it
claimed in attorneys’ fees and costs, stating that NQCI’s lack of success and
other factors warranted a substantial reduction in the sums claimed.
The
arbitrator stated in pertinent part: “National’s success in the arbitration has
been only partial and this is directly relevant to the question of the quantum
of attorneys’ fees which should be awarded. … National sought eight or nine
figure damages, but was awarded none. … Further, National asserted claims for
fraud, interference with contract, and other torts, all of which were rejected.
His lack of success warrants a substantial reduction in the sums claimed.” NQCI
asked for a total of $4.04 million in attorneys’ fees and costs. The arbitrator
awarded NQCI a total of $1.87 million.
In
an
August 29, 2008 Order Re Issuance of Xcorporeal Shares, the arbitrator stated
that the shares should be issued directly to NQCI’s stockholders. However, on
September 4, 2008, the arbitrator issued an order that we should issue and
deliver the 9,230,000 shares directly to NQCI, rather than directly to NQCI
stockholders, if we obtain stockholder approval and elect to proceed with the
Technology Transaction.
The
Second Interim Award requires that we file a registration statement under the
Securities Act to register for resale the shares to be issued to NQCI within
30
days after the closing of the Technology Transaction. The arbitrator
acknowledged that our obligation is to file the registration statement and
to
use reasonable efforts to have the shares registered and not to guarantee
registration and resultant actual public tradability. However, the arbitrator
nevertheless ordered that the registration statement must be declared effective
within 90 days. We have no control over whether the registration statement
will
be declared effective by the Securities and Exchange Commission, and no way
to
predict what further action, if any, the arbitrator may order if it is not
declared effective.
The
arbitrator has stated that he has not yet issued a final award that may be
confirmed or challenged in a court of competent jurisdiction. A party to the
arbitration could challenge the interim award in court, even after stockholders
approve the transaction. In addition, the arbitrator could again change the
award by granting different or additional remedies, even after stockholders
approve the transaction. We cannot guarantee that the arbitrator would order
that stockholders be given another opportunity to vote on the transaction,
even
if such changes are material. Arbitrators have broad equitable powers, and
arbitration awards are difficult to challenge in court, even if the arbitrator
makes rulings that are inconsistent or not in accordance with the law or the
evidence.
Shares
to be issued
We
intend
to seek approval from our stockholders to issue 9,230,000 shares of our common
stock to NQCI in order to close the Technology Transaction and obtain ownership
of intellectual property rights described above. As of November 17, 2008, there
were 14,704,687 shares of our common stock issued and outstanding. Accordingly,
following Closing of the Technology Transaction, NQCI would own approximately
39%of our total outstanding shares.
As
a
result, NQCI may have the ability to substantially influence the outcome of
issues submitted to our stockholders. The interests of NQCI may not coincide
with our interests or the interests of other stockholders, and it may act in
a
manner that advances its best interests and not necessarily those of other
stockholders. One consequence to this substantial interest is that it may deter
unsolicited takeovers, including transactions in which stockholders might
otherwise receive a premium for their shares over then current market
prices.
The
Technology
The
Merger Agreement provides that, at the Closing of the Technology Transaction,
NQCI shall absolutely, unconditionally, validly and irrevocably sell, transfer,
grant and assign to Operations all of the Technology, including, but not limited
to, the inventions embodied or described in the Licensor Patents and Patent
Applications as defined in the License Agreement.
Under
the
License Agreement, NQCI grants to us an exclusive license for 99 years (or,
if
earlier, until the expiration of NQCI's proprietary rights in the Technology)
for an annual royalty of 7% of net sales, with a minimum annual royalty of
$250,000. We are required to "make commercially reasonable efforts to develop
and commercially exploit the Technology to generate revenues" during the term
of
the License Agreement. The License Agreement does not provide for termination
in
the event the Merger Agreement is terminated; instead it provides for an
adjustment of the royalty to 6.5%, 7.5%, or 8.5% depending on the grounds on
which the Merger Agreement was terminated. Either party has the right to
terminate the License Agreement in the event of a material breach by the other
party which remains uncured for a period of 30 days after notice. In the event
of a termination of the License Agreement, we are required to cease all use
of
the Technology and return all "Licensee Confidential Information" to NQCI.
The
Technology relates primarily to the WAK.
ITEM
1A. Risk Factors.
Investing
in our common stock involves a high degree of risk. In addition to the
information in this report, you should carefully consider the risks described
under Risk Factors in Part I, Item 1 of our Annual Report on Form 10-KSB for
the
year ended December 31, 2007, and the revised risk factors noted below. If
any
of such risks actually occurs, our business, results of operations and financial
condition will likely suffer. As a result the trading price of our common stock
may decline, and you might lose part or all of your
investment
An
unfavorable result in the pending arbitration could have a material adverse
effect on our capital structure, business and financial condition.
We
consider the protection of our proprietary technology for treatment of kidney
failure, which we have licensed and are developing, to be critical to our
business prospects. We obtained the rights to the wearable artificial kidney
(WAK) through a License Agreement with National Quality Care, Inc. (NQCI).
On
December 1, 2006, Operations initiated arbitration against NQCI for failure
to
fully perform its obligations under our License Agreement. NQCI filed
counterclaims seeking to invalidate the License Agreement and claiming monetary
damages against us. In interim awards, the arbitrator has found that the License
Agreement will not survive if the Technology Transaction contemplated by the
Merger Agreement entered into concurrently with the License Agreement fails
to
close. If this determination were upheld by a court of competent jurisdiction,
we could be prevented from using the WAK technology we licensed from it. In
addition, if it were found that our rights to the portable artificial kidney
(PAK) are derived from the licensed technology, that could significantly impact
our ability to develop, manufacture and sell our PAK, which would have a
material adverse effect on our business and results of operations.
The
interim awards state that NQCI is entitled to reimbursement for reasonable
attorneys’ fees. NQCI has made a claim for approximately $3.9 million in such
fees, which we have opposed and a lower amount of $1.87 million awarded by
the
arbitrator. The interim settlement of legal fees has been accrued in the three
and nine months ending September 30, 2008. NQCI has also made a claim for
reimbursement of approximately $690,000 in alleged expenses related to the
License Agreement which has been accrued at June 30, 2008. If we ever become
obligated to pay all or a substantial portion of such amounts, doing so could
have a material adverse effect on our liquidity and financial ability to
continue with ongoing operations as currently planned.
The
interim awards also state that 9,230,000 shares of our common stock would have
to be issued to effectuate the Technology Transaction, if Closing such a
transaction were to be approved by our stockholders. The issuance of such shares
would result in NQCI owning approximately 39% of our total outstanding shares,
diluting current stockholders and giving it the ability to substantially
influence the outcome of matters submitted to stockholders.
We
expect to incur negative cash flows and net losses for the foreseeable future
and may not be able to continue as a going concern.
As
a
result of our expectation of negative cash flows and net losses for the
foreseeable future, based on our current plans, we believe our existing cash
reserves will not be sufficient to meet our operating expenses and capital
requirements before we achieve profitability. Our ability to meet our cash
obligations as they become due will depend on our ability to secure financing
on
acceptable terms. Unless we are able to raise capital sufficient to support
our operations there will be substantial doubt of our ability to continue as
a
going concern.
Approximately
42% of our stock is controlled by a single stockholder who has the ability
to
substantially influence the election of directors and the outcome of matters
submitted to stockholders.
As
of
September 30, 2008, CNL, a limited liability company whose managing member
is a
member of our board of directors, directly owned 6,232,596 shares, which
represent approximately 42.4% of our 14,704,687 shares of outstanding common
stock. As a result, CNL presently and is expected to continue to have the
ability to determine the outcome of issues submitted to our stockholders. The
interests of this stockholder may not always coincide with our interests or
the
interests of other stockholders, and it may act in a manner that advances its
best interests and not necessarily those of other stockholders. One consequence
to this substantial stockholder’s interest is that it may be difficult for
investors to remove management of the company. It could also deter unsolicited
takeovers, including transactions in which stockholders might otherwise receive
a premium for their shares over then current market prices.
Sales
of common stock by our existing stockholders, or the perception that such sales
may occur, could depress our stock price.
The
market price of our common stock could decline as a result of sales by, or
the
perceived possibility of sales by, our existing stockholders, including
stockholders who recently purchased their shares from CNL. Most of our
outstanding shares were registered on a Form S-4 registration statement in
connection with our October 2007 merger, and are eligible for public resale.
Approximately half of our shares of common stock are currently held by our
affiliates and may be sold pursuant to an effective registration statement
or in
accordance with the volume and other limitations of Rule 144 under the
Securities Act of 1933, as amended, or pursuant to other exempt transactions.
Future sales of common stock by significant stockholders, including those who
acquired their shares in private placements or who are affiliates, or the
perception that such sales may occur, could depress the price of our common
stock.
ITEM
2. Unregistered Sales of Equity Securities; Use of Proceeds from Registered
Securities.
For
the
three months ended September 30, 2008, we did not have unregistered sales of
equity securities or use of proceeds from registered
securities.
ITEM
6. Exhibits.
No.
|
|
Description
of Exhibit
|
10.1
|
|
Lease
for Operating Facility
|
31.1
|
|
Certification
of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002
|
31.2
|
|
Certification
of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002
|
32.1
|
|
Certification
of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
|
32.2
|
|
Certification
of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
|
SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant
has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
Date:
November 19, 2008
|
By:
|
/s/
Robert Weinstein
|
|
|
Robert
Weinstein
Chief
Financial Officer
(Principal
Financial Officer and Principal
Accounting
Officer)
|