As Filed with the Securities and Exchange Commission on September 27, 2007

Registration No. 333-      

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

 

 

Vermillion, Inc.

(Exact name of registrant as specified in its charter)

 

 

6611 Dumbarton Circle

Fremont, California 94555

(510) 505-2100

(Address, Including Zip Code, and Telephone Number,

Including Area Code, of Registrant’s Principal Executive Offices)

 

Copies to:

 

 

Approximate date of commencement of proposed sale to the public:  From time to time after the effective date of this registration statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  þ

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

CALCULATION OF REGISTRATION FEE

 

 

 

 

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date, as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

SUBJECT TO COMPLETION, DATED SEPTEMBER 27, 2007

 

PROSPECTUS

 

43,935,269 Shares of Common Stock

 

 

We are registering our common stock, par value $0.001 per share, for resale by the selling stockholders identified in this prospectus.

 

The selling stockholders or their permitted transferees or other successors in interest may, but are not required to, sell their common stock in a number of different ways and at varying prices. See “Plan of Distribution” on page 82 for a description of how the selling stockholders may dispose of the shares covered by this prospectus. We do not know when or in what amount the selling stockholders may offer the shares for sale.

 

We will not receive any of the proceeds from sales of common stock made by the selling stockholders pursuant to this prospectus. We have agreed to pay certain expenses related to the registration of the shares of common stock.

 

Our common stock trades in the Nasdaq Capital Market under the symbol “VRML”. On September 26, 2007, the last reported sale price of our common stock on the Nasdaq Capital Market was $1.00 per share.

 

Investing in our common stock involves risks. See ‘‘Risk Factors” beginning on page 6.

 

Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

 

 

You should rely only on the information contained in this prospectus. We have not authorized anyone else to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. You should assume that the information appearing in this prospectus is accurate only as of its date.

 

 

 

 

The date of this prospectus is          , 2007.

 

TABLE OF CONTENTS

 

Common stock offered by selling stockholders.		43,935,269 shares
Use of Proceeds		We will not receive any proceeds from the shares of common stock offered by this prospectus, however, we will receive proceeds from the exercise of warrants to purchase the shares included in the shares that are being offered by the selling stockholders hereunder. Any proceeds we receive from such exercises of warrants will be used for working capital purposes. See “Use of Proceeds” on page 15.
Risk Factors		See “Risk Factors” beginning on page 6 and other information included in this prospectus for a discussion of factors you should carefully consider before deciding to invest in the shares.
Nasdaq Capital Market Trading Symbol		VRML

		Six Months Ended
		June 30,								Year Ended December 31,
		2007				2006				2006				2005				2004				2003				2002
		(in thousands, except per share amounts)
		(unaudited)
Consolidated Statements of Operations Data:
Total revenue		$	21			$	12,337			$	18,215			$	27,246			$	40,181			$	43,638			$	29,208
Loss from operations			(11,951	)			(12,336	)			(18,897	)			(34,509	)			(34,317	)			(38,654	)			(32,139	)
Loss from continuing operations			(12,873	)			(13,199	)			(22,066	)			(36,387	)			(36,571	)			(38,818	)			(30,660	)
Income from discontinued operations			—				—				—				954				16,730				2,071				1,588
Net loss		$	(12,873	)		$	(13,199	)		$	(22,066	)		$	(35,433	)		$	(19,841	)		$	(36,747	)		$	(29,072	)
Basic and diluted income (loss) per share:
Loss from continuing operations		$	(0.33	)		$	(0.37	)		$	(0.61	)		$	(1.13	)		$	(1.25	)		$	(1.38	)		$	(1.14	)
Income from discontinued operations			—				—				—				0.03				0.57				0.07				0.06
Net loss		$	(0.33	)		$	(0.37	)		$	(0.61	)		$	(1.10	)		$	(0.68	)		$	(1.31	)		$	(1.08	)
Shares used to compute basic and diluted loss per common share			39,245				36,024				36,465				32,321				29,244				28,154				26,965

		June 30,				December 31,
		2007				2006				2005				2004				2003				2002
		(in thousands)
		(unaudited)
Consolidated Balance Sheets Data:
Cash and cash equivalents		$	9,553			$	17,711			$	25,738			$	35,392			$	32,853			$	25,145
Investment in securities			—				—				2,240				2,175				14,463				17,396
Working capital			4,182				12,994				27,130				39,932				51,970				47,667
Total assets			13,155				23,016				52,811				74,377				102,026				87,615
Long-term debt and capital lease obligations, including current portion			28,553				25,511				31,512				29,397				31,865				2,816
Total stockholders’ equity (deficit)			(22,252	)			(9,901	)			6,523				26,715				47,892				68,354

 

RISK FACTORS

 

An investment in our common stock involves a high degree of risk. You should carefully consider the following risk factors together with all of the other information contained in this prospectus, including our audited consolidated financial statements and the notes thereto, before deciding whether to invest in shares of our common stock. Each of these risks could harm our business, operating results, financial condition and/or growth prospects. As a result, the trading price of our common stock could decline and you might lose all or part of your investment. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our operations.

 

Risks Related to Our Business

 

We expect to continue to incur net losses in 2007 and 2008. If we are unable to significantly increase our revenues, we may never achieve profitability.

 

From our inception through June 30, 2007, we have generated cumulative revenue from the sale of products and services to customers of $229.3 million and have incurred net losses of $230.7 million. We have experienced significant operating losses each year since our inception and expect these losses to continue for at least the next several quarters, resulting in an expected net loss for 2007 and 2008. For example, we experienced net losses of $22.1 million in 2006 and $12.9 million for the six months ended June 30, 2007. Our losses have resulted principally from costs incurred in research and development, sales and marketing, litigation, and general and administrative costs associated with our operations. These costs have exceeded our gross profit which, to date, has been generated principally from product sales derived from a business that we have now sold. We expect to incur additional operating losses and these losses may be substantial. We may never achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.

 

We will need to raise additional capital in the future, and if we are unable to secure adequate funds on terms acceptable to us, we may be unable to execute our business plan.

 

We believe that our current cash balances may not be sufficient to fund planned expenditures. Additional financing opportunities may not be available, or if available, may not be on favorable terms. The availability of financing opportunities will depend, in part, on market conditions, and the outlook for our company. Any future equity financing would result in substantial dilution to our stockholders. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, through debt covenants or other restrictions. If adequate and acceptable financing is not available, we may have to delay development or commercialization of certain of our products or license to third parties the rights to commercialize certain of our products or technologies that we would otherwise seek to commercialize. We may also reduce our marketing or other resources devoted to our products. Any of these options could reduce our ability to successfully execute our business plan.

 

Substantial leverage and debt service obligations may adversely affect our cash flows.

 

As of June 30, 2007, we had $19.0 million aggregate principal amount of convertible senior notes outstanding and $10.0 million outstanding under our secured line of credit with Quest Diagnostics. As a result of this indebtedness, we have high principal and interest payment obligations. The degree to which we are leveraged could, among other things:

 

 

Our ability to meet our debt service obligations will depend upon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control.

 

We may not succeed in developing diagnostic products and even if we do succeed in developing diagnostic products, they may never achieve significant commercial market acceptance.

 

Our success depends on our ability to develop and commercialize diagnostic products. There is considerable risk in developing diagnostic products based on our biomarker discovery efforts as potential tests may fail to validate results in larger clinical studies and may not achieve acceptable levels of clinical sensitivity and specificity. If we do succeed in developing diagnostic tests with acceptable performance characteristics, we may not succeed in achieving significant commercial market acceptance for those tests. Our ability to successfully commercialize diagnostic products that we may develop, such as tests, kits and devices, will depend on several factors, including:

 

 

These factors present obstacles to significant commercial acceptance of our potential diagnostic products, which we will have to spend substantial time and money to overcome, if we can do so at all. Our inability to successfully do so would prevent us from generating additional revenue from diagnostic products and we could be unable to develop a profitable business.

 

Our ability to commercialize our potential diagnostic tests is heavily dependent on our strategic alliance with Quest Diagnostics.

 

On July 22, 2005, Vermillion and Quest Diagnostics entered into a strategic alliance, which focuses on commercializing up to three assays chosen from our pipeline. The term of the agreement ends on the later of (i) the three-year anniversary of the agreement and (ii) the date on which Quest Diagnostics commercializes the three diagnostic tests covered by such agreement. If this strategic alliance does not continue for its full term or if Quest Diagnostics fails to diligently perform its obligations as a part of the strategic alliance, such as independently developing, validating, and commercializing potential diagnostic tests, our ability to commercialize our potential diagnostic tests would be seriously harmed. Due to the current uncertainty with regard to FDA regulation of analyte specific reagents, referred to herein as ASRs, or for other reasons, Quest Diagnostics may elect to forgo development of ASR “home brew” laboratory tests and instead elect to wait for the development of IVD test kits, which would adversely affect our revenues. If we elect to increase our expenditures to fund diagnostic development programs or research programs on our own, we will need to obtain additional capital, which may not be available on acceptable terms, or at all. If we fail to develop diagnostic tests, our ability to expand our business would be seriously harmed.

 

The commercialization of our potential diagnostic tests may be adversely affected by changing FDA regulations.

 

The current regulatory environment with regard to ASRs and in vitro diagnostic multivariate index assays, or IVDMIAs, such as our potential ovarian cancer diagnostic test, is unclear. To the extent the FDA requires that our potential diagnostic tests receive FDA 510(k) clearance or pre-market approval, our ability to develop and commercialize our potential diagnostic tests may be prevented or significantly delayed, which would adversely affect our revenues.

If we fail to continue to develop our technologies, we may not be able to successfully foster adoption of our products and services or develop new product offerings.

 

Our technologies are new and complex, and are subject to change as new discoveries are made. New discoveries and further progress in our field are essential if we are to foster the adoption of our product offerings. Development of these technologies remains a substantial risk to us due to various factors, including the scientific challenges involved, our ability to find and collaborate with others working in our field, and competing technologies, which may prove more successful than ours. In addition, we have reduced our research and development headcount and expenditures, which may adversely affect our ability to further develop our technologies.

 

If we fail to maintain our rights to utilize intellectual property directed to diagnostic biomarkers, we may not be able to offer diagnostic tests using those biomarkers.

 

One aspect of our business plan is to develop diagnostic tests based on certain biomarkers, which we have the right to utilize through licenses with our academic collaborators, such as The Johns Hopkins University School of Medicine and The University of Texas M.D. Anderson Cancer Center. In some cases, our collaborators own the entire right to the biomarkers. In other cases we co-own the biomarkers with our collaborators. If, for some reason, we lose our license to biomarkers owned entirely by our collaborators, we may not be able to use those biomarkers in diagnostic tests. If we lose our exclusive license to biomarkers co-owned by us and our collaborators, our collaborators may license their share of the intellectual property to a third party that may compete with us in offering diagnostic tests.

 

If the USPTO significantly narrows or cancels the claims of United States Patent 6,734,022, which is presently under reexamination, we will not receive a $2,000,000 potential payment and may lose market exclusivity for certain of our potential products.

 

In connection with the sale of assets and liabilities of our Instrument Business on November 13, 2006, Bio-Rad withheld $2,000,000 from the sales proceeds until the issuance of a reexamination certificate confirming the ‘022 Patent. If the USPTO does not issue a reexamination certificate confirming the patentability of all of the claims as originally issued in the ‘022 Patent, or claims of equivalent scope, we will not be entitled to receive the $2,000,000 withheld by Bio-Rad. The ‘022 Patent is directed to a fundamental process of SELDI that involves capturing an analyte from a sample on the surface of a mass spectrometry probe derivatized with an affinity reagent, applying matrix and detecting the captured analyte by laser desorption mass spectrometry. In March 2007, the USPTO issued a final office action in the reexamination, rejecting all of the claims of the ‘022 Patent. Although the office action was designated “final”, we, under the USPTO rules, advocated the outstanding rejections and the patentability of the claimed invention with the patent examiners on March 30, 2007 and on April 11, 2007. In addition, on April 18, 2007, we filed a response to the final office action with the USPTO. On June 28, 2007, the USPTO sent us a notice of intent to issue an ex parte reexamination certificate on the ‘022 Patent. There can be no assurance that the USPTO will not reverse its decision to issue the reexamination certificate.

 

We have drawn $10,000,000 from the secured line of credit provided by Quest Diagnostics. If we fail to achieve the milestones for the forgiveness of the loan set forth therein, we will be responsible for full repayment of the secured line of credit.

 

As of June 30, 2007, we have drawn $10,000,000 from the secured lined of credit in connection with our strategic alliance with Quest Diagnostics. We borrowed in monthly increments of $417,000 over a two-year period, with monthly interest payments. Funds from this collateralized line of credit may only be used to pay certain costs and expenses directly related to the strategic alliance, with forgiveness of the repayment obligations based upon our achievement of milestones related to the development, regulatory approval and commercialization of laboratory tests. Should we fail to achieve these milestones, we would be responsible for the repayment of the outstanding principal amount and any unpaid interest on the secured line of credit on or before July 22, 2010.

If a competitor infringes our proprietary rights, we may lose any competitive advantage we may have as a result of diversion of management time, enforcement costs and the loss of the exclusivity of our proprietary rights.

 

Our success depends in part on our ability to maintain and enforce our proprietary rights. We rely on a combination of patents, trademarks, copyrights and trade secrets to protect our technology and brand. In addition to our licensed SELDI technology, we also have submitted patent applications directed to subsequent technological improvements and application of the SELDI technology, including patent applications covering biomarkers that may have diagnostic or therapeutic utility. Our patent applications may not result in additional patents being issued.

 

If competitors engage in activities that infringe our proprietary rights, our management’s focus will be diverted and we may incur significant costs in asserting our rights. We may not be successful in asserting our proprietary rights, which could result in our patents being held invalid or a court holding that the competitor is not infringing, either of which would harm our competitive position. We cannot be sure that competitors will not design around our patented technology.

 

We also rely upon the skills, knowledge and experience of our technical personnel. To help protect our rights, we require all employees and consultants to enter into confidentiality agreements that prohibit the disclosure of confidential information. These agreements may not provide adequate protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use or disclosure.

 

If others successfully assert their proprietary rights against us, we may be precluded from making and selling our products or we may be required to obtain licenses to use their technology.

 

Our success also depends on avoiding infringing on the proprietary technologies of others. If a third party were to assert claims that we are violating their patents, we might incur substantial costs defending ourselves in lawsuits against charges of patent infringement or other unlawful use of another’s proprietary technology. Any such lawsuit may not be decided in our favor, and if we are found liable, we may be subject to monetary damages or injunction against using their technology. We may also be required to obtain licenses under their patents and such licenses may not be available on commercially reasonable terms, if at all.

 

Current and future litigation against us could be costly and time consuming to defend.

 

We are from time to time subject to legal proceedings and claims that arise in the ordinary course of business, such as claims brought by our clients in connection with commercial disputes, employment claims made by our current or former employees, and claims brought by third parties alleging infringement on their intellectual property rights. In addition, we may bring claims against third parties for infringement on our intellectual property rights. Litigation may result in substantial costs and may divert management’s attention and resources, which may seriously harm our business, financial condition and results of operations.

 

An unfavorable judgment against us in any legal proceeding or claim could require us to pay money damages. In addition, an unfavorable judgment in which the counterparty is awarded equitable relief such as an injunction could have an adverse impact on our licensing and sublicensing activities which could harm our business, financial condition and results of operations.

 

On September 17, 2007, we were served with a complaint naming us and Bio-Rad as defendants and MAS as the plaintiff. In the complaint, MAS alleges that we are in breach of our license agreement with MAS relating to SELDI technology as a result of our entry into a sublicense agreement with Bio-Rad. Given the early stage of this action, we cannot predict the ultimate outcome of this matter at this time.

 

We depend on a single supplier to commercialize and assemble our products and any interruption in this supplier relationship could materially and adversely affect our operating results.

 

In connection with the sale of our Instrument Business, we entered into a manufacture and supply agreement with Bio-Rad pursuant to which Bio-Rad commercializes and assembles our SELDI instruments and ProteinChip^® Arrays. The initial term of the agreement expires on November 12, 2011 and is renewable

for two additional two-year terms. If the manufacture and supply agreement is terminated or is not renewed or if Bio-Rad ceases manufacturing our products for another reason, we would have to find another third party supplier or begin commercializing and assembling our products ourselves. We or another third-party supplier may not be able to produce those products at a cost, quantity or quality that are available from Bio-Rad. In addition, any such interruption could delay or diminish our ability to satisfy our customers’ orders which could reduce our revenues and adversely affect our relationships with our customers and materially and adversely affect our operating results.

 

If we or our suppliers fail to comply with FDA requirements, we may not be able to market our products and services and may be subject to stringent penalties; further improvements to our or our suppliers’ manufacturing operations may be required that would entail additional costs.

 

The commercialization of our products could be affected by being delayed, halted or prevented by applicable FDA regulations. If the FDA were to view any of our actions as non-compliant, it could initiate enforcement actions such as a warning letter and possible imposition of penalties. In addition, ASRs that we may provide will be subject to a number of FDA requirements, including compliance with the FDA’s Quality System Regulations, referred to herein as QSRs, which establish extensive requirements for quality assurance and control as well as manufacturing procedures. Failure to comply with these regulations could result in enforcement actions for us or our potential suppliers. Adverse FDA actions in any of these areas could significantly increase our expenses and limit our revenue and profitability. Although we are ISO 9001:2000 certified with respect to the manufacturing processes used for our previous ProteinChip^® products, we will need to undertake additional steps to maintain our operations in line with the FDA’s QSRs. Our suppliers’ manufacturing facilities are subject to periodic regulatory inspections by the FDA and other federal and state regulatory agencies. If and when we begin commercializing and assembling our products ourselves, our facilities will be subject to the same inspections. We or our suppliers may not satisfy such regulatory requirements, and any such failure to do so would have an adverse effect on our diagnostics efforts.

 

Because our business is highly dependent on key executives and employees, our inability to recruit and retain these people could hinder our business plans.

 

We are highly dependent on our executive officers and certain key employees. Our product development could be delayed or curtailed if we lose the services of any of these people. To continue our research and product development efforts, we need people skilled in areas such as bioinformatics, biochemistry and information services. Competition for qualified employees is intense.

 

Our diagnostic efforts may cause us to have significant product liability exposure.

 

The testing, manufacturing and marketing of medical diagnostic tests entail an inherent risk of product liability claims. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. Our existing insurance will have to be increased in the future if we are successful at introducing diagnostic products and this will increase our costs. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the limits of our insurance coverage, our liabilities could exceed our total assets.

 

Business interruptions could limit our ability to operate our business.

 

Our operations as well as those of the collaborators on which we depend are vulnerable to damage or interruption from fire, natural disasters, computer viruses, human error, power shortages, telecommunication failures, international acts of terror and similar events. Our primary facility is located in Fremont, California, where we also have laboratories. Although we have certain business continuity plans in place, we have not established a formal comprehensive disaster recovery plan, and our back-up operations and our business interruption insurance may not be adequate to compensate us for losses we may suffer. A significant business interruption could result in losses or damages incurred by us and require us to cease or curtail our operations.

Legislative actions resulting in higher compliance costs are likely to adversely affect our future financial position, cash flows and results of operations.

 

Compliance with laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new Securities and Exchange Commission, or SEC, regulations and Nasdaq listing requirements, are resulting in increased compliance costs. We, like all other public companies, are incurring expenses and diverting management’s time in an effort to comply with Section 404 of the Sarbanes-Oxley Act of 2002. We are a non-accelerated filer and we are in the early stages of process documentation and evaluation of our systems of internal control. We are required to assess our compliance with Section 404 of the Sarbanes-Oxley Act of 2002 for the year ending December 31, 2007. We expect to devote the necessary resources, including additional internal and supplemental external resources, to support our assessment. If, in the future, we identify one or more material weaknesses, or our external auditors are unable to attest that our management’s report is fairly stated or to express an opinion on the effectiveness of our internal controls, this could result in a loss of investor confidence in our financial reports, have an adverse effect on our stock price and/or subject us to sanctions or investigation by regulatory authorities. Compliance with these evolving standards will result in increased general and administrative expenses and may cause a diversion of management time and attention from revenue-generating activities to compliance activities.

 

We are subject to environmental laws and potential exposure to environmental liabilities.

 

We are subject to various international, federal, state and local environmental laws and regulations that govern our operations, including the handling and disposal of nonhazardous and hazardous wastes, the recycling and treatment of electrical and electronic equipment, and emissions and discharges into the environment. Failure to comply with such laws and regulations could result in costs for corrective action, penalties or the imposition of other liabilities. We also are subject to laws and regulations that impose liability and clean-up responsibility for releases of hazardous substances into the environment. Under certain of these laws and regulations, a current or previous owner or operator of property may be liable for the costs of remediating hazardous substances or petroleum products on or from its property, without regard to whether the owner or operator knew of, or caused, the contamination, as well as incur liability to third parties affected by such contamination. The presence of, or failure to remediate properly, such substances could adversely affect the value and the ability to transfer or encumber such property. Based on currently available information, although there can be no assurance, we believe that such costs and liabilities have not had and will not have a material adverse impact on our financial results.

 

Risks Related to Owning Our Stock

 

Our principal stockholders own a significant percentage of our outstanding common stock and are, and will continue to be, able to exercise significant influence over our affairs.

 

As of August 31, 2007, Quest Diagnostics possessed voting power over 8,605,952 shares, or 13.49%, and Phronesis Partners, L.P., referred to herein as Phronesis, possessed voting power over 6,665,678 shares, or 10.45%, of our outstanding common stock. As a result, Quest Diagnostics and Phronesis are able to determine a significant part of the composition of our Board of Directors, hold significant voting power with respect to matters requiring stockholder approval and are able to exercise significant influence over our operations. The interests of Quest Diagnostics and Phronesis may be different than the interests of other stockholders on these and other matters. This concentration of ownership also could have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could reduce the price of our common stock.

 

Although we currently meet the standards for continued listing on the Nasdaq Capital Market, there is no guarantee that we will continue to meet these standards in the future and if we are delisted the value of your investment in Vermillion may substantially decrease.

 

To remain listed on the Nasdaq Capital Market we must have (i) a minimum of $2.5 million in stockholders’ equity, (ii) a market value of at least $35.0 million or (iii) $500,000 of net income from

continuing operations for the most recently completed fiscal year or two of the three most recently completed fiscal years. Between January 1, 2006 and September 10, 2007, our market value fluctuated between $25.5 million and $84.6 million. Based on our market value being below $35.0 million for a period of ten consecutive trading days, the Nasdaq Stock Market sent us a delisting notice on August 15, 2007. On September 15, 2007, we received a notice from the Nasdaq Stock Market that we had regained compliance with this listing requirement.

 

In addition, Nasdaq requires that the bid price for our common stock may not be below $1.00 per share for more than 30 consecutive business days. We received a second delisting notice on September 6, 2007, following a period of 30 business days during which the bid price for our stock was below $1.00. We have until March 4, 2008 to regain compliance otherwise Nasdaq may provide written notification that the Company’s securities will be delisted, at which time, we may appeal Nasdaq’s decision.

 

There is no guarantee that we will continue to meet the standards for listing in the future. Upon delisting from the Nasdaq Capital Market, our stock would be traded over-the-counter, more commonly known as OTC. OTC transactions involve risks in addition to those associated with transactions in securities traded on the Nasdaq Capital Market. Many OTC stocks trade less frequently and in smaller volumes than Nasdaq-listed stocks. Accordingly, delisting from the Nasdaq Capital Market would adversely affect the trading price of our common stock, significantly limit the liquidity of our common stock and impair our ability to raise additional funds.

 

Anti-takeover provisions in our charter, bylaws and stockholder rights plan and under Delaware law could make a third party acquisition of us difficult.

 

Our certificate of incorporation, bylaws and stockholder rights plan contain provisions that could make it more difficult for a third party to acquire us, even if doing so might be deemed beneficial by our stockholders. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. We are also subject to certain provisions of Delaware law that could delay, deter or prevent a change in control of us. The rights issued pursuant to our stockholder rights plan will become exercisable the tenth day after a person or group announces acquisition of 15% or more of our common stock or announces commencement of a tender or exchange offer the consummation of which would result in ownership by the person or group of 15% or more of our common stock. If the rights become exercisable, the holders of the rights (other than the person acquiring 15% or more of our common stock) will be entitled to acquire, in exchange for the rights’ exercise price, shares of our common stock or shares of any company in which we are merged, with a value equal to twice the rights’ exercise price.

 

Because we do not intend to pay dividends, our stockholders will benefit from an investment in our common stock only if it appreciates in value.

 

We have never declared or paid any cash dividends on our common stock. We currently intend to retain our future earnings, if any, to finance the expansion of our business and do not expect to pay any cash dividends in the foreseeable future. As a result, the success of an investment in our common stock will depend entirely upon any future appreciation. There is no guarantee that our common stock will appreciate in value or even maintain the price at which our investor purchased his shares.

 

Limitations on net loss carryforwards and research and development deferred tax assets related to state and federal income taxes may have an impact on our future results of operations.

 

We are evaluating the net operating loss carryforwards, and research and development deferred tax assets to determine whether there is a limit due to prior year ownership changes. It is possible that a portion of these deferred tax assets may be limited in their use. We expect to complete the studies by the end of 2007.

Our stock price has been highly volatile, and an investment in our stock could suffer a decline in value.

 

The trading price of our common stock has been highly volatile and could continue to be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:

 

 

In addition, the stock market in general, and the Nasdaq Capital Market and the market for technology companies in particular, have experienced significant price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Further, there has been significant volatility in the market prices of securities of life science companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted. A securities class action suit against us could result in substantial costs, potential liabilities and the diversion of management’s attention and resources.

 

We may need to sell additional shares of our common stock or other securities to meet our capital requirements. If we need to sell additional shares of our common stock or other securities to meet our capital requirements, or upon conversion of our convertible notes and exercises of currently outstanding options and warrants, the ownership interests of our current stockholders could be substantially diluted. The possibility of dilution posed by shares available for future sale could reduce the market price of our common stock and could make it more difficult for us to raise funds through equity offerings in the future.

 

As of August 31, 2007, we had 63,776,934 shares of common stock outstanding. In addition, as of August 31, 2007, there were 7,475,681 shares of common stock reserved for future issuance to employees, directors and consultants pursuant to our employee stock plans, of which 5,734,229 shares of common stock were subject to outstanding options. In addition, as of August 31, 2007, warrants to purchase 22,931,470 shares of common stock were outstanding at exercise prices ranging from $0.925 to $2.50 per share, with a weighted exercise price of $1.079 per share. In addition, there are 272,082 shares of common stock reserved for issuance upon conversion of our outstanding 4.5% Convertible Senior Notes due 2008, referred to herein as the 4.5% Notes, and 8,250,000 shares of common stock reserved for issuance upon conversion of our 7.0% Convertible Senior Notes due 2011, referred to herein as the 7.0% Notes. The exercise or conversion of all or a portion of these securities would dilute the ownership interests of our stockholders. Furthermore, future sales of substantial amounts of our common stock in the public market, or the perception that such sales are likely to occur, could affect prevailing trading prices of our common stock and the value of the notes.

Cautionary Note Regarding Forward-Looking Statements

 

Some statements in this prospectus are deemed forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. We claim the protection of such safe harbor, and disclaim any intent or obligation to update any forward-looking statement. You can identify these statements by forward-looking words such as “may”, “will”, “expect”, “intend”, “anticipate”, “believe”, “estimate”, “plan”, “could”, “should” and “continue” or similar words. These forward-looking statements may also use different phrases. We have based these forward-looking statements on our current expectations and projections about future events. Examples of forward-looking statements include the following statements:

 

 

These statements are subject to significant risks and uncertainties, including those identified in the section of this prospectus entitled “Risk Factors”, that could cause actual results to differ materially from those projected in such forward-looking statements due to various factors, including our ability to generate sales after completing product development of new diagnostic products; managing our operating expenses and cash resources consistent with our plans; our evaluation of the net operating loss carryforwards and research and development deferred tax credits to determine whether there is a limit due to prior year ownership changes; our ability to conduct new diagnostic product development using both our internal research and development resources, and collaboration partners within the budgets and time frames we have established; the ability of the ProteinChip^® technology to discover protein biomarkers that have diagnostic, theranostic and/or drug development utility; the continued emergence of proteomics as a major focus of biological research and drug discovery; and our ability to protect and promote our proprietary technologies. We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to accurately predict or that we do not fully control that could cause actual results to differ materially from those expressed or implied in our forward-looking statements.

 

USE OF PROCEEDS

 

We will receive no proceeds from the sale of the shares by the selling stockholders. However, this prospectus covers the offer of shares of common stock issuable in the future upon the exercise of (i) warrants to purchase up to an aggregate of 18,626,709 shares of common stock at an exercise price of $0.925 per share, subject to certain adjustments, which are exercisable until August 29, 2012, (ii) warrants to purchase up to an aggregate of 45,000 shares of common stock at an exercise price of $1.26 per share, subject to certain adjustments, which are exercisable until August 2, 2011 and (iii) warrants to purchase up to an aggregate of 45,000 shares of common stock at an exercise price of $1.26 per share, subject to certain adjustments, which are exercisable until November 14, 2011. If all of these warrants are exercised in full for cash, we would receive aggregate gross proceeds of approximately $17,343,000. There can be no assurance any of these warrants will be exercised by the selling stockholders or, if exercised, that we will receive any cash proceeds upon such exercises. We expect to use proceeds, if any, from exercise of these warrants for general working capital purposes. We cannot assure that any selling stockholder will sell any or all of the shares of common stock registered pursuant to the registration statement of which this prospectus is a part.

 

We will pay certain expenses related to the registration of the shares of common stock.

 

DETERMINATION OF OFFERING PRICE

 

The selling stockholders will determine at what price they may sell the offered shares, and such sales may be made at prevailing market prices, or at privately negotiated prices.

 

MARKET FOR COMMON STOCK

 

Our common stock is traded on the Nasdaq Capital Market under the symbol “VRML”.

 

The following sets forth the quarterly high and low trading prices as reported by the Nasdaq Capital Market for the periods indicated.

 

 

The closing price for our common stock on September 26, 2007 was $1.00. As of September 20, 2007, there were approximately 143 holders of record of our common stock, excluding shares held in book-entry form through The Depository Trust Company, and we estimate that the number of beneficial owners of shares of our common stock was approximately 4,169 as of such date.

 

DIVIDEND POLICY

 

We have never paid or declared any dividend on our common stock and we do not anticipate paying cash dividends on our common stock in the foreseeable future. If we pay a cash dividend on our common stock, we also may be required to pay the same dividend on an as-converted basis on any outstanding preferred stock, warrants, convertible notes or other securities. Moreover, any preferred stock or other senior debt or equity securities to be issued and any future credit facilities might contain restrictions on our ability to declare and pay dividends on our common stock. We intend to retain all available funds and any future earnings to fund the development and expansion of our business.

 

SELECTED CONSOLIDATED FINANCIAL DATA

 

You should read the following selected consolidated financial data in conjunction with our audited consolidated financial statements and the notes thereto, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus. The following tables set forth our consolidated balance sheet data as of June 30, 2007, and December 31, 2006, 2005, 2004, 2003 and 2002 and our consolidated statements of operations data for the six months ended June 30, 2007 and 2006, and the years ended December 31, 2006, 2005, 2004, 2003 and 2002. We derived the selected consolidated financial data for the years ended December 31, 2006, 2005 and 2004 from our audited consolidated financial statements included elsewhere in this prospectus. The consolidated statements of operations data for the years ended December 31, 2003 and 2002, and the consolidated balance sheet data as of December 31, 2004, 2003 and 2002, were derived from our audited consolidated financial statements that are excluded from this prospectus. The summary consolidated financial data as of June 30, 2007, and for the six months ended June 30, 2007 and 2006 are derived from our unaudited consolidated financial statements included elsewhere in this prospectus.

 

Our historical results are not necessarily indicative of the results that may be expected for any future period. The results of operations data for the six-month periods presented below are not necessarily indicative of the operating results for the entire year or any other future interim period.

 

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

 

You should read the following discussion in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this prospectus. The following discussion includes certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those referred to in the forward-looking statements as a result of various factors, including those discussed in “Risk Factors” and elsewhere in this prospectus.

 

Overview

 

We are dedicated to the discovery, development and commercialization of specialty diagnostic tests that provide physicians with information with which to manage their patients’ care and to improve patient outcomes. We intend to do this using translational proteomics, which is the process of answering clinical questions by utilizing advanced protein separation methods to identify and resolve variants of specific biomarkers, developing assays, and commercializing tests.

 

Through collaborations with leading academic and research institutions, including The Johns Hopkins School of Medicine, The University of Texas M.D. Anderson Cancer Center, University College London, The University of Texas Medical Branch, The Katholieke Universiteit Leuven, The Ohio State University Research Foundation, and Stanford University, we plan to develop diagnostic tests in the fields of hematology/oncology, cardiovascular disease and women’s health. The clinical questions we are addressing include early disease detection, treatment response, monitoring of disease progression, prognosis and others.

 

These research collaborations have provided us with the clinical data and intellectual property portfolio that form the basis of our product pipeline. We are now engaged in product development and commercialization of discoveries made under these collaborations. In July 2005, we entered into a strategic alliance agreement with Quest Diagnostics pursuant to which the parties have agreed to develop and commercialize up to three diagnostic tests. The term of the agreement ends on the later of (i) the three-year anniversary of the agreement and (ii) the date on which Quest Diagnostics commercializes the three diagnostic tests. Thus, our major initiatives are currently aimed at commercializing these tests, both within the context of our strategic alliance agreement with Quest Diagnostics as well as in markets outside of Quest Diagnostics, to the extent permitted under the agreement. In May 2007, we hired Steve Lundy as our Senior Vice President of Sales and Marketing. We anticipate adding additional members to our sales and marketing team to expedite these activities.

 

Our most established programs are in the field of ovarian cancer. Commonly known as the “silent killer”, ovarian cancer leads to approximately 15,000 deaths each year in the United States. Approximately 20,000 new cases are diagnosed each year, with the majority in patients with late stage disease, where the cancer has spread beyond the ovary. Unfortunately, the prognosis is poor in these patients, leading to the high mortality from this disease. We believe that one unmet clinical need is a diagnostic test that can provide adequate predictive value to stratify patients with a pelvic mass into those with a high risk of invasive ovarian cancer versus those with a low risk. We believe that there are at least 5 million testing opportunities each year addressing this need. We have developed a panel of biomarkers we believe provides risk stratification information for ovarian cancer based on a series of studies involving over 2,500 clinical samples from more than five sites.

 

In a cohort study we were able to show, in 525 consecutively sampled women, a significant increase in the positive predictive value using our marker panel over the baseline level. This translates into the potential to enrich the concentration of ovarian cancer cases referred to a gynecologic oncologist by more than two-fold. We are undertaking a prospective clinical trial to support submission to the FDA for approval as an IVD test kit.

 

A second major program is a test intended to aid in the detection of PAD. This test, which is based on research done in collaboration with Stanford University, fills the unmet clinical need for a blood test that can be used as an adjunct to detect PAD, which affects 10 million Americans but is underdiagnosed. Accurate

diagnosis of PAD permits aggressive lifestyle modification and therapeutic intervention that can decrease the risk of major adverse cardiovascular events. We reported in August the publication of a discovery of two blood markers for PAD in the peer-reviewed journal Circulation, which is published by the American Heart Association. We are currently performing clinical validation of this test, which will be commercialized with Quest Diagnostics under the terms of the strategic alliance agreement.

 

We were originally incorporated in California on December 9, 1993, under the name Abiotic Systems. In March 1995, we changed our corporate name to Ciphergen Biosystems, Inc. and in May 2000, we reincorporated in Delaware. We had our initial public offering in September 2000. On November 13, 2006, we sold assets and liabilities of our Instrument Business to Bio-Rad in order to concentrate our resources on developing clinical protein biomarker diagnostic products and services. On August 21, 2007, we changed our corporate name to Vermillion, Inc.

 

As a result of the sale of the assets and liabilities of our Instrument Business to Bio-Rad, we have substantially reduced the size of our staff. Prior to the November 13, 2006 sale of assets and liabilities of our Instrument Business to Bio-Rad, our sales were driven by the need for new and better tools to perform protein discovery, characterization, purification, identification and assay development. Many of the ProteinChip^® Systems sold to our customers also generated a recurring revenue stream from the sale of consumables and maintenance contracts. In addition, some of our customers would enhance their ProteinChip^® Systems by adding automation accessories and advanced software. This recurring revenue stream was sold to Bio-Rad as part of the sale of assets and liabilities of the Instrument Business. Additionally, our expenses have consisted primarily of materials, contracted manufacturing services, labor and overhead costs to manufacture our ProteinChip^® Systems and ProteinChip^® Arrays and to support customer services, marketing and sales activities, research and development programs, litigation, and general and administrative costs associated with our operations.

 

Since November 13, 2006, our expenses have consisted primarily of research and development costs related to our diagnostics efforts, and general and administrative costs including litigation expenses and accounting and auditing expenses.

 

We expect to incur net losses in 2007 and 2008. To become profitable, we will need to begin achieving revenue from our diagnostics efforts. Due to the sale of assets and liabilities of our Instrument Business to Bio-Rad, we will have limited revenues until our diagnostic tests are developed and successfully commercialized. To become profitable, we will need to complete development of key diagnostic tests, obtain FDA approval and successfully commercialize our products. We have a limited history of operations in developing diagnostic tests, and we anticipate that our quarterly results of operations will fluctuate for the foreseeable future due to several factors, including market acceptance of current and new products, the timing and results of our research and development efforts, the introduction of new products by our competitors and possible patent or license issues. Our limited operating history as a diagnostics business makes accurate prediction of future results of operations difficult.

 

Recent Developments

 

On August 23, 2007, we entered into a securities purchase agreement in connection with a private placement with a group of existing and new investors. The transaction closed on August 29, 2007. We received approximately $20.6 million in gross proceeds from the sale of 24,513,092 shares of our common stock and warrants for the purchase of an additional 20,531,470 shares of our common stock with an exercise price of $0.925 per share. The net proceeds of the transaction will be used for general working capital needs.

 

In connection with the closing of the transaction we amended a warrant issued on July 22, 2005, to Quest Diagnostics. Pursuant to the terms of the amendment, the exercise price for the purchase of our common stock under such warrant was reduced from $3.50 per share to $2.50 per share and the expiration date of such warrant was extended from July 22, 2010 to July 22, 2011.

 

In August 2007, we announced the discovery of biomarkers that could assist in the diagnosis of PAD. These findings, which were made in collaboration with Stanford University, form the basis of a novel blood

test for PAD. The biomarkers are currently undergoing validation. The results were published in the journal Circulation, which is published by the American Heart Association. Quest Diagnostics has accepted the PAD test for further development under the strategic alliance agreement.

 

On September 17, 2007, we were served with a complaint filed in the Superior Court of California for the County of Santa Clara naming us and Bio-Rad as defendants and MAS as plaintiff. The complaint alleges, among other things, that we are in breach of our license agreement with MAS relating to SELDI technology as a result of our entry into a sublicense agreement with Bio-Rad. In connection with the sale of assets and liabilities of our Instrument Business to Bio-Rad, we sublicensed to Bio-Rad certain rights to the SELDI technology that we obtained under the MAS license for use outside of the clinical diagnostics field. We retained exclusive rights to the technology for use in the field of clinical diagnostics for a five-year period, after which we will retain nonexclusive rights in that field. Given the early stage of this action, we cannot predict the ultimate outcome of this matter at this time.

 

On June 26, 2006, Health Discovery Corporation filed a lawsuit against us in the United States District Court for the Eastern District of Texas, Marshall Division, claiming that software used in certain of our ProteinChip^® Systems infringes on three of its United States patents. Health Discovery Corporation sought injunctive relief as well as unspecified compensatory and enhanced damages, reasonable attorney’s fees, prejudgment interest and other costs. On August 1, 2006, we filed an unopposed motion with the Court to extend the deadline for us to answer or otherwise respond until September 2, 2006. We filed our answer and counterclaim to the complaint with the Court on September 1, 2006. Concurrent with our answer and counterclaims, we filed a motion to transfer the case to the Northern District of California. On January 10, 2007, the Court granted our motion to transfer the case to the Northern District of California. The parties met for a scheduled mediation on May 7, 2007. On July 10, 2007, we entered into a license and settlement agreement with Health Discovery Corporation, pursuant to which we licensed more than 25 patents covering Health Discovery Corporation’s support vector machine technology for use with SELDI technology. Under the terms of the HDC Agreement, we receive a worldwide, royalty-free, non-exclusive license for life sciences and diagnostic applications of the technology and have access to any future patents resulting from the underlying intellectual property in conjunction with use of SELDI systems. Pursuant to the HDC Agreement, we paid $200,000 to Health Discovery Corporation upon entry into the agreement in July 2007. The remaining $400,000 payable under the HDC Agreement is payable as follows: $100,000 three months following the date of the agreement, $150,000 twelve months following the date of the agreement and $150,000 twenty-four months following the date of the agreement. The HDC Agreement settles all disputes between us and Health Discovery Corporation.

 

At our annual stockholders’ meeting on June 29, 2007, stockholders approved amendments to our Certificate of Incorporation to increase the number of authorized shares of common stock from 80,000,000 to 150,000,000 and to change the name of the company from Ciphergen Biosystems, Inc. to Vermillion, Inc. On July 13, 2007, we amended and restated our certificate of incorporation with the State of Delaware for the increased authorized shares. We amended our certificate of incorporation to reflect our name change on August 21, 2007.

 

In connection with the sale of assets and liabilities of our Instrument Business on November 13, 2006, Bio-Rad withheld $2,000,000 from the sales proceeds until the issuance of a reexamination certificate confirming the ’022 Patent. If the USPTO does not issue a reexamination certificate confirming the patentability of all of the claims as originally issued in the ’022 Patent, or claims of equivalent scope, we will not be entitled to receive the $2,000,000 withheld by Bio Rad. The ’022 Patent is directed to a fundamental process of SELDI that involves capturing an analyte from a sample on the surface of a mass spectrometry probe derivatized with an affinity reagent, applying matrix and detecting the captured analyte by laser desorption mass spectrometry. In March 2007, the USPTO issued a final office action in the reexamination, rejecting all of the claims of the ‘022 Patent. Although the office action was designated “final”, we, under the USPTO rules, advocated the outstanding rejections and the patentability of the claimed invention with the patent examiners on March 30, 2007, and on April 11, 2007. In addition, on April 18, 2007, we filed a response to the final office action with the USPTO. On June 28, 2007, the USPTO sent us a notice of intent to issue a reexamination certificate of the ‘022 Patent.

In May 2007, the European Patent Office issued an EU Patent, “Biomarkers of Transitional Cell Carcinoma of the Bladder,” for aiding in bladder cancer diagnosis when used in conjunction with the current standard of care, cystoscopy (a diagnostic procedure that uses a scope to view the bladder). The patent describes using mass spectrometry to detect certain protein biomarkers that are present in patients with bladder cancer versus patients who do not have bladder cancer. These discoveries were made under our collaborative agreement with Eastern Virginia Medical School. We retain exclusive rights to these discoveries for diagnostic development.

 

Results of Operations

 

Six Months Ended June 30, 2007 Compared to Six Months Ended June 30, 2006

 

The following table sets forth selected summary financial and operating data of Vermillion for the six months ended June 30, 2007 and 2006:

 

 

Products Revenue.  There was no products revenue for the six months ended June 30, 2007, compared to $8,005,000 for the same period in 2006. The decrease was the result of the sale of assets and liabilities of our Instrument Business to Bio-Rad. We are currently putting in place the infrastructure and sales and marketing resources in preparation for the launch of our diagnostic programs and as a result, we do not expect to have significant revenues from these diagnostic programs for the remainder of 2007.

 

Services Revenue.  Services revenue decreased to $21,000 for the six months ended June 30, 2007, from $4,332,000 for the same period in 2006. Services revenue for the six months ended June 30, 2007, was from

ongoing support services provided to a customer. This decrease was the result of the sale of assets and liabilities of our Instrument Business to Bio-Rad. As a result of such sale, we expect little or no services revenue from our remaining customer that we have retained for the remainder of 2007.

 

Cost of Products Revenue.  There was no cost of products revenue for the six months ended June 30, 2007, compared to $4,143,000 for the same period in 2006. This decrease was the result of the sale of assets and liabilities of our Instrument Business to Bio-Rad. We expect limited cost of products revenue for the remainder of 2007, corresponding to the launch of a new diagnostic test scheduled for the end of this year.

 

Cost of Services Revenue.  Cost of services revenue decreased to $15,000 for the six months ended June 30, 2007, from $2,208,000 for the same period in 2006. Cost of services revenue for the six months ended June 30, 2007, was from ongoing support services provided to a customer. This decrease was the result of the sale of assets and liabilities of our Instrument Business to Bio-Rad. As a result of the sale of assets and liabilities of our Instrument Business to Bio-Rad, we expect little or no cost of services revenue for the remainder of 2007. This corresponds to any services revenue generated from our remaining customer that we have retained from the sale of assets and liabilities of our Instrument Business to Bio-Rad.

 

Research and Development Expenses.  Research and development expenses decreased by $1,751,000, or 29.9%, to $4,115,000 for the six months ended June 30, 2007, from $5,866,000 for the same period in 2006. This decrease is primarily due to our transition from a proteomic tools business to a specialty diagnostic testing business following the sale of assets and liabilities of our Instrument Business to Bio-Rad. This transition resulted in reductions in employee headcount to fourteen at June 30, 2007, from twenty-seven at June 30, 2006, and correspondingly salaries, payroll taxes, employee benefits and stock-based compensation decreased by $1,240,000; materials and supplies used in the development of new products decreased by $369,000; equipment related expenses decreased by $294,000; occupancy costs decreased by $100,000; outside services decreased by $117,000; and other operating costs decreased by $122,000. These decreases were offset by the increased collaboration cost spending of $563,000. Stock-based compensation expense included in research and development expenses was $77,000 and $194,000 for the six months ended June 30, 2007 and 2006, respectively. We expect research and development expenses for the remainder of 2007 to remain consistent with the first six months of 2007. For the remainder of 2007, we anticipate higher clinical study costs related to our diagnostic tests under development offset by lower collaboration costs as compared to the first six months of 2007.

 

Sales and Marketing Expenses.  Sales and marketing expenses decreased to $924,000 for the six months ended June 30, 2007, from $7,448,000 for the same period in 2006. The decrease was largely due to the sale of assets and liabilities of our Instrument Business to Bio-Rad. Correspondingly, employee headcount decreased to six at June 30, 2007, from sixty-six at June 30, 2006, which resulted in a decline in salaries, payroll taxes, employee benefits and stock-based compensation of $4,121,000. This also resulted in reductions in travel by $830,000; internal consumption of ProteinChip^® Arrays and other consumables for customer demonstrations and support by $455,000; outside services by $321,000; and equipment related expenses by $834,000. Stock-based compensation expense included in sales and marketing expenses was $46,000 and $186,000 for the six months ended June 30, 2007 and 2006, respectively. We are currently putting in place a sales and marketing team in preparation for the sales launch of our new diagnostic tests and as a result, we expect sales and marketing expenses for the remainder of 2007 to increase from the first six months of 2007.

 

General and Administrative Expenses.  General and administrative expenses increased to $6,536,000 for the six months ended June 30, 2007, from $5,008,000 for the same period in 2006, an increase of $1,528,000 or 30.5%. The increase was primarily due to the settlement of the Health Discovery Corporation lawsuit of $600,000; incremental costs of $120,000 to support the financial reporting obligations; increased professional services of $263,000 primarily from our corporate name change and printing costs associated with the annual proxy and annual financial report; increased legal fees of $234,000 primarily due to filings of new patent applications, costs incurred from the Health Discovery Corporation lawsuit and costs incurred from the ‘022 Patent reexamination; and increased accounting and audit fees of $459,000 due to the timing of domestic and international services performed. Employee headcount declined to fourteen at June 30, 2007, from twenty at June 30, 2006. Stock-based compensation expense included in general and administrative expenses was

$322,000 and $450,000 for the six months ended June 30, 2007 and 2006, respectively. We expect general and administrative expenses for the remainder of 2007 to decrease from the first six months of 2007, which included the settlement of the Health Discovery Corporation lawsuit and completion of the ’022 Patent reexamination issue. Additionally, for the remainder of 2007, we expect to incur costs of performing a management assessment of compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

 

Loss on Sale of Instrument Business.  Loss on sale of the Instrument Business was from a charge of $382,000 for the six months ended June 30, 2007, related to a post-closing adjustment resulting from the sale of assets and liabilities of the Instrument Business to Bio-Rad.

 

Interest and Other Expense, Net.  Interest income was $289,000 for the six months ended June 30, 2007, compared to $464,000 for the same period in 2006. Interest income decreased primarily due to the liquidation of short-term investments during 2006 to fund operations.

 

Interest expense was $1,131,000 for the six months ended June 30, 2007, compared to $1,099,000 for the same period in 2006. Interest expense in both periods consisted largely of interest related to our convertible senior notes and borrowings from Quest Diagnostics. Interest expense included the amortization of the beneficial conversion feature associated with the convertible senior notes amounting to $126,000 and $265,000 for the six months ended June 30, 2007 and 2006, respectively.

 

Net other expense was $78,000 for the six months ended June 30, 2007, compared to $58,000 for the same period in 2006. Net other expense for the six months ended June 30, 2006, included $160,000 received in settlement of a claim against a service provider. Net other expense included the amortization of the offering costs related to the convertible notes amounting to $37,000 and $187,000 for the six months ended June 30, 2007 and 2006, respectively.

 

Income Tax Expense.  Income tax expense for the six months ended June 30, 2007, was $2,000 compared to $170,000 for the same period in 2006. The decrease in expense was primarily due to reduction of net income in our foreign operations as a result of the sale of assets and liabilities of our Instrument Business to Bio-Rad.

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

 

The following table sets forth selected summary financial and operating data of Vermillion for the years ended December 31, 2006 and 2005:

 

 

Products Revenue.  Products revenue was $11.3 million in 2006 and $18.4 million in 2005. The $7.1 million or 39% decrease in products revenue from 2005 to 2006 was largely the result of a 38% decrease in revenue from sales of our ProteinChip^® Systems, accessories and software, as well as a 39% decrease in revenue from our arrays and consumables. The decrease in systems and related revenue was due to a 55% decrease in unit sales of ProteinChip^® Systems from 76 systems in 2005 to 34 systems in 2006 in part due to the asset sale of our Instrument Business to Bio-Rad. During the first half of 2006, products revenues trended down by about 10% from the prior year and dropped significantly following the announcement of the proposed transaction with Bio-Rad. The decrease in array and consumable sales was largely driven by lower unit sales due in part to significantly reduced new instrument placements, as new instrument placements typically included a significant initial purchase of consumables.

In the third quarter of 2005, we sold nine ProteinChip^®Systems to one customer for $601,000. We also entered into a product development agreement with this same customer, whereby the customer will develop for us a specific new product and we may pay the customer up to $500,000 based on the customer’s attainment of specified development milestones. Under this agreement, we paid this customer $300,000 of development fees during 2005. This was recorded, following EITF 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”, as a reduction to revenue, resulting in net revenue from this customer of approximately $301,000 in 2005. This constituted approximately 2% of products revenue and 1% of total revenue for 2005. No additional payment was made in 2006. With the divestiture of the Instrument Business to Bio-Rad, this product development agreement was transferred to Bio-Rad.

 

Services Revenue.  Services revenue was $6.9 million in 2006 and $8.9 million in 2005. The $2.0 million or 22% decrease in services revenue from 2005 to 2006 was primarily due to fewer new instrument placements, which typically include an initial registration for one or more training classes, and the closing of the asset sale to Bio-Rad in the fourth quarter of 2006.

 

We expect that future revenues for our business will be affected by, among other things, our ability to develop and commercialize diagnostic tests, new product and application introductions, customer budgets, competitive conditions and government funding for research in our field. We expect limited revenues in 2007 until the new diagnostic tests are developed and launched.

 

Cost of Products Revenue.  Cost of products revenue was $5.8 million in 2006 and $9.4 million in 2005. The $3.6 million or 38% decrease in cost of products revenue from 2005 to 2006 resulted from a decrease in unit sales of our ProteinChip^® Systems, accessories, software, arrays and other consumables. The decrease in gross margin of $3.5 million for products revenue was largely due to the aforementioned drop in unit sales. Gross margin as a percentage of sales for products revenue was relatively flat at 48.9% of sales in 2005 and 48.5% of sales in 2006.

 

Stock-based compensation expense related to employee stock options under SFAS No. 123 (revised), “Share-Based Payment”, or SFAS 123(R), in cost of products revenue was $144,000 in 2006. There was no deferred stock-based compensation expense in cost of products revenue for 2005.

 

Cost of Services Revenue.  Cost of services revenue was $3.5 million in 2006 and $4.3 million in 2005. From 2006 to 2005, cost of services revenue decreased $0.8 million or 19% primarily due the 22% decrease in services revenue. The gross margin for services revenue decreased from 51% in 2005 to 49% in 2006 due to the drop in services revenue.

 

We believe that gross profits for 2007 will be minimal until the new diagnostic tests are developed and successfully commercialized.

 

Research and Development Expenses.  Research and development expenses were $11.5 million in 2006 and $13.2 million in 2005. From 2005 to 2006, research and development expenses decreased $1.7 million or 13% primarily due to a decrease of $2.4 million in salaries, payroll taxes and employee benefits due to transition to diagnostic testing and away from tools development following the asset sale to Bio-Rad. Materials and supplies used in the development of new products also decreased by $0.6 million, depreciation decreased by $0.1 million, travel expenses decreased by $0.1 million and consulting fees decreased by $0.1 million, consistent with the scaling back of research programs related to our instrument platform. These decreases were partially offset by a $1.4 million increase in clinical collaboration expenses and a $0.3 million increase in stock-based compensation expense related to employee stock options under SFAS 123(R). Spending on diagnostics research under the strategic alliance with Quest Diagnostics was approximately $5.4 million in 2006 and $2.2 million in 2005.

 

Stock-based compensation expense related to employee stock options under SFAS 123(R) in research and development expenses was $337,000 in 2006. There was no deferred stock-based compensation expense in research and development expenses for 2005.

 

We expect research and development expenses to decline in 2007 relative to 2006 due to having fewer research and development employees in 2006 needed to support our research and development activities

associated with developing and commercializing diagnostic tests as part of our strategic alliance with Quest Diagnostics, and discovering biomarkers that could potentially be developed into additional diagnostic products.

 

Sales and Marketing Expenses.  Sales and marketing expenses were $12.6 million in 2006 and $18.0 million in 2005. From 2005 to 2006, sales and marketing expenses decreased $5.4 million or 30%, largely due to lower payroll-related costs as a result of a reduction in sales and marketing headcount from 72 people in 2005 to 6 people at the end of 2006 due to the asset sale of our Instrument Business to Bio-Rad. The primary components of the decrease in expense from 2005 were payroll and related costs of approximately $2.8 million, $0.9 million decrease in travel expenses and a $0.6 million decrease in field materials and supplies expense.

 

Stock-based compensation expense related to employee stock options under SFAS 123(R) in sales and marketing expenses was $321,000 in 2006. There was no deferred stock-based compensation expense in sales and marketing expenses for 2005.

 

We expect sales and marketing expenses to decrease in 2007 relative to 2006 as a result of a smaller sales force and reduced associated selling expenses until the launch of new diagnostics tests.

 

General and Administrative Expenses.  General and administrative expenses were $10.7 million in 2006 and $14.4 million in 2005. From 2005 to 2006, general and administrative expenses decreased $3.7 million or 26%, largely driven by a $2.1 million reduction in payroll and related costs resulting from a reduction in headcount related expenses due to the asset sale to Bio-Rad. Outside legal fees decreased approximately $0.4 million due to decreased patent registration activity which were partially offset by legal fees related to defense of a SELDI patent. Other audit and accounting fees decreased $1.3 million as 2005 audit costs were much higher due to the restatement of earnings in 2005.

 

Stock-based compensation expense related to employee stock options under SFAS 123(R) in general and administrative expenses were $813,000 in 2006. There were no deferred stock-based compensation expense in general and administrative expenses for 2005.

 

We expect general and administrative expenses to drop slightly in 2007 relative to 2006 due to lower headcount in the administration function which will be partially offset by the costs of performing a management assessment of compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

 

Goodwill Impairment.  We recorded goodwill principally as a result of our acquisition of BioSepra in 2001, the increases in our ownership of Ciphergen Biosystems KK in 2002 and 2004, and the acquisitions of Ciphergen Technologies, Inc. and IllumeSys Pacific, Inc. in 1997 and 1998. We performed annual impairment tests from 2002 through 2004 and determined that no impairment had occurred. The goodwill related to BioSepra was written off against the sale of the BioSepra business in 2004. Due to Ciphergen Biosystems KK’s lower than expected operating results and cash flows throughout 2005 and based on revised forecasted results, a goodwill impairment loss of $2.5 million was recognized in the fourth quarter of 2005. The fair value of Ciphergen Biosystems KK was estimated using expected discounted cash flows (see Notes 5 and 8 to our audited consolidated financial statements included elsewhere in this prospectus).

Gain From Sale of Instrument Business, Net of Tax.  The $6.9 million gain recognized in 2006 on the November 13, 2006, asset sale of our Instrument Business to Bio-Rad is summarized as follows (in thousands):

 

 

We entered into a stock purchase agreement with Bio-Rad for the private sale of shares of our common stock to Bio-Rad for an aggregate purchase price of $3,000,000. The purchase price of $0.972 per share was based on the average closing price for the five days preceding the stock purchase agreement on August 14, 2006. For accounting purposes, the 3,086,420 shares purchased were valued at $1.17 per share, the closing price on November 13, 2006, the day the transaction closed. The resulting value of $3.611 million was allocated between common stock (3.086 million shares at $0.001 par value) and additional paid-in capital of $3.608 million. An additional $4.0 million of contingent cash consideration included $2.0 million, subject to certain adjustments, to be held in escrow as security for certain of our obligations for three years following the closing, and $2.0 million as a holdback amount to be held by Bio-Rad until the issuance of a re-examination certificate confirming a SELDI patent (see Notes 6 and 22 to our audited consolidated financial statements included elsewhere in this prospectus).

 

Loss on Extinguishment of Debt.  The loss from extinguishment of debt represents the expensing of $868,000 of unamortized debt discount and $613,000 of unamortized prepaid offering costs related to the exchange of $27.5 million of our 4.5% Notes for $16.5 million of our 7.0% Notes and $11 million in cash (see Note 11 to our audited consolidated financial statements included elsewhere in this prospectus).

 

Interest and Other Income (Expense), Net.  Interest income was $843,000 in 2006 and $839,000 in 2005. Interest income from money market and accounts remained flat between 2005 and 2006. Although money market account balances decreased from $28.0 million in 2005 to $17.7 million in 2006 this was offset by interest yield, which steadily increased from 2.9% in June 2005 to 5.9% in December 2006. Interest expense was $2.3 million in 2006 and $2.0 million in 2005. Interest expense increased $0.3 million from 2005 to 2006 primarily due to the increase in interest paid to Quest Diagnostics due to our outstanding loan balance from Quest Diagnostics increasing from $2.5 million to $7.1 million from December 31, 2005, to December 31, 2006.

 

Other expense was $125,000 in 2006 and $717,000 in 2005. In 2006 other expense consisted primarily of $332,000 of amortization of issuance costs for the convertible senior notes partially offset by $81,000 for the return of a lease deposit. In 2005, other expense consisted primarily of $373,000 of expense for the

amortization of issuance costs for the convertible senior notes and foreign exchange losses of approximately $232,000, largely due to the impact on the transaction losses from the decline of the U.S. dollar against the British pound and the Japanese yen.

 

Income Tax Expenses.  Our provision for income taxes was due to current foreign income taxes, which were $152,000 and $7,000 for the years ended December 31, 2006 and 2005, respectively, including discontinued operations. Excluding discontinued operations, current foreign income taxes were an expense of $152,000 and $7,000 for the years ended December 31, 2006 and 2005, respectively.

 

We have incurred net losses since inception and consequently are not subject to corporate income taxes in the U.S. to the extent of our tax loss carryforwards. At December 31, 2006 we had net operating loss carryforwards of approximately $125.0 million for federal and $58.8 million for state tax purposes. If not utilized, these carryforwards will begin to expire beginning in 2009 for federal purposes and 2007 for state purposes. As of December 31, 2006, we had $2.9 million of net operation carryforwards from our Japan operations. If not utilized, this carry forward will begin to expire in 2012. We also have research credit carryforwards of approximately $4.4 million and $4.7 million for federal and state tax purposes, respectively. If not utilized, the federal research credit carryforwards will expire in various amounts beginning in 2011. The California research credit can be carried forward indefinitely. The utilization of net operating loss carryforwards to reduce future income taxes will depend on our ability to generate sufficient taxable income prior to the expiration of the net operating loss carryforwards. In addition, the maximum annual use of the net operating loss carryforwards may be limited in situations where changes occur in our stock ownership.

 

We have incurred income tax liabilities primarily in France and Japan, as well as in most of the other countries outside the U.S. in which we operate. We have used net operating loss carryforwards to reduce our income tax liabilities in Japan and the United Kingdom. The 2005 and 2006 net loss can be carried forward for seven years.

 

Gain From Sale of BioSepra Business, Net of Tax.  We received $1.0 million that was placed in an interest-bearing escrow account for one year and $21,000 of accrued interest related to the BioSepra business and treated the amount as an additional gain of $1,021,000 on the sale in 2005. This was partly offset by a $67,000 reduction of the gain on the sale of the BioSepra business for a post-closing adjustment in 2005, in accordance with the related asset purchase agreement, resulting in a net gain of $954,000 in 2005.

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

The following table sets forth selected summary financial and operating data of Vermillion for the years ended December 31, 2005 and 2004:

 

 

Products Revenue.  Products revenue was $18.4 million in 2005 and $31.4 million in 2004. The $13.0 million or 42% decrease in products revenue from 2004 to 2005 was largely the result of a 54% decrease in revenue from sales of our ProteinChip^® Systems, accessories and software, as well as a 14% decrease in revenue from our arrays and consumables. The decrease in systems and related revenue was due to a 41% decrease in unit sales of ProteinChip^® Systems and a 22% decrease in average revenue per system sold due to increased discounting and incentives we offered to expedite orders, discounts offered to customers on trade-ins of their older model ProteinChip^® Systems for a new Series 4000, and the competitive environment. The decrease in array and consumable sales was largely driven by lower unit sales due in part to fewer new instrument placements, which typically include a significant initial purchase of consumables. In Japan, the strengthening of the U.S. dollar against the Japanese yen resulted in a decrease in products revenue of approximately $370,000.

In the third quarter of 2005, we sold nine ProteinChip^® Systems to one customer for $601,000. We also entered into a product development agreement with this same customer, whereby the customer will develop a specific new product for us and we may pay the customer up to $500,000 based on the customer’s attainment of specified development milestones. Under this agreement, we paid this customer $300,000 of development fees during 2005. This was recorded, following EITF 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”, as a reduction to revenue, resulting in net revenue from this customer of approximately $301,000 in 2005. This constituted approximately 2% of products revenue and 1% of total revenue for 2005.

 

Services Revenue.  Services revenue was $8.9 million in 2005 and $8.8 million in 2004. The $93,000 or 1% increase in services revenue from 2004 to 2005 was primarily due to a $313,000 increase in revenue from collaboration services handled through our Biomarker Discovery Center laboratories due to the completion of several large contracts in 2005, and from a $97,000 increase in revenue from maintenance contracts, driven by growth in our installed base. However, revenue from training and consulting services decreased $317,000 primarily due to fewer new instrument placements, which typically include an initial registration for one or more training classes.

 

Cost of Products Revenue.  Cost of products revenue was $9.4 million in 2005 and $11.2 million in 2004. The $1.8 million or 16% decrease in cost of products revenue from 2004 to 2005 resulted from a decrease in unit sales of ProteinChip^® Systems, accessories, software, arrays and other consumables, as well as a $1.1 million decrease in the provision for excess and obsolete inventories in 2005 compared to 2004. We introduced our Series 4000 platform in 2004 and concurrently increased inventory reserves for older products. These decreases were partially offset by higher costs of materials recorded in 2005, compared to 2004 when a portion of sales included instruments with components previously charged to research and development. The gross margin for products revenue decreased from 64% in 2004 to 49% in 2005. The decrease in gross margin for products revenue was largely due to lower gross margins for arrays and consumables resulting from lower production volumes in 2005 compared to 2004, thus spreading our fixed manufacturing overhead costs over fewer units produced and eroding gross margin on products revenue by approximately 12% of products revenue. The decrease in gross margin from 2004 to 2005 was also due to lower gross margins for ProteinChip^®Systems as a result of increased discounting.

 

Deferred stock-based compensation expense in cost of products revenue was $0 in 2005 and $45,000 in 2004.

 

Cost of Services Revenue.  Cost of services revenue was $4.3 million in 2005 and $3.9 million in 2004. From 2004 to 2005, cost of services revenue increased $445,000 or 11% primarily due to increased costs associated with paid projects performed by our Biomarker Discovery Center laboratories and customer training. The gross margin for services revenue decreased from 56% in 2004 to 51% in 2005 mainly due to lower gross margins realized on Biomarker Discovery Center contracts, which have costs that typically vary based on the complexity and difficulty of the work being undertaken, and lower gross margins on our training services.

 

Research and Development Expenses.  Research and development expenses were $13.2 million in 2005 and $19.3 million in 2004. From 2004 to 2005, research and development expenses decreased $6.1 million or 32% primarily due to a decrease of $2.2 million in salaries, payroll taxes and employee benefits due to a 39% decline in research and development staff. Materials and supplies used in the development of new products also decreased by $1.9 million and consulting fees decreased by $1.0 million, consistent with the scaling back of research programs related to our instrument platform.

 

Deferred stock-based compensation expense in research and development expenses was $0 in 2005 and $37,000 in 2004.

 

Sales and Marketing Expenses.  Sales and marketing expenses were $18.0 million in 2005 and $26.0 million in 2004. From 2004 to 2005, sales and marketing expenses decreased $8.0 million or 31%, largely due to lower payroll-related costs as a result of a 40% decrease in the sales and marketing staff thereby decreasing payroll and related costs approximately $4.1 million. The reduction in our sales force also resulted in a $1.6 million decrease

in travel expenses and a $0.6 million decrease in ProteinChip^® Arrays and lab supplies used for customer demonstrations. The cost of advertising, trade shows and other promotional activities declined by approximately $1.2 million as 2004 expenses were unusually high in 2004 due to the launch of the Series 4000 ProteinChip^® System.

 

Deferred stock-based compensation expense in sales and marketing expenses was $0 in 2005 and $93,000 in 2004.

 

General and Administrative Expenses.  General and administrative expenses were $14.4 million in 2005 and $14.1 million in 2004. From 2004 to 2005, general and administrative expenses increased $268,000 or 2%, largely driven by $679,000 in severance costs for two former executives, partly offset by a $142,000 reduction in payroll and related costs resulting from a 32% reduction in administrative staff, which occurred in the second half of 2005. Outside professional fees increased approximately $429,000 as a result of work done to assist us with our restatement of our second quarter 2005 financial statements. Other audit and accounting fees increased $321,000, largely the result of efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002. These increases were partially offset by decreases of $427,000 in stock-based compensation expense, $249,000 in costs of temporary help, $165,000 in travel expenses and $124,000 in the provision for bad debts.

 

Deferred stock-based compensation expense in general and administrative expenses was $0 in 2005 and $427,000 in 2004.

 

Goodwill Impairment.  We recorded goodwill principally as a result of our acquisition of BioSepra in 2001, the increases in our ownership of Ciphergen Biosystems KK in 2002 and 2004, and the acquisitions of Ciphergen Technologies, Inc. and IllumeSys Pacific, Inc. in 1997 and 1998. We performed annual impairment tests from 2002 through 2004 and determined that no impairment had occurred. The goodwill related to BioSepra was written off against the sale of the BioSepra business in 2004. Due to Ciphergen Biosystems KK’s lower than expected operating results and cash flows throughout 2005 and based on revised forecasted results, a goodwill impairment loss of $2.5 million was recognized in the fourth quarter of 2005. The fair value of Ciphergen Biosystems KK was estimated using expected discounted cash flows (see Notes 5 and 8 to our audited consolidated financial statements included elsewhere in this prospectus).

 

Interest and Other Income (Expense), Net.  Interest income was $839,000 in 2005 and $505,000 in 2004. The increase of $334,000 from 2004 to 2005 was largely due to higher interest rates. Interest expense was $2.0 million in both 2005 and 2004.

 

Other expense was $717,000 in 2005 and $649,000 in 2004. In 2005, other expense consisted primarily of $373,000 of expense for the amortization of issuance costs for the convertible senior notes and foreign exchange losses of approximately $232,000, largely due to the impact on the transaction losses from the decline of the U.S. dollar against the British pound and the Japanese yen. In 2004, other expense consisted mainly of $373,000 in expense associated with the amortization of issuance costs for the convertible senior notes. Subsequent to our acquisition of majority control of Ciphergen Biosystems KK on August 31, 2002 and prior to our acquisition of 100% control of Ciphergen Biosystems KK at the end of the first quarter of 2004, we attributed a share of this joint venture’s income or losses to SC BioSciences’ (a subsidiary of Sumitomo Corporation) minority interest. For 2004, we attributed $0 of loss to minority interest, as cumulative losses attributable to the minority shareholder exceeded previous income.

 

Income Tax Expenses.  Our provision for income taxes was due to current foreign income taxes, which were $7,000 and $172,000 for the years ended December 31, 2005 and 2004, respectively, including discontinued operations. Excluding discontinued operations, current foreign income taxes were an expense of $7,000, and $109,000, for the years ended December 31, 2005 and 2004, respectively.

 

Income (Loss) From Discontinued Operations, Net of Tax.  Discontinued operations includes all revenue, cost of revenue, operating expenses, interest expense, other income (expense) and tax provisions related to our BioSepra business, which was sold to Pall Corporation on November 30, 2004. Loss from discontinued operations was $0 in 2005 and $1.8 million in 2004.

The operating results of the BioSepra business for the eleven months ended November 30, 2004, are presented in the following table (in thousands):

 

 

BioSepra’s business was characterized by a relatively low number of orders for large quantities of customer-specific products, often $250,000 to $1.5 million or more per order that were utilized and consumed by pharmaceutical customers to manufacture biological therapeutics. Filling these large orders entailed a lengthy and highly controlled manufacturing process at BioSepra, and customers typically ordered several years of supply to be manufactured at one time and provided to them in a few large deliveries for storage in environmentally-controlled facilities to minimize batch variability. BioSepra generally priced its products in Euros.

 

Gain From Sale of BioSepra Business, Net of Tax.  The $18.5 million gain we recognized in 2004 on the sale of our BioSepra business is summarized as follows (in thousands):

 

 

Liquidity and Capital Resources

 

From our inception through June 30, 2007, we have financed our operations principally with $229.3 million from the sales of products and services to customers and $163.8 million of net proceeds from debt and equity financings. This includes net proceeds of $92.4 million from our initial public offering on September 28, 2000; net proceeds of $26.9 million from our Series E Preferred Stock financing in March 2000; net proceeds of $15.0 million from the sale of 6,225,000 shares of our common stock and a warrant for 2,200,000 shares of our common stock to Quest Diagnostics on July 22, 2005; and net proceeds of $18.2 million in connection with our sale of assets and

liabilities of the Instrument Business and 3,086,420 shares of common stock to Bio-Rad on November 13, 2006. In connection with the strategic alliance agreement dated July 22, 2005, Quest Diagnostics agreed to provide the Company with a $10.0 million secured line of credit (see Note 2 to our audited consolidated financial statements included elsewhere in this prospectus). As of June 30, 2007, we have drawn $10.0 million from this secured line of credit with Quest Diagnostics solely to fund certain development activities related to our strategic alliance. Under the terms of this secured line of credit, the interest rate is at the prime rate plus 0.5% and is payable monthly. We also received net proceeds of $27.0 million from the sale of our BioSepra^® business on November 24, 2004, and an additional $1.0 million held in an interest-bearing escrow account for one year after the sale and $21,000 of related interest on December 1, 2005. Subsequent to June 30, 2007, we received $20.6 million in gross proceeds from the private placement of 24,513,092 shares of our common stock and warrants to purchase 20,531,470 shares of our common stock on August 29, 2007.

 

Cash and cash equivalents at June 30, 2007, was $9.6 million. Working capital (defined as current assets less current liabilities) at June 30, 2007, was $4.2 million. The decrease in working capital for the six months ended June 30, 2007, was principally due to a net $8.2 million decrease in cash and cash equivalents to fund our operating losses of $12.9 million. After completing the private placement on August 29, 2007, cash and cash equivalents was $23.8 million at August 31, 2007. Cash, cash equivalents and short-term investments at December 31, 2006 were $17.7 million, compared to $28.0 million at December 31, 2005. Working capital at December 31, 2006 was $13.0 million, compared to $27.1 million at December 31, 2005. The decrease in working capital was principally due to a net $10.3 million decrease in cash and investments to fund our operating losses of $22.1 million and $11.0 million of repayments on our 4.5% Notes, partially offset by cash receipts of $16.0 million for the sale of our Instrument Business to Bio-Rad, $4.6 million in loan proceeds from Quest Diagnostics, and $3.0 million in proceeds for the sale of common stock to Bio-Rad. In addition, there was a $3.2 million decrease in accounts receivable net of accounts receivable transferred to Bio-Rad, reflecting the decline in revenue from continuing operations in 2006 compared to 2005, and a $0.2 million decrease in inventory net of inventory sold to Bio-Rad which resulted from our reducing purchases of raw materials as we generally no longer need inventory for sale until we obtain FDA approvals for the diagnostic tests currently under development. These decreases in working capital were partially offset by a $1.1 million decrease in accounts payable and accrued liabilities due to our cost-cutting measures and reduced inventory purchases, and a $1.2 million decrease in current deferred revenue consistent with our lower revenues. Cash, cash equivalents and short-term investments at December 31, 2005 were $28.0 million, compared to $37.6 million at December 31, 2004. Working capital at December 31, 2005 was $27.1 million, compared to $39.9 million at December 31, 2004. The decrease in working capital was principally due to a net $27.1 million decrease in cash and investments to fund our operating losses, partly offset by a $17.5 million cash increase resulting from the sale of our common stock to, and loans from, Quest Diagnostics. In addition, there was a $5.0 million decrease in accounts receivable, reflecting the decline in revenue from continuing operations in 2005 compared to 2004, and a $1.3 million decrease in inventory which resulted from our reducing and delaying raw materials purchases. These decreases were partially offset by a $1.2 million decrease in accrued liabilities due to our cost-cutting measures and reduced inventory purchases, and a $1.4 million decrease in current deferred revenue consistent with our lower revenues.

 

Net cash used in operating activities was $10.9 million for the six months ended June 30, 2007, primarily as a result of the $12.9 million net loss reduced by $1.6 million of noncash expenses for the loss related to the sale of assets and liabilities of our Instrument Business to Bio-Rad, depreciation and amortization, stock-based compensation and amortization of debt issuance costs and increased by $361,000 of cash usage from changes in operating assets and liabilities. Net cash used in operating activities was $20.4 million in 2006 compared to $22.9 million in 2005. Less cash was collected from customers in 2006 as compared to 2005 due primarily to a $9.0 million drop in sales in 2006 resulting in a $3.2 million net drop in accounts receivables and $0.1 million in inventory after considering the transfer of accounts receivable and inventory to Bio-Rad as part of the asset sale, partially offset by an combined decrease in accounts payable and deferred revenue of $2.2 million. Net cash used in operating activities was $22.9 million in 2005 compared to $32.5 million in 2004. Less cash was collected from customers in 2005 as compared to 2004 due to $13.0 million in lower sales in 2005. Cash used in operating activities was mainly to fund payroll, inventory purchases and operating

expenses. The decrease in cash collected was offset by an increase in interest income received in 2005 as compared to 2004 as a result of higher interest rates.

 

Net cash used in investing activities was $219,000 for the six months ended June 30, 2007, which resulted from the acquisition of robotics machinery and other equipment for laboratory use and service of collaboration partner instruments. Net cash provided by investing activities was $16.5 million in 2006 compared to net cash used in investing activities of $3.5 million in 2005. Net cash provided by investing activities in 2006 primarily resulted from $16.0 million in proceeds from the asset sale of our Instrument Business to Bio-Rad and $2.2 million in maturities of short term investments partially offset by purchases of fixed assets of $0.6 million, asset sale transaction costs of $0.8 million, and $0.5 million for a technology license related to our litigation which was settled in 2003. Net cash used in investing activities was $3.5 million in 2005 compared to net cash provided by investing activities of $34.0 million in 2004. Net cash used in investing activities in 2005 included property and equipment purchases of $2.8 million and payments of $587,000 for a technology license related to our litigation which was settled in 2003. We also paid $1.1 million to Pall Corporation for post-closing adjustments related to the sale of our BioSepra business, and we received $1.0 million plus $21,000 of accrued interest from an escrow account related to the sale of our BioSepra business. We anticipate spending approximately $750,000 in total capital expenditures in 2007 to support our clinical trials.

 

Net cash provided by financing activities was $3.0 million for the six months ended June 30, 2007, which primarily resulted from the receipt of proceeds from the secured line of credit with Quest Diagnostics. Total long-term debt at June 30, 2007 was $28.6 million, compared to $25.5 million at December 31, 2006. Net cash used in financing activities was $4.2 million in 2006 compared with net cash provided by financing activities in 2005 of $17.2 million in 2005. The decrease resulted primarily from $11.0 million for repayments of senior convertible debt partially offset by the receipt of $4.6 million in loans from Quest Diagnostics and the sale of $3.0 million of capital stock to Bio-Rad. Total long-term debt at December 31, 2006 was $25.5 million, compared to total long-term debt and capital lease obligations at December 31, 2005, of $31.5 million. Net cash provided by financing activities was $17.2 million in 2005 compared to $792,000 in 2004. The increase resulted primarily from $15.0 million in net proceeds from the sale of our common stock to Quest Diagnostics and the receipt of $2.5 million in loans from Quest Diagnostics. There was also a repayment of one stockholder loan in the aggregate principal amount of $349,000, and the issuance of common stock under our stock option and employee stock purchase plans of $349,000, offset by repayments of an equipment financing loan of $925,000 and the repayment of capital lease obligations of $24,000. Long-term debt and capital lease balances at December 31, 2005, totaled $31.5 million, compared to $29.4 million at December 31, 2004. At December 31, 2006, the Company had an accumulated deficit of $217.9 million.

 

Our consolidated financial statements were prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. We have incurred significant net losses and negative cash flows from operations since inception. At June 30, 2007, we had an accumulated deficit of $230.7 million. After completing the private placement on August 29, 2007, management believes that our current available resources will be sufficient to maintain current and planned operations through the next twelve months. We will, however, be required to raise additional capital at some point in the future. At such time as we require additional funding, we may seek to raise such additional funding from various sources, including the public equity market, private financings, sales of assets, collaborative arrangements and debt. If additional capital is raised through the issuance of securities convertible into equity, stockholders will experience dilution, and such securities may have rights, preferences or privileges senior to those of the holders of common stock or convertible senior notes. If we obtain additional funds through arrangements with collaborators or strategic partners, we may be required to relinquish our rights to certain technologies or products that we might otherwise seek to retain. There can be no assurance that we will be able to obtain such financing, or obtain it on acceptable terms. If we are unable to obtain financing on acceptable terms, we may be unable to execute our business plan, we could be required to delay or reduce the scope of our operations, and we may not be able to pay off the 4.5% Notes and/or 7.0% Notes if and when they come due.

Our inability to operate profitably and to consistently generate cash flows from operations, and our reliance on external funding either from loans or equity, raise substantial doubt about our ability to continue as a going concern.

 

The following summarizes our contractual obligations at June 30, 2007, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).