As filed with the Securities and Exchange Commission on July 3, 2006

Registration No. 333-          

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

 

 

OCULUS INNOVATIVE SCIENCES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

 

 

1129 N. McDowell Blvd.

Petaluma, CA 94954

(707) 782-0792

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

 

 

 

Hojabr Alimi

Chief Executive Officer and President

1129 N. McDowell Blvd.

Petaluma, CA 94954

(707) 782-0792

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

 

 

Copies to:

 

 

 

 

 

Approximate date of commencement of proposed sale to the public:  As soon as practicable 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.  o 

 

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 JULY 3, 2006

 

PRELIMINARY PROSPECTUS

 

           Shares

 

 

Oculus Innovative Sciences, Inc.

 

Common Stock

 

 

 

 

We are offering           shares of our common stock. This is our initial public offering, and no public market currently exists for our shares. We anticipate that the initial public offering price will be between $      and $      per share. We have applied for quotation of our common stock on the Nasdaq National Market under the symbol “OCLS.”

 

 

 

 

Investing in our common stock involves a high degree of risk. Before buying any shares, you should carefully consider the risk factors described in “Risk Factors” beginning on page 7 of this prospectus.

 

 

 

 

 

The underwriters may also purchase up to an additional      shares from us at the public offering price, less the underwriting discount, within 30 days after the date of this prospectus to cover over-allotments.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

The underwriters expect to deliver the shares on or about          , 2006.

 

 

 

 

 

 

 

 

 

The date of this prospectus is          , 2006

 

TABLE OF CONTENTS

 

 

 

You should rely only on the information contained in this prospectus. We have not, and the underwriters have not, authorized anyone to provide you with different information. We are not making an offer to sell these securities in any jurisdiction where the offer is not permitted. You should not assume that the information contained in this prospectus is accurate as of any date other than the respective dates as of which the information is given.

 

PROSPECTUS SUMMARY

	•	many antiseptics, including Betadine, hydrogen peroxide and Dakin’s solution, are toxic, can destroy human cells and tissue, may cause allergic reactions and can impede the wound healing process;
	•	silver-based products are expensive and require precise dosage and close monitoring by trained medical staff to minimize the potential for allergic reactions and bacterial resistance; and
	•	the increase in antibiotic resistant bacterial strains, such as MRSA and VRE, have compromised the efficacy of some widely used topical antibiotics, including Neosporin or Bacitracin.

	•	Effective.  In physician clinical studies, our products eliminated a wide range of pathogens that cause infection in a variety of acute and chronic wounds without promoting the development of resistant bacteria.
	•	Safe.  Clinical data shows that our products are non-toxic, do not cause skin irritation and do not inhibit wound healing. Throughout our clinical trials and physician clinical studies to date and since commercialization in 2004, we have received no reports of adverse events related to the use of Microcyn.
	•	Easy to Use.  Our products require no preparation before use or at time of disposal, and caregivers can use our products without significant training. In addition, Microcyn has a shelf life ranging from one to two years depending on the size and type of packaging, can be stored at room temperature and does not require any specific handling procedures.
	•	Cost Effective.  Treatment of many wounds requires extended hospitalization and care, including the use of systemic antibiotics. Infection of wounds prolongs the healing time and increases the use of systemic antibiotics. Our clinical trials and physician clinical studies to date indicate that Microcyn eliminates infection, accelerates healing time and reduces the use of systemic antibiotics, thereby lowering overall patient cost.

	•	drive adoption of Microcyn as the standard of care in the wound care market to prevent and eliminate infection;
	•	obtain additional regulatory approvals in the United States;
	•	expand our direct sales force and distribution networks;
	•	pursue opportunities to combine Microcyn with other treatments;
	•	develop strategic collaborations in the wound care market; and
	•	leverage our Microcyn platform to address additional markets.

Common stock to be offered by us		shares
Common stock to be outstanding after the offering		shares
Initial public offering price per share		$
Use of proceeds		We intend to use the net proceeds from this offering to expand our sales and marketing capabilities, to fund clinical trials and related research, to expand our manufacturing capabilities and for general corporate purposes, including working capital. See “Use of Proceeds.”
Proposed Nasdaq National Market symbol		OCLS

	•	8,116,174 shares of our common stock issuable upon the exercise of outstanding stock options and options granted in connection with this offering, at a weighted-average exercise price of $1.05 per share;
	•	3,782,396 shares of our common stock issuable upon the exercise of outstanding warrants, at a weighted average exercise price of $2,61 per share; and
	•	up to 2,201,643 additional shares of our common stock reserved for issuance under our equity plans.

	•	gives effect to the conversion of all outstanding shares of our preferred stock into 15,934,718 shares of our common stock upon the completion of this offering;
	•	does not reflect the exercise of outstanding warrants or options to purchase shares of our common stock;
	•	assumes that the underwriters do not exercise their over-allotment option to purchase additional shares in this offering;
	•	reflects a  -for-one split of our common stock to be effected before completion of this offering;
	•	reflects our reincorporation in Delaware from California; and
	•	reflects the amendment of our certificate of incorporation in connection with this offering to, among other things, change the number of shares authorized for issuance.

	•	on an actual basis;
	•	on a pro forma basis to give effect to the automatic conversion of all outstanding shares of our convertible preferred stock into 15,934,718 shares of our common stock upon the closing of this offering; and
	•	on a pro forma as adjusted basis to further give effect to the sale of           shares of common stock in this offering at an assumed initial public offering price of $           per share, after deducting the underwriting discount and our estimated offering expenses.

		Year Ended March 31,
		2004				2005				2006
Consolidated Statements of Operations Data:
Revenues
Product		$	95			$	473			$	1,966
Service			807				883				618
Total revenues			902				1,356				2,584
Cost of revenues
Product(1)			1,403				2,211				3,899
Service(1)			1,265				1,311				1,003
Total cost of revenues			2,668				3,522				4,902
Gross loss			(1,766	)			(2,166	)			(2,318	)
Operating expenses:
Research and development(1)			1,413				1,654				2,600
Selling, general and administrative(1)			3,918				12,492				15,933
Total operating expenses			5,331				14,146				18,533
Loss from operations			(7,097	)			(16,312	)			(20,851	)
Interest expense			(178	)			(372	)			(172	)
Interest income			3				8				282
Other income (expense), net			(26	)			146				(377	)
Net loss from continuing operations			(7,298	)			(16,530	)			(21,118	)
Loss on discontinued operations			—				—				(1,981	)
Net loss			(7,298	)			(16,530	)			(23,099	)
Preferred stock dividends			—				—				(121	)
Net loss available to common stockholders		$	(7,298	)		$	(16,530	)		$	(23,220	)
Net loss per common share: basic and diluted		$	(0.47	)		$	(1.06	)		$	(1.40	)
Weighted-average shares outstanding: basic and diluted			15,647				15,659				16,602
Pro forma net loss per common share: basic and diluted										$	(0.75	)
Pro forma weighted-average shares outstanding: basic and diluted											30,728

(1)		Includes the following stock-based compensation charges:

		Year Ended March 31,
		2004				2005				2006
Cost of revenues
Product		$	—			$	2			$	2
Service			10				3				1
Operating expenses
Research and development			56				5				52
Selling, general and administrative			358				2,339				542
Total		$	424			$	2,349			$	597

		As of March 31, 2006
						Pro Forma
		Actual				As Adjusted
						(unaudited)
Consolidated Balance Sheet Data:
Cash and cash equivalents(1)		$	7,448
Working capital(1)			5,127
Total assets(1)			12,689
Total liabilities			5,351
Total stockholders’ equity(1)			7,338

(1)		A $1.00 increase (decrease) in the assumed initial public offering price of $      per share would increase (decrease) this amount on a pro forma as adjusted basis by approximately $      million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discount and our estimated offering expenses.

 

Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below with all of the other information included in this prospectus before making an investment decision. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. In that case, the market price of our common stock could decline and you could lose all or part of your investment in our common stock. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.

 

Risks Related to Our Business

 

We have a history of losses, we expect to continue to incur losses and we may never achieve profitability.

 

We have incurred significant net losses in each fiscal year since our inception, including losses of $7.3 million, $16.5 million and $23.1 million for the years ended March 31, 2004, 2005 and 2006, respectively. Our accumulated deficit as of March 31, 2006 was $50.3 million. We have yet to demonstrate that we can generate sufficient sales of our products to become profitable. The extent of our future operating losses and the timing of profitability are highly uncertain, and we may never achieve profitability. Even if we do generate significant revenues from our product sales, we expect that increased operating expenses will result in significant operating losses in the near term as we, among other things:

 

 

As a result of these activities, we will need to generate significant revenue in order to achieve profitability and may never become profitable. We must also maintain specified cash reserves in connection with our loan and security agreement which may limit our investment opportunities. Failure to maintain these reserves could result in our lender foreclosing against our assets or imposing significant restrictions on our operations. Even if we do achieve profitability, we may not be able to sustain or increase profitability on an ongoing basis.

 

Because all of our products are based on our Microcyn platform technology, we will need to generate sufficient revenues from the sale of Microcyn to execute our business plan.

 

All of our products are based on our Microcyn platform technology, and we do not have any non-Microcyn product candidates that will generate revenues in the foreseeable future. Accordingly, we expect to derive substantially all of our future revenues from sales of our Microcyn products. We have only been selling our products since July 2004, and substantially all of our historical product revenues have been from sales of Microcyn in Mexico. Although we began selling in Europe in October 2004 and in the United States in June 2005, our product revenues outside of Mexico to date have not been significant. For example, product revenues from countries outside of Mexico were 9.1% of our product revenues for the year ended March 31, 2006. Microcyn has not been adopted as a standard of care for wound treatment in any country and may not gain acceptance among physicians, nurses, patients, third-party payors and the medical community. Existing protocols for wound care are well established within the medical community and tend to vary geographically, and healthcare providers may be reluctant to alter their protocols to include the use of Microcyn. If Microcyn does not achieve an adequate level of acceptance, we will not generate sufficient revenues to become profitable.

We do not have the necessary regulatory approvals to market Microcyn as a drug in the United States.

 

We have obtained three 510(k) clearances in the United States that permit us to sell Microcyn as a medical device to clean, moisten and debride wounds. However, we do not have the necessary regulatory approvals to market Microcyn in the United States as a drug, which we will need to obtain in order to execute our business plan. Before we are permitted to sell Microcyn as a drug in the United States, we must, among other things, successfully complete additional well-controlled clinical trials, submit a New Drug Application, or NDA, to the FDA and obtain FDA approval. We have not completed the clinical trials that will be necessary to support an NDA for Microcyn. We intend to file an NDA for Microcyn as a pre-operative skin preparation in late 2006, and we also intend to seek FDA approval for the use of Microcyn to prevent and eliminate infection and accelerate healing in wounds. The FDA approval process is expensive and uncertain, requires detailed and comprehensive scientific and other data and generally takes several years. Despite the time and expense exerted, approval is never guaranteed. We do not know whether we will obtain the necessary regulatory approvals to market Microcyn as a drug in the United States. We anticipate that the earliest we could obtain approval to sell Microcyn as a pre-operative skin preparation in the United States is 2007, and any approval of Microcyn to prevent and eliminate infection in wounds in the United States will take even longer. Even if we obtain FDA approval to sell Microcyn as a drug, we may not be able to successfully commercialize Microcyn as a drug in the United States and may never recover the substantial costs we have invested in the development of our Microcyn products.

 

Delays or adverse results in clinical trials could result in increased costs to us and delay our ability to generate revenue.

 

Clinical trials are long and expensive, and the outcome of clinical trials are uncertain and subject to delays. It may take several years to complete clinical trials, if at all, and a product candidate may fail at any stage of the clinical trial process. The length of time required varies substantially according to the type, complexity, novelty and intended use of the product candidate. Interim results of a preclinical study or clinical trial do not necessarily predict final results, and acceptable results in preclinical studies or early clinical trials may not be repeatable in later subsequent clinical trials. The commencement or completion of any of our clinical trials may be delayed or halted for a variety of reasons, including the following:

 

 

We do not know whether our existing or any future clinical trials will demonstrate safety and efficacy sufficiently to result in additional FDA approvals. While a number of physicians have conducted clinical studies assessing the safety and efficacy of Microcyn for various indications, the data from these studies is not sufficient to support approval of Microcyn as a drug in the United States, and we will be required to complete additional, well-controlled clinical studies in compliance with FDA requirements before we submit an NDA for Microcyn. Our failure to adequately demonstrate the safety and efficacy of our product candidates to the satisfaction of the FDA will prevent our receipt of FDA approval for additional indications and, ultimately, impact commercialization of our products in the United States. If we experience significant delays or adverse results in clinical trials, our financial results and the commercial prospects for products based on Microcyn will be harmed, our costs would increase and our ability to generate revenue would be delayed.

If we fail to obtain, or experience significant delays in obtaining, regulatory clearances to market our current or future products, we will be unable to commercialize these products.

 

Developing, testing, manufacturing, marketing and selling of medical technology products are subject to extensive regulation by numerous governmental authorities in the United States and other countries. The process of obtaining regulatory clearance and approval of medical technology products is costly and time consuming. Even though the underlying product formulation may be the same or similar, our products are subject to different regulations and approval processes depending upon their intended use. In the United States, use of Microcyn to cleanse and debride a wound comes within the medical device regulation framework, while use of Microcyn to prepare the skin pre-operatively and to control infection in wounds will require us to seek FDA approval of Microcyn as a drug in the United States.

 

To obtain regulatory approval of our products as drugs in the U.S., we must first show that our products are safe and effective for target indications through preclinical studies (animal testing) and clinical trials (human testing). The FDA generally clears marketing of a medical device through the 510(k) pre-market clearance process if it is demonstrated that the new product has the same intended use and is substantially equivalent to another legally marketed device, including a 510(k)-cleared product, and otherwise meets the FDA’s requirements. Product modifications, including labeling the product for a new intended use, may require the submission of a new 510(k) clearance before the modified product can be marketed. Some higher-risk medical devices must receive pre-market approval, or PMA, before they may be commercialized. The PMA process is more costly, lengthy and uncertain than the 510(k) clearance process and requires the development and submission of clinical studies supporting the safety and effectiveness of the device. We cannot assure you that any new products or any product enhancements we develop will be subject to the shorter 510(k) clearance process instead of the more lengthy PMA or drug approval processes.

 

We do not know whether our products based on Microcyn will receive approval from FDA as a drug. The data from clinical studies of Microcyn conducted by physicians to date will not satisfy FDA’s regulatory criteria for approval of an NDA. We are therefore conducting, and will need to conduct additional, well-controlled clinical trials in order to generate data that demonstrates to the satisfaction of FDA that Microcyn is safe and effective for the indications we seek in our NDAs. The outcomes of clinical trials are inherently uncertain, and there is no guarantee that the results of our clinical trials will replicate the data obtained from the physician clinical studies and that these clinical trials will support FDA approval of Microcyn as a drug. In addition, we do not know whether the necessary approvals or clearances will be granted for future products or that FDA review or actions will not involve delays caused by the FDA’s request for additional information or clinical testing that could adversely affect the time to market and sale of products as drugs. If we do not obtain the requisite regulatory clearances and approvals, we will be unable to commercialize our products as drugs and may never recover any of the substantial costs we have invested in the development of Microcyn.

 

Distribution of our products outside the United States is subject to extensive government regulation. These regulations, including the requirements for approvals or clearance to market, the time required for regulatory review and the sanctions imposed for violations, vary from country to country. We do not know whether we will obtain regulatory approvals in such countries or that we will not be required to incur significant costs in obtaining or maintaining these regulatory approvals. In addition, the export by us of certain of our products that have not yet been cleared for domestic commercial distribution may be subject to FDA export restrictions. Failure to obtain necessary regulatory approvals, the restriction, suspension or revocation of existing approvals or any other failure to comply with regulatory requirements would have a material adverse effect on our future business, financial condition, and results of operations.

 

We may incur significant liabilities in connection with our prior relationship with a distributor in Mexico, and our results of operations may be negatively affected by the termination of this relationship.

 

On June 16, 2005, we entered into a series of agreements with Quimica Pasteur, or QP, a Mexico-based distributor of pharmaceutical products to hospitals and health care entities owned or operated by the Mexican Ministry of Health, or MOH. These agreements provided, among other things, for QP to act as our exclusive distributor of Microcyn to the MOH for a period of three years. We concurrently acquired a small equity interest in QP and an option to acquire the remaining equity of QP directly from its principals. In addition,

two of our employees were appointed as officers of QP, which resulted in the establishment of financial control of QP by our company under applicable accounting literature.

 

As a result of our agreements, we were required to consolidate QP’s operations with our financial results. In connection with our audit of QP’s financial statements in late 2005, we were made aware of a number of facts that suggested that QP or its principals may have engaged in some form of tax avoidance practice prior to the execution of the agreements between our company and QP. We did not discover these facts prior to our execution of these agreements or for several months thereafter. Our audit committee engaged an outside law firm to conduct an investigation whose findings implicated QP’s principals in a systemic tax avoidance practice prior to June 16, 2005. We estimate that taxes, interest and penalties related to these practices could amount to $7 million or more. Based on the results of this investigation, we terminated our agreements with QP effective March 26, 2006.

 

Although we believe that we are not responsible for any tax avoidance practices of QP’s principals prior to June 16, 2005, the Mexican taxing authority could make a claim against us or our Mexican subsidiary.

 

QP had a well-established relationship with the MOH. We lost the benefit of this relationship when we terminated our agreements with QP. Although we currently market Microcyn in Mexico through a dedicated contract sales force and we continue to market Microcyn to the MOH, we do not know whether our future sales in Mexico will decline as a result of the termination of our relationship with QP.

 

If our competitors develop products similar to Microcyn, we may need to modify or alter our business strategy, which may delay the achievement of our goals.

 

Competitors may develop products with similar characteristics as Microcyn. Such similar products marketed by larger competitors can hinder our efforts to penetrate the market. As a result, we may be forced to modify or alter our business and regulatory strategy and sales and marketing plans, as a response to changes in the market, competition and technology limitations, among others. Such modifications may pose additional delays in achieving our goals.

 

If we are unable to expand our direct domestic sales force, we may not be able to successfully sell our products in the United States.

 

We currently sell Microcyn in the United States through a network of one national and five regional distributors and a direct sales force comprised of four persons. We plan to sell directly into the U.S. market and are expanding our domestic sales force. Our intent is to expand our domestic sales force by December 2007 to coincide as closely as possible with our anticipated receipt of FDA approval to market and sell Microcyn as a drug for pre-operative skin preparation. Developing a sales force is expensive and time consuming, and the lack of qualified sales personnel could delay or limit the success of our product launch. Our domestic sales force, if established, will be competing with the sales operations of our competitors, which are better funded and more experienced. We may not be able to develop domestic sales capacity on a timely basis or at all.

 

Our dependence on distributors for sales could limit or prevent us from selling our products and from realizing long-term revenue growth.

 

We currently depend on distributors to sell Microcyn in the United States, Europe and other countries and intend to continue to sell our products primarily through distributors in Europe and the United States for the foreseeable future. In addition, if we are unable to expand our direct sales force, we will continue to rely on distributors to sell Microcyn. Our existing distribution agreements are generally short-term in duration, and we may need to pursue alternate distributors if the other parties to these agreements terminate or elect not to

renew their agreements. If we are unable to retain our current distributors for any reason, we must replace them with alternative distributors experienced in supplying the wound care market, which could be time-consuming and divert management’s attention from other operational matters. In addition, we will need to attract additional distributors to expand the geographic areas in which we sell Microcyn. Distributors may not commit the necessary resources to market and sell our products to the level of our expectations, which could harm our ability to generate revenues. In addition, some of our distributors may also sell products that compete with ours. If current or future distributors do not perform adequately, or we are unable to locate distributors in particular geographic areas, we may not realize long-term revenue growth.

 

We depend on a contract sales force to sell our products in Mexico.

 

We currently depend on a contract sales force to sell Microcyn in Mexico. Our existing agreement is short-term in duration and can be terminated by either party upon 30 days written notice. If we are unable to retain our current agreement for any reason, we may need to build our own internal sales force or find an alternate source for contract sales people. We may be unable to find an alternate source, or the alternate source’s sales force may not generate sufficient revenue. If our current or future contract sales force does not perform adequately, we may not realize long-term revenue growth in Mexico.

 

If we fail to comply with ongoing regulatory requirements, or if we experience unanticipated problems with our products, these products could be subject to restrictions or withdrawal from the market.

 

Regulatory approvals or clearances that we currently have and that we may receive in the future are subject to limitations on the indicated uses for which the products may be marketed, and any future approvals could contain requirements for potentially costly post-marketing follow-up studies. In addition, the manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion, distribution and record-keeping for approved products are subject to extensive regulation. Our manufacturing facilities, processes and specifications are subject to periodic inspection by FDA, KEMA, and other regulatory authorities and from time to time, we may receive notices of deficiencies from these agencies as a result of such inspections. Our failure to continue to meet regulatory standards or to remedy any deficiencies could result in restrictions being imposed on products or manufacturing processes, fines, suspension or loss of regulatory approvals or clearances, product recalls, termination of distribution or product seizures or the need to invest substantial resources to comply with various existing and new requirements. In the more egregious cases, criminal sanctions, civil penalties, disgorgement of profits or closure of our manufacturing facilities are possible. The subsequent discovery of previously unknown problems with Microcyn, including adverse events of unanticipated severity or frequency, may result in restrictions on the marketing of our products, and could include voluntary or mandatory recall or withdrawal of products from the market.

 

New government regulations may be enacted and changes in FDA policies and regulations, their interpretation and enforcement, could prevent or delay regulatory approval of our products. We cannot predict the likelihood, nature or extent of adverse government regulation that may arise from future legislation or administrative action, either in the United States or abroad. Therefore, we do not know whether we will be able to continue to comply with any regulations or that the costs of such compliance will not have a material adverse effect on our future business, financial condition, and results of operations. If we are not able to maintain regulatory compliance, we will not be permitted to market our products and our business would suffer.

 

Our competitive position depends on our ability to protect our intellectual property and our proprietary technologies.

 

Our ability to compete and to achieve and maintain profitability depends on our ability to protect our intellectual property and proprietary technologies. We currently rely on a combination of patents, patent applications, trademarks, trade secret laws, confidentiality agreements, license agreements and invention assignment agreements to protect our intellectual property rights. We also rely upon unpatented know-how and continuing technological innovation to develop and maintain our competitive position. These measures may not be adequate to safeguard our Microcyn technology. In addition, we granted a security interest in our assets under a loan and security agreement. The security interest extends to our intellectual property in the event we

fail to maintain specified cash reserves under the loan. If we do not protect our rights adequately, third parties could use our technology, and our ability to compete in the market would be reduced.

 

Although we have filed U.S. and foreign patent applications related to our Microcyn based products, the manufacturing technology for making the products, and their uses, no patents have been issued from these applications.

 

Our pending patent applications and any patent applications we may file in the future may not result in issued patents, and we do not know whether any of our in-licensed patents or any additional patents that might ultimately be issued by the U.S. Patent and Trademark Office will protect our Microcyn technology. Any claims that issue may not be sufficiently broad to prevent third parties from producing competing substitutes and may be infringed, designed around, or invalidated by third parties. Even issued patents may later be found to be invalid, or may be modified or revoked in proceedings instituted by third parties before various patent offices or in courts.

 

The degree of future protection for our proprietary rights is more uncertain in part because legal means afford only limited protection and may not adequately protect our rights, and we will not be able to ensure that:

 

 

The policies we use to protect our trade secrets may not be effective in preventing misappropriation of our trade secrets by others. In addition, confidentiality and invention assignment agreements executed by our employees, consultants and advisors may not be enforceable or may not provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosures. We cannot be certain that the steps we have taken will prevent the misappropriation and use of our intellectual property, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. For example, one of our former contract partners, Nofil Corporation, whom we relied upon to manufacture our proprietary machines had access to our proprietary information and we believe undertook the development and manufacture of the machines to be sold to third parties in violation of our agreement with such company. We have brought a claim against Nofil in the Northern District of California. We believe that a former officer of our Mexico subsidiary collaborated in these acts, misappropriated our trade secrets, and is currently selling products in Mexico that are competitive to our products. In addition, we believe that, through the licensor of the patents that we in-license and who has also assigned patents to us, a company in Japan obtained one of our patent applications, translated it into Hangul and filed it under such company’s and the licensor’s name in South Korea. These and any other leak of confidential data into the public domain or to third parties could allow our competitors to learn our trade secrets.

 

We are in a dispute with the licensor of all of our current issued patents, which could result in our losing all rights under such patents and have a material adverse impact on our business opportunities in Japan.

 

In March 2003, we obtained an exclusive license to six issued Japanese patents and five Japanese published pending patent applications owned by Coherent Technologies. The issued Japanese patents and pending Japanese patent applications relate to an early generation of super-oxidized water product and aspects of the method and apparatus for producing such product and will expire between 2011 and 2014. In June 2006, we received written notice from Coherent advising us that the patent license was terminated, citing various reasons with which we disagree. Although we do not believe Coherent has grounds to terminate the license, we may have to take legal action to preserve our rights under the license and to enjoin Coherent from

breaching its terms. We do not know whether we would prevail in any such action, which would be costly and time consuming, and we could lose our rights under the license, which could have a material adverse impact on our business opportunities in Japan. In addition, we could have to defend ourselves against infringement claims from Coherent in Japan based on their position on termination of the license.

 

We may face intellectual property infringement claims that could be time-consuming, costly to defend and could result in our loss of significant rights and the assessment of treble damages.

 

From time to time, we may receive notices of claims of infringement, misappropriation or misuse of other parties’ proprietary rights. In September 2005, a complaint was filed against us in Mexico claiming confusion in trademarks with respect to our Microcyn60 mark. We have tentatively agreed to change the name Microcyn60 within twelve months from the date of a proposed settlement. The party has referred the matter to the Mexico Trademark Office. We could incur a liability of approximately $100,000 for the use of the name Microcyn60 during the twelve month period following the date of settlement. We cannot be sure that we will not be required to take additional actions, including making additional payments related to this matter, or that changing our product name will not have a negative impact on our product sales in Mexico.

 

In addition, we may have disputes regarding intellectual property rights with the parties that have licensed those rights to us. Some claims received from third parties may lead to litigation. We cannot assure you that we will prevail in these actions, or that other actions alleging misappropriation or misuse by us of third-party trade secrets, infringement by us of third-party patents and trademarks or the validity of our patents, will not be asserted or prosecuted against us. We may also initiate claims to defend our intellectual property. Intellectual property litigation, regardless of outcome, is expensive and time-consuming, could divert management’s attention from our business and have a material negative effect on our business, operating results or financial condition. If there is a successful claim of infringement against us, we may be required to pay substantial damages (including treble damages if we were to be found to have willfully infringed a third party’s patent) to the party claiming infringement, develop non-infringing technology, stop selling our products or using technology that contains the allegedly infringing intellectual property or enter into royalty or license agreements that may not be available on acceptable or commercially practical terms, if at all. Our failure to develop non-infringing technologies or license the proprietary rights on a timely basis could harm our business. In addition, modifying our products to include the non-infringing technologies could require us to seek re-approval or clearance from various regulatory bodies for our products, which would be costly and time consuming. Also, we may be unaware of pending patent applications that relate to our technology. Parties making infringement claims on future issued patents may be able to obtain an injunction that would prevent us from selling our products or using technology that contains the allegedly infringing intellectual property, which could harm our business.

 

Our ability to generate revenue will be diminished if we are unable to obtain acceptable prices or an adequate level of reimbursement from third-party payors of healthcare costs.

 

The continuing efforts of governmental and other third-party payors, including managed care organizations such as health maintenance organizations, or HMOs, to contain or reduce costs of health care may affect our future revenue and profitability, and the future revenue and profitability of our potential customers, suppliers and collaborative or license partners and the availability of capital. For example, in certain foreign markets, pricing or profitability of prescription pharmaceuticals is subject to government control. In the United States, governmental and private payors have limited the growth of health care costs through price regulation or controls, competitive pricing programs and drug rebate programs. Our ability to commercialize our products successfully will depend in part on the extent to which appropriate coverage and reimbursement levels for the cost of our Microcyn products and related treatment are obtained from governmental authorities, private health insurers and other organizations, such as HMOs.

 

There is significant uncertainty concerning third-party coverage and reimbursement of newly approved medical products and drugs. Third-party payors are increasingly challenging the prices charged for medical products and services. Also, the trend toward managed healthcare in the United States and the concurrent growth of organizations such as HMOs, as well as legislative proposals to reform healthcare or reduce government insurance programs, may result in lower prices for or rejection of our products. The cost

containment measures that health care payors and providers are instituting and the effect of any health care reform could materially and adversely affect our ability to generate revenues.

 

In addition, given ongoing federal and state government initiatives directed at lowering the total cost of health care, the U.S. Congress and state legislatures will likely continue to focus on health care reform, the cost of prescription pharmaceuticals and on the reform of the Medicare and Medicaid payment systems. While we cannot predict whether any proposed cost-containment measures will be adopted, the announcement or adoption of these proposals could reduce the price that we receive for our Microcyn products in the future.

 

We could be required to indemnify third parties for alleged infringement, which could cause us to incur significant costs.

 

Some of our distribution agreements contain commitments to indemnify our distributors against liability arising from infringement of third party intellectual property such as patents. We may be required to indemnify our customers for claims made against them or license fees they are required to pay. If we are forced to indemnify for claims or to pay license fees, our business and financial condition could be substantially harmed.

 

A significant part of our business is conducted outside of the United States, exposing us to additional risks that may not exist in the United States, which in turn could cause our business and operating results to suffer.

 

We have international operations in Mexico and Europe. For the fiscal years ended March 31, 2004, 2005 and 2006, approximately 10%, 35% and 75%, respectively, of our total revenue was generated from sales outside of the United States. Our business is highly regulated for the use, marketing and manufacturing of our Microcyn products both domestically and internationally. Our international operations are subject to risks, including:

 

 

We plan to continue to expand internationally to respond to customer requirements and market opportunities. We currently have international manufacturing facilities in Mexico and The Netherlands. Establishing operations in any foreign country or region presents risks such as those described above as well as risks specific to the particular country or region. In addition, until a payment history is established over time with customers in a new geography or region, the likelihood of collecting receivables generated by such operations could be less than our expectations. As a result, there is a greater risk that reserves set with respect to the collection of such receivables may be inadequate. If our international expansion efforts in any foreign country are unsuccessful, we could incur significant losses and we may not achieve profitability.

 

In addition, changes in policies or laws of the United States or foreign governments resulting in, among other things, changes in regulations and the approval process, higher taxation, currency conversion limitations, restrictions on fund transfers or the expropriation of private enterprises, could reduce the anticipated benefits of our international expansion. If we fail to realize the anticipated revenue growth of our future international operations, our business and operating results could suffer.

Our sales in international markets subject us to foreign currency exchange and other risks and costs which could harm our business.

 

A substantial portion of our revenues are derived from outside the United States, and primarily from Mexico. We anticipate that revenues from international customers will continue to represent a substantial portion of our revenues for the foreseeable future. Because we generate revenues in foreign currencies, we are subject to the effects of exchange rate fluctuations. For the years ended March 31, 2004, 2005 and 2006, approximately 10%, 35% and 75%, respectively, of our revenues were denominated in currencies other than the U.S. dollar. We incurred foreign currency exchange losses of $4,000 and $283,000 for the years ended March 31, 2004 and 2006, respectively, and a gain of $134,000 for the fiscal year ended March 31, 2005. The functional currency of our Mexican subsidiary is the Mexican Peso and the functional currency of our subsidiary in The Netherlands is the Euro. For the preparation of our consolidated financial statements, the financial results of our foreign subsidiaries are translated into U.S. dollars on average exchange rates during the applicable period. If the U.S. dollar appreciates against the Mexican Peso or the Euro, as applicable, the revenues we recognize from sales by our subsidiaries will be adversely impacted. Foreign exchange gains or losses as a result of exchange rate fluctuations in any given period could harm our operating results and negatively impact our revenues. Additionally, if the effective price of our products were to increase as a result of fluctuations in foreign currency exchange rates, demand for our products could decline and adversely affect our results of operations and financial condition.

 

The loss of key members of our senior management team, one of our directors or our inability to retain highly skilled scientists, technicians and salespeople could adversely affect our business.

 

Our success depends largely on the skills, experience and performance of key members of our executive management team, including Hojabr Alimi, our Chief Executive Officer, and Akihisa Akao, a member of our Board of Directors and one of our consultants. The efforts of these people will be critical to us as we continue to develop our products and as we attempt to commercialize products in the chronic and acute wound care market. If we were to lose one or more of these individuals, we may experience difficulties in competing effectively, developing our technologies and implementing our business strategies.

 

Our research and development programs depend on our ability to attract and retain highly skilled scientists and technicians. We may not be able to attract or retain qualified scientists and technicians in the future due to the intense competition for qualified personnel among medical technology businesses, particularly in the San Francisco Bay Area. We also face competition from universities and public and private research institutions in recruiting and retaining highly qualified personnel. In addition, our success depends on our ability to attract and retain salespeople with extensive experience in wound care and close relationships with the medical community, including physicians and other medical staff. We may have difficulties locating, recruiting or retaining qualified salespeople, which could cause a delay or decline in the rate of adoption of our products. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will adversely affect our ability to support our research, development and sales programs.

 

We maintain key-person life insurance only on Mr. Alimi. We may discontinue this insurance in the future, it may not continue to be available on commercially reasonable terms or, if continued, it may prove inadequate to compensate us for the loss of Mr. Alimi’s services.

 

We may be unable to manage our future growth effectively, which would make it difficult to execute our business strategy.

 

We may experience periods of rapid growth as we expand our business, which will likely place a significant strain on our limited personnel and other resources. Any failure by us to manage our growth effectively could have an adverse effect on our ability to achieve our commercialization goals.

 

Furthermore, we conduct business in a number of geographic regions and are seeking to expand to other regions. We have not established a physical presence in many of the international regions in which we conduct or plan to conduct business, but rather we manage our business from our headquarters in Northern California.

As a result, we conduct business at all times of the day and night with limited personnel. If we fail to appropriately target and increase our presence in these geographic regions, we may not be able to effectively market and sell our Microcyn products in these locations or we may not meet our customers’ needs in a timely manner, which could negatively affect our operating results.

 

Future growth will also impose significant added responsibilities on management, including the need to identify, recruit, train and integrate additional employees. In addition, rapid and significant growth will place strain on our administrative and operational infrastructure, including sales and marketing and clinical and regulatory personnel. Our ability to manage our operations and growth will require us to continue to improve our operational, financial and management controls, reporting systems and procedures. If we are unable to manage our growth effectively, it may be difficult for us to execute our business strategy.

 

The wound care industry is highly competitive and subject to rapid technological change. If our competitors are better able to develop and market products that are less expensive or more effective than any products that we may develop, our commercial opportunity will be reduced or eliminated.

 

The wound care industry is highly competitive and subject to rapid technological change. Our success depends, in part, upon our ability to stay at the forefront of technological change and maintain a competitive position.

 

We compete with large healthcare, pharmaceutical and biotechnology companies, along with smaller or early-stage companies that have collaborative arrangements with larger pharmaceutical companies, academic institutions, government agencies and other public and private research organizations. Many of our competitors have significantly greater financial resources and expertise in research and development, manufacturing, pre-clinical testing, conducting clinical trials, obtaining regulatory approvals and marketing approved products than we do. Our competitors may:

 

 

As a result, we may not be able to successfully commercialize any future products.

 

Our inability to raise additional capital on acceptable terms in the future may limit our ability to develop and commercialize new products and technologies.

 

We expect capital outlays and operating expenditures to increase over the next several years as we work to commercialize our products and expand our infrastructure and research and development activities. We may need to raise additional capital to, among other things:

 

 

Our present and future funding requirements will depend on many factors, including:

 

 

If we raise additional funds by issuing equity securities, dilution to our stockholders could result. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. If we raise additional funds by issuing debt securities, these debt securities would have rights, preferences and privileges senior to those of holders of our common stock, and the terms of the debt securities issued could impose significant restrictions on our operations. If we raise additional funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our technologies or products, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we may have to scale back our operations or limit our research and development activities.

 

The success of our research and development efforts may depend on our ability to find suitable collaborators to fully exploit our capabilities. If we are unable to establish collaborations or if these future collaborations are unsuccessful, our research and development efforts may be unsuccessful, which could adversely affect our results of operations and financial condition.

 

An important element of our business strategy will be to enter into collaborative or license arrangements under which we license our Microcyn technology to other parties for development and commercialization. We expect that while we may initially seek to conduct initial clinical trials on our drug candidates, we may need to seek collaborators for a number of our potential products because of the expense, effort and expertise required to continue additional clinical trials and further develop those potential products candidates. Because collaboration arrangements are complex to negotiate, we may not be successful in our attempts to establish these arrangements. Also, we may not have products that are desirable to other parties, or we may be unwilling to license a potential product because the party interested in it is a competitor. The terms of any arrangements that we establish may not be favorable to us. Alternatively, potential collaborators may decide against entering into an agreement with us because of our financial, regulatory or intellectual property position or for scientific, commercial or other reasons. If we are not able to establish collaborative agreements, we may not be able to develop and commercialize new products, which would adversely affect our business and our revenues.

 

In order for any of these collaboration or license arrangements to be successful, we must first identify potential collaborators or licensees whose capabilities complement and integrate well with ours. We may rely on these arrangements for, not only financial resources, but also for expertise or economies of scale that we expect to need in the future relating to clinical trials, manufacturing, sales and marketing, and for licenses to technology rights. However, it is likely that we will not be able to control the amount and timing of resources that our collaborators or licensees devote to our programs or potential products. If our collaborators or licensees prove difficult to work with, are less skilled than we originally expected, or do not devote adequate resources to the program, the relationship will not be successful. If a business combination, involving a collaborator or licensees and a third party were to occur, the effect could be to diminish, terminate or cause delays in development of a potential product.

 

We may acquire other businesses or form joint ventures that could harm our operating results, dilute your ownership of us, increase our debt or cause us to incur significant expense.

 

As part of our business strategy, we may pursue acquisitions of complementary businesses and assets, as well as technology licensing arrangements. We also intend to pursue strategic alliances that leverage our core

technology and industry experience to expand our product offerings or distribution. We have no experience with respect to acquiring other companies and limited experience with respect to the formation of collaborations, strategic alliances and joint ventures. If we make any acquisitions, we may not be able to integrate these acquisitions successfully into our existing business, and we could assume unknown or contingent liabilities. Any future acquisitions by us also could result in significant write-offs or the incurrence of debt and contingent liabilities, any of which could harm our operating results. Integration of an acquired company also may require management resources that otherwise would be available for ongoing development of our existing business. We may not identify or complete these transactions in a timely manner, on a cost-effective basis, or at all, and we may not realize the anticipated benefits of any acquisition, technology license, strategic alliance or joint venture.

 

To finance any acquisitions, we may choose to issue shares of our common stock as consideration, which would dilute your ownership interest in us. If the price of our common stock is low or volatile, we may not be able to acquire other companies for stock. Alternatively, it may be necessary for us to raise additional funds for acquisitions through public or private financings. Additional funds may not be available on terms that are favorable to us, or at all.

 

If we are unable to comply with broad and complex federal and state fraud and abuse laws, we could face substantial penalties and our products could be excluded from government healthcare programs.

 

We are subject to various broad and complex federal and state laws pertaining to healthcare fraud and abuse, which, among other things, prohibit payments to induce the referral of products and services and the fraudulent billing of federal healthcare programs. Any violations of these laws, or any action against us for violation of these laws, even if we successfully defend against it, could result in a material adverse effect on our business, financial condition and results of operations. If there is a change in law, regulation or administrative or judicial interpretations, we may have to change our business practices or our existing business practices could be challenged as unlawful, which could have a material adverse effect on our business, financial condition and results of operations.

 

The frequency of suits to enforce these laws have increased significantly in recent years and have increased the risk that a healthcare company will have to defend a false claim action, pay fines or be excluded from the Medicare, Medicaid or other federal and state healthcare programs as a result of an investigation arising out of such action. We cannot assure you that we will not become subject to such litigation or, if we are not successful in defending against such actions, that such actions will not have a material adverse effect on our business, financial condition and results of operations. In addition, we cannot assure you that the costs of defending claims or allegations under the False Claims Act will not have a material adverse effect on our business, financial condition and results of operations.

 

Our efforts to discover and develop potential products may not lead to the discovery, development, commercialization or marketing of actual drug products.

 

We are currently engaged in a number of different approaches to discover and develop new product applications and product candidates. At the present time, we have one drug candidate in clinical trials. We also have a non-Microcyn based compound in the research and development phase. This compound has potential applications in oncology. Discovery and development of potential drug candidates are expensive and time-consuming, and we do not know if our efforts will lead to discovery of any drug candidates that can be successfully developed and marketed. If our efforts do not lead to the discovery of a suitable drug candidate, we may be unable to grow our clinical pipeline or we may be unable to enter into agreements with collaborators who are willing to develop our drug candidates.

 

We must implement additional and expensive finance and accounting systems, procedures and controls as we grow our business and organization and to satisfy new reporting requirements, which will increase our costs and require additional management resources.

 

As a public reporting company, we will be required to comply with the Sarbanes-Oxley Act of 2002 and the related rules and regulations of the Securities and Exchange Commission, including expanded disclosures and accelerated reporting requirements and more complex accounting rules. Compliance with Section 404 of

the Sarbanes-Oxley Act and other requirements will increase our costs and require additional management resources. We recently have been upgrading our finance and accounting systems, procedures and controls and will need to continue to implement additional finance and accounting systems, procedures and controls as we grow our business and organization, enter into complex business transactions and take actions designed to satisfy new reporting requirements. Specifically, our transaction with QP may indicate that we need to better plan for complex transactions and the application of complex accounting principles relating to those transactions. If we are unable to complete the required Section 404 assessment as to the adequacy of our internal control over financial reporting, if we fail to maintain or implement adequate controls, or if our independent registered public accounting firm is unable to provide us with an unqualified report as to the effectiveness of our internal control over financial reporting as of the date of our first Annual Report on Form 10-K for which compliance is required and thereafter, our ability to obtain additional financing could be impaired. In addition, investors could lose confidence in the reliability of our internal control over financial reporting and in the accuracy of our periodic reports filed under the Exchange Act. A lack of investor confidence in the reliability and accuracy of our public reporting could cause our stock price to decline.

 

We may not be able to maintain sufficient product liability insurance to cover claims against us.

 

Product liability insurance for the healthcare industry is generally expensive to the extent it is available at all. We may not be able to maintain such insurance on acceptable terms or be able to secure increased coverage if the commercialization of our products progresses, nor can we be sure that existing or future claims against us will be covered by our product liability insurance. Moreover, the existing coverage of our insurance policy or any rights of indemnification and contribution that we may have may not be sufficient to offset existing or future claims. A successful claim against us with respect to uninsured liabilities or in excess of insurance coverage and not subject to any indemnification or contribution could have a material adverse effect on our future business, financial condition, and results of operations.

 

Risks Related to Our Common Stock

 

Purchasers in this offering will experience immediate and substantial dilution in the book value of their investment.

 

The initial public offering price of our common stock is substantially higher than the net tangible book value per share of our common stock immediately after this offering. Therefore, if you purchase our common stock in this offering, you will incur an immediate dilution of $      in net tangible book value per share from the price you paid, based on the assumed initial public offering price of $      per share. The exercise of outstanding options will result in further dilution of your investment. For additional information, please see “Dilution.”

 

Our operating results may fluctuate, which could cause our stock price to decrease.

 

Fluctuations in our operating results may lead to fluctuations, including declines, in our share price. Our operating results and our share price may fluctuate from period to period due to a variety of factors, including:

 

 

 

Variations in the timing of our future revenues and expenses could also cause significant fluctuations in our operating results from period to period and may result in unanticipated earning shortfalls or losses. In addition, the Nasdaq National Market in general, and the market for life sciences companies in particular, have experienced significant price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies.

 

If an active, liquid trading market for our common stock does not develop, you may not be able to sell your shares quickly or at or above the initial offering price.

 

Prior to this offering, there has not been a public market for our common stock. An active and liquid trading market for our common stock may not develop or be sustained following this offering. You may not be able to sell your shares quickly or at or above the initial offering price if trading in our stock is not active. The initial public offering price may not be indicative of prices that will prevail in the trading market. See “Underwriting” for more information regarding the factors that will be considered in determining the initial public offering price.

 

Future sales of shares by our stockholders could cause the market price of our common stock to drop significantly, even if our business is doing well.

 

After this offering, we will have           outstanding shares of common stock based on the number of shares outstanding at          , 2006. This includes the           shares we are selling in this offering, which (other than shares purchased by our affiliates) may be resold in the public market immediately. Subject to the lock-up arrangements described in “Underwriting” and volume and other restrictions as applicable under Rule 144 and 701 under the Securities Act, the remaining shares will become available for resale in the public market as shown in the chart below.

 

 

We do not expect to pay dividends in the foreseeable future. As a result, you must rely on stock appreciation for any return on your investment.

 

We do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will also depend on our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our board of directors. Accordingly, you will have to rely on appreciation in the price of our common stock, if any, to earn a return on your investment in our common

stock. Furthermore, we may in the future become subject to contractual restrictions on, or prohibitions against, the payment of dividends.

 

We may allocate net proceeds from this offering in ways with which you may not agree.

 

Our management will have broad discretion in using the proceeds from this offering and may use the proceeds in ways with which you may disagree. Because we are not required to allocate the net proceeds from this offering to any specific investment or transaction, you cannot determine at this time the value or propriety of our application of the proceeds. Moreover, you will not have the opportunity to evaluate the economic, financial or other information on which we base our decisions on how to use our proceeds. We may use the proceeds for corporate purposes that do not immediately enhance our prospects for the future or increase the value of your investment. As a result, you and other stockholders may not agree with our decisions.

 

Anti-takeover provisions in our charter, by-laws and Delaware law may make it difficult for you to change our management and may also make a takeover difficult.

 

Our corporate documents and Delaware law contain provisions that limit the ability of stockholders to change our management and may also enable our management to resist a takeover. These provisions include limitations on persons authorized to call a special meeting of stockholders and advance notice procedures required for stockholders to make nominations of candidates for election as directors or to bring matters before an annual meeting of stockholders. These provisions might discourage, delay or prevent a change of control or in our management. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors and cause us to take other corporate actions. In addition, the existence of these provisions, together with Delaware law, might hinder or delay an attempted takeover other than through negotiations with our board of directors.

 

This prospectus contains forward-looking statements that involve risks and uncertainties, such as statements about our plans, objectives, expectations, assumptions, and future events. In some cases, you can identify forward-looking statements by terminology such as “anticipate,” “estimate,” “plan,” “project,” “continue,” “ongoing,” “potential,” “expect,” “predict,” “believe,” “intend,” “may,” “will,” “should,” “could,” “would,” and similar expressions. These statements involve estimates, assumptions, known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from any future results, performances, or achievements expressed or implied by the forward-looking statements. Consequently, you should not place undue reliance on these forward-looking statements. We discuss many of these risks in greater detail under the heading “Risk Factors” above.

 

Forward-looking statements include, but are not limited to, statements about:

 

 

The forward-looking statements speak only as of the date on which they are made, and, except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination

of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

This prospectus contains statistical and market data that we obtained from third-party sources. Although we believe that this information is reliable, we have not independently verified this information.

 

We expect to receive net proceeds of approximately $      million from this offering, based on an assumed initial public offering price of $      per share, after deducting the underwriting discount and estimated offering expenses. If the underwriters exercise their over-allotment option in full, our estimated net proceeds will be approximately $      million. A $1.00 increase or decrease in the assumed initial public offering price of $      per share would increase or decrease, as applicable, the net proceeds to us by approximately $     , assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discount and our estimated offering expenses.

 

We currently intend to use the proceeds of this offering as follows:

 

 

While we have estimated the particular uses for the net proceeds to be received upon the completion of this offering, the actual amounts and timing of any expenditure will depend upon the rate of growth, if any, of our business, the amount of cash generated by our operations, status of our research and development efforts, competitive and technological developments and the amount of proceeds actually raised in this offering. A portion of the net proceeds may also be used to acquire or invest in complementary businesses, technologies, services or products, although we have no agreements with respect to any such transactions as of the date of this prospectus. Accordingly, our management will have significant flexibility in applying the net proceeds from this offering.

 

We believe that the net proceeds from this offering, together with our future revenues, cash and cash equivalent balances and interest we earn on these balances will be sufficient to meet our anticipated cash requirements through at least the next 12 months. Pending these uses described above, we intend to invest the net proceeds in short-term, investment grade securities.

 

We have never declared or paid any cash dividends on our common stock. Upon the completion of this offering, we anticipate that any earnings will be retained for development and expansion of our business, and we do not anticipate paying any cash dividends in the foreseeable future on our common stock. Our board of directors has sole discretion to pay cash dividends based on our financial condition, results of operations, capital requirements, contractual obligations and other relevant factors. In the future, we may also obtain loans or other credit facilities that may restrict our ability to declare or pay dividends.

 

The following table describes our cash, cash equivalents and capitalization as of March 31, 2006:

 

 

 

You should read this table together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing elsewhere in this prospectus.

 

 

 

The outstanding share information set forth in the table excludes as of March 31, 2006:

 

 

Our net tangible book value as of March 31, 2006 was approximately $7.3 million, or $0.43 per share of common stock. Our net tangible book value per share represents the amount of our total tangible assets less total liabilities, divided by the number of shares of common stock outstanding. Dilution of pro forma net tangible book value per share represents the difference between the amount per share paid by purchasers of shares of common stock in this offering and the pro forma as adjusted net tangible book value per share of common stock immediately after completion of this offering. After giving effect to the sale of           shares of common stock at an assumed initial public offering price of $      per share, which is the midpoint of our expected offering range, and after deducting the underwriting discount and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of March 31, 2006 would have been $     million, or $      per share of common stock. This represents an immediate increase in net tangible book value of $      per share of common stock to existing common stockholders and an immediate dilution in pro forma as adjusted net tangible book value of $      per share to new investors purchasing shares of common stock in this offering. The following table illustrates this per share dilution:

 

 

A $1.00 increase or decrease in the assumed initial public offering price of $     per share would increase or decrease, as applicable, our pro forma as adjusted net tangible book value by $     million, the pro forma as adjusted net tangible book value per share by $     per share and the dilution in the pro forma net tangible book value to new investors in this offering by $     per share, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discount and estimated offering expenses payable by us.

 

The following table summarizes as of March 31, 2006, the number of shares of common stock purchased from us, the total consideration paid and the average price per share paid to us by existing and new investors purchasing shares of common stock in this offering assuming an initial public offering price of $      per share, which is the midpoint of our expected offering range, before deducting the underwriting discount and estimated offering expenses.

 

 

A $1.00 increase or decrease in the assumed initial public offering price of $     per share would increase or decrease, as applicable, total consideration paid by new investors and total consideration paid by all stockholders by $      million, assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same.

 

If the underwriters exercise their over-allotment option in full, our existing stockholders would own  % and our new investors would own  % of the total number of shares of our common stock outstanding after this offering.

 

The number of shares of our common stock referred to above that will be outstanding immediately after completion of this offering is based on 16,875,928 shares of our common stock outstanding as of March 31,

2006, reflects the automatic conversion of our preferred stock into 15,934,718 shares of common stock and excludes:

 

 

If all of our outstanding options and warrants as of March 31, 2006 were exercised, the pro forma as adjusted net tangible book value per share after this offering would be $      per share, representing an increase attributable to new investors of $      per share, and there would be an immediate dilution of $      per share to new investors.

 

In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in further dilution to our stockholders.

 

You should read the following selected consolidated financial data together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus. The selected consolidated statements of operations data for each of the years ended March 31, 2004, 2005 and 2006 and the selected consolidated balance sheet data as of March 31, 2005 and 2006 have been derived from our audited consolidated financial statements that are included elsewhere in this prospectus. The selected consolidated statements of operations data for the years ended March 31, 2002 and 2003 and the selected consolidated balance sheet data at March 31, 2002, 2003 and 2004 have been derived from our consolidated financial statements not included in this prospectus. The selected consolidated statement of operations data for the year ended March 31, 2003 and the selected consolidated balance sheet data as of March 31, 2003 have not been audited. Our historical results are not necessarily indicative of the results that may be expected in the future.

 

 

 

 

 

 

 

The following discussion of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included elsewhere in this prospectus. This discussion contains forward-looking statements based upon current expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors,” “Information Regarding Forward-looking Statements” and elsewhere in this prospectus.

 

Overview

 

We develop, manufacture and market a family of products intended to prevent and eliminate infection in chronic and acute wounds. Infection is a serious potential complication in both chronic and acute wounds, and controlling infection is a critical step in wound healing. Our platform technology, called Microcyn, is a non-toxic, super-oxidized water-based solution that is designed to eliminate a wide range of pathogens including viruses, fungi, spores and antibiotic resistant strains of bacteria such as Methicillin-resistant Staphylococcus aureus, or MRSA, and Vancomycin-resistant Enterococcus, or VRE. In clinical testing, our products eliminated a wide range of pathogens and were found to be safe, easy to use and complementary with most existing treatment methods in wound care. Our experience and clinical data indicate that the use of Microcyn may shorten hospital stays, lower aggregate patient care costs and, in certain cases, reduce the need for systemic antibiotics. Microcyn also has applications in several other large consumer and professional markets, including hard surface disinfectant, respiratory, dermatology, mold and atmospheric remediation and dental.

 

We believe that Microcyn is the first topical product that eliminates a broad range of bacteria and other infectious microbes without causing toxic side effects on, or irritation of, healthy tissue. Unlike most antibiotics, Microcyn does not target specific strains of bacteria, a practice which has been shown to promote the development of resistant bacteria. Because our products are shelf stable and require no special preparation, they can be used in hospitals, clinics, burn centers, extended care facilities and in the home.

 

We currently sell Microcyn in the United States through a four-person direct sales force and through one national and five regional distributors. In Europe, we have an eight-person direct sales force and exclusive distribution agreements with four distributors, all of which are experienced suppliers to the wound care market, with an aggregate combined sales force of over 25 full-time equivalent salespeople. In Mexico, we sell through a dedicated 75-person contract sales force, including salespeople, nurses and clinical support staff, and a network of distributors to both the public and private sector. The MOH, which approves product selection and procurement for government hospitals and healthcare institutions, has approved reimbursement for Microcyn. We plan to expand our direct sales force in the United States, Europe and Mexico to support our distribution network.

 

We have incurred significant net losses since our inception and had an accumulated deficit of $50.3 million as of March 31, 2006. We expect to incur significant expenses in the foreseeable future as we seek to commercialize our products, and we cannot be sure that we will achieve profitability.

 

Financial Operations Overview

 

Revenues

 

We derive our revenues from product sales and service arrangements. Product revenues are generated from the sale of Microcyn to hospitals, medical centers, doctors, pharmacies, distributors and strategic partners, and are generally recorded upon shipment following receipt of a purchase order or upon obtaining proof of sell-through by a distributor. Product sales are made either through direct sales personnel or distributors. Historically, a significant majority of our product sales have been in Mexico.

 

Service revenues are derived from consulting and testing contracts. Service revenues are generally recorded upon performance under the service contract. Revenues generated from testing contracts are recorded upon completion of the test and when the final report is sent to the customer. We have refocused our business

efforts away from consulting and testing services toward the commercialization of Microcyn. As a result, we expect service revenues to continue to significantly decline in future periods.

 

Cost of Revenues

 

Cost of product revenues represents the costs associated with the manufacturing of our products, including operating expenses for our various facilities which are permanently fixed, and related personnel cost and the cost of materials used to produce our products. Cost of service revenues consists primarily of personnel related expenses and supplies.

 

Research and Development Expense

 

Research and development expense consists of costs related to the research and development of Microcyn and our manufacturing process. Research and development expense represents costs incurred to enhance our manufacturing process, to develop products and new delivery systems for our products and to carry out preclinical studies and clinical trials to obtain various regulatory approvals. Research and development expense is charged as incurred.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense consists of personnel related costs, including salaries and sales commissions, and education and promotional expenses associated with Microcyn and costs related to administrative personnel and senior management. These expenses also include the costs of educating physicians and other healthcare professionals regarding our products and participating in industry conferences and seminars. Selling, general and administrative expense also includes travel costs, outside consulting services, legal and accounting fees and other professional and administrative costs.

 

Stock-Based Compensation Expense

 

We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, or APB No. 25, “Accounting for Stock Issued to Employees,” and its interpretations and comply with the disclosure requirements of Statement of Financial Accounting Standard, or SFAS, No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of the Financial Accounting Standards Board Statement No. 123.” We have elected to continue to follow Interpretation of No. 44, or FIN 44, “Accounting for Certain Transactions Involving Stock Compensation and Interpretation of APB No. 25”, in accounting for employee stock options. Under APB No. 25, compensation expense is based upon the excess of the estimated fair value of our stock over the exercise price, if any, on the grant date. Employee stock-based compensation is amortized on a straight-line basis over the vesting period of the underlying options. SFAS No. 123 defines a “fair value” based method of accounting for an employee stock option or similar equity instrument.

 

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123(R) “Share Based Payment.” This statement is a revision of SFAS Statement No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, ““Accounting for Stock Issued to Employees”, and its related implementation guidance. SFAS 123(R) addresses all forms of share-based payment, or SBP, awards including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. Under SFAS 123(R), SBP awards result in a cost that will be measured at fair value on the awards’ grant date, based on the estimated number of awards that are expected to vest and will result in a charge to operations for stock-based compensation expense. We are subject to requirements of SFAS 123(R) effective April 1, 2006. Management is evaluating the requirements of SFAS 123(R) and expects that the adoption of this pronouncement will have a significant effect on our consolidated results of operations and earnings (loss) per share.

Discontinued Operations

 

On June 16, 2005, we entered into a series of agreements with Quimica Pasteur, or QP, a Mexico-based distributor of pharmaceutical products to hospitals and health care entities owned and/or operated by the Mexican Ministry of Health, or MOH. These agreements provided, among other things, for QP to act as our exclusive distributor of Microcyn to the MOH for a period of three years. We concurrently acquired, for no additional consideration, a 0.25% equity interest in QP and an option to acquire the remaining 99.75% of QP directly from its principals in exchange for 600,000 shares of common stock, contingent upon QP’s attainment of certain financial milestones. The distribution and related agreements were cancelable by us on thirty days notice without cause and featured certain provisions to hold us harmless from debts incurred by QP outside the scope of the distribution and related agreements. We terminated these agreements with QP on March 26, 2006. For additional information, please see “Risk Factors — We may incur significant liabilities in connection with our prior relationship with a distributor in Mexico, and our results of operations may be negatively affected by the termination of this relationship.”

 

Due to its liquidity circumstances, QP was unable to sustain operations without our financial and management support. Accordingly, QP was deemed to be a variable interest entity in accordance with FIN 46R and the results of QP were therefore consolidated with our financial statements for the period from June 16, 2005 through March 26, 2006, the effective termination date of the distribution and related agreements.

 

In accordance with SFAS 144, we have reported QP’s results for the period of June 16, 2005 through March 26, 2006 as discontinued operations because the operations and cash flows of QP have been eliminated from our ongoing operations as a result of the termination of these agreements. We no longer have any continuing involvement with QP as of the date on which the agreements were terminated. Amounts associated with the loss upon the termination of the agreements with QP, which consists of funds we advanced to QP to provide it with working capital, are presented separately from QP’s operating results.

 

Critical Accounting Policies

 

The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to exercise its judgment. We exercise considerable judgment with respect to establishing sound accounting polices and in making estimates and assumptions that affect the reported amounts of our assets and liabilities, our recognition of revenues and expenses, and disclosure of commitments and contingencies at the date of the financial statements.

 

On an ongoing basis, we evaluate our estimates and judgments. Areas in which we exercise significant judgment include, but are not necessarily limited to, our valuation of accounts receivable, inventory, depreciation, amortization, recoverability of long-lived assets, income taxes, equity transactions (compensatory and financing) and contingencies. We have also adopted certain polices with respect to our recognition of revenue that we believe are consistent with the guidance provided under Securities and Exchange Commission Staff Accounting Bulletin No. 104.

 

We base our estimates and judgments on a variety of factors including our historical experience, knowledge of our business and industry, current and expected economic conditions, the attributes of our products, regulatory environment, and in certain cases, the results of outside appraisals. We periodically re-evaluate our estimates and assumptions with respect to these judgments and modify our approach when circumstances indicate that modifications are necessary.

 

While we believe that the factors we evaluate provide us with a meaningful basis for establishing and applying sound accounting policies, we cannot guarantee that the results will always be accurate. Since the determination of these estimates requires the exercise of judgment, actual results could differ from such estimates.

A description of significant accounting polices that require us to make estimates and assumptions in the preparation of our consolidated financial statements is as follows:

 

Revenue Recognition and Accounts Receivable

 

We generate product revenues from sales of our products to hospitals, medical centers, doctors, pharmacies, distributors and strategic partners. We sell our products directly to third parties and to distributors through various cancelable distribution agreements. We have also entered into an agreement to license our products.

 

We apply the revenue recognition principles set forth in Securities and Exchange Commission Staff Accounting Bulletin, or SAB, 104 “Revenue Recognition,” with respect to all of our revenues. Accordingly, we record revenues when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability of the sale is reasonable assured.

 

We require all of our product sales to be supported by evidence of a sale transaction that clearly indicates the selling price to the customer, shipping terms and payment terms. Evidence of an arrangement generally consists of a contract or purchase order approved by the customer. We have ongoing relationships with certain customers from which we customarily accept orders by telephone in lieu of a purchase order.

 

We recognize revenues at the time in which we receive a confirmation that the goods were either tendered at their destination when shipped “FOB destination,” or transferred to a shipping agent when shipped “FOB shipping point.” Delivery to the customer is deemed to have occurred when the customer takes title to the product. Generally, title passes to the customer upon shipment, but could occur when the customer receives the product based on the terms of the agreement with the customer.

 

While we have a policy of investigating the creditworthiness of our customers, we have, under certain circumstances, shipped goods in the past and deferred the recognition of revenues when available information indicates that collection is in doubt. We establish allowances for doubtful accounts when available information causes us to believe that a credit loss is probable.

 

We market a substantial portion of our goods through distributors. In Europe, we defer recognition of distributor-generated revenues until the time we confirm that distributors have sold these goods. Although our terms provide for no right of return, our products have a finite shelf life and we may, at our discretion, accommodate distributors by accepting returns to avoid the distribution of expired goods.

 

Service revenues are recorded upon performance of the service contracts. Revenues generated from testing contracts are recorded when the test is completed and the final report is sent to the customer.

 

Inventory and Cost of Revenues

 

We state our inventory at the lower of cost, determined using the first-in, first-out method, or market, based on standard costs. Establishing standard manufacturing costs requires us to make estimates and assumptions as to the quantities and costs of materials, labor and overhead that are required to produce a finished good. Cost of service revenues is expensed when incurred.

 

Income Taxes

 

We are required to determine the aggregate amount of income tax expense or loss based upon tax statutes in jurisdictions in which we conduct business. In making these estimates, we adjust our results determined in accordance with generally accepted accounting principles for items that are treated differently by the applicable taxing authorities. Deferred tax assets and liabilities, as a result of these differences, are reflected on our balance sheet for temporary differences in loss and credit carryforwards that will reverse in subsequent years. We also establish a valuation allowance against deferred tax assets when it is more likely than not that some or all of the deferred tax assets will not be realized. Valuation allowances are based, in part, on predictions that management must make as to our results in future periods. The outcome of events could differ over time which would require that we make changes in our valuation allowance.

Equity Transactions

 

Under generally accepted accounting principles, we have the ability to choose between two alternative methods of accounting for employee stock based compensation: the intrinsic value method or the fair value method. Although we have adopted the intrinsic value method, the results we could derive under the fair value method could differ significantly. In addition, since our stock is not publicly traded, we must estimate its fair value. We have used outside valuation specialists that have relied upon information provided by management to determine value of our stock and have also made valuation estimates based on concurrent sales of equity securities for cash and other business related information.

 

Deferred Stock-Based Compensation Expense

 

Stock-based compensation expense, which is a non-cash charge, results from stock option grants at exercise prices that, for financial reporting purposes, are deemed to be below the fair value of the underlying common stock. We recognize stock-based compensation expense on a straight-line basis over the vesting period of the underlying option, which is generally five years. The amount of stock-based compensation expense expected to be amortized in future periods may decrease if unvested options for which deferred stock-based compensation expense has been recorded are subsequently cancelled or may increase if future option grants are made with exercise prices below the deemed fair value of the common stock on the date of measurement.

 

During the period from April 1, 2005 to March 31, 2006, we granted options to purchase a total of 3,148,000 shares of common stock with exercise prices ranging from $1.10 to $3.00 per share and at a weighted average exercise price of $2.30 per share. We obtained a contemporaneous valuation from an independent valuation specialist in July 2005. This valuation was used by our board of directors to establish the fair market value of our common stock with respect to the majority of options granted in the year ended March 31, 2006. Our other options were granted at fair market value as determined by our board of directors. Given the absence of an active market for our common stock and resulting lack of liquidity in the year ended March 31, 2006, our board of directors determined the estimated fair value of our common stock on the date of grant based on several factors, including the offering prices and liquidation preferences of our preferred stock, progress and milestones achieved in our business, our financial condition, equity market conditions, trading ranges of comparable public companies and the likelihood of achieving a liquidity event such as an initial public offering or a sale of the company given prevailing market conditions.

 

After receipt of the independent valuation in July 2005, our board of directors reassessed the value of our common stock. In reassessing the value of our common stock, we used a straight-line approach because we determined no single event supported incremental movement in the underlying stock. Further, we believe this approach is consistent with valuation methodologies applied by similar companies pursuing an initial public offering. Based upon this process, we determined that the reassessed fair value of options granted from August 7, 2003 through April 1, 2005 ranged from $0.82 to $2.28 per share. Accordingly, we recorded deferred stock-based compensation of $233,000, $2.8 million and $401,000 during the years ended March 31, 2004, 2005 and 2006, respectively, in accordance with Accounting Principles Board, or APB, Opinion 25. The deferred stock-based compensation is being amortized on a straight-line basis over the vesting period of the related awards, which is generally five years. For the years ended March 31, 2004, 2005 and 2006, we recorded employee stock-based compensation of $30,000, $2.3 million and $279,000, respectively. Stock-based compensation expense recorded during the year ended March 31, 2005 includes $1.7 million for the intrinsic value of options to purchase 1.2 million shares of common stock granted to our Chief Executive Officer.

 

The information regarding net loss as required by SFAS No. 123 presented in Note 3 to our consolidated financial statements, has been determined as if we had accounted for our employee stock options under the fair value method. The resulting effect on net loss pursuant to SFAS No. 123 is not likely to be representative of the effect on net loss pursuant to SFAS No. 123 in future years, since future years are likely to include additional grants and the impact of future years’ vesting.

Comparison of Years Ended March 31, 2006 and March 31, 2005

 

Revenues

 

Revenues increased $1.2 million, or 48%, to $2.6 million for the year ended March 31, 2006, from $1.4 million for the year ended March 31, 2005. Product revenues increased $1.5 million, or 316%, to $2.0 million for the year ended March 31, 2006, from $473,000 for the year ended March 31, 2005. This increase was primarily due to a $1.4 million increase in sales of Microcyn60 in Mexico following the expansion of our sales force in that country and the receipt of product reimbursement by the MOH.

 

The increase in product revenues was partially offset by a $265,000 decrease in service revenues during the year ended March 31, 2006, as compared to the prior year. The decrease in service revenues was a result of a shift in our focus from services to the development of our Microcyn products in fiscal 2006.

 

We expect that product revenues will continue to increase as we expand our sales and marketing efforts worldwide. We expect that our service revenues will remain flat or decline in future periods, as we continue our strategy of focusing primarily on our Microcyn business.

 

Cost of Revenues

 

Cost of revenues increased $1.4 million, or 39%, to $4.9 million for the year ended March 31, 2006, from $3.5 million for the year ended March 31, 2005. Cost of revenues from product sales principally include fixed costs associated with plant and labor and to a lesser extent variable costs associated with packaging and other raw materials. Cost of revenues from product sales increased $1.7 million, or 76%, to $3.9 million in the year ended March 31, 2006, from $2.2 million in the year ended March 31, 2005. This increase was due primarily to European product manufacturing beginning in the middle of the year ended March 31, 2005 as compared to a full year of costs in the year ended March 31, 2006. As such, total cost of product revenues in Europe increased $637,000 to $1.0 million for the year ended March 31, 2006 from $381,000 for the year ended March 31, 2005. Additionally, we incurred charges we believe to be non-recurring. We wrote off $1.0 million of inventory due to product labeling issues and expiring shelf life of products as a result of a one-time build-up of excess product inventory. We also relocated our manufacturing facility in Mexico and incurred approximately $200,000 of labor and severance charges related to the move. These increases were partially offset by a $308,000, or 23%, decrease in costs related to service revenues to $1.0 million in the year ended March 31, 2006, from $1.3 million in the year ended March 31, 2005. The lower cost of service revenues was related to lower our shifted in focus to product development and the sale of our Microcyn products during fiscal 2006.

 

We expect that cost of revenues will continue to increase in absolute dollars as product sales increase in the year ended March 31, 2007 and subsequent years. We anticipate cost of revenues will continue to exceed revenues until we achieve a significant increase in the volumes of our product sales.

 

Research and Development Expense

 

Research and development expense increased $946,000, or 57%, to $2.6 million in the year ended March 31, 2006, from $1.7 million in the year ended March 31, 2005. This increase was primarily attributable to the expansion of our regulatory team, which focused on EPA, FDA and KEMA approvals for Microcyn products during the period. Additionally, in September 2005, we commenced our pre-operative skin preparation pilot studies to support our application for an FDA drug clearance indicating microbial load reduction. Total spending on regulatory trials, other clinical studies, and related expenses increased $1.2 million, or 164%, to $1.9 million for the year ended March 31, 2006, from $735,000 during the year ended March 31, 2005. This increase was partially offset by a $418,000 decrease in spending on new product development of $497,000 in the year ended March 31, 2006.

 

We expect that research and development expense will continue to increase substantially in future years as we seek additional regulatory approvals of our Microcyn products. We expect to expand the scope of our new product development, which may also result in substantial increases in research and development expense.

Selling, General and Administrative Expense

 

Selling, general and administrative expense increased $3.4 million, or 28%, to $15.9 million during the year ended March 31, 2006, from $12.5 million during the year ended March 31, 2005. This increase was partially due to a $1.8 million increase in U.S. selling, general and administrative expense primarily as a result of higher outside consulting and service fees during the year ended March 31, 2006. Specifically, outside accounting fees increased by $653,000 due to the preparation and completion of an audit of our last four fiscal years, legal fees increased by $507,000 due to expanded intellectual property and general legal support, and outside consulting and service fees increased by $294,000 due to consulting expenses related to the marketing of our products in Asia.

 

In addition, sales and marketing expense in Europe increased $429,000 due to the hiring of additional sales and marketing personnel during the year ended March 31, 2006.

 

Selling, general and administrative expense in Mexico increased $3.3 million in the year ended March 31, 2006 compared to the prior year primarily due to expanded sales and marketing efforts in Mexico, as well as non-recurring charges associated with the relocation of our Mexican subsidiary’s facility. During the year ended March 31, 2006, we began utilizing 75 full-time, direct sales personnel in the major districts of Mexico, dedicated to the sale of Microcyn60 in the hospital and pharmacy markets in Mexico. As a result, sales and marketing expense in Mexico increased $2.7 million during the year ended March 31, 2006, compared to the prior year.

 

The increase in selling, general and administrative expense was offset by a $1.8 million decrease in non-cash stock compensation expense in the year ended March 31, 2006 compared to the prior year. Approximately $1.7 million incurred in the year ended March 31, 2005 was related to the grant of an option to purchase 1.2 million shares of common stock to our Chief Executive Officer.

 

We expect that selling, general and administrative expense will increase during the year ended March 31, 2007 and in future years as we increase sales and marketing personnel, expand our legal and accounting staff and infrastructure to support the requirements of being a public company.

 

Interest Expense and Interest Income

 

Interest expense decreased $200,000, or 54%, to $172,000 in the year ended March 31, 2006, from $372,000 in the year ended March 31, 2005. This decrease was primarily the result of lower borrowings during the year. Interest income increased $274,000, to $282,000 in the year ended March 31, 2006, from $8,000 in the year ended March 31, 2005. This increase was primarily the result of higher balances of interest-bearing instruments during the year ended March 31, 2006.

 

Other Income (Expense), Net

 

Other income (expense), net was $377,000 net expense in the year ended March 31, 2006, compared with $146,000 net income in the year ended March 31, 2005. This change was primarily attributable to a $283,000 loss on foreign exchange transactions in the year ended March 31, 2006, as compared to a gain of $134,000 in the year ended March 31, 2005.

 

Discontinued Operations

 

Loss on discontinued operations was $2.0 million in the year ended March 31, 2006. This loss consisted of $818,000 classified as a loss from operations of discontinued business and $1.2 million of loss on the disposal of discontinued business. This charge represents the net operating loss of QP, which was consolidated with our financial results as required by FIN 46(R). The relationship was terminated in the fourth quarter of the year ended March 31, 2006 and the loss was classified as a discontinued operation on our statements of operations. In addition, $1.2 million of net assets associated with this entity were written off and classified as a loss on disposal of discontinued business. As no relationship existed with this entity prior to the year ended March 31, 2006, no charges were recognized in prior years.

Comparison of Years Ended March 31, 2005 and March 31, 2004

 

Revenues

 

Revenues increased $454,000, or 50%, to $1.4 million for the year ended March 31, 2005, from $902,000 for the year ended March 31, 2004. Product revenues increased $378,000 to $473,000 for the year ended March 31, 2005, as compared to $95,000 in the prior year. This increase was primarily attributable to the hiring of new sales and marketing personnel in Mexico and an increased demand for Microcyn60 in the Mexican private hospital market.

 

Service revenues increased $76,000, or 9%, to $883,000 for the year ended March 31, 2005, as compared to $807,000 for the prior year. This increase was primarily the result of increased demand for our laboratory testing services.

 

Cost of Revenues

 

Cost of revenues increased $854,000, or 32%, to $3.5 million for the year ended March 31, 2005, from $2.7 million for the year ended March 31, 2004. Cost of product revenues increased $808,000 primarily due to the expansion of our manufacturing capacity in the United States and Europe and related costs, including operating expenses for new facilities and an increase in personnel.

 

Cost of service revenues was $1.3 million for both the years ended March 31, 2005 and 2004.

 

Cost of revenues exceeded revenue in both the year ended March 31, 2005 and March 31, 2004, due to expenses incurred to develop our manufacturing sites in the United States, Europe and Mexico prior to significant sales in those countries.

 

Research and Development Expense

 

Research and development expense increased $241,000, or 17%, to $1.7 million for the year ended March 31, 2005, from $1.4 million for the year ended March 31, 2004. This increase was primarily related to a $194,000 increase in salary expense related to the expansion of our research and development and regulatory teams and a $102,000 increase in consulting services in the year ended March 31, 2005, as compared to the prior year.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense increased $8.6 million, or 219%, to $12.5 million for the year ended March 31, 2005, from $3.9 million for the year ended March 31, 2004. This increase was due in part to a $4.1 million increase in personnel costs associated with hiring additional senior management, sales and marketing, operations and administrative personnel. Additionally, selling, general and administrative expense was higher due to a $2.0 million increase in non-cash stock compensation expense in the year ended March 31, 2005 compared to the prior year.

 

 

Interest Expense

 

Interest expense increased $194,000, or 109%, to $372,000 in the year ended March 31, 2005, from $178,000 in the year ended March 31, 2004. This increase was primarily due to an increase in non-cash interest expense charged on warrants issued in connection with debt financing transactions in the year ended March 31, 2005.

 

Other Income (Expense), net

 

Other income (expense), net was net income of $146,000 in the year ended March 31, 2005, compared to net expense of $26,000 in the year ended March 31, 2004. The change was primarily attributable to a gain of $134,000 on foreign exchange transactions in the year ended March 31, 2005, compared to a loss of $4,000 in the prior year.

Liquidity and Capital Resources

 

Since our inception, we have incurred significant losses and, as of March 31, 2006, we had an accumulated deficit of approximately $50.3 million. We have not yet achieved profitability. We expect that our research and development and selling, general and administrative expenses will continue to increase and, as a result, we will need to generate significant product revenues to achieve profitability. We may never achieve profitability.

 

Sources of Liquidity

 

Since our inception, substantially all of our operations have been financed through the sale of our common and preferred stock. Through March 31, 2006, we had received net proceeds of $3.5 million from the sale of common stock, $6.6 million from the sale of Series A preferred stock, $43.7 million from the sale of Series B preferred stock and $304,000 from the issuance of common stock to employees, consultants and directors in connection with the exercise of stock options. We have received additional funding through loans and capital equipment leases, as described below. We have also used our revenues to date as a source of additional liquidity. As of March 31, 2006, we had cash and cash equivalents of $7.4 million and debt under our notes payable and equipment loans of $770,000.

 

In June 2006, we entered into a Loan and Security Agreement with a financial institution to borrow a maximum of $5.0 million. The facility allows us to borrow a maximum of $2.8 million in working capital, $1.3 million in accounts receivable financing and $1.0 million in equipment financing, subject to certain conditions. In conjunction with this agreement, we agreed to issue warrants to purchase up to 300,000 shares of our Series B preferred stock at an exercise price of $4.50 per share. Warrants to purchase 215,000 shares were earned and exercisable at execution of the agreement, and warrants to purchase 85,000 shares will be earned on a pro rata basis upon our use of this facility. As of June 30, 2006, we had borrowed $4.2 million against this facility at an interest rate of 8.5%. Future draws under this facility will bear interest at prime plus one-half percent.

 

Cash Flows

 

As of March 31, 2006, we had $7.4 million in cash and cash equivalents, compared to $3.3 million at March 31, 2005. The increase was due primarily to the issuance of $27.0 million of preferred stock during the year ended March 31, 2006, partially offset by net losses from continuing operations of $21.1 million during the same period.

 

Net cash used in operating activities was $5.6 million, $13.5 million and $19.7 million in the years ended March 31, 2004, 2005 and 2006, respectively. Net cash used in each of these periods primarily reflects net loss for these periods, offset in part by non-cash charges in operating assets and liabilities, non-cash stock-based compensation and depreciation.

 

Net cash used in investing activities was $1.0 million, $1.1 million and $897,000 for the years ended March 31, 2004, 2005 and 2006, respectively. Cash was used primarily to invest in fixed assets and other capital expenditures to support increased personnel and manufacturing facility expansion in Europe and Mexico during the years ended March 31, 2004 and 2005. We expect to continue to make significant investments in the purchase of property and equipment to support our expanding operations.

 

Net cash provided by financing activities for the years ended March 31, 2004, 2005 and 2006 was $7.3 million, $17.2 million and $26.6 million, respectively. This increase was primarily attributable to the sale of preferred stock, which generated $6.6 million, $16.7 million and $27.0 million for the years ended March 31, 2004, 2005 and 2006, respectively, and common stock, which generated $203,000 for the year ended March 31, 2004. In addition, net proceeds from debt financing added $574,000, $1.2 million and $257,000 for the year ended March 31, 2004, 2005 and 2006, respectively. Debt financing consisted primarily of notes payable to individuals and secured notes issued to finance the purchase of capital equipment and corporate insurance premiums.

Contractual Obligations

 

As of March 31, 2006, we had contractual obligations as follows (long-term debt and capital lease amounts include principal payments only):

 

 

We have leases covering approximately 31,000 square feet of office and manufacturing space in Petaluma, California, expiring in 2006, approximately 19,000 square feet of office and manufacturing space in Sittard, The Netherlands expiring in 2009, and approximately 12,000 square feet of office and manufacturing space and 5,000 square feet of warehouse space in Zapopan, Mexico, expiring in 2011 and 2007, respectively.

 

We do not have any off-balance sheet arrangements as such term is defined in rules promulgated by the SEC.

 

Operating Capital and Capital Expenditure Requirements

 

We expect to continue to incur substantial operating losses in the future and to make capital expenditures to support the expansion of our research and development programs and to expand our commercial operations. We anticipate using a portion of the proceeds from this offering to finance these activities. It may take several years to obtain the necessary regulatory approvals to commercialize Microcyn as a drug in the United States.

 

We expect to use the net proceeds from this offering to fund approximately $      million in expenses related to the expansion of our sales and marketing capabilities, including the expansion of our direct sales forces in the United States, Europe and Mexico, approximately $      million to fund clinical trials and related research, approximately $      million to expand our manufacturing facilities and the remaining proceeds for general corporate purposes, including working capital. A portion of the net proceeds may also be used to acquire or invest in complementary businesses, technologies, services or products. The amount and timing of actual expenditures may vary significantly depending upon the rate of growth, if any, of our business, the amount of cash generated by our operations, status of our research and development efforts, competitive and technological developments and the amount of proceeds actually raised in this offering.

 

We currently anticipate that our cash and cash equivalents, together with proceeds from this offering and revenue generated by the sale of our products, will be sufficient to fund our operations for at least the next 12 months.

 

Our future funding requirements will depend on many factors, including:

 

 

 

If we are unable to generate a sufficient amount of revenue to finance our operations, research and development and regulatory plans, we may seek to raise additional funds through public or private equity offerings, debt financings, capital lease transactions, corporate collaborations or other means. We may seek to raise additional capital due to favorable market conditions or strategic considerations even if we have sufficient funds for planned operations. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. To the extent that we raise additional funds through collaborative arrangements, it may be necessary to relinquish some rights to our technologies or grant licenses on terms that are not favorable to us. We do not know whether additional funding will be available on acceptable terms, or at all. If we are not able to secure additional funding when needed, we may have to delay, reduce the scope of or eliminate one or more research and development programs or sales and marketing initiatives.

 

Recent Accounting Pronouncements

 

In Emerging Issues Task Force, or EITF, Issue No. 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share,” the EITF reached a consensus that contingently convertible instruments, such as contingently convertible debt, contingently convertible preferred stock and other such securities should be included in diluted earnings per share (if dilutive) regardless of whether the market price trigger has been met. The consensus became effective for reporting periods ending after December 15, 2004. The adoption of this pronouncement did not have material effect on our financial statements.

 

In May 2005, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3”, or SFAS 154. This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed.

 

APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this Statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. This Statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not believe that the adoption of SFAS 154 will have a significant effect on our financial statements.

 

On June 29, 2005, the EITF ratified Issue No. 05-2, “The Meaning of ‘Conventional Convertible Debt Instrument’ in EITF Issue No. 00-19, ‘Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”’ EITF Issue 05-2 provides guidance on determining whether a convertible debt instrument is “conventional” for the purpose of determining when an issuer is required to bifurcate a conversion option that is embedded in convertible debt in accordance with SFAS 133. Issue No. 05-2 is effective for new instruments entered into and instruments modified in reporting periods beginning

after June 29, 2005. We do not believe that the adoption of this pronouncement will have a significant effect on our financial statements.

 

In September 2005, the EITF ratified Issue No. 05-4, “The Effect of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject to EITF Issue No. 00-19, ‘Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock’. EITF 05-4 provides guidance to issuers as to how to account for registration rights agreements that require an issuer to use its “best efforts” to file a registration statement for the resale of equity instruments and have it declared effective by the end of a specified grace period and, if applicable, maintain the effectiveness of the registration statement for a period of time or pay a liquidated damage penalty to the investor. We are currently in the process of evaluating the effect that the adoption of this pronouncement may have on our financial statements.

 

In September 2005, the FASB ratified the EITF Issue No. 05-7, “Accounting for Modifications to Conversion Options Embedded in Debt Instruments and Related Issues,” which addresses whether a modification to a conversion option that changes its fair value affects the recognition of interest expense for the associated debt instrument after the modification and whether a borrower should recognize a beneficial conversion feature, not a debt extinguishment if a debt modification increases the intrinsic value of the debt (for example, the modification reduces the conversion price of the debt). This issue is effective for future modifications of debt instruments beginning in the first interim or annual reporting period beginning after December 15, 2005. We do not believe that the adoption of this pronouncement will have a significant effect on our financial statements.

 

In September 2005, the FASB also ratified the EITF’s Issue No. 05-8, “Income Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature,” which discusses whether the issuance of convertible debt with a beneficial conversion feature results in a basis difference arising from the intrinsic value of the beneficial conversion feature on the commitment date, which is treated and recorded in the shareholder’s equity for book purposes, but as a liability for income tax purposes, and, if so, whether that basis difference is a temporary difference under FASB Statement No. 109, “Accounting for Income Taxes.” This Issue should be applied by retrospective application pursuant to Statement 154 to all instruments with a beneficial conversion feature accounted for under Issue 00-27 included in financial statements for reporting periods beginning after December 15, 2005. We do not believe that the adoption of this pronouncement will have a significant effect on our financial statements.

 

In February 2006, the FASB issued SFAS No. 155 “Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140”, or FAS 155. FAS 155 addresses the following: a) permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133; c) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and e) amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We are currently evaluating the requirements of FAS 155, but do not expect that the adoption of this pronouncement will have a material effect on our financial statements.

 

In March 2006, the FASB issued SFAS 156 — “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140,” or SFAS 156. SFAS 156 is effective for the first fiscal year beginning after September 15, 2006. SFAS 156 changes the way entities account for servicing assets and obligations associated with financial assets acquired or disposed of. We have not yet completed our evaluation of the impact of adopting SFAS 156 on our results of operations or financial position, but do not expect that the adoption of SFAS 156 will have a material impact.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on our consolidated financial statements upon adoption.

 

Income Taxes

 

Since inception, we have incurred operating losses and, accordingly, have not recorded a provision for income taxes for any of the periods presented. As of March 31, 2006, we had net operating loss carryforwards for federal, state and foreign income tax purposes of approximately $28.8 million, $25.9 million and $17.4 million, respectively. The carryforwards expire beginning 2020, 2010 and 2014, respectively. We also had, as of March 31, 2006, federal and state research credit carryforwards of approximately $104,000 and $108,000, respectively. The federal credits expire beginning 2026, and the state credits have no expiration.

 

We have experienced substantial ownership changes in connection with financing transactions completed through the year ended March 31, 2006. Accordingly, our utilization of net operating loss and tax credit carryforwards against taxable income in future periods, if any, is subject to substantial limitations under the Change in Ownership rules of Section 382 of the Internal Revenue Code. After considering all available evidence, we have fully reserved for these and other deferred tax assets since it is more likely than not such benefits will not be realized in future periods. We will continue to evaluate our deferred tax assets to determine whether any changes in circumstances could affect the realization of their future benefit. If it is determined in future periods that portions of our deferred income tax assets satisfy the realization standard of SFAS No. 109, the valuation allowance will be reduced accordingly.

 

Quantitative and Qualitative Disclosures About Market Risk

 

Market risk represents the risk of changes in the value of market risk sensitive instruments caused by fluctuations in interest rates, foreign exchange rates and commodity prices. Changes in these factors could cause fluctuations in our results of operations and cash flows.

 

Our exposure to interest rate risk is confined to our excess cash in highly liquid money market funds. The primary objective of our investment activities is to preserve our capital to fund operations. We also seek to maximize income from our investments without assuming significant risk. We do not use derivative financial instruments in our investment portfolio. Our cash and investments policy emphasizes liquidity and preservation of principal over other portfolio considerations.

 

We have operated primarily in the United States; however we do have two significant subsidiaries, one each in Europe, and Mexico. In order to mitigate our exposure to foreign currency rate fluctuations, we maintain minimal cash balances in the foreign subsidiaries. However, if we are successful in our efforts to grow internationally, our exposure to foreign currency rate fluctuations, primarily the Euro and Mexican Peso, may increase. We are exposed to foreign currency risk related to the Euro denominated and Mexican Peso denominated intercompany receivables. Because our intercompany receivables are accounted for in Euros and Mexican Pesos, any appreciation or devaluation of the Euro or Mexican Peso will result in a gain or loss to the consolidated statements of operations.

 

Overview

 

We develop, manufacture and market a family of products intended to prevent and eliminate infection in chronic and acute wounds. Infection is a serious potential complication in both chronic and acute wounds, and controlling infection is a critical step in wound healing. Our platform technology, called Microcyn, is a non-toxic, super-oxidized water-based solution that is designed to eliminate a wide range of pathogens, including viruses, fungi, spores and antibiotic resistant strains of pathogens such as Methicillin-resistant Staphylococcus aureus, or MRSA, and Vancomycin-resistant Enterococcus, or VRE. In clinical testing, our products eliminated a wide range of pathogens and were found to be safe, easy to use and complementary with most existing treatment methods in wound care. Our experience and clinical data indicate that the use of Microcyn may shorten hospital stays, lower aggregate patient care costs and, in certain cases, reduce the need for systemic antibiotics. Microcyn also has applications in several other large consumer and professional markets, including hard surface disinfectant, respiratory, dermatology, mold and atmospheric remediation and dental.

 

In 2004, chronic and acute wound care represented an aggregate of $9 billion in global product sales, of which $3.3 billion was spent for the treatment of skin ulcers, $1.5 billion to treat burns and $4.2 billion for the treatment of surgical and trauma wounds, according to Kalorama Information, a life sciences market research firm. Common methods of controlling infection, including topical antiseptics and antibiotics, have proven to be moderately effective in combating infection in the wound bed. However, topical antiseptics tend to inhibit the healing process due to their toxicity and may require specialized preparation or handling. Antibiotics can lead to the emergence of resistant bacteria, such as MRSA and VRE. Systemic antibiotics may not be effective in controlling infection in patients with disorders affecting circulation, such as diabetes, which are commonly associated with chronic wounds. As a result, no single treatment is used across all types of wounds and stages of healing.

 

We believe Microcyn provides significant advantages over current methods of care in the treatment of a wide range of chronic and acute wounds throughout all stages of treatment. These stages include debridement, cleaning, prevention and elimination of infection and wound moistening. We believe that Microcyn is the first topical product that eliminates a broad range of bacteria and other infectious microbes without causing toxic side effects on, or irritation of, healthy tissue. Unlike most antibiotics, Microcyn does not target specific strains of bacteria, a practice which has been shown to promote the development of resistant bacteria. Because our products are shelf stable and require no special preparation, they can be used in hospitals, clinics, burn centers, extended care facilities and in the home.

 

Our goal is to become a worldwide leader in wound care by establishing Microcyn as the standard of care for preventing and eliminating infection in chronic and acute wounds. We intend to seek regulatory clearances and approvals for, and to market, Microcyn worldwide. We initiated our commercial activities in Mexico, where, after receiving approval for the use of Microcyn as an antiseptic, disinfectant and sterilant, we began selling in July 2004. Since then, physicians in the United States, Europe and Mexico have conducted eleven physician clinical studies in which Microcyn eliminated infection in a variety of wounds, including hard-to-treat wounds such as diabetic ulcers and burns and, in some cases, reduced the need for systemic antibiotics. We used the data generated from some of these studies to support our application for the CE Mark for wound cleaning and reduction of infection, which we received in November 2004. To date, Microcyn has received three FDA 510(k) clearances for use as a medical device in wound debridement, lubricating, moistening and dressing. We expect to complete our pivotal clinical trial for pre-operative skin preparation in the third quarter of 2006 and intend to file a New Drug Application, or NDA, for the use of Microcyn as a pre-operative skin preparation in late 2006.

 

In addition, we intend to seek FDA approval for the use of Microcyn to eliminate infections and accelerate healing in wounds. We have established a protocol, based on comments from the FDA, for a Phase IIb clinical trial to be conducted in patients with diabetic foot ulcers and other open wounds comparing the clinical cure rates and healing time of wounds treated with Microcyn with those not treated with Microcyn. This clinical trial is scheduled to begin in late 2006 and is anticipated to last up to nine months.

We currently sell Microcyn in the United States through a four-person direct sales force and through one national and five regional distributors. In Europe, we have an eight-person direct sales force and exclusive distribution agreements with four distributors, all of which are experienced suppliers to the wound care market, with an aggregate combined sales force of over 25 full-time equivalent salespeople. In Mexico, we sell through a dedicated 75-person contract sales force, including salespeople, nurses and clinical support staff, and a network of distributors to both the public and private sector. The MOH, which approves product selection and procurement for government hospitals and healthcare institutions, has approved reimbursement for Microcyn. We plan to expand our direct sales force in the United States, Europe and Mexico to support our distribution network.

 

Industry Background

 

Wound Care Industry Overview

 

According to Medtech Insight, a Division of Windhover Information, there were over 90 million incidents of wounds in the United States during 2004. Of these, over six million were chronic wounds, including arterial, diabetic, pressure and venous ulcers. The remaining 84 million were acute wounds, which follow the normal process of healing and commonly include burns, traumatic wounds, and approximately 67 million surgical incisions.

 

Key trends in wound care include:

 

 

Wound care is complex, and controlling infection is a critical step in wound healing. Difficult-to-heal wounds can result from traumatic injury, diabetes, peripheral vascular disease, complications following surgery, rheumatoid arthritis, congestive heart failure, arterial or venous ulcers and many other conditions which compromise circulation. Without proper medical intervention and control of infection, these types of wounds typically remain open and chronically infected.

 

Chronic Wounds

 

Chronic wounds are wounds that do not heal within a normally expected time frame under standard care. The most frequently occurring chronic wounds are venous, arterial, pressure and diabetic foot ulcers. According to Medtech Insight, in 2004, the incidence of chronic wounds in the United States was approximately 6.1 million, comprised of 2.0 million pressure ulcers, 1.7 million arterial ulcers, 1.6 million venous ulcers and 800,000 diabetic foot ulcers. In addition to being expensive to treat, chronic wounds are debilitating, painful and can result in amputations and other serious consequences. Clinical studies suggest that, depending on the severity of the wound, up to 43% of patients with diabetic foot ulcers undergo an amputation. Furthermore, the five year survival rate for patients undergoing amputations is 20%.

 

The increasing incidence of chronic wounds is driven by the large and growing elderly, diabetic and obese populations.

 

Aging.  People aged 65 and over are more susceptible to wounds that become chronic than the overall population. In 2006, there were more than 37 million people in the United States over 65, representing more

than 12% of the population. By 2030, this group is expected to comprise more than 19% of the total population of the United States, according to U.S. Census Bureau projections. Furthermore, according to the Centers for Disease Control and Prevention, or CDC, the incidence of diabetes is significantly higher in people over 65: in 2004, 16% of people over 65 were diabetic compared to 7.5% of the total population. Additionally, according to Medtech Insight, 70% of the pressure ulcers occur in people age 70 years or older and 25% of patients in nursing homes suffer from pressure ulcers.

 

Diabetes.  Diabetics are particularly vulnerable to chronic wounds as a result of the debilitating effect of diabetes on the circulatory system. According to CDC, one of three children born in 2000 in the United States will develop diabetes. There are currently approximately 14.7 million diabetic Americans, representing 5% of the total population, up from 2.7% in 1990.

 

Obesity.  Obesity is a leading cause of Type II, or “adult onset,” diabetes, making the obese population more likely to eventually sustain chronic wounds. Obesity in the United States is a growing problem. According to the National Institute of Diabetes and Digestive and Kidney Diseases in 2000, more than 30% of the United States population was obese, up from 13% in 1960.

 

Acute Wounds

 

Acute wounds are typically caused by traumatic injury or surgical incision and are broadly categorized as those that can be expected to heal within a definable timeframe. However, the healing process may be affected by complicating factors such as infection, leading to chronic wounds.

 

All acute wounds have the potential for infection and may require prophylactic treatment to prevent infection. According to Medtech Insight, in 2004, about 16.2 million traumatic wounds were treated, including 8.7 million open wounds. Also according to Medtech Insight, in 2004, approximately 67 million surgical wounds were reported in the United States, including 36 million completed under anesthesia. Despite modern infection control procedures, and technologies at hospitals and surgery centers, every time the skin is opened there is a risk of infection. We believe that there is a higher likelihood of infection in surgeries involving anesthesia because of the length of time the wound is open. In a clinical study on surgical infections, it was shown that infection rates vary with the time required to complete the surgery. For example, infection rates varied from about 3.6% for surgeries taking less than 30 minutes to about 16.4% for those longer than 5 hours.

 

Critical Steps for Wound Treatment

 

Infection Control

 

One out of every 20 patients contracts an infection while in the hospital. Certain infections are increasingly dangerous because they cannot be effectively controlled by commonly used antibiotics. According to industry estimates, infections add more than $30 billion annually to health care costs in the United States. In addition, each year in the United States, approximately two million patients contract infections while in hospitals and, of those, an estimated 100,000 die as a result. According to a recent study, patients with surgical site infections incur almost triple the average hospital costs of other patients. Surgical site infections account for approximately 500,000 hospital acquired infections in the United States each year, according to CDC. Surgical site infections are estimated to cost hospitals more than $1.0 billion each year in additional medical treatment.

 

Staphylococcus aureus, or Staph, is one of the most common hospital acquired infections. One of the deadliest forms of Staph infection is MRSA. According to data from CDC, in 2003, 57% of the Staph infections reported were MRSA, up from 22% in 1995 and 2% in 1974. Patients who do survive MRSA often spend months in the hospital and endure repeated surgeries to remove infected tissue.

 

When infection is present in a wound, standard treatments can include cleansing, debridement and systemic antibiotics. Many cleansing agents can harm tissue, causing irritation and sensitization and impeding the wound healing process. Some forms of debridement may increase scar tissue and complicate skin grafting. Systemic antibiotics may be ineffective if the patient’s metabolic state is compromised. Additionally,the

efficacy of oral or systemic antibiotics in diabetic foot ulcer patients may be diminished due to the patient’s poor circulation, limiting delivery of the antibiotics to the wound site.

 

Because there is a risk of infection with many surgical procedures, clinicians perform several procedures before and after surgery designed to prevent infection. Pre-operative procedures generally involve preparing the surgical site with an anti-bacterial agent, such as Betadine. Post-operative procedures can include an anti-infective irrigation, a body cavity lavage and the use of systemic antibiotics.

 

     Wound Healing and Closure

 

Wound healing is a cascade process comprised of inflammation, proliferation and maturation. The first stage of the wound healing is the inflammatory phase, which is associated with swelling, redness and heat, and involves the migration of healthy cells to the wound bed. Removing dead tissue or debris from the wound prepares the wound bed for regeneration of new tissue. The second phase is the proliferative phase, which involves collagen synthesis, formation of blood vessels and tissue growth. The final phase, maturation, occurs as the wound begins to take on its permanent form as collagen undergoes remodeling, forming new skin. None of these phases, however, will progress normally in the presence of infection.

 

     Advanced Technologies

 

Techniques and devices have been developed to treat complex and hard-to-treat wounds, ranging from specialized devices to antimicrobial dressings. Negative pressure wound therapy, hyperbaric oxygen chambers and localized devices, sophisticated water-based debriders, oxygenated mist devices and tissue engineered skin substitutes are some of the most advanced devices available to the wound care specialist. Although relatively effective, many of these treatments have limitations or drawbacks in that they cannot be used on certain types of wounds or are expensive and complex to use. Despite these advanced technologies, treatment of challenging wounds continues to be multi-modal, with a number of adjunctive therapies employed in an attempt to achieve wound closure.

 

     Market Opportunity — Key Limitations of Existing Treatments

 

Commonly used topical antiseptics and antibiotics have limitations and side effects that may constrain their usage. For example:

 

 

Our Solution

 

We believe Microcyn provides significant advantages over current methods of care in the treatment of chronic and acute wounds, including the following:

 

 

 

Our Strategy

 

Our goal is to become a worldwide leader in wound care by establishing Microcyn as the standard of care for preventing and eliminating infection in chronic and acute wounds throughout all stages of treatment. We also intend to leverage our expertise in wound care into additional market opportunities. The key elements of our strategy include the following:

 

 

We believe our products are well positioned to become the standard of care in preventing and eliminating infection. We seek to drive adoption of Microcyn as the standard of care in the wound care market through data from physician clinical studies, clinical trials and key opinion leader programs. We intend to continue to maintain a marketing presence in key medical communities throughout the world through targeted direct marketing and sponsorships of physician presentations at medical conferences and seminars.

 

 

We intend to seek additional regulatory approvals, which we believe will allow us to accelerate adoption of our products by wound care specialists worldwide. We expect to complete our pivotal clinical trial for pre-operative skin preparation in the third quarter of 2006 and, if the results are positive, intend to file an NDA for use of Microcyn as a pre-operative skin preparation in late 2006. In addition, we have developed a protocol, based on comments from the FDA, for a Phase IIb trial to be conducted in subjects with diabetic foot ulcers and other open wounds comparing the healing time of wounds treated with Microcyn with those not treated with Microcyn. This clinical trial is intended to support the safety as well as the efficacy of Microcyn for infection control and wound healing.

 

 

We intend to expand our direct sales force and distribution networks in the United States, Europe and the rest of the world. In the United States, Europe and Mexico, we sell our products through distribution networks supported by our direct sales force. We have distribution agreements for our products in India, Southeast Asia and the Middle East. We select distributors based on their demonstrated expertise in selling to wound care professionals and facilities.

 

 

We believe our products are compatible with and enhance the efficacy of a variety of existing wound care treatment methods including negative pressure wound therapy, pulse and jet lavage and tissue engineered skin substitutes. Combining Microcyn with these therapies has improved their efficacy in

eliminating infection, as demonstrated in physician clinical studies. We believe combination treatment methods to eliminate infection are gaining acceptance by wound care professionals and may prove to be clinically and commercially attractive.

 

 

We intend to pursue strategic relationships with respect to both product development and distribution. To accelerate adoption of our products, we may enter into strategic relationships with healthcare companies that have product lines or distribution channels that are complementary to ours. These relationships may take the form of co-promotion agreements, distribution agreements or joint ventures. In addition, we may expand our offerings of new products or technologies through acquisitions or licensing agreements.

 

 

We believe our products have applications in several other large consumer and professional markets, including the hard surface disinfectant, respiratory, dermatology, veterinary, mold and atmospheric remediation and dental markets. We intend to access these markets through strategic partnerships or joint ventures. To date, we have entered into distribution agreements in the hard surface disinfectant, veterinarian and mold and atmospheric remediation markets.

 

Our Products — Microcyn Platform

 

The following are products we currently offer:

 

 

Mechanism of Action

 

We believe Microcyn’s ability to prevent and eliminate infection is based on its uniquely engineered chemistry. Laboratory studies conducted on Microcyn show that it reduces various bacteria, spores, fungi and viruses. Unlike current treatments, physician clinical studies indicate that Microcyn does not cause adverse effects on human tissue. We believe this is due to the specialized combination of oxidizing chemical species produced through our proprietary process of electrolyzation. Our laboratory studies suggest that Microcyn reacts with and damages the cell wall of the organism, causing rupture of the cell. Laboratory and physician clinical studies suggest that this process destroys only single cell organisms such as bacteria, spores, fungi and viruses.

 

This rupture of the cell wall appears to occur through a fundamentally different process than that which occurs as a result of contact with chlorine-based solution because experiments have confirmed that Microcyn kills chlorine-resistant bacteria.

 

In laboratory tests, Microcyn has been shown to eliminate certain biofilms. A biofilm is a complex aggregation of microorganisms or bacteria marked by the formation of a protective and adhesive matrix, allowing the bacteria to collect and proliferate. It is estimated that over 65% of microbial infections in the body involve bacteria growing as a biofilm. Bacteria living in a biofilm typically have significantly different properties from free-floating bacteria of the same species. One result of this film environment is increased resistance to antibiotics and to the body’s immune system. In chronic wounds, biofilms interfere with the normal healing process and halt or slow wound closure. In laboratory studies, Microcyn was shown to destroy two common biofilms after five minutes of exposure.

 

It is widely accepted that reducing inflammation surrounding an injury or wound is beneficial to wound healing. Our laboratory research indicates that Microcyn inhibits histamine production and cytokine release. These factors are critical components of the body’s natural inflammatory response to injury or wounds, as well as other conditions, such as rhinosinusitis. Inhibition of cytokine release blocks the initial stages of the inflammation process, in which cells (including mast cells) involved in triggering the inflammatory response are prevented from releasing the inflammation signal to the rest of the body. Our laboratory research suggests that Microcyn’s interference with these cells is selective to only the inflammation signaling pathway and does not interfere with other functions of these cells. Additionally, physician clinical studies suggest that Microcyn only inhibits this function in tissue that is directly exposed to the solution.

Clinical Trials and Physician Studies

 

     Current and Planned Trials

 

Pre-Operative Skin Preparation Trial.  In September 2005, we initiated our pivotal pre-operative skin preparation trial, using 64 healthy volunteers. Patients were selected for enrollment based on the presence of a baseline microbial load in specific areas of the body and received a Microcyn scrub in the same manner as preparation for surgery. The patients were evaluated for microbial load reduction at intervals throughout the day. The results of this trial are expected to be received in the third quarter of 2006. If the trial is successful, we anticipate filing our NDA with the FDA in late 2006. There can be no assurance that the outcome of the trial will be successful, and even if successful, the FDA may not agree with our interpretation of the data and may require additional pivotal trials.

 

Open Wound Trial.  We have established, based on comments from the FDA, the protocol for our Phase IIb clinical trial of Microcyn in patients with diabetic foot ulcers and other open wounds. This study will evaluate a total of approximately 160 patients in two groups of 80 patients each and is intended to assess clinical cure and wound healing time in open and infected wounds. We expect to begin enrollment in late 2006 and to complete this trial within nine month. The result will be used to determine the sample size of a subsequent Phase III pivotal trial, which we estimate may require up to 500 patients enrolled in 30 to 40 centers in the United States and Europe. The current FDA guidelines for this indication require only a single pivotal trial for marketing clearance although there is no guarantee that the FDA will not require us to conduct additional clinical studies in support of our NDA for this indication. The pivotal trial is intended to demonstrate safety and efficacy of Microcyn in eliminating infections in diabetic foot and venous stasis ulcers and deep wounds.

 

Physician Clinical Studies.  A number of other physician clinical studies are planned comparing the results of using Microcyn with the current standard of care. These studies are intended to provide supporting data as to microbial load reduction, healing time, eliminating infections, compatibility with dressings and devices, effects on blood flow, bone healing rates, the prevention of post-surgical complications, the prevention of intubation-related pneumonia and a reduction in the cost of care.

 

These physician clinical studies may provide supporting data for our applications for regulatory approval when they are conducted in strict compliance with the guidance on good clinical practices and meet other requirements of the regulatory authority. Based on the number of patients and variety of wound types treated, the safety data from these studies may allow us to truncate the FDA clinical trial process, which usually involves three phases of development. See “Business—Government Regulation—Pharmaceutical Product Regulation.” We believe these studies will be supportive of our future regulatory applications.

 

     Completed Trials and Studies

 

Physicians in the United States, Europe and Mexico have conducted eleven clinical studies of Microcyn, some sponsored by us and some physician initiated, generating data indicating that Microcyn is safe and effective for the indications under study and that it results in reduced costs to healthcare providers and patients.

 

Since there is not one universal standard of care in wound treatment, healthcare providers use many different devices, antiseptics, bandages and antibiotics to treat various types of wounds. For example, in the United States, a typical protocol for treatment of diabetic foot ulcers includes treatment with saline solution or topical antibiotics as an infection control agent, whereas the typical protocol for diabetic foot ulcers in Europe often includes treatment with Betadine. Efforts to change formal or favored protocols meet with resistance unless clear evidence of greater safety, superior efficacy, reduction in cost, or other benefits is demonstrated.

 

Dr. David E. Allie, a cardiovascular surgeon and head of the Cardiovascular Institute of the South in Lafayette, Louisiana and a member of our Business and Medical Advisory Board, completed a retrospective study in January 2006 comparing the use of Microcyn on 60 patients to a comparable matched control group. The study was designed to examine the effect on wound healing, limb salvage and skin irritation. The results of this study showed improvements in wound healing time and in rates of limb salvage. Furthermore, the

Microcyn group experienced no skin irritation while 13% of the patients in the control group did experience skin irritation. The following is a summary of those results:

 

 

Dr. Luca Dalla Paola, an Endocrinologist and surgeon and Chief of the Diabetic Foot Unit of Presidio Ospedaliero Abano Terme in Padova, Italy, conducted a controlled physician clinical study in Italy in November 2004 designed to assess the rate of elimination of infection when Microcyn was used on diabetic foot ulcers localized below the ankle. In the study, patients were treated daily using gauze soaked with Microcyn or Betadine. Microbiological specimens were taken at the time of the enrollment and weekly thereafter until wound closure occurred. The results showed that patients treated with Microcyn had less than one-third the strains of bacteria than those treated with Betadine. The following table summarizes the results of the study:

 

 

Dr. Alfredo Barrera, a gastrointestinal surgeon and head of the Department of Surgery at the Hospital Ruben Leñoro, Mexico, conducted a six-month controlled physician clinical study in Mexico in 2004. The study was designed to test microbial load reduction in patients with extensive abdominal peritonitis. In this study, patients were given a comprehensive therapy using saline solution lavage plus Microcyn or given the same comprehensive therapy with saline solution only, a widely used standard of care. Patients treated with Microcyn experienced greater microbial load reduction and shorter hospital stays. The following table summarizes the results of the study:

 

 

Dr. Ariel Miranda, a board certified plastic surgeon and Chief of the Burn Unit of the Civil Hospital of Guadalajara, Mexico, conducted a retrospective clinical study in Mexico in 2004, using Microcyn on pediatric burn patients. The study was designed to evaluate the rate of infection, the need for skin grafts and antibiotics, and the duration of hospital stays in pediatric burn patients. In this study, Dr. Miranda used Microcyn for initial debridement and to moisten the burn site for 5-15 minutes, three times a day until elimination of the infection. No gels or dressings were applied to the wound. An independent statistician reviewed and analyzed the results of this study and compared it to the results from burn patients treated by Dr. Miranda with silver sulfadiazine. The patients treated with Microcyn suffered no adverse effects or related complications. In addition, the use of Microcyn enabled Dr. Miranda to reduce the use of systemic antibiotics without the

development of infections. Dr. Miranda also noted that, due to the flexible and smooth quality of the healed skin, the patients treated with Microcyn needed less skin grafting. The following table summarizes the results of the independent statistician’s analysis of the study:

 

 

Seven additional physician clinical studies in the United States, Europe and Mexico have been completed using Microcyn to eliminate infection in a variety of different wounds, including diabetic foot and venous stasis ulcers and oral surgery.

 

In addition, there are several ongoing and planned physician clinical studies being conducted in the United States and Europe to assess Microcyn’s effectiveness in preventing and eliminating infection in wounds. For example, we are supporting with a research grant a study by Dr. David Armstrong of the Scholl College of Podiatric Medicine in Chicago, Illinois and Dr. Andrew Boulton, Head of the Manchester Diabetes Centre at the Manchester Royal Infirmary in the United Kingdom. This is a study of diabetic foot ulcers using the VersaJet lavage system in two groups of 20 patients each, one utilizing Microcyn and the other utilizing saline. The endpoints are microbial load reduction and time to complete wound healing. Dr. Dalla Paola is conducting a study involving 100 patients comparing Microcyn to Polyhexanid in the treatment of diabetic foot necrobiosis, with time to wound healing the primary endpoint. Dr. Tom Wolvos, a board certified surgeon who is the Medical Director at the Scottsdale Healthcare Wound Management Center in Arizona, is conducting a forty patient study comparing Microcyn to saline solution with the VAC Negative Pressure Wound Therapy system from Kinetic Concepts, Inc., in the treatment of a variety of wounds. Lastly, Cheryl Bongiovanni, Ph.D., Director of the Lake Wound Clinics in Lakeview, Oregon, is conducting two patient studies focusing on both the potential savings from the use of Microcyn in treating a variety of wounds as well as a 20 patient study comparing Microcyn with saline solution in the treatment of leg ulcers.

 

We provide financial support for some of these studies in the form of research funding, expense reimbursement and supply of product. In addition, Drs. Allie and Dalla Paola are members of our Physician Advisory Board. Dr. Dalla Paola is compensated $1,000 per month for his participation on this committee. Dr. Allie is a paid consultant, investor and stockholder. For additional information, please see “Management - Advisory Board Compensation.”

 

Regulatory Strategy

 

Our regulatory strategy is to seek the necessary clearances and approvals for Microcyn to accelerate its adoption by wound care specialists worldwide as the standard of care in preventing and eliminating infection throughout all stages of treatment. We intend to seek and obtain FDA approval of Microcyn as a topical antimicrobial to treat infected wounds. We expect to complete a pivotal pre-operative skin trial using 64 healthy volunteers in the third quarter of 2006 and expect to file an NDA for this indication in late 2006. Concurrently, we intend to apply for similar or expanded clearances in Europe and other parts of the world. In addition, we have developed a protocol, based on comments from the FDA, for a Phase IIb trial to be conducted in subjects with diabetic foot ulcers and other open wounds comparing the healing time of wounds treated with Microcyn with those not treated with Microcyn. This clinical trial is intended to support the safety as well as the efficacy of Microcyn in terms of rate of clinical cure and wound healing.

 

In November 2004, we received CE Mark approval to market and sell Microcyn in Europe as a wound care product as part of a comprehensive wound care treatment for microbial load reduction. We have obtained three 510(k) clearances for Microcyn as a medical device for moistening, cleansing, lubricating and debriding acute and chronic dermal lesions, such as stage IV pressure ulcers, stasis ulcers, diabetic ulcers, post-surgical

wounds, first and second degree burns, abrasions and minor irritations of the skin. Based on the CE Mark and FDA approvals, we filed for and received clearance to market Microcyn in India, Singapore and Pakistan.

 

Sales and Marketing

 

We are developing distribution and sales networks to market our products in the United States and Europe. We expect to expand our existing sales force in the United States, Europe and Mexico as we obtain additional regulatory claims. Our products are purchased by hospitals, physicians, nurses and other healthcare practitioners who are the primary caregivers to patients being treated for acute or chronic wounds as well as those patients undergoing surgical procedures.

 

Our strategy is to enter into agreements with established regional distributors, provide ongoing sales support and utilize clinical studies and key opinion leader programs to accelerate product adoption. Implementation of our strategy includes the development of relationships with wound care specialists through targeted direct marketing and communications programs and through sponsorship of physician presentations at medical conferences and seminars.

 

In the United States, we currently distribute our products through one national and five regional distributors and are actively recruiting additional distributors. We employ four full-time direct salespeople, in addition to our distributors, with marketing contacts in leading wound care clinics, hospitals and health care agencies that provide wound care services. We intend to hire additional salespeople in the United States beginning in the fourth quarter of 2006.

 

In Europe, we have distribution arrangements in Germany, Italy, Sweden and the Czech Republic with an aggregate of over 25 full-time equivalent salespeople focused on the sale of Microcyn and are actively pursuing additional distribution arrangements in other European countries. We currently have an eight-person direct sales force in our European regional sales office in The Netherlands, and intend to hire additional direct sales people to support our distributors.

 

In Mexico, we market our products through our established distribution network and direct sales organization. We have a dedicated 75-person sales force, including salespeople, nurses and clinical support staff responsible for selling Microcyn to over 250 private and public hospitals and to retail independent pharmacies.

 

We have established distributors for our disinfectant and wound care products in India, Bangladesh, Pakistan, Singapore, United Arab Emirates and Saudi Arabia. In December 2005, we entered into a distribution agreement with Alkem Laboratories, a large, privately-held pharmaceutical firm headquartered in Mumbai, India, employing more than 800 salespeople servicing the Indian healthcare market. In January 2006, the Indian Ministry of Health approved Microcyn for use in chronic and acute wounds, and we commenced sales to Alkem in April 2006.

 

In Canada, we are currently recruiting wound care specialty distributors and expect to commence product sales following receipt of our drug identification number from Canadian regulatory authorities. Sales in Canada are currently supported by one employee resident in our headquarters in Petaluma, California. We intend to hire two additional direct sales persons for Canada by the first quarter of 2007.

 

Other Market Opportunities

 

We believe our products have applications in several other large consumer and professional markets and intend to access these markets through strategic partnerships or joint ventures. These markets include:

 

     Hard Surface Disinfectant

 

In the United States, we obtained Environmental Protection Agency, or EPA, clearance for use of the Microcyn technology as a disinfectant in May 2004. Our product, Cidalcyn, is a hospital-grade multi-purpose disinfectant cleaner and food contact sanitizer used in patient care areas, households, child care facilities,

health clubs, laboratories and on food contact surfaces where cross-contamination of treated surfaces can occur.

 

According to Global Industry Analysts, Inc., the worldwide disinfectant market is estimated to be $1.7 billion, of which approximately $270 million is attributable to the United States. Disinfectants currently in the marketplace, such as bleach and ammonia, may have adverse effects after long-term use for the person applying the disinfectant, and there are other environmental, biodegradability and general concerns regarding toxicity. Most leading brands of disinfectant products are classified by the EPA as having a high level of toxicity and require appropriate warning statements. Based on the EPA toxicity categorization of antimicrobial products, Cidalcyn received the lowest toxicity rating and, as a result, precautionary labeling statements are not required.

 

In December 2005, we entered into an exclusive distribution agreement with a leading manufacturer of wet wipes and moist towelette products for the consumer, food service and healthcare industries. The distribution agreement allows our distributor to market, sell and distribute our hard-surface disinfectant products under the distributor’s private label in the United States, Canada, Caribbean and Latin America, excluding Mexico. We expect our distributor to launch this product in the fourth quarter of 2006.

 

     Respiratory

 

Our nasal product candidate is an anti-microbial solution designed to be self-administered into a patient’s nasal cavity for the treatment of chronic rhinosinusitis. In animal studies, it has been shown to kill the bacteria that causes rhinosinusitis. We are currently conducting pre-clinical animal studies seeking to support efficacy and safety and intend to seek FDA approval once clinical trials are successfully completed for this product and indication.

 

Rhinosinusitis, or inflammation of the nasal sinuses, affects an estimated 35 million Americans. There is no FDA-approved therapy for chronic rhinosinusitis. Most treatment methods have focused on the symptoms of the disease and include the use of antibiotics, antihistamines, corticosteroids and sinus surgery.

 

     Dermatology

 

We are developing dermatology-focused product candidates using our Microcyn technology for the treatment of various fungal and bacterial skin infections, including:

 

 

Our dermatology product candidates will be administered in a liquid suspension and a gel formulation. In laboratory and clinical tests, our anti-fungal product candidates were effective in treating these fungal infections without the need for long-term exposure to systemic antibiotics. We intend to seek FDA approval to sell our dermatology products by prescription and over-the-counter.

 

Despite the significant sales of prescription products for treatment of diseases of the skin, we believe that many serious limitations remain in the treatment of these diseases. Existing treatments are often inadequate for reasons of efficacy, toxicity or patient noncompliance.

 

     Veterinary Medicine

 

Our animal wound care product, Vetericyn, was launched in late 2004 and is currently available for purchase by veterinarians through MWI Veterinary Supply, Inc., a distributor of animal health products. Veterinarians in the United States use Vetericyn in a variety of applications, including, for example, to treat hard-to-heal equine wounds. We believe a non-toxic wound spray or gel that is safe for use in animals has

wide application. According to the American Veterinary Medical Association, as of December 31, 2005, there were more than 54,000 veterinarians in private practice in more than 27,000 veterinary practices nationwide.

 

     Mold and Atmospheric Remediation

 

We plan to commercialize our Microcyn technology in liquid and mist form for the industrial and residential remediation markets. Tests have shown that our Microcyn products are non-irritating and non-sensitizing to humans and yet contain ingredients with potent kill times. Our products are safe, non-corrosive, non-flammable and easy to use, requiring no significant training or experience. In addition, unlike other competitive products, Microcyn does not need to be removed after application, thereby saving time and labor costs. Our Microcyn products have been granted the lowest class EPA toxicity rating and are therefore safe to use to remediate blackwater, mold and other household and industrial damage due to flooding.

 

Recent scientific data suggests an association between exposure to mold or damp indoor environments and the development of cough and upper respiratory tract symptoms, wheezing, and asthma symptoms in sensitized persons.

 

In July 2005, we entered into a license agreement with a provider of restoration and remediation services in Canada, for the restoration of residential, commercial, industrial and business property damaged by fire, flood and wind. We expect to begin commercializing this product following receipt of appropriate regulatory approvals.

 

     Dental and Oral Care

 

We are developing an oral rinse and antimicrobial toothpaste for the oral care market. Based on data from the Freedonia Group, the U.S. market for mouthwash and dental rinse products was $600 million in 2003. Our oral rinse product candidate is expected to compete with consumer oral rinses, such as Listerine, Scope and Cepacol, and prescription rinses, such as Peridex and Perigard. Our Microcyn oral rinse product candidate has been tested in clinical studies and shown to be safe for use in oral surgery. We intend to seek FDA approval to market our dental and oral care product either by prescription or over-the-counter as FDA designates.

 

Research and Development

 

The goals of our research and development program are to design, develop and produce products to treat acute and chronic wounds, and to identify new applications for our technology. Our research and development efforts are divided into three areas: science, new product development and engineering.

 

Our scientists work to continually improve our product performance by evaluating variations of the formulations and chemical structures of our products. For example, we are evaluating alterations to Microcyn to increase the speed at which it kills certain bacteria and viruses.

 

The focus of our current development efforts is new formulations, applications and delivery systems for Microcyn, including the following:

 

 

 

Our engineers seek to optimize our manufacturing process by reducing costs and increasing yield. For example, we have significantly decreased the waste product resulting from our manufacturing process, and we continue to experiment to find ways of decreasing it further.

 

We also intend to develop other products for use in non-medical markets based on our core technology and intellectual property portfolio. These potential products include the following:

 

 

We also intend to focus efforts on our L3 anti-viral compound for the treatment of early stage cancers, initially targeting cervical dysplasia. Based on our research, L3 has inhibited the growth of certain cancer cells in preclinical studies.

 

As of May 31, 2006, we had nine full-time employees engaged in research and development activities. Our director of research and development coordinates all such activities. We plan to increase our research and development staff in the future to address market demands identified in our direct market research and to expand our product line by using our Microcyn technology in different medical and non-medical applications.

 

Manufacturing

 

We manufacture Microcyn through a proprietary electrolysis process within a multi-chamber system. We are able to control the passage of ions through proprietary membranes, yielding electrolyzed water with only trace amounts of chlorine. This process is fundamentally different from the processes for manufacturing hydrogen peroxide and bleach and is the basis for our technology’s efficacy and safety.

 

We manufacture our products in Petaluma, California, Sittard, The Netherlands and Zapopan, Mexico. We have developed an automated manufacturing process and conduct quality assurance testing on each production batch in accordance with current U.S. Good Manufacturing Practices, or cGMP. Our manufacturing process produces very little waste, which is disposed of as water after a simple non-toxic chemical treatment. Our facilities are required to meet and maintain regulatory standards applicable to the manufacture of products. Our United States and Netherlands facilities are ISO 13485 certified and comply with cGMP guidelines. Our Mexico facility has been approved by the MOH.

 

Our machines are subjected to a series of tests, which is part of a validation protocol mandated by cGMP and ISO requirements. This validation is designed to ensure that the final product is manufactured with the same level of consistency and quality in all manufacturing sites, and includes the testing of all internal and external components, mechanical and electrical parts and the software in each machine. Certain materials used in manufacturing our machines are proprietary.

 

We believe we have a sufficient number of machines to produce Microcyn as required to meet anticipated future requirements for at least the next two years. As we expand into other geographic markets, we may establish additional manufacturing facilities in or near new markets.

 

Intellectual Property

 

Our success depends in part on our ability to obtain and maintain proprietary protection for our product technology and know-how, to operate without infringing proprietary rights of others, and to prevent others

from infringing our proprietary rights. We seek to protect our proprietary position by, among other methods, filing, when possible, U.S. and foreign patent applications relating to our technology, inventions and improvements that are important to our business. We also rely on trade secrets, know-how, continuing technological innovation, and in-licensing opportunities to develop and maintain our proprietary position.

 

In March 2003, we obtained an exclusive license to six issued Japanese patents and five Japanese published pending patent applications owned by Coherent Technologies, or Coherent. The issued Japanese patents and pending Japanese patent applications relate to an early generation of super-oxidized water product and aspects of the method and apparatus for producing Microcyn and will expire between 2011 and 2014. In June 2006, we received written notice from Coherent advising us that the patent license was terminated, citing various reasons with which we disagree. Although we do not believe Coherent has grounds to terminate the license, we may have to take legal action to preserve our rights under the license and to enjoin Coherent from breaching its terms. We do not know whether we would prevail in any such action, which would be costly and time consuming, and we could lose our rights under the license, which could have a material adverse impact on our business opportunities in Japan. In addition, we may have to defend ourselves against infringement claims from Coherent in Japan based on their position on termination of the license. We do not believe the Japanese patents disclose or cover certain innovations in our products, which we developed independently and are the subject of our own patent applications.

 

As of May 31, 2006, we had twelve U.S. pending patent applications and fifteen foreign pending patent applications. These applications include U.S. provisional applications for which the one-year period to file a non-provisional application has not yet expired as well as international PCT applications that have not yet reached the deadline to file corresponding national phase applications. Our portfolio of pending applications can be divided into two groups. The first group includes three U.S. and seven foreign patent applications that relate to early generation super-oxidized water product, methods of using super-oxidized water, and aspects of the method and apparatus for manufacturing super-oxidized water. We have received a Notice of Allowance from the U.S. Patent and Trademark Office for one of our pending U.S. applications in this group. Before a patent may issue, a second review of our application must be completed. The second group includes nine U.S. and eight foreign applications that relate to Microcyn, the method and apparatus for manufacturing Microcyn, and its uses.

 

Although we work to protect our technology, we cannot assure you that any patent will issue from currently pending patent applications or from future patent applications. We also cannot assure you that the scope of any patent protection will exclude competitors or provide competitive advantages to us, that any of our patents will be held valid if subsequently challenged, or that others will not claim rights in or ownership of our patents and proprietary rights. Furthermore, we cannot assure you that others have not developed or will develop similar products, duplicate any of our products or design around our patents.

 

We have also filed for trademark protection for marks used with our Microcyn products in each of the United States, Europe, certain countries in Central and South America, including Mexico and Brazil, Latin America, certain countries in Asia, including Japan, China and the Republic of Korea, and Australia.

 

In addition to patents and trademarks, we rely on trade secret and other intellectual property laws, nondisclosure agreements and other measures to protect our intellectual property rights. We believe that in order to have a competitive advantage, we must develop and maintain the proprietary aspects of our technologies. We require our employees, consultants and advisors to execute confidentiality agreements in connection with their employment, consulting or advisory relationship with us. We also require our employees, consultants and advisors who we expect to work on our products to agree to disclose and assign to us all inventions made in the course of our working relationship with them, while using our property or which relate to our business. Despite any measures taken to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products or to wrongfully obtain or use information that we regard as proprietary.

Competition

 

We believe the principal competitive factors in our target market include improved patient outcomes, such as time in the hospital, healing time, adverse events, safety of products, ease of use, stability, spore killing and cost effectiveness. The medical device industry, and in particular the wound care market, is highly competitive. We compete with a number of large well-established and well-funded companies that sell a broad range of wound care products, including topical anti-infectives and antibiotics, as well as some advanced wound technologies, such as skin substitutes, growth factors and sophisticated delayed release silver-based dressings. Kinetic Concepts, Inc., Smith & Nephew plc, Johnson & Johnson, Healthpoint, Ltd., a subsidiary of DFB Pharmaceuticals Inc., Kendall, a division of Tyco International Ltd., ConvaTec, a division of Bristol-Myers Squibb Company and Coloplast Ltd. have a wide range of product offerings for the wound market. Collectively, these companies have a substantial share of the wound care market. Several large well-funded drug companies also develop and sell topical antibiotics.

 

Our competitors enjoy several competitive advantages, including:

 

 

While many companies are able to produce oxidized water, their products, unlike ours, are typically stable for not more than 48 hours, have an acidic pH, which irritates the skin and has a much higher chlorine content. One such company, PuriCore, sells electrolysis machines used to manufacture brine-based oxidized water primarily as a sterilant.

 

Our products compete with a large number of products that include over-the-counter treatments and prescription drugs, including topical anti-infectives, such as Betadine, silver sulfadiazine, hydrogen peroxide, Dakin’s solution, hypochlorous acid, and topical antibiotics, such as Neosporine and Bacitracin. Currently, no single anti-infective product dominates the chronic or acute wound markets because many of the products have serious limitations or tend to inhibit the wound healing process.

 

Our products can also replace the use of sterile saline for debriding and moistening a dressing as well as for use as a complementary product with many advanced wound care technologies, such as the VAC from Kinetic Concepts Inc., skin substitute products from Smith & Nephew, Integra Life Sciences, Life Cell, Organogenesis and Ortec International, and ultrasound from Celleration. We believe that Microcyn can enhance the effectiveness of many of these advanced wound care technologies. Because Microcyn is competitive with some of the large wound care companies’ products and complementary with others, we may compete with such companies in some product lines and complement other product lines.

 

Government Regulation

 

Government authorities in the United States at the federal, state and local levels and foreign countries extensively regulate, among other things, the research, development, testing, manufacture, labeling, promotion, advertising, distribution, sampling, marketing, and import and export of pharmaceutical products, biologics and medical devices. All of our products in development will require regulatory approval by government agencies prior to commercialization. In particular, human therapeutic products are subject to rigorous pre-clinical and clinical trials and other approval procedures of the FDA and similar regulatory authorities in foreign countries. Various federal, state, local and foreign statutes and regulations also govern testing,

manufacturing, safety, labeling, storage and record-keeping related to such products and their marketing. The process of obtaining these approvals and the subsequent process of maintaining substantial compliance with appropriate federal, state, local, and foreign statutes and regulations require the expenditure of substantial time and financial resources. In addition, statutes, rules, regulations and policies may change and new legislation or regulations may be issued that could delay such approvals.

 

     Medical Device Regulation

 

New medical devices, such as Microcyn, are subject to FDA approval and extensive regulation under the FDCA. Under the FDCA, medical devices are classified into one of three classes: Class I, Class II or Class III. The classification of a device into one of these three classes generally depends on the degree of risk associated with the medical device and the extent of control needed to ensure safety and effectiveness.

 

Class I devices are those for which safety and effectiveness can be assured by adherence to a set of general controls. These general controls include compliance with the applicable portions of the FDA’s Quality System Regulation, which sets forth good manufacturing practice requirements; facility registration and product reporting of adverse medical events listing; truthful and non-misleading labeling; and promotion of the device only for its cleared or approved intended uses. Class II devices are also subject to these general controls, and any other special controls as deemed necessary by the FDA to ensure the safety and effectiveness of the device. Review and clearance by the FDA for these devices is typically accomplished through the so-called 510(k) pre-market notification procedure. When 510(k) clearance is sought, a sponsor must submit a pre-market notification demonstrating that the proposed device is substantially equivalent to a previously approved device. If the FDA agrees that the proposed device is substantially equivalent to the predicate device, then 510(k) clearance to market will be granted. After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or could require pre-market approval, or PMA.

 

Clinical trials are almost always required to support a PMA application and are sometimes required for a 510(k) pre-market notification. These trials generally require submission of an application for an investigational device exemption, or IDE. An IDE must be supported by pre-clinical data, such as animal and laboratory testing results, which show that the device is safe to test in humans and that the study protocols are scientifically sound. The IDE must be approved in advance by the FDA for a specified number of patients, unless the product is deemed a non-significant risk device and is eligible for more abbreviated investigational device exemption requirements.

 

Both before and after a medical device is commercially distributed, manufacturers and marketers of the device have ongoing responsibilities under FDA regulations. The FDA reviews design and manufacturing practices, labeling and record keeping, and manufacturers’ required reports of adverse experiences and other information to identify potential problems with marketed medical devices. Device manufacturers are subject to periodic and unannounced inspection by the FDA for compliance with the Quality System Regulation, current good manufacturing practice requirements that govern the methods used in, and the facilities and controls used for, the design, manufacture, packaging, servicing, labeling, storage, installation and distribution of all finished medical devices intended for human use.

 

If the FDA finds that a manufacturer has failed to comply or that a medical device is ineffective or poses an unreasonable health risk, it can institute or seek a wide variety of enforcement actions and remedies, ranging from a public warning letter to more severe actions such as:

 

 

 

The FDA also has the authority to require repair, replacement or refund of the cost of any medical device.

 

The FDA also administers certain controls over the export of medical devices from the U.S., as international sales of medical devices that have not received FDA approval are subject to FDA export requirements. Additionally, each foreign country subjects such medical devices to its own regulatory requirements. In the European Union, a single regulatory approval process has been created, and approval is represented by the CE Mark.

 

The Company is currently pursuing anti-microbial claims through the Center for Drug Evaluation and Research.

 

     Pharmaceutical Product Regulation

 

In the United States, the FDA regulates drugs under the Federal Food, Drug, and Cosmetic Act, or FDCA, and implementing regulations that are adopted under the FDCA. In the case of biologics, the FDA regulates such products under the Public Health Service Act. If we fail to comply with the applicable requirements under these laws and regulations at any time during the product development process, approval process, or after approval, we may become subject to administrative or judicial sanctions. These sanctions could include the FDA’s refusal to approve pending applications, withdrawals of approvals, clinical holds, warning letters, product recalls, product seizures, total or partial suspension of our operations, injunctions, fines, civil penalties or criminal prosecution. Any agency enforcement action could have a material adverse effect on us. The FDA also administers certain controls over the export of drugs and biologics from the U.S.

 

Under the U.S. regulatory scheme, the development process for new pharmaceutical products can be divided into three distinct phases: