10-Q 1 f67007e10-q.txt FORM 10-Q FOR QUARTERLY PERIOD ENDED SEPT.30, 2000 1 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q X Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2000 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from to Commission file number 0-19707 INNERDYNE, INC. (Exact name of Registrant as specified in its charter) DELAWARE 87-0431168 (State or other (I.R.S. Employer jurisdiction of Identification No.) incorporation or organization)

1244 REAMWOOD AVENUE, SUNNYVALE, CA 94089 (Address, including zip code, of principal executive offices) Registrant's telephone number, including area code: (408) 745-6010 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No [ ] The number of shares of Registrant's Common Stock issued and outstanding as of November 3, 2000 was 23,135,396. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 2 TABLE OF CONTENTS

3 PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS INNERDYNE, INC. CONDENSED BALANCE SHEETS ASSETS

*Condensed from audited financial statements. See accompanying notes to condensed financial statements. 2 4 INNERDYNE, INC. CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)

See accompanying notes to condensed financial statements. 3 5 INNERDYNE, INC. CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED)

See accompanying notes to condensed financial statements. 4 6 INNERDYNE, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying interim condensed financial statements and notes are unaudited, but in the opinion of management reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of such periods. The results of operations for any interim period are not necessarily indicative of results for the respective full year. These condensed financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) for the nine-month period ended September 30, 2000 should be read in conjunction with the audited financial statements and notes thereto and MD&A included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999. (2) INVENTORIES Inventories consist of the following:

(3) COMPREHENSIVE INCOME The Company adopted Statement of Financial Accounting Standard No.130 ("SFAS 130"), "Reporting Comprehensive Income," effective January 1, 1998. SFAS 130 establishes standards for reporting and display of comprehensive income and its components in financial statements. For the periods ended September 30, 2000 and 1999 comprehensive income was equal to the net income as presented in the accompanying statement of operations. (4) NET INCOME PER COMMON SHARE Basic net income per common share is the amount of income for the period available to each share of common stock outstanding during the reporting period. Diluted net income per common share is the amount of income for the period available to each share of common stock outstanding during the reporting period and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the period. 5 7 In calculating net income per common share, the net income was the same for both the basic and diluted calculation. Reconciliation between the basic and diluted weighted-average number of common shares for the three and nine-month periods ended September 30, 2000 and 1999 is summarized as follows:

Common stock equivalents of approximately 76,950 and 689,563 shares outstanding during the nine-month periods ended September 30, 2000 and 1999 that could potentially dilute basic earnings per share in the future were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for the period. (5) OPERATING SEGMENTS The Company operates in one line of business, the development and commercialization of access products for minimally invasive procedures. The Company has and/or is also pursuing licensing opportunities related to its proprietary radial dilation and biocompatible coating technologies. As such, the Company has only one reportable operating segment as defined by the Financial Accounting Standards Board Statement No. 131, Disclosures About Segments of an Enterprise and Related Information. (6) RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS No. 133"), that establishes new accounting and reporting standards for companies to report information about new accounting and reporting standards for companies to report information about derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. For a derivative not designated as a hedging instrument, changes in the fair value of the derivative are recognized in earnings in the period of change. The Company must adopt SFAS No. 133 by January 1, 2001. Management does not believe the adoption of SFAS No. 133 will have a material effect on the Company's results of operations, financial position or liquidity. 6 8 In December 1999, the Securities and Exchange Commission staff released Staff Accounting Bulletin No. 101, Revenue Recognition, ("SAB No. 101") to provide guidance on the recognition, presentation and disclosure of revenue in financial statements; however, SAB No. 101 does not change existing literature on revenue recognition. SAB No. 101 explains the staff's general framework for revenue recognition, stating that four criteria need to be met in order to recognize revenue. The four criteria, all of which must be met, are the following: o There must be persuasive evidence of an arrangement; o Delivery must have occurred or services must have been rendered; o The selling price must be fixed or determinable; and o Collectibility must be reasonably assured. The Company will adopt SAB No. 101 during the fourth quarter of 2000. The Company continues to evaluate the impact, if any, of SAB No. 101 and any possible, subsequent interpretations of SAB No. 101 on the Company's policies and procedures. The FASB issued Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation - an Interpretation of APB Opinion No. 25 (FIN No. 44) in March 2000. The interpretation clarifies the application of Opinion 25 for only certain issues such as the following: (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. The Company adopted FIN No. 44 during the third quarter of 2000. The adoption of this interpretation did not have a material effect on the Company's results of operations, financial position or liquidity. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Except for the historical information contained in this Quarterly Report on Form 10-Q, the matters discussed throughout this Quarterly Report on Form 10-Q are forward-looking statements that are subject to certain risks and uncertainties that could cause the actual results to differ materially from those projected. Factors that could cause actual results to differ materially include, but are not limited to, the impact of intense competition in the Company's market, the extent of market acceptance of the Company's StepTM family of products, the timely development and market acceptance of new products, the compliance of the Company's manufacturing facilities with Good Manufacturing Practices ("GMP") regulations, the continued acceptance of minimally invasive surgical ("M.I.S.") procedures, the Company's ability to further expand into international markets, present uncertainty and incremental expenses related to the pending stock tender offer for all of the Company's outstanding shares by an affiliate of Tyco International Ltd., public policy relating to healthcare reform in the United States and other countries, approval of the Company's products by government agencies such as the United States Food and Drug Administration (the "FDA") and the risks set forth in greater detail below under the heading "Additional Factors that May Affect Future Results", as well as those set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 1999 and included from time to time 7 9 in the Company's other Securities and Exchange Commission ("SEC") reports and press releases, copies of which are available from the Company upon request. The Company undertakes no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. INTRODUCTION On October 4, 2000, InnerDyne, Inc. (the "Company" or "InnerDyne") and Tyco International Ltd. ("Tyco") announced the execution of a definitive agreement covering the terms of a stock tender offer by an affiliate of Tyco for all of the outstanding shares of InnerDyne. The tender offer to InnerDyne stockholders, which includes and is subject to customary representations and conditions, including regulatory reviews and clearances, was initiated on October 18, 2000. The Company's Board of Directors have unanimously recommended that stockholders tender their shares according to the terms of the tender offer. If a majority of InnerDyne shares are tendered, and assuming no unanticipated delays are encountered, the change in ownership is likely to occur during the fourth quarter of 2000. InnerDyne is primarily focused upon the development and commercialization of access products based on its proprietary radial dilation technology used to perform M.I.S. procedures. InnerDyne designs, develops, manufactures and commercializes minimally invasive surgical access products incorporating its proprietary radial dilation technology in the fields of general surgery, gynecology, pediatric laparoscopy, and urology. The Company has entered into an agreement with Maxxim Medical, Inc. to facilitate the commercialization of its radial dilation technology to enhance percutaneous access for vascular procedures. The Company has proprietary technology in the areas of biocompatible coatings, radiation delivery for the potential treatment of various types of cancer, and drug attachment and diffusion, which it intends to continue to develop either internally or through strategic alliances. InnerDyne, Inc. common stock is traded on the Nasdaq National Market under the symbol IDYN. INNERDYNE'S PRODUCTS AND TECHNOLOGY Radial Dilation Technology The primary focus of the Company is the development and commercial application of its proprietary radial dilation technology. The key feature of this proprietary technology is the capability to enter the body of a patient by creating a small puncture wound which can subsequently be dilated, or increased in size, to create a larger working channel. Employment of radial dilation within an expandable sheath permits the dilation to be accomplished in a manner that tends to minimize tissue trauma. Upon completion of a procedure, the dilation sequence is reversed, resulting in a smaller residual wound than would be experienced through the employment of similarly sized conventional access devices. Potential benefits of radial dilation technology include reduced risk, less patient trauma and reduced procedure time. Step Product Line. The Company has developed a family of products utilizing InnerDyne's proprietary radial dilation technology. The initial Step products were introduced commercially in late 1994 and are designed to provide access to the abdominal cavity in order to facilitate the visualization and treatment of target areas within the cavity while minimizing the tissue trauma associated with such access. Step. The Step device incorporates the Company's proprietary radial dilation technology and was InnerDyne's first product to be launched on a commercial basis. The Company has received 510(k) clearances 8 10 from the FDA to market this device for laparoscopic and thorascopic M.I.S. procedures. The Company's Step access device replaces trocars, eliminating the risk of internal organ damage from contact with the sharp surfaces of a trocar. In contrast to conventional trocars, the Step device utilizes a standard insufflation needle for penetration through the abdominal wall, creating only a small puncture wound. Following removal of the needle, a sheath that surrounds the needle is then dilated to a larger working channel through the insertion of a tapered dilator and cannula. Following dilation, the dilator is removed, leaving a rigid sheath that serves as a working channel with an integral insufflation valve at the proximal end. The radial dilation of tissue to an appropriately sized working channel holds the cannula in place and obviates the need for an anchoring system, which may cause a larger residual wound. After completion of a procedure, the rigid cannula is removed and the sheath retracts permitting the opening in each of the muscular layers of the abdominal wall to recover. The residual wound is approximately half the size of that made using a conventional trocar of similar size. The Step product is currently utilized primarily in minimally invasive general, gynecological and pediatric surgical procedures. Management believes that positive attributes of the Step product could significantly affect health care system costs and patient satisfaction with M.I.S. procedures in which trocars have traditionally been used. The results of a Company-sponsored retrospective comparative outcome study examining this issue were released during late 1995. The study included 98 patients and compared an almost equal number of procedures performed using Step devices and conventional trocars for access. Statistically significant results of that study indicated that Step reduced device-related complications during surgery by over 90% and resulted in an approximate 22% savings in surgery time. Based upon published operating room costs, this time savings would equate to dollar savings of $345 to $515 per procedure, a substantial outcome for a product that is believed to be competitively priced with conventional trocars. Management also believes that post-procedure complications, such as infection and incisional hernias at access sites, may be reduced with the use of the Step device as compared to conventional trocars. In January 1999, InnerDyne reported the clearance by the FDA of the Company's 510(k) premarket notification based on the demonstrated safety and clinical performance of the Step line of minimally invasive surgical access devices. The product safety premarket notification resulted from the submittal of substantial information related to the comparative safety of the Step radially expanding dilation technology for surgical access versus standard cutting trocars. The FDA clearance acknowledged that the Step radially expanding surgical access technology had been shown in independent clinical comparative studies versus conventional cutting trocars to provide safety benefits including, but not limited to: (1) a lower prevalence of abdominal wall bleeding; (2) a lower prevalence of bowel and bladder injuries; (3) a lower incidence of post operative incisional hernias; and (4) a lower prevalence of major vascular injury. In addition, the FDA clearance noted that a substantial number of patients reported reduced pain from Step access sites when compared to conventional trocar sites. The FDA recently notified the Company that it has determined a 510(k) filing is not required, both historically and in the future, for labeling claims related to relative patient safety arising from the use of access products. By December 31, 1999 more than 30 peer reviewed papers or presentations had been published or presented, concluding that patient safety is enhanced when the Step product is used. A paper presented in November 1999 at the American Association of Gynecological Laparoscopy Annual Meeting involved more than 8,000 procedures and more than 21,000 Step insertions. The study concluded that, based on a comparison to a control group where standard access devices of various types were used, an adverse event was about ten times more likely to occur with conventional trocars versus InnerDyne's Step products. The Company's clinical database presently covers almost 20,000 procedures in which Step has demonstrated statistically significant 9 11 reductions of complications and enhanced patient safety and comfort. Other competitors have claimed that their access devices can provide some benefits similar to the Step products, though to date, the clinical evidence to support such competitive claims has been limited. Short Step(TM). The Short Step is a conventional Step device that has been reduced in length to be particularly suitable for M.I.S. procedures involving smaller individuals, especially children and thin females. The Short Step was commercially introduced in 1995. In January 1996, the Company announced that its Short Step device had been awarded the Seal of Acceptance by the Alliance of Children's Hospitals, Inc. ("Alliance"). The Alliance is a wholly owned subsidiary of Child Health Corporation of America, which is comprised of approximately 35 freestanding children's hospitals across the United States. The Alliance selected the Step system, after extensive research and review, based upon its ability to reduce both the trauma and operative complications associated with pediatric laparoscopic surgical procedures. In exchange for an ongoing royalty payment, the Company is entitled to use this seal in connection with the marketing and sale of its Step line of products. The Company hopes that the Seal of Acceptance will continue to help the Company expand awareness and sales of its Step product line for use in the pediatric environment. Reposable Step(TM). Launched in 1996, the Reposable Step incorporates the radial dilation features of disposable Step devices in a partially reusable access device. A substantial market for reusable trocars exists, and management expects a trend toward a somewhat more frequent usage of reusable devices. The Reposable Step includes a number of reusable components consisting of a combination of metal and plastic parts that may be cleaned and sterilized by most conventional methods. The dilator, cannula and needle are reusable, while the sheath and valve are single use components designed to be disposed of following surgery. Mini Step(TM). The Mini Step is a small-diameter radially dilating access device designed for use in tubal ligation, pediatric procedures, and micro-laparoscopic surgeries utilizing small instruments. The working diameter of the Mini Step ranges from a nominal 2mm to 8mm. Like the Step device, Mini Step is expected to offer clinicians the potential to reduce device-related surgical complications and surgery time. The Mini Step devices were commercially introduced in 1997. One Step(TM). The One Step is a device with a universally adjustable valve and seal system designed to eliminate the need for a reducer. The device is intended to maintain insufflation while accommodating most conventional surgical instruments. The One-Step device was commercially introduced in 1998. Open Step(TM). The Open Step is a device designed to establish access into the abdominal cavity using a technique known as open laparoscopy. The Open Step device was commercially introduced in 1998. Nephro-Step(TM). The Nephro-Step product is intended to provide percutaneous access to the kidney and bladder to facilitate the performance of selected urological procedures. The Company initiated a limited commercial launch of the Nephro-Step during the third quarter of 2000. Management believes that the positive attributes of the Step product line may also enable minimally invasive access to organs within the abdominal cavity. The current alternative for this type of access involves the insertion of a long flexible channel and scope through a natural body orifice such as the mouth or the rectum, and only limited procedures are possible due to the restricted size of the channel and the tortuous path that must be navigated. The Step product line has been shown to enable laparoscopic access through the abdominal wall and across the peritoneal space into the stomach for the treatment of benign tumors. InnerDyne believes that the use of Step products could substantially reduce recovery times for these types of procedures. 10 12 The Company also believes that the enhanced capabilities of radially expanding dilation may enable additional surgical procedures to be performed through minimally invasive techniques. InnerDyne expects to complete development of an intra-organ access device based on its proprietary radially expanding dilation technology during 2000, and assuming this effort is successful, to commercially launch an intra-organ product in 2001. Distribution of Step Products. The Step family of products is distributed to health care professionals in both domestic and international markets. In the United States, the Company's M.I.S. access product line is generally sold directly to health care professionals by a network of sales representatives, a limited number of whom are employees of the Company. InnerDyne management employees manage these sales representatives on a regional basis. In order to enhance the effectiveness of these domestic sales activities, agreements with buying groups that represent multiple provider institutions have been pursued. InnerDyne signed two buying group agreements in 1997. These agreements cover approximately 1,350 hospitals across the United States. Additional buying group agreements were signed in 1999, adding approximately 2,150 hospitals and surgery centers to those covered by agreements. In May 2000, InnerDyne announced the signing of an agreement with Premier Purchasing Partners. The agreement, which covers the approximately 1,800 member institutions in the Premier system, took effect on July 1, 2000. In selected foreign countries, local distributors purchase products from the Company for subsequent resale to their respective countries' health care systems. Distributors in selected foreign markets can and have been changed when the Company has deemed the performance of individual distributor organizations to be unsatisfactory. Other Applications & Technology. During the second quarter of 1997, InnerDyne established a business unit to better define the value that radial dilation technology could potentially bring to interventional cardiology and radiology procedures and to develop access products based on this assessment. The Company proceeded with animal studies and device refinements in 1997 and continued testing the product concept in conjunction with cardiology advisors in 1998. The study results were positive and human use trials to demonstrate the clinical benefits were initiated in Europe during the second quarter of 1998. In September 1998, InnerDyne announced that it had received clearance from the FDA of a 510(k) application for its radially dilatable access device for use in gaining percutaneous access for the performance of vascular procedures. Limited domestic use evaluations of a vascular access product were conducted in 1999. An additional related 510(k) application was filed with the FDA in August 1999, and cleared in June 2000, to update labeling involving the most current version of the radially expanding vascular access ("INNERVASC(TM)") product. In March, 2000 InnerDyne announced the signing of an agreement with Maxxim Medical, Inc. covering the distribution by Maxxim of the Company's INNERVASC vascular access product in the United States and South America. The initial shipment of radially dilatable INNERVASC sleeves to Maxxim took place in June 2000, and ongoing shipments to Maxxim are expected to continue until at least 2002. The Company also signed an agreement involving its radial dilation access technology with a small private development stage company during the first quarter of 2000. This agreement will permit the partner entity to potentially utilize InnerDyne's technology in the diagnosis and treatment of selected cancer tumors. There can be no assurance that current or future new product developments will generate product opportunities that can be commercially sold in sufficient quantities; failure to achieve commercial success with any or all new product applications could have a material adverse impact on the Company's profitability and operations. 11 13 InnerDyne announced an agreement covering the development and potential use of its proprietary radial dilation technology for specialized vascular access with EndoTex Interventional Systems ("EndoTex") in 1996. In January 1999, the management of EndoTex notified InnerDyne that it was ceasing to make payments required for EndoTex to use radial dilation for specialized vascular access. The termination of the EndoTex agreement did not have a material impact on the Company's business, financial condition, and results of operations. The Company entered into an agreement covering the development of a less traumatic means of placing enteral feeding tubes with Sherwood-Davis & Geck ("SDG") in 1997. The Company announced that it had received the single regulatory milestone payment associated with the SDG agreement during the second quarter of 1997. In the first quarter of 1998, InnerDyne and SDG terminated the development agreement when SDG was acquired. In the future, the Company may decide to develop a feeding tube placement system. During 1997 and early 1998, InnerDyne committed resources to an investigation of the market opportunity for a radially dilatable access device for arthroscopic procedures. Clinical evaluation of an FDA cleared arthroscopic access product indicated that clinical benefits of the technology in this market were not sufficient to warrant further investment, and the project was terminated. Biocompatible Coating Technologies The Company possesses certain proprietary technologies in the area of biocompatible coatings. The technologies that comprise the Company's thromboresistant coating ("TRC") capability are believed to have application when foreign objects remain in contact with various areas of the body, particularly within the blood stream, for sustained periods of time. These technologies include the ability to deposit an extremely thin layer (approximately one micron) of siloxane on a surface and the ability to graft a bioactive substance, such as the drug heparin, to that siloxane layer. The Company's TRC utilizes a "tether" molecule to attach heparin, other bioactive molecules or radioisotopes to the previously applied siloxane subsurface. One end of the tether molecule is covalently bonded to the siloxane coating and the other end of the tether molecule is covalently bonded to the bioactive molecule or radioisotope. Because both points of attachment may utilize covalent bonds, the Company believes that its coating process may result in a stronger bond to the surface of a device than some other methods presently in use. TRC coatings, employed with the siloxane layer alone or in combination with bioactive substances, can extend the life of blood-gas exchange devices or provide the capability to extend the duration of contact of a coated device with blood or other body fluids while minimizing the physiological impacts of such contact. InnerDyne is developing a proprietary technology that coats materials with a coating to which rhenium-188 or another radioisotope can be attached, to potentially reduce restenosis in patients who have undergone interventional vascular procedures. InnerDyne completed stent-based animal studies using rhenium-188 for the treatment of restenosis in early 2000. Though the results of this animal study demonstrated clinical efficacy, recently published human clinical results from a competing catheter-based technology have reduced the probability that the Company can attract a corporate stent partner that will license the technology under acceptable terms, if at all. InnerDyne is not currently allocating technical resources to further pursuit of radiation coatings for restenosis applications. In the fourth quarter of 1999, the Company allocated resources to investigate a proprietary therapeutic coating which may potentially provide a proprietary bioactive treatment for restenosis. A limited animal trial intended to further evaluate the potential impact of this coating to reduce restenosis was initiated during the third quarter of 2000, with results expected in early 2001. If preliminary promising results of this investigation 12 14 are confirmed in these and future investigations, the Company may increase associated resources, and endeavor to attract a corporate partner interested in the technology. There can be no assurances that the results of this further investigation will be positive, or that a corporate partner will be interested in licensing or developing this technology on acceptable terms, if at all. The Company has begun a research program aimed at developing absorbable brachytherapy products for the treatment of focal or site-specific cancers such as breast, prostate, cervical, and neurological cancers. The program's goal is to develop biocompatible and bio-absorbable brachytherapy sources for use in radiotherapy or simultaneous radiotherapy and chemotherapy drug delivery. These novel combined brachytherapy/chemotherapeutic drug sources are being designed for potential use in the local-regional treatment of primary cancer, including treatment of the tumor bed after removal of a tumor. The final product could fundamentally differ from both current brachytherapy sources and drug-delivery sources and could provide an efficient mechanism to control cancer growth and limit cancer recurrence. The advantage of localized therapy over other therapies is the potential to eliminate cancerous cells while sparing normal cells. Other therapies, such as systemic chemotherapy and external beam radiation, affect both cancerous and non-cancerous cells and can result in greater pain, longer recovery times, and higher treatment costs. In contrast, localized therapy may lower the cost of the therapeutic procedure, reduce hospital stays, and reduce the pain and suffering experienced by the patient. In December 1997, InnerDyne and Oak Ridge National Laboratory ("ORNL") announced that the Department of Energy had awarded ORNL and Brookhaven National Laboratories ("BNL") a cooperative research and development agreement ("CRADA") to support the development of InnerDyne's proprietary method of labeling or attaching radioactivity to implantable devices. Initially, the ORNL researchers helped to optimize chemical methods required to efficiently attach a radioactive source to stents. Generators from ORNL and the new technology were provided to investigators at BNL who, in conjunction with the Interventional Cardiology Group at the State University of New York at Stonybrook, prepared radioactive stents and implanted them into the arteries of swine and rabbits to evaluate the effectiveness of this unique approach to inhibit restenosis. Initial testing confirmed the Company's ability to attach radionuclides to metal stents and other substrates. Additional testing demonstrating the efficacy in animals of InnerDyne's technology for the treatment of restenosis was completed in early 2000. As indicated previously, upon positive developments by other entities with competing cardiovascular radiation systems, management has decided to suspend the Company's radioactive stent research program. In October 1998, the CRADA's scope of work was modified to include the development of absorbable brachytherapy devices for the treatment of focal cancers because of the rapid strides made under the radiation coated stent development program. In January 1999, InnerDyne announced that it had been awarded a California Cancer Research Program ("CRP") Cycle I grant, a Community Initiated Research Collaboration Award ("CIRCA"), to examine the clinical benefits and the development of absorbable brachytherapy devices. The grant has been extended to support the completion of limited related initial work. In June 1999, the Company announced that the National Institutes of Health awarded the Company a Small Business Innovation Research ("SBIR") phase 1 research grant to support development of a new form of cancer treatment. This grant has expired, after the completion of limited initial work. The Company has recently filed additional S.B.I.R. grant applications to potentially fund advanced coatings development work in 13 15 the area of therapeutic stent coatings. There can be no assurances that these grant applications will be accepted or approved. In 1994, the Company signed a license agreement with SENKO Medical Manufacturing Co., Ltd. ("SENKO"), a Japan-based manufacturer and marketer of membrane oxygenators used in open-heart surgery, pursuant to which the Company licensed one of its technologies to SENKO. In connection with this agreement, the Company transferred its siloxane coating technology to SENKO for the coating of microporous hollow fibers used in the production of oxygenators. The initial technology transfer was completed during the first quarter of 1995, at which time the Company received the balance of an initial payment from SENKO, and the royalty payment period commenced. In 1996, InnerDyne received an order from SENKO to build a second fiber coating system, which was delivered during the first half of 1997. In April 1998, in exchange for an initial payment and continuing material purchases, SENKO licensed InnerDyne's less complex method for coating devices with heparin on a non-exclusive basis. The addition of this new means of attaching the drug heparin to prevent the formation of blood clots on a surface is expected to further enhance SENKO's oxygenator product offering. If SENKO continues to use the Company's technologies, royalties will be received through 2004. In April 1996, the Company announced the signing of an agreement with Boston Scientific Corporation ("Boston Scientific") covering the potential application and use of InnerDyne's proprietary biocompatible coating technologies with Boston Scientific's stents, grafts, vena cava filters and other implantable medical devices. The agreement involved an equity investment by Boston Scientific in InnerDyne, initial research support, license fees and future royalty payments. Boston Scientific Corporation notified InnerDyne in August 1998 that it had decided to proceed with the transfer of technology for the application and use of InnerDyne's proprietary biocompatible coating technology with Boston Scientific's stents, grafts, vena cava filters, and other implantable medical devices. The transfer of the technology was completed during 1999. If Boston Scientific decides to use the Company's technology in conjunction with commercially sold products, the Company may receive future related royalties. In June 1998, InnerDyne announced the signing of an agreement with U.S. Surgical ("U.S. Surgical") Corporation covering the licensing of InnerDyne's proprietary siloxane coating technology to enhance the performance of selected products used in minimally invasive surgical procedures. Under the terms of the agreement, InnerDyne constructed a custom coating system and provided coated product samples for testing by U.S. Surgical, in exchange for payment of initial license fees and capital equipment costs. In June 2000, U.S. Surgical indicated they would not use the Company's technology for valve and seal coating on current products. Therefore, InnerDyne expects that no further license or royalty payments will be realized as a result of the agreement with U.S. Surgical, unless alternative applications for the technology are mutually agreed upon by InnerDyne and U.S. Surgical. Because of the strength of the covalent bonds used in the Company's TRC technology and other properties noted above, the Company believes that its technology may have advantages over some presently available bioactive coating technologies. Potential applications include the treatment of restenosis and specific focal cancers when vascular stents, grafts, vena cava filters and other implantable devices may be coated with drugs and/or isotopes using InnerDyne's proprietary technology. The Company has undertaken a number of discussions with potential licensees of the Company's coating technologies, and samples of coated products have been provided to several companies. These discussions have been with parties interested in the use of the technologies to enhance drug delivery or gas exchange, as well as third parties interested in the possible coating of in-dwelling devices for various applications. There can be no assurance that additional agreements with third parties, if any, will be on acceptable terms. 14 16 Other Technologies In September 1999, the Company licensed to William Cook Europe A/S ("Cook") rights to a Rotatably Actuated Constricting Catheter Valve on a non-exclusive basis for use in the treatment of aortic aneurysms. The agreement requires that Cook pay InnerDyne a licensing fee in two installments, and annual minimum royalty payments. InnerDyne has received the first license fee installment. In December 1999, InnerDyne licensed to Alung Technologies, Inc. certain assets related to the Company's earlier development of an implantable lung assist product, and associated technologies. Under the terms of the agreement, InnerDyne received an initial license fee payment in the fourth quarter of 1999 and is to receive a license fee payment in the fourth quarter of 2000. Licensing, contract and grant revenues will fluctuate from year to year, and from quarter to quarter, based upon the number of agreements in effect, the amount and timing of the payments to be made to InnerDyne pursuant to such agreements, and the ability of the parties to satisfy performance milestones. The future success of the Company will depend upon its ability to develop and gain regulatory clearance for new and enhanced versions of products in a timely fashion and to attract corporate partners interested in licensing its radial dilation and coating technologies. In addition, the Company may seek to identify opportunities to obtain products or technologies from third parties. There can be no assurance that the Company will be able to successfully develop or acquire new products or technologies, license its proprietary technologies to third parties, obtain regulatory clearance for its products, or gain market acceptance of new and enhanced products. Delays in development, clearance or acceptance of new products could have a material adverse effect on the Company's business, results of operations and financial condition. RESULTS OF OPERATIONS Total revenue for the three and nine month periods ended September 30, 2000 was $6,412,280 and $18,054,091, respectively, compared to $5,310,622 and $14,807,403 for the corresponding periods in 1999. Total revenue is comprised of revenue from product sales and licensing and contract revenue. Revenue from product sales increased to $6,394,644 and $17,888,609, respectively, for the three and nine month periods ended September 30, 2000, from $5,217,427 and $14,480,866 for the corresponding periods in 1999, reflecting increased sales of the Company's Step devices. Licensing and contract revenue for the three and nine month periods ended September 30, 2000 was $17,636 and $165,480, respectively, compared to $93,195 and $326,537 for the same periods in 1999. Licensing and contract revenue for the September 30, 2000 and September 30, 1999 periods related to agreements with third parties covering the licensing of the Company's proprietary biocompatible coating and radial dilation technologies. Licensing and contract revenue fluctuates from quarter to quarter, based upon the number of agreements in effect and the amount and timing of the payments to be made to InnerDyne pursuant to such agreements. Cost of sales was $1,658,640 and $4,652,026, respectively, for the three and nine month periods ended September 30, 2000, compared to $1,475,822 and $4,238,872 for the same periods in 1999. The increase in cost of sales for the three and nine month periods ended September 30, 2000 is attributable to the increase in production and sales volume compared to the same periods in 1999. Cost of sales as a percentage of revenue was 26% and 26%, respectively, for the three and nine month periods ended September 30, 2000, compared to 15 17 28% and 29% for each of the same periods in 1999. This decrease primarily reflects the impact of increased volume on the Company's manufacturing overhead, which increased at a slower rate than revenues. Improvements in the efficiency of the Company's manufacturing operations also positively impacted the cost of goods as a percentage of revenue, while expenses associated with the initial manufacture of the INNERVASC and Nephro-Step products negatively impacted the Company's cost of sales in the third quarter of 2000. Research, development, regulatory and clinical expenses for the three and nine month periods ended September 30, 2000 were $670,522 and $2,179,422, respectively, compared to $737,987 and $2,126,799 for the corresponding periods in 1999, reflecting the continuing support of new product development. The Company expects that research, development, regulatory and clinical expenditures are likely to increase in absolute dollars in future periods, though it is possible that expenses associated with one or more research programs could be funded from outside the Company, thereby reducing expected costs. Sales and marketing expenses were $2,350,235 and $7,099,983, respectively, for the three and nine month periods ended September 30, 2000, compared to $2,211,616 and $5,995,226 for the corresponding periods in 1999, reflecting the growth of the Company's sales and marketing functions to support commercialization of its M.I.S. products. InnerDyne expects that sales and marketing expenses will generally continue to increase in absolute dollars in future periods. General and administrative expenses were $605,969 and $1,858,736, respectively, for the three and nine month periods ended September 30, 2000, compared to $559,490 and $1,635,053 for the corresponding periods in 1999. The growth of general and administrative expenses are primarily associated with increased costs for outside professional services. The Company anticipates that general and administrative expenses will generally increase in absolute dollars in future periods to support expanding operations. The Company generated operating income, before interest and tax, of $1,126,914 and $2,263,924, respectively, for the three and nine month periods ended September 30, 2000, compared to $325,707 and $811,453 in the corresponding periods of 1999. The improvement in operating income primarily reflected higher margins on increased revenues. The Company generated net income after interest and tax of $1,186,826 and $3,567,269, respectively, for the three and nine month periods ended September 30, 2000, compared to $358,945 and $917,284 in the corresponding periods of 1999. Results in the first half of 2000 included an income tax benefit of $1,116,700 resulting from the recognition of a portion of a deferred tax asset. On December 31, 1999, the Company had a deferred tax asset totaling $16.4 million, primarily a result of net operating loss carryforwards, which was fully reserved. At December 31, 1999, the deferred tax asset had a 100% reserve due to the uncertainty of the Company's ability to generate future taxable income. However, based on recent quarters' operating income, historical experience over the last year, and expected future operating income, management believes the Company will have the ability to utilize a portion of its deferred tax assets and has reduced the valuation allowance on the Company's deferred tax asset during 2000. LIQUIDITY AND CAPITAL RESOURCES From its inception to September 30, 2000, the Company incurred a cumulative net loss of $46.7 million. Prior to 1992, the Company was funded primarily through private placements of equity securities. In 1992, the Company completed an initial public offering of 2,875,000 shares of its Common Stock at $11.00 per share, which raised approximately $28.8 million (net of underwriter's commissions and offering expenses). The 1994 acquisition of InnerDyne Medical, Inc. was accomplished through the issuance of additional Common Stock of 16 18 the Company. In June 1995, the Company closed a private placement of 1,435,599 shares of the Company's Common Stock and warrants to purchase 287,200 additional shares of Common Stock, with gross proceeds to the Company of approximately $3.2 million. In March and April of 1996, holders of warrants to purchase an aggregate of 242,952 shares of Common Stock exercised such warrants, resulting in gross proceeds to the Company of $704,561. The Company concluded a public offering on May 20, 1996, with the sale of 2,650,000 shares of Common Stock at $3.50 per share, which raised $8,015,268 (net of underwriters' commissions and offering expenses). At September 30, 2000, cash and cash equivalents totaled $9,469,418 compared to total cash and cash equivalents balance of $6,862,313 at December 31, 1999. The Company had $50,739 and $203,507, respectively, in capital expenditures in the three and nine-month periods ended September 30, 2000. Working capital totaled $14,855,898 at September 30, 2000. The Company is able to borrow up to $2,000,000 on a revolving line of credit with a commercial bank at prime plus one-quarter of one percent (9.75 percent at September 30, 2000) based on eligible receivables. This revolving line of credit was renewed on April 22, 2000. During the third quarter of 2000, the Company elected to pay outstanding balances and retired its debt, based on its expectation that it will continue to generate operating profits and cash in the immediate future. The Company may desire to borrow funds again in the future. ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS InnerDyne experienced operating losses from 1985 until mid 1998. InnerDyne reported net income of $3,567,269 on revenues of $18,054,091, $1,480,375 on revenues of $20,415,733, $425,030 on revenues of $17,610,237, and a loss of $907,000 on revenues of $15,664,365 for the nine months ended September 30, 2000 and the fiscal years ended December 31, 1999, 1998 and 1997, respectively. As of September 30, 2000, InnerDyne had an accumulated net deficit of $46,709,372. Operating results may fluctuate substantially from quarter to quarter as a result of general economic conditions. Accordingly, the Company could generate operating losses, and may have cash outflow requirements as a result of expenditures related to expansion of sales and marketing capability, expansion of manufacturing capacity, research and development activities, compliance with regulatory requirements, and possible investment in or acquisition of additional complementary products, technologies or businesses. The timing and amounts of these expenditures will depend upon many factors, such as the availability of capital, progress of the Company's research and development, and factors that may be beyond the Company's control, such as the results of product trials, the requirements for and the time required to obtain regulatory approval for existing products and any other products that may be developed or acquired, the market acceptance of the Company's products, and the actions of competitors in the Company's primary markets. The cash needs of the Company have changed significantly as a result of the merger completed during 1994 and the support requirements of the added business focus areas. There can be no assurance that the Company will not incur future losses, that the Company will be able to raise or generate cash, as necessary, to fund operations or that the Company will maintain profitable operations. Intense Competition. The primary industry in which the Company competes, minimally invasive surgery, is dominated by two large, well-positioned entities that are intensely competitive and frequently offer substantial discounts as a competitive tactic. U.S. Surgical, a unit of Tyco International, Ltd., is primarily engaged in developing, manufacturing and marketing surgical wound management products, and has historically been the firm responsible for providing products that led to the growth of the industry. U.S. Surgical 17 19 supplies a broad line of products to the M.I.S. industry, including products which facilitate access, assessment and treatment. Ethicon Endosurgery, a unit of Johnson and Johnson ("Ethicon"), made a major investment in the M.I.S. field in recent years and the parent company is one of the leading suppliers of hospital products in the world. Furthermore, U.S. Surgical and Ethicon each utilize purchasing contracts that link discounts on the purchase of one product to purchases of other products in their broad product lines. Substantially all of the hospitals in the United States have purchasing contracts with one or both of these entities. Accordingly, customers may be dissuaded from purchasing access products from the Company rather than U.S. Surgical or Ethicon to the extent it would cause them to lose discounts on products that they regularly purchase from U.S. Surgical or Ethicon. The Company faces a formidable task in successfully gaining significant revenues within the M.I.S. access market. In order to succeed, management believes that the Company will need to objectively demonstrate substantial product benefits, and its sales effort must be able to effectively present such benefits to both clinicians and health care administrators. The M.I.S. access market is dominated by U.S. Surgical and Ethicon. Both entities introduced new access devices during the past three years. A number of other entities participate in various segments of the M.I.S. market, including access. The Company's products will encounter competition from other companies as its radial dilation platforms expand into new clinical areas. Within the urology field, management expects its products will compete with product offerings from Cook, Boston Scientific, and C.R. BARD, among others. In vascular access, Maxxim Medical, Inc. will face competition from St. Jude/Daig, Medtronic/AVE, Bard, Boston Scientific and others. There can be no assurance that competitors will not succeed in developing technologies and products that are more effective than any which have been or are being developed by the Company or that would render the Company's technologies or products obsolete or not competitive. Such competition could have a material adverse effect on the Company's business, financial condition and results of operations. As a result of the entry of large and small companies into the market, and continuing consolidation within the medical device and supply industry, the Company expects competition for devices to generally increase. There can be no assurance that the Company or its partners will be able to successfully compete in the M.I.S. access, urology access, or vascular access markets, and failure to do so would have a material adverse effect on the Company's business, financial condition and results of operations. Continued Dependence on Step Products. To date, substantially all of the Company's revenues from product sales are attributable to Step products, and InnerDyne currently anticipates that sales of Step products will represent the majority of the Company's revenues for the immediate future. Accordingly, the success of the Company is largely dependent upon increased market acceptance of its Step product line by the medical community as a reliable, safe and cost-effective access product for minimally invasive surgery. InnerDyne commenced commercial sales of its Step product in the fourth quarter of 1994 and, to date, sales have been made to a relatively limited number of physicians and hospitals. Recommendations and endorsements by influential members of the medical community are important for the increased market acceptance of the Company's Step products, and there can be no assurance that existing recommendations or endorsements will be maintained or that new ones will be obtained. Failure to increase market acceptance of the Company's Step products would have a material adverse effect upon the Company's business, financial condition and results of operations. 18 20 Reliance on Future Products and New Applications; Uncertainty of Technology Changes. The medical device industry is characterized by innovation and technological change. The Company has made significant investments in researching and developing its proprietary technologies, including radial dilation and biocompatible coatings. During the next year, the Company may commercially introduce urology and intra-organ access products, and through a corporate partner, a vascular access product. The future success of the Company will depend in part on the timely commercial introduction and market acceptance of these and other possible products. There can be no assurance that these products will be timely introduced in commercial quantities, if at all, or that such products will achieve market acceptance. A failure by the Company to timely introduce such products or a failure of such products to achieve market acceptance could have a material adverse effect on the Company's business, financial condition and results of operations. The future success of the Company will also depend upon, among other factors, the ability to develop and gain regulatory clearance for new and enhanced versions of products in a timely fashion. There can be no assurance that the Company will be able to successfully develop new products or technologies, manufacture new products in commercial volumes, obtain regulatory approvals on a timely basis or gain market acceptance of such products. Delays in development, manufacturing, regulatory approval or market acceptance of new or enhanced products could have a material adverse impact on the Company's business, financial condition and results of operations. Limited Manufacturing Experience; Compliance with Quality Systems Regulations. The Company initiated manufacture of commercial quantities of its Step access device in its Salt Lake City, Utah facility during late 1994. Accordingly, the Company has relatively limited experience in manufacturing M.I.S. access products or other products in commercial quantities at acceptable costs. The Company's success will depend in part on its ability to manufacture its products in compliance with the FDA's regulations and other regulatory requirements in sufficient quantities and on a timely basis, while maintaining acceptable product quality and manufacturing costs. Manufacturers often encounter difficulties in scaling up production of new products, including problems involving production yields, quality control and assurance, component supply and shortages of qualified personnel. In connection with its ISO 9001 certification, InnerDyne now undergoes periodic audits by a regulatory body. Regulatory changes recently introduced by the FDA have resulted in a system of United States regulatory requirements for manufacturers of medical devices which more closely resembles the ISO 9000 series of quality systems standards adopted by most European countries. The FDA may also periodically inspect the Company's operations and business practices to evaluate conformance to these standards. Failure to maintain satisfactory regulatory system compliance could have a significant impact on the Company's ability to continue to manufacture and distribute its products and, in the most serious cases, result in the seizure or recall of products. Failure to maintain production volumes or increase production volumes in a timely or cost-effective manner would have a material adverse effect on the Company's business, financial condition and results of operations. Potential Fluctuations in Operating Results. The Company's quarterly operating results have in the past fluctuated and will continue to fluctuate significantly in the future depending on the timing and shipment of product orders; new product introductions and changes in pricing policies by the Company or its competitors; the timing and market acceptance of the Company's new products and product enhancements; the continued market acceptance of InnerDyne's Step product line by the medical community; the Company's product mix; the mix of distribution channels through which the Company's products are sold; the extent to which the Company recognizes non-product revenues during a quarter; and the Company's ability to obtain sufficient supplies of sole or limited source components for its products. In particular, fluctuations in production volumes can affect gross margins from quarter to quarter. Furthermore, gross margins and net income or loss can fluctuate from quarter to quarter to the extent the Company recognizes non-product revenue during a quarter because the Company typically derives higher margins from non-product revenue than from product sales. In response to 19 21 competitive pressures or new product introductions, the Company may take certain pricing or other actions that could materially and adversely affect the Company's operating results. In addition, new product introductions by the Company could contribute to quarterly fluctuations in operating results as orders for new products commence and orders for existing products decline. The Company's expense levels are based, in part, on its expectations of future revenues. Because a substantial portion of the Company's revenue in each quarter normally results from orders booked and shipped in the final weeks of that quarter, revenue levels are extremely difficult to predict. If revenue levels are below expectations, net income will be disproportionately affected because only a small portion of the Company's expenses varies with its revenue during any particular quarter. In addition, the Company typically does not operate with any material backlog as of any particular date. As a result of the foregoing factors and potential fluctuations in operating results, results of operations in any particular quarter should not be relied upon as an indicator of future performance. In addition, in some future quarter, the Company's operating results may be below the expectations of public market analysts and investors. In such event, the price of the Company's Common Stock would likely be materially and adversely affected. Reliance on Collaborative Relationships; Restrictions on Activities. The Company has entered into, and intends to continue to pursue, collaborative arrangements with corporations and research institutions with respect to the research, development, regulatory approval and marketing of certain of its potential products. InnerDyne's future success may depend, in part, on its relationship with such third parties, their strategic interest in the potential products under development and, eventually, their success in marketing or willingness to purchase any such products. The Company's existing and anticipated contracts with such third parties may restrict the rights of InnerDyne to engage in certain areas of product development, manufacturing and marketing. In addition, these third parties may have the unilateral right to terminate any such arrangement without significant penalty. There can be no assurance that InnerDyne will be successful in establishing or maintaining any such collaborative arrangements or that any such arrangements will be successful. Limited Sales, Marketing and Distribution Experience. InnerDyne began commercial sales of its first M.I.S. access product in the fourth quarter of 1994 and, therefore, has limited sales, marketing and distribution experience. The Company is marketing its M.I.S. access products mainly to general surgeons, gynecologists and pediatric laparoscopists. In the United States, InnerDyne markets its products primarily through direct representatives who are employed by the Company within selected geographical areas and a network of independent sales representatives who typically sell other complementary M.I.S. products to the same customer base. If the need arises, the Company may expand its sales force, which will require recruiting and training additional personnel. There can be no assurance that the Company will be able to recruit and train such additional personnel in a timely fashion. Loss of a significant number of InnerDyne's current sales personnel or independent sales representatives, or failure to attract additional personnel, could have a material adverse effect on the Company's business, financial condition and results of operations. The Company markets its products outside of the United States through international distributors in selected foreign countries after regulatory approvals, if necessary, are obtained. Although InnerDyne currently has relationships with a limited number of international distributors, there can be no assurance that the Company will be able to build or maintain a network of international distributors capable of effectively marketing its M.I.S. access products or that such distributors will generate significant sales of such products. 20 22 The Company has limited experience in marketing its products and faces substantial competition from well-entrenched and formidable competitors. As a result, there can be no assurance that the Company will successfully achieve acceptable levels of product sales at prices which provide an adequate return. Failure to do so would have a material adverse effect on the Company's business, financial condition and results of operations. Patents and Proprietary Rights. The Company's success will depend in large part on its ability to obtain patent protection for products and processes, to preserve its trade secrets and to operate without infringing the proprietary rights of third parties. Although InnerDyne has obtained certain patents and applied for additional United States and foreign patents covering certain aspects of its technology, no assurance can be given that any additional patents will be issued or that the scope of any patent protection will exclude competitors or provide a competitive advantage, or that any of the Company's patents will be held valid if subsequently challenged. The validity and breadth of claims covered in medical technology patents involves complex legal and factual questions and therefore may be highly uncertain. InnerDyne also relies upon unpatented trade secrets, and no assurance can be given that others will not independently develop or otherwise acquire substantially equivalent trade secrets. In addition, whether or not the Company's patents are issued, others may hold or receive patents that contain claims having a scope that covers products developed by InnerDyne. There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry, and companies in the medical device industry have used litigation to gain competitive advantage. Litigation involving the Company would result in substantial cost to and diversion of management attention from the day-to-day operation of the business, but could be necessary to enforce patents issued to the Company, to protect trade secrets and other specialized knowledge unknown to outside parties, to defend the Company against claimed infringement of the rights of others or to determine the scope and validity of the proprietary rights of others. An adverse determination in litigation could subject the Company to significant liabilities to third parties, could require the Company to seek licenses from third parties under less favorable terms than might otherwise be possible and could prevent the Company from manufacturing, selling or using its products, any of which could have a material adverse effect on the Company's business, financial condition and results of operations. The Company has in the past, and may in the future, receive correspondence from third parties claiming that the Company's products or technology infringe intellectual property rights of such third parties. The Company and its patent counsel thoroughly review such claims and no such outstanding claims currently exist. However, there can be no assurance that InnerDyne will not receive additional claims that its products or technology infringe third party rights or that third parties will not litigate such claims. Any such occurrence could have a material adverse effect on the Company's business, financial condition and results of operations. Government Regulation. Clinical testing, manufacture and sale of the Company's products, including the Step product line and the Company's biocompatible coating technology, are subject to regulation by the FDA and corresponding state and foreign regulatory agencies. Pursuant to the Federal Food, Drug, and Cosmetic Act, and the regulations promulgated thereunder, the FDA regulates the pre-clinical and clinical testing, manufacture, labeling, distribution and promotion of medical devices. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant pre-market clearance or pre-market approval for devices, withdrawal of marketing approvals and criminal prosecution. The FDA also has the authority to request recall, repair, replacement or refund of the cost of any device manufactured or distributed by the Company. 21 23 Before a new device can be introduced in the market, the manufacturer must generally obtain FDA clearance of 510(k) notification or approval of a PMA. A PMA application must be filed if a proposed device is not "substantially equivalent" to a legally marketed Class I or Class II device, or if it is a Class III device for which the FDA has called for PMAs. The PMA process can be expensive, uncertain and lengthy, and a number of devices for which FDA approval has been sought by other companies have never been approved for marketing. A 510(k) clearance will be granted if the submitted information establishes that the proposed device is substantially equivalent to a legally marketed Class I or Class II medical device or a Class III medical device for which the FDA has not called for PMAs. For any of the Company's devices cleared through the 510(k) process, modifications or enhancements that could significantly affect the safety or effectiveness of the device or that constitute a major change to the intended use of the device will require a new 510(k) submission. There can be no assurance that the Company will obtain 510(k) premarket clearance within a reasonable time frame, or at all, for any of the devices or modifications for which it may file a 510(k). The Company has received clearance from the FDA for the marketing of its Step device for use in accessing the abdominal and thoracic cavities for the performance of minimally invasive surgical procedures. The Company has also received FDA clearance for the marketing of its R.E.D. product for use in the areas of gastrostomy, cystostomy, cholecystotomy, the dilation of biliary and urethral strictures, laparoscopy and enterostomy. The Company has also received market clearance for alternative versions of its Step and R.E.D. products, including products designed to employ its radial dilation technology in vascular, urological, and arthroscopic applications and for biliary indications. Although the Company has been successful in preparing requests for 510(k) clearance, there can be no assurance that 510(k) clearances for future products or product modifications can be obtained in a timely manner or at all, or that any existing clearance can be successfully maintained. A delay in receipt of, or failure to receive or maintain, such clearances would have a material adverse effect on the Company's business, financial condition and results of operations. Although the Company is strictly limited to marketing its products for the indications for which they were cleared, physicians are not prohibited by the FDA from using the products for indications other than those cleared by the FDA. There can be no assurance that the Company will not become subject to FDA action resulting from physician use of its products outside of their approved indications. The Company has made modifications to its cleared devices that the Company believes do not require the submission of new 510(k) notices. There can be no assurance, however, that the FDA would agree with any of the Company's determinations not to submit a new 510(k) notice for any of these changes or would not require the Company to submit a new 510(k) notice for any of the changes made to the device. If the FDA requires the Company to submit a new 510(k) notice for any device modification, the Company may be prohibited from marketing the modified device until the 510(k) notice is cleared by the FDA. Any devices manufactured or distributed by the Company pursuant to FDA clearance or approval are subject to pervasive and continuing regulation by the FDA and certain state agencies and various foreign governments. Manufacturers of medical devices for marketing in the United States are required to adhere to applicable regulations setting forth detailed Quality Systems Regulations ("QSR") requirements, which include testing, control and documentation requirements. Manufacturers must also comply with requirements that a firm report to the FDA any incident in which its product may have caused or contributed to a death or serious injury, 22 24 or in which its product malfunctioned and, if the malfunction were to recur, it would be likely to cause or contribute to a death or serious injury. The Company is registered as a manufacturer of medical devices with the FDA. The Company is subject to routine inspection by the FDA and certain state agencies for compliance with QSR requirements, MDR requirements and other applicable regulations. Failure of the Company to maintain satisfactory regulatory compliance could have a significant adverse effect on the Company's ability to continue to manufacture and distribute its products and, in the most serious cases, could result in the seizure or recall of products, injunctions and/or civil fines. Dependence on Sole Sources. The materials utilized in the Company's products consist of both standard and custom components that are purchased from a variety of independent sources. The plastic parts used in the Step product are injection molded by outside vendors. The majority of these parts are produced utilizing molds that have been specially machined for and are owned by the Company. Although the Company maintains significant inventories of molded parts, any inability to utilize these molds for any reason might have a material adverse effect on the Company's ability to meet its customers' demand for product. In addition to plastic parts produced from injection molds owned by the Company, a number of other materials are available only from a limited number of sources at the present time, including the sheath component of the Company's Step products. Efforts to identify and qualify additional sources of this sheath component and other key materials and components are underway. Although InnerDyne believes that alternative sources of these components can be obtained, internal testing and qualification of substitute vendors could require significant lead times and additional regulatory submissions. There can be no assurance that such internal testing and qualification or additional regulatory approvals will be obtained in a timely fashion, if at all. Any interruption of supply of raw materials could have a material adverse effect on the Company's ability to manufacture its products and, therefore, on its business, financial condition and results of operations. Uncertainty Relating to Third Party Reimbursement. In the United States, health care providers that purchase medical devices, such as the Company's products, generally rely on third-party payors, principally federal Medicare, state Medicaid and private health insurance plans, to reimburse all or part of the cost of the procedure in which the medical device is being used. In addition, certain health care providers are moving toward a managed care system in which such providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures. The Company is unable to predict what changes will be made in the reimbursement methods utilized by third-party health care payors. Furthermore, the Company could be adversely affected by changes in reimbursement policies of governmental or private health care payors, particularly to the extent any such changes affect reimbursement for procedures in which the Company's products are used. Failure by physicians, hospitals and other users of the Company's products to obtain sufficient reimbursement from health care payors for procedures in which the Company's products are used or adverse changes in governmental and private third-party payors' policies toward reimbursement for such procedures would have a material adverse effect on the Company's business, financial condition and results of operations. If the Company obtains the necessary foreign regulatory approvals, market acceptance of the Company's products in international markets would be dependent, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country, and include both government-sponsored health care and private insurance. The Company intends to seek international reimbursement approvals, although there can be no 23 25 assurance that any such approvals will be obtained in a timely manner, if at all, and failure to receive international reimbursement approvals could have an adverse effect on market acceptance of the Company's products in the international markets in which such approvals are sought. Dependence on International Sales. In the future, the Company expects to derive a portion of its revenue from international sales. To the extent that the Company's international sales increase in future periods, a portion of the Company's revenues could be subject to the risks associated with international sales, including economic or political instability, shipping delays, changes in applicable regulatory policies, fluctuations in foreign currency exchange rates and various trade restrictions, all of which could have a significant impact on the Company's ability to deliver products on a competitive and timely basis. Future imposition of, or significant increases in the level of, customs duties, import quotas or other trade restrictions could have an adverse effect on the Company's business, financial condition and results of operations. The regulation of medical devices, particularly in the European Economic Community, continues to expand, and there can be no assurance that new laws or regulations will not have an adverse effect on the Company. Dependence on Key Personnel. InnerDyne is dependent upon a limited number of key management and technical personnel. The Company's future success will depend in part upon its ability to attract and retain highly qualified personnel. The Company will compete for such personnel with other companies, academic institutions, government entities and other organizations. There can be no assurance that the Company will be successful in hiring or retaining qualified personnel. The loss of key personnel or the inability to hire or retain qualified personnel could have a material adverse effect on the Company's business, financial condition and results of operations. Product Liability; Claims in Excess of Insurance Coverage. The development, manufacture and sale of the Company's products entail the risk of product liability claims, involving both potential financial exposure and associated adverse publicity. The Company's current product liability insurance coverage limits are $2,000,000 per occurrence and $2,000,000 in the aggregate, and there can be no assurance that such coverage limits are adequate to protect the Company from any liabilities it might incur in connection with the development, manufacture and sale of its current and potential products. Product liability insurance is expensive and may not be available in the future on acceptable terms, or at all. In addition, if such insurance is available, there can be no assurance that the limits of coverage of such policies will be adequate. A successful product liability claim in excess of the Company's insurance coverage could have a material adverse effect on the Company's business, financial condition and results of operations. Stock Price Volatility. The stock market in general and stocks of medical device companies in particular, have from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. In addition, the market price of the Company's Common Stock has been and is likely to continue to be highly volatile. Factors such as fluctuations in the Company's operating results, announcements of technological innovations or new products by the Company or its competitors, FDA and international regulatory actions, actions with respect to reimbursement matters, developments with respect to patents or proprietary rights, public concern as to the safety of products developed by the Company or others, changes in health care policy in the United States and internationally, changes in stock market analyst recommendations regarding the Company, other medical device companies or the medical device industry generally or general market conditions may have a significant effect on the market price of the Common Stock. 24 26 Environmental Regulations. The Company is subject to a variety of local, state and federal governmental regulations relating to the use, storage, handling, manufacture and disposal of toxic and other hazardous substances used to manufacture the Company's products. The Company believes that it is currently in compliance in all material respects with applicable governmental environmental regulations. Nevertheless, the failure by the Company to comply with current or future environmental regulations could result in the imposition of substantial fines on the Company, suspension of production, alteration of its manufacturing processes or cessation of operations. Compliance with such regulations could require the Company to acquire expensive remediation equipment or to incur substantial expenses. Any failure by the Company to control the use, disposal, removal or storage of, or to adequately restrict the discharge of, or assist in the cleanup of, hazardous or toxic substances, could subject the Company to significant liabilities, including joint and several liability under certain statutes. The imposition of such liabilities could have a material adverse effect on the Company's business, financial condition, and results of operations. Anti-Takeover Effect of Certain Charter Provisions of Common Stock. Provisions of the Company's Certificate of Incorporation that allow the Company to issue Preferred Stock without any vote or further action by the stockholders, the fact that the Company's Certificate of Incorporation does not permit stockholders to cumulate votes in the election of directors as well as the Company's adoption of a poison pill Preferred Share Purchase Rights plan in September 1997 may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of the Company. Certain provisions of Delaware law applicable to the Company could also delay or make more difficult a merger, tender offer or proxy contest involving the Company, including Section 203, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. The possible issuance of Preferred Stock, the inability of stockholders to cumulate votes in the election of directors, the poison pill and provisions of Delaware law could have the effect of delaying, deferring or preventing a change in control of the Company, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of the Company's Common Stock. The possible issuance of Preferred Stock, the poison pill and these provisions could also limit the price that investors might be willing to pay in the future for shares of the Company's Common Stock. For information about the stock tender offer announced by the Company on October 4, 2000, you should read the information set forth above under the heading "Introduction." Risks Associated With Computer Software and Hardware. InnerDyne relies on a variety of internal computer systems and programs in the operations of its business. The Company also utilizes outside computer systems in the management of certain business functions. The Company's internal systems run on personal computers and microprocessor-based computer servers set up in a workstation environment which the Company believes are not susceptible to universal failures. These systems were extensively tested as part of the Company's preparations for the Year 2000 changeover. The Company believes that the failure of a system would not materially affect the Company's ability to conduct its business operations, though such failure could cause the expenditure of significant funds to affect a rapid remedy to a systems failure. However, should a system fail, and the Company was unable to restore or replace its function within a reasonable time frame, such failure could have a material impact upon the Company's business, financial condition, or results of operations. Similarly, should the Company internal or external computer systems experience widespread failure that could not be remedied quickly, such failure could have a similar impact. 25 27 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The following discusses our exposure to market risk related to changes in interest rates, equity prices, and foreign currency exchange rates. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth above under the heading "Additional Factors That May Affect Future Results." INTEREST RATE RISK As of September 30, 2000, InnerDyne had short-term investments of $8,042,727. Substantially all of these short-term investments consist of highly liquid money market funds and commercial paper investments with remaining maturities at the date of purchase of less than ninety days. These investments are subject to interest rate risk and will decrease in value if market interest rates increase. A hypothetical increase or decrease in market interest rates by 10% from the September 30, 2000 rates would cause the fair market value of these short-term investments to change by an immaterial amount. The Company presently has the ability to hold these investments until maturity; and therefore, the value of these investments is not expected to be affected to any significant degree by sudden changes in market interest rates. Declines in interest rates over time will, however, reduce interest income. The Company has not used derivative financial instruments. InnerDyne does not own any equity investments; therefore, the Company is not currently exposed to any direct equity price risk. FOREIGN CURRENCY RISK International revenues represented less than 10% of total revenues as of September 30, 2000. International sales are made mostly through international distributors with payments to the Company typically denominated in U.S. dollars. The Company's international business is subject to risks typical of an international business, including but not limited to differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. The Company's future results could be materially adversely impacted by changes in these or other factors. The effect of foreign exchange rate fluctuations on the Company during the three and nine-month periods ended September 30, 2000 was not material. 26 28 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 27.1 Financial Data Schedule (b) Reports on Form 8-K: The Company did not file any reports on Form 8-K during the quarter ended September 30, 2000. 29 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INNERDYNE, INC. /s/ William G. Mavity ---------------------- William G. Mavity President, Chief Executive Officer and Acting Chief Financial Officer and Principal Financial Officer (Duly Authorized Signatory) Date: November 8, 2000 28 30 EXHIBIT INDEX

INNERDYNE INC 10-Q