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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 333-13287
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EARTHSHELL CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 77-0322379
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
6740 CORTONA DRIVE, SANTA BARBARA, CALIFORNIA 93117
(Address of principal executive office) (Zip Code)
(805) 571-8232
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12 (b) of the Act:
NONE
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Securities registered pursuant to Section 12 (g) of the Act:
Common Stock $.01 par value
(Title of each class)
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 |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. Yes |X|
Indicate by checkmark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No |_|
The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of June 30, 2003 was $42,344,627.
The number of shares outstanding of the Registrant's Common Stock as of
March 31, 2004 was 14,128,966.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Registrant's Annual Meeting of
Stockholders to be held on June 28, 2004 are incorporated by reference in Part
III of this Annual Report on Form 10-K.
As used herein, the terms "EarthShell" and the "Company" shall mean
EarthShell Corporation unless the context otherwise indicates and the term
"Proxy Statement" shall mean the Proxy Statement for the Company's 2004 Annual
Meeting of Stockholders to be held on June 28, 2004.
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ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
PART I
ITEM 1. BUSINESS........................................................................................... 1
ITEM 2. PROPERTIES......................................................................................... 10
ITEM 3. LEGAL PROCEEDINGS.................................................................................. 10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS................................................ 10
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.............................. 11
ITEM 6. SELECTED FINANCIAL DATA............................................................................ 11
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............. 12
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......................................... 20
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA........................................... 20
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE............... 20
ITEM 9A. CONTROLS AND PROCEDURES............................................................................ 21
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................................................. 21
ITEM 11. EXECUTIVE COMPENSATION............................................................................. 21
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS..... 21
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..................................................... 21
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES............................................................. 21
PART IV
ITEM 15. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K..................... 22
PART I
ITEM 1. BUSINESS
THE COMPANY
EarthShell(R) Corporation ("EarthShell" or the "Company") was organized in
November 1992 as a development stage company engaged in the commercialization of
a proprietary composite material technology, designed with the environment in
mind, for the manufacture of disposable packaging for the foodservice industry.
Current and future products include hinged-lid containers, plates, bowls,
foodservice wraps, cups, and cutlery ("EarthShell Packaging").
The EarthShell composite material is primarily made from abundantly
available and low cost natural raw materials such as limestone and potato
starch. The Company believes that foodservice disposables made of this material
and offering certain environmental benefits, will have comparable or superior
performance characteristics, such as greater strength and rigidity, and can be
commercially produced and sold at prices that are competitive with comparable
conventional paper and plastic foodservice disposables.
The Company's objective is to establish EarthShell Packaging(R) as the
preferred disposable packaging material for the foodservice industry throughout
the world based on comparable performance, environmental superiority and
competitive pricing. EarthShell's approach for achieving this objective has been
to: (i) license the EarthShell technology to strategically selected
manufacturing or operating partners to manufacture, market, distribute and sell
EarthShell Packaging; (ii) attain customer acceptance and demand for EarthShell
Packaging through key market leaders and environmental groups; and (iii)
demonstrate the manufacturability and improved economics with initial strategic
partners. The Company believes that this approach aligns key market segments
with select industry partners, minimizes potential direct competition from these
producers, enables effective brand management, captures the value of
manufacturing process improvements and creates potential for continuing income
streams beyond the life of the patents.
INDUSTRY OVERVIEW
Based on industry studies, the Company believes that the annual spending
on foodservice disposable packaging is approximately $12 billion in the U.S. and
over $28 billion globally. According to industry studies of the U.S. market,
approximately 54% of the total foodservice disposable packaging is purchased by
quick-service restaurants and 46% by other institutions such as hospitals,
stadiums, airlines, schools, restaurants (other than quick-service restaurants),
and retail stores. The Company believes that of the foodservice disposables
purchased in the U.S. by quick-service restaurants and other institutions,
approximately 45% are made of coated or plastic laminated paper and 55% are made
of non-paper materials such as plastic, polystyrene or foil. A breakdown of the
various components of the global market for foodservice disposables is as
follows:
POTENTIAL GLOBAL MARKET FOR FOODSERVICE DISPOSABLE PACKAGING
($ IN MILLIONS) MARKET SIZE
-----------------------------
$ %
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COMMERCIAL PRODUCTS
Plates, Bowls ....................... $ 4,500 16%
Hinged-Lid Containers ............... 1,750 6
COMMERCIAL PROTOTYPES
Wraps ............................... 2,000 7
Hot Cups ............................ 3,000 11
CONCEPT PROTOTYPES
Cold Cups ........................... 5,500 20
Containers, Trays ................... 4,000 14
Straws, Cup Lids .................... 3,000 11
Pizza Boxes ......................... 2,250 8
Cutlery ............................. 2,000 7
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TOTAL ............................... $28,000 100%
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1
In addition to the U.S., the market opportunity for EarthShell Packaging
is particularly strong in Europe and parts of Asia due to heightened
environmental concerns and government regulations. In Europe, environmental
legislation, such as the so-called "Green Dot" laws have created an opportunity
for environmentally preferable products. Meanwhile, new regulations in many
Asian countries have mandated a reduction in polystyrene production stimulating
an increased demand for foodservice packaging manufactured from acceptable
alternative materials. Furthermore, improvements in the Asian and European
composting and recycling infrastructure are expected to facilitate the use of
environmentally preferable products.
PRODUCTS
EarthShell Packaging is based on a patented composite material technology
licensed on an exclusive worldwide basis from E. Khashoggi Industries LLC, the
largest stockholder of the Company, and, on a limited exclusive, worldwide
basis, from its wholly owned subsidiaries (collectively "EKI"). The Company's
licensed field of use of the technology is for the development, manufacture and
sale of disposable packaging for use in the foodservice industry and for certain
specific food packaging applications.
Traditional foodservice disposables, wraps, and paperboard are currently
manufactured from a variety of materials, including paper and plastic. The
Company believes that none of these materials fully addresses three of the
principal challenges facing the foodservice industry; namely performance, cost,
and environmental impact. The Company believes that EarthShell Packaging
addresses the combination of these challenges better than traditional
alternatives and therefore will be able to achieve a significant share of the
foodservice disposable packaging market.
EarthShell Packaging can be categorized into four types: foam laminate,
flexible wraps, injection-molded articles and paperboard substitutes. Through
2003, the EarthShell technology has been used to produce plates, bowls, and
hinged-lid containers intended for use by all segments of the foodservice
disposable packaging market, including quick-service restaurants, food and
facilities management companies, the U.S. government, universities/colleges, and
retail operations. These products were developed using detailed environmental
assessments and carefully selected raw materials and processes to minimize the
harmful impact on the environment without sacrificing competitive price or
performance.
Environment
EarthShell's foodservice disposable products were developed over many
years based on environmental models to reduce the environmental concerns of
foodservice disposable packaging through the careful selection of raw materials,
manufacturing processes and suppliers. For example, EarthShell Packaging reduces
risk to wildlife compared to polystyrene foam packaging because it biodegrades
when exposed to moisture in nature and can be composted in a commercial facility
(where available) or even in consumers' backyards.
Performance
The Company believes that it has demonstrated that its foam laminate
products, including hinged-lid containers, plates and bowls meet the critical
performance requirements of the marketplace, including strength, graphic
capabilities, insulation, shipping, handling and packaging. The Company
believes its foodservice wraps also meet critical performance
requirements of the marketplace, including flexibility, folding
characteristics, graphic capabilities, insulation, shipping, handling and
packaging. Finally, the Company believes that its paperboard substitute
product, which is currently under development, may be manufactured using the
same basic raw materials as the foam laminate disposables and wraps and will be
readily accepted by the market when available.
2
Some examples of where EarthShell Packaging(R) plates, bowls, and
hinged-lid containers have been used include:
Quick-Service Restaurants McDonald's Corporation ("McDonalds")
Facilities Management Sodexho
Bon Appetit
Aramark
Government U.S. Department of the Interior
U.S. Department of Defense
Environmental Protection Agency
General Services Administration
Universities University of California, Davis
Hampshire College
Allegheny College
Retail Wal-Mart Stores
Green Earth Office Supply
In addition to rigid packaging products, the Company will be introducing
second generation foodservice wraps through its licensee, Hood Packaging
Corporation, and is preparing to sell these products on an introductory basis to
key customers in test markets.
Cost
Since EarthShell Packaging(R) is uniquely engineered from commonly
available, low cost natural raw materials such as limestone and starch, the
Company believes EarthShell products can be manufactured cost-effectively at
commercial levels.
Product Recognition
To date, the Company has won the following awards for EarthShell
Packaging:
AWARD/RECOGNITION DATE ORGANIZATIONS
------------------------------------------------------------ --------- ---------------------------------------------------------
Closing the Circle Award--Won by EarthShell's demonstration 2002 White House Task Force on Waste Prevention and Recycling
partner, the U.S. Dept. of the Interior
Best of the Best Award--1st Place--foam packaging 2002 Foodservice and Packaging Institute
DuPont Award for Innovation in Food Processing and 2002 DuPont, National Food Processors Association, and
Packaging Campden & Chorleywood Food Research Association
Green Seal Certification 2000 Green Seal
(hinged-lid container)
Innovation in Real Materials Award 1998 Innovation in Materials Conference
3
BUSINESS STRATEGY
The Company's objective is to establish EarthShell Packaging as the
preferred foodservice disposable packaging in the foodservice industry. The
Company's strategies to achieve this objective are to:
o Develop products that deliver comparable or greater performance and
cost-competitiveness with environmental advantages as compared to
traditional packaging alternatives
o Demonstrate customer demand as well as product performance and
positioning
o Prove manufacturability and economics of EarthShell Packaging
o License the EarthShell technology to leading manufacturing partners
to manufacture, market, distribute and sell EarthShell Packaging
o Expand the business by replicating the EarthShell model across
multiple operating partners to increase capacity
o Educate the market and build awareness for the EarthShell brand
o Defend a portfolio of patents relating to the EarthShell technology
Creating Consumer Demand for EarthShell Packaging: The Company believes
that the use of EarthShell Packaging by key foodservice operators will
accelerate the acceptance of the products by other users. To this end, the
Company has worked with major purchasers of foodservice disposables in the
development and testing of production order to demonstrate superior product
performance, highlight cost-benefit and build demand for EarthShell Packaging.
The Company also expects that the EarthShell Packaging brand name will appear on
EarthShell products.
Licensing Existing Manufacturers of Foodservice Disposables: The Company's
strategy includes licensing the EarthShell technology to, or joint venturing
with, strategically selected manufacturing or operating partners for the
manufacture, marketing, distribution and sale of EarthShell Packaging. The
Company expects that licensing the technology to companies such as Sweetheart
Cup Company ("Sweetheart"), recently acquired by The Solo Cup Company ("Solo"),
will enable the Company to take advantage of their manufacturing expertise
and existing sales and distribution networks. This approach should also
minimize the need to hire sales and marketing personnel. The Company is
actively seeking additional qualified licensees and will provide each of its
licensees with technical and ongoing support to facilitate the application
of the EarthShell technology, further refine manufacturing processes and
reduce production costs. The Company will monitor product quality at licensee
operations.
Developing International Markets: The Company's international strategy is
to license the technology to strategic partners in major international markets.
Initial markets with strong interest in the environmental advantages offered by
EarthShell include Europe and the Far East.
LICENSING BUSINESS MODEL
The licensing model enables the Company to concentrate on the continuing
development of quality food service packaging products with reduced impact on
the environment. This approach contemplates that manufacturing, marketing,
distribution and sale of EarthShell Packaging will be the responsibility of the
Company's manufacturing licensees. EarthShell believes that its licensing
business model will enable it to generate a sustainable royalty revenue stream.
Beyond the revenue opportunities, the Company believes the licensing model
has positive implications for the Company's cost structure. As the Company has
moved to the product commercialization phase and has reduced its investment in
demonstration manufacturing operations, it has been able to significantly reduce
monthly operating costs and position itself to take advantage of the operating
leverage provided by the licensing model.
EarthShell Packaging will be manufactured by the Company's licensed
manufacturing partners. Given the low cost of the raw materials required, these
strategic manufacturing partners should have a financial incentive to produce
EarthShell Packaging rather than comparable traditional paperboard/polystyrene
products even after a royalty payment to EarthShell.
4
While the Company believes it will be successful in developing cost
competitive products with its partners, delays in developing such products could
adversely impact the introduction and market acceptance of EarthShell Packaging
and could have an adverse effect on the Company's business, financial condition
and results of operations.
STRATEGIC RELATIONSHIPS
The Company believes that it has demonstrated that EarthShell plates,
bowls and hinged-lid containers are commercially competitive in terms of
performance and that there is a customer base that is willing to buy them. A
critical task for 2004 is the installation and start-up of commercial
manufacturing capacity to supply EarthShell products to the marketplace. The
Company's licensees are committing capital to purchase equipment to provide
EarthShell Packaging products or otherwise develop the EarthShell products or
production capacity. For example, Sweetheart has ordered initial commercial
turnkey manufacturing equipment from Detroit Tool & Engineering ("DTE"). The
Company intends to proliferate the use of EarthShell Packaging in the U.S. and
international markets through agreements with additional licensed partners.
Current strategic partners include Solo/Sweetheart and Hood Packaging.
In February 2004, the Company entered into a definitive license agreement
with Hood Packaging ("Hood") under which Hood became the exclusive
manufacturer/distributor of EarthShell food wraps for the North American market,
subject to maintaining certain monthly and annual performance targets. Hood is
producing initial quantities of the second-generation EarthShell food service
wrap and is preparing to introduce these wraps into selected markets.
The Company entered into an agreement with Sweetheart in late 1997 to
develop and operate manufacturing lines at Sweetheart's Owings Mills facility
for the production of hinged-lid containers for McDonald's Big Mac(R)
sandwiches. For several years, the Company worked closely with Sweetheart and
McDonald's to create an acceptable product design and meet required performance
standards. During that period, over 20 million EarthShell Packaging hinged-lid
containers for Big Mac sandwiches were used on a trial basis. As a result of
these efforts, the EarthShell hinged-lid container became an approved product
for use in the McDonald's system. At this time, EarthShell Packaging hinged-lid
containers are no longer being produced for McDonald's while Solo/Sweetheart
determines its plans for future production capacity (see Manufacturing).
In October 2002, as a result of the demonstration of a viable
manufacturing process for plates, bowls and hinged-lid containers and the
commitment to supply turnkey manufacturing equipment with performance guarantees
from qualified equipment suppliers, Sweetheart and the Company entered into a
new Sublicense & Operating Agreement. This agreement was further amended in July
of 2003. The agreement gives Solo/Sweetheart a priority right to the U.S. retail
market segment, provided they build and operate manufacturing capacity at a
prescribed level. In December of 2002, Sweetheart issued its initial purchase
orders for new equipment to manufacture plates and bowls but revised its order
late in 2003. The first of this new equipment is currently planned to become
available by mid-to-late 2004. DTE has built four plate and four bowl
manufacturing modules and has demonstrated to EarthShell's satisfaction that
this equipment is fully capable of continuous commercial service. Delivery,
installation and start-up of this equipment is expected to occur in the second
half of 2004.
In July 2002, the Company and DuPont signed a strategic Alliance Agreement
to develop environmentally preferred packaging and systems. The Company worked
with DuPont to explore and develop potential applications for DuPont's Biomax(R)
biopolymer resins as a component of EarthShell Packaging. DuPont worked on
commercializing EarthShell foodservice wraps using their proprietary composite
biopolymer blends to initial select customers, but discontinued the manufacture
and sale of this product in 2003.
In October 2001, the Company entered into license agreements with GEP and
GP. These two entities, formed specifically to commercialize EarthShell
Packaging in the U.S. and Asia, are subsidiaries of Dominance, Inc., part of a
Malaysian group of companies with over 50 years of manufacturing experience. GEP
planned to produce plates and bowls for U.S. markets, while GP planned to
produce noodle bowls for Asian markets. In mid-2003, the Company and GEP and GP
ended these licensing agreements.
In May 1999, the Company signed an agreement with Huhtamaki creating
Polarcup Earthshell ApS, a joint venture to commercialize EarthShell Packaging
throughout western Europe, Australia and New Zealand. In cooperation with the
joint venture, EarthShell designed and commissioned the construction of a
commercial line for the manufacture of hinged-lid containers in Europe. In
mid-2002, the joint venture assumed responsibility for the installation and
start-up of the manufacturing line at Huhtamaki's Goettingen, Germany facility.
In December of 2003, the Company and Huhtamaki concluded their joint venture
structure. Huhtamaki has expressed an interest in becoming a non-exclusive
licensee on more standard terms and conditions.
5
The Company has garnered support and achieved commercial validation for
EarthShell Packaging from key environmental groups and foodservice purchasers.
The Company has also devoted resources to the optimization of product design and
the development of cost-effective manufacturing processes. In cooperation with
existing manufacturing partners, the Company financed and built initial
commercial demonstration production capacity and sold limited quantities of
plates, bowls, and hinged-lid containers. Having demonstrated the
manufacturability of EarthShell foam products, the Company has now ceased
commercial demonstration production activities and is relying on its equipment
manufacturing partners to demonstrate and guarantee the long-term
manufacturability of EarthShell Packaging(R).
EarthShell believes it has a high quality and cost-effective product and
the profitable business model necessary to take advantage of a significant
market opportunity. With the introduction of commercial production capacity and
expected sales of its products in 2004, EarthShell expects its products to
continue to gain acceptance in the marketplace and believes it is poised to
support capacity expansion and market penetration by its licensees leading to
commencement and growth of its own royalty revenue.
MANUFACTURING
The EarthShell manufacturing process for foam laminate products consists
of blending the component ingredients of a proprietary composite material in a
mixer, depositing the mixture into heated cavity molds, heating the molded
mixture for approximately one minute, removing the product, trimming excess
material, and applying functional coatings with desired graphics. EarthShell
Packaging uses commonly available natural raw materials, such as limestone,
potato or corn starch, as well as natural fiber and functional coatings. The
Company believes that these raw materials are currently available from multiple
existing suppliers in quantities sufficient to satisfy projected demand.
Over the past several years, the Company has been working to demonstrate
the commercial viability of its manufacturing processes to enable its operating
partners to compete effectively with conventional disposable foodservice
packaging and to transfer the operational and financial responsibility of its
production lines to its operating partners. To date the Company has produced
limited amounts of EarthShell Packaging at production volumes that are low
relative to the intended and necessary capacities of the manufacturing lines
that are required to achieve efficiencies and cost effectiveness.
The Company entered into an Operating Agreement with Sweetheart in late
1997 whereby the Company financed and built production capacity at Sweetheart's
Owings Mills, Maryland manufacturing facility to demonstrate that its hinged-lid
containers could be produced commercially for McDonald's. For several years the
Company worked closely with McDonald's and created an acceptable product design
which met required performance standards. After a lengthy commercial validation
process, during which McDonald's purchased and used over 20 million EarthShell
Packaging hinged-lid containers in select restaurants, McDonald's approved the
product design for national use in March 2001. After an attempt to make the
initial equipment at Owings Mills work at a commercially viable level,
Sweetheart and EarthShell decided to invite qualified equipment builders to
implement the EarthShell technology on a guaranteed turnkey basis and production
at the Owings Mills facility ceased in 2002. As of December 31, 2002, the
Company's Owings Mills manufacturing lines were carried on its balance sheet at
a net book value of zero.
In May 2002, the Company announced that it had licensed and certified
various equipment builders to supply turnkey manufacturing equipment to
EarthShell licensees. These equipment builders offer performance guarantees. The
Company believes that this development will facilitate the expansion of
production capacity for foam laminate plates, bowls, hinged-lid containers and
cups. Detroit Tool and Engineering ("DTE") was the first certified manufacturer
to provide performance guarantees for turnkey manufacturing modules and is
building the first commercial machinery for Solo/Sweetheart for delivery in
mid-to-late 2004. The Company believes that the combined capacity of its
licensed equipment vendors will be sufficient to meet the expected licensee
demand for foam laminate production manufacturing lines for the foreseeable
future.
Although the manufacturing processes currently being used to manufacture
EarthShell Packaging are based on generally available methods and equipment, it
has taken much longer and has cost much more than anticipated to integrate the
machinery in an automated fashion and to refine the manufacturing processes and
equipment to operate at commercially viable levels.
6
The Company also manufactured EarthShell Packaging plates and bowls at a
pilot facility in Goleta, California initially developed in cooperation with
GEP. Plates and bowls from this facility were used to supply EarthShell
customers such as the U.S. government and Wal-Mart until early to mid-2003, when
the demand from these customers was temporarily met with output from the DTE
equipment.
PATENTS, PROPRIETARY RIGHTS AND TRADEMARKS
The technology that the Company licenses from EKI is the subject of
numerous issued and pending patents in the U.S. and internationally. The Company
believes the patents and pending patent applications provide broad protection
covering foam laminate EarthShell Packaging, material composition and the
manufacturing processes. As of December 31, 2003, EKI had over 130 U.S. and
international patents and has pending patent applications relating to the
compositions, products and manufacturing processes used to produce EarthShell
Packaging(R) food and beverage containers. Patents currently issued do not begin
to expire until 2012 and provide some protection until 2020. Pending patents, if
granted, would extend protection through 2022. Sixteen of the issued U.S.
patents and five of the pending U.S. patents relate specifically to molded food
and beverage containers manufactured from the new composite material, the
formulation of the new composite material used in virtually all of the
EarthShell Packaging currently under development. The Company and EKI will
continue to seek domestic and international patent protection for further
developments in the technology and will vigorously enforce rights against any
person infringing on the technology.
The Company owns the EarthShell trademark and certain other trademarks,
and has been licensed by EKI to use the trademark ALI-ITE for the composite
material.
RELATIONSHIP WITH AND RELIANCE ON EKI
The Company has an exclusive, worldwide, royalty-free license to use and
license the EKI technology to manufacture and sell disposable, single-use
containers for packaging or serving food or beverages intended for consumption
within a short period of time (less than 24 hours).
On July 29, 2002, the Company entered into an amendment to its Amended and
Restated License Agreement with EKI (the "License Agreement") expanding the
field of use for the EarthShell technology to include noodle bowls used for
packaging instant noodles, a worldwide market that the Company estimates to be
approximately $1 billion. Because the noodle bowl development was made at no
cost to EarthShell and is an incremental field of use, EarthShell will pay to
EKI 50% of any royalty or other consideration it receives in connection with the
sale of products within this particular field of use.
In addition, on July 29, 2002 the Company entered into a License &
Information Transfer Agreement with bio-tec Biologische Naturverpackungen GmbH &
Co. KG and bio-tec Biologische Naturverpackungen Forschungs und Entwicklungs
GmbH, together known as "Biotec", a wholly owned subsidiary of EKI, to utilize
the Biotec technology for foodservice applications, including the food wraps and
cutlery used in foodservice applications (the "Biotec Agreement"). EKI had
previously granted to the Company priority rights to license certain product
applications on an exclusive basis from Biotec in consideration for the
Company's payment of a $100,000 monthly licensing fee to Biotec. In addition, in
consideration of the monthly payment, Biotec agreed to render technical services
to the Company at Biotec's cost plus 5%. The licensing fee and services
arrangements were continued in the Biotec Agreement. Under the terms of the
Biotec Agreement, Biotec is entitled to receive 25% of any royalties or other
consideration that the Company receives in connection with the sale of products
utilizing the Biotec technology.
During 2002, and January 2003, EKI made a series of loans to the Company
totaling approximately $5.8 million. These loans were used to pay operating
costs and accrued interest at 7% or 10% per annum. In connection with the
issuance and sale in March 2003 of the Company's 2% secured convertible
debentures due in 2006 (the "2006 Debentures") to a group of institutional
investors, EKI agreed to subordinate the repayment of these loans to the payment
in full of the Company's obligations under the 2006 Debentures. In addition, EKI
and Biotec agreed to subordinate certain payments referenced above to which they
were otherwise entitled under the License Agreement and the Biotec Agreement
(other than their respective percentages of any royalties received by the
Company) to the satisfaction in full of the Company's obligations under the 2006
Debentures. They further agreed not to assert any claims against the Company for
breaches of the License Agreement or the Biotec Agreement (other than the
assertion of certain equitable remedies to enjoin the Company from, for example,
selling products outside its field of use) until such time as the Company's
obligations under the 2006 Debentures are satisfied in full. EKI and Biotec also
agreed to allow the Company to pledge its interest in the License Agreement to
secure its obligations under the 2006 Debentures, and certain additional
concessions were made by EKI and Biotec to permit the Company greater
flexibility in selling its rights under the License Agreement and the Biotec
Agreement to third parties in an insolvency context. These rights terminate upon
the satisfaction in full of the obligations under the 2006 Debentures. In
consideration for its willingness to subordinate the payments and advances that
are owed to it, the Company issued to EKI in March 2003 a warrant to acquire
83,333 shares of the Company's common stock at a price of $6.00 per share with a
ten year term.
7
Under the terms of the License Agreement and the Amended and Restated
Patent Agreement for the Allocation of Patent Costs between the Company and EKI,
any patents granted in connection with the EarthShell technology are the
property of EKI, and EKI may obtain a benefit therefrom, including the
utilization and/or licensing of the patents and related technology in a manner
or for uses unrelated to the license granted to the Company in the foodservice
disposables field of use. Effective January 1, 2001, EarthShell assumed direct
responsibility to manage and maintain the patent portfolio underlying the
License Agreement with EKI and to pay directly all related costs.
In connection with the issuance and sale of the 2006 Debentures, Mr. Essam
Khashoggi, who controls EKI and is the beneficial owner of approximately 35% of
the Company's common stock, agreed for himself and on behalf of EKI, not to sell
any of the Company's shares for an 18 month period concluding in August 2004
(excluding shares issuable to former EKI employees under existing option grants
and shares pledged under an existing security agreement with a third party
lender).
COMPETITION
Competition among food and beverage container manufacturers in the
foodservice industry is intense. Virtually all of these competitors have greater
financial and marketing resources at their disposal than does the Company, and
many have established supply, production and distribution relationships and
channels. Companies producing competitive products may reduce their prices or
engage in advertising or marketing campaigns designed to protect their
respective market shares and impede market acceptance of EarthShell Packaging.
In addition, some of the Company's licensees and joint venture partners
manufacture paper, plastic or foil packaging that may compete with EarthShell
Packaging.
Several paper and plastic disposable packaging manufacturers and
converters and others have made efforts to increase the recycling of these
products. Increased recycling of paper and plastic products could lessen their
harmful environmental impact, one major basis upon which the Company intends to
compete. A number of companies have introduced or are attempting to develop
biodegradable starch-based materials, plastics, or other materials that may be
positioned as potential environmentally superior packaging alternatives. It is
expected that many existing packaging manufacturers may actively seek to develop
competitive alternatives to the Company's products and processes. While the
Company believes its patents uniquely position it to incorporate a proportion of
low cost, inorganic fillers with its material, which, relative to other
starch-based or specialty polymers, will result in lower material costs, the
development of competitive, environmentally attractive, disposable foodservice
packaging could render the Company's technology obsolete and could have an
adverse effect on the business, financial condition and results of operations of
the Company.
CERTAIN RISK FACTORS
On March 8, 2004, the Company's common stock was delisted from the Nasdaq
Smallcap Market because the Company's market capitalization failed to meet the
minimum required standard. In addition, the Company did not make interest
payments related to the 2006 Debentures as required on January 31, 2004. These
actions put the Company in non-compliance with its covenants under the 2006
Debentures. Management is currently negotiating with the debenture holders for
appropriate relief or waiver of these covenants. One of the debenture holders
has notified the Company in writing that they are in default and has requested
that the Company repurchase the entire principal amount of the 2006 Debentures
that they hold at the price specified in the debenture, along with any accrued
and unpaid interest. Because the Company can not assure that it will be able to
negotiate appropriate relief or a waiver of the applicable covenants, the entire
outstanding principal amount of the 2006 Debentures has been classified as
a current liability as of December 31, 2003.
8
The SEC adopted regulations which generally define a "penny stock" to be
any non-Nasdaq equity security that has a market price of less than $5.00 per
share, subject to certain exceptions. Based upon the price of EarthShell common
stock as currently traded, EarthShell common stock is subject to Rule 15g-9
under the Exchange Act which imposes additional sales practice requirements on
broker-dealers which sell securities to persons other than established customers
and "accredited investors." For transactions covered by this rule, a
broker-dealer must make a special suitability determination for the purchaser
and have received a purchaser's written consent to the transaction prior to
sale. Consequently, this rule may have a negative effect on the ability of
stockholders to sell common shares of the Company in the secondary market.
Because the Company is still in its developmental stage and has limited
operating history, it remains subject to the inherent challenges and risks of
establishing a new business enterprise. To date, production volumes of
EarthShell Packaging products have been low relative to intended and necessary
capacity of the manufacturing lines. The success of future operations depends
upon the ability of our licensees to manufacture products made with EarthShell
Packaging in sufficient quantities so as to be commercially feasible and then to
distribute and sell those products at competitive costs. Consistent commercially
feasible production volumes had not been achieved and assured competitive cost
figures had not yet been proven as of December 31, 2003.
As of December 31, 2003, the Company had not yet reported any operating
revenues and had experienced aggregate net losses of approximately $314.4
million from inception. The Company does not expect to operate profitably during
fiscal year 2004. Although the Company is actively seeking third party financing
to meet its operating and capital needs, there is no assurance that additional
funding will be available to the Company, and, even if it is available, such
financing may be (i) extremely costly, (ii) dilutive to existing stockholders
and/or (iii) restrictive to the Company's ongoing operations.
The Company's current business model is to license the manufacturing and
distribution of EarthShell Packaging foodservice disposables to licensees.
Agreements with the licensees permit them to manufacture and sell other
foodservice disposable packaging products that are not based on EarthShell
Packaging. The licensees may also manufacture paper or polystyrene packaging
which could compete with EarthShell products, and they may not devote sufficient
resources or otherwise be able successfully to manufacture, distribute or market
EarthShell Packaging. Their failure to do so would be grounds for termination of
exclusivity provisions in their license agreement, but might also delay the
rollout of EarthShell Packaging into the marketplace.
The success of the Company depends substantially on its ability to design,
develop and manufacture foodservice disposables that are not as harmful to the
environment as conventional disposable foodservice containers made from paper,
plastic and polystyrene. Although EarthShell Packaging offers a number of
environmental advantages over conventional packaging products, it may also
possess characteristics that consumers or environmental groups could perceive as
negative for the environment. In particular, EarthShell Packaging may result in
more solid waste by weight, and manufacturing them may release greater amounts
of some pollutants than the manufacture of some other packaging would release.
The Company does not own the technology necessary to manufacture
EarthShell Packaging and is dependent upon the License Agreement to use that
technology. The licensed technology is limited to the development, manufacture
and sale of specified foodservice disposables for use in the foodservice
industry, and there is no right to exploit opportunities to apply this
technology or improve it outside this field of use. If EKI were to file for or
be declared bankrupt, the Company would likely be able to retain its rights
under the License Agreement with respect to U.S. patents; however, it is
possible that steps could be taken to terminate its rights under the License
Agreement with respect to international patents. EKI is the controlling
stockholder of the Company, and conflicts could arise with regard to performance
under the license agreement, corporate opportunities or time devoted to the
business of the Company by officers and directors who are common to both EKI and
the Company.
GOVERNMENT REGULATION
The manufacture, sale and use of EarthShell Packaging are subject to regulation
by the U.S. Food and Drug Administration (the "FDA"). The FDA's regulations are
concerned with substances used in food packaging materials, not with specific
finished food packaging products. Thus, food and beverage containers will be in
compliance with FDA regulations if the components used in the food and beverage
containers: (i) are approved by the FDA as indirect food additives for their
intended uses and comply with the applicable FDA indirect food additive
regulations; or (ii) are generally recognized as safe for their intended uses
and are of suitable purity for those intended uses.
9
The Company believes that EarthShell Packaging plates, bowls and
hinged-lid containers and all other current and prototype EarthShell Packaging
products of the Company are in compliance with all requirements of the FDA and
do not require additional FDA approval. The Company cannot be certain, however,
that the FDA will agree with these conclusions.
EMPLOYEES
As of January 1, 2004, the Company had 13 employees. The Company's
employees are not represented by a labor union, and the Company believes it has
a good relationship with its employees.
AVAILABLE INFORMATION
The Company's internet website is www.earthshell.com. The Company
makes available free of charge on its website its annual report on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, reports
filed pursuant to Section 16 of the Securities Exchange Act of 1934, as
amended (the "Exchange Act") and amendments to those reports as soon as
reasonably practicable after such materials are electronically filed or
furnished to the SEC. Materials the Company files with the SEC may be read
and copied at the SEC's Public Reference Room at 450 Fifth Street, NW,
Washington, DC 20549. This information may also be obtained by calling the
Securities and Exchange Commission at 1-800-SEC-0330. The Securities and
Exchange Commission also maintains an internet website that contains reports,
proxy and information statements, and other information regarding issuers
that file electronically with the SEC at www.sec.gov. The Company will provide
a copy of any of the foregoing documents to shareholders upon request.
ITEM 2. PROPERTIES
In September 2003, the Company leased 4,000 square feet of office and
research and development space in Santa Barbara, California, under a lease that
expired on December 31, 2003. In January 2004, the lease was extended through
April 2004. The Company's monthly lease payment with respect to this space is
$5,000. In addition, the Company leases 3,353 square feet of office space in
Lutherville, Maryland, on a month to month basis. The Company's monthly lease
payment with respect to this space is $5,780.
The Company believes it will be able to lease comparable space at a
comparable price when these leases expire.
ITEM 3. LEGAL PROCEEDINGS
In September 2003, two lawsuits were filed against the Company by Green
Packaging ("GP") and Green Earth Packaging ("GEP"), both of which had signed
license agreements with the Company permitting their use of EarthShell
proprietary, biodegradable-packaging technology. The first lawsuit alleged
breach of an oral contract involving manufacturing equipment that GP and GEP
purchased to make biodegradable packaging using EarthShell proprietary
technology. The second lawsuit alleged violations of California's antitrust law
and Unfair Practices Act involving the commercial viability of the
biodegradable-packaging technology that the Company licensed to GP and GEP.
The Company filed petitions seeking to compel the court to send both
lawsuits to arbitration. While those motions were pending, the Company held a
mediation with GP and GEP and resolved both actions conclusively in February
2004 to the satisfaction of both parties on terms in which no party admitted
liability. The parties are in the process of documenting the settlement.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
10
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock is currently listed through the Pink Sheets published
by the National Quotation Bureau, Inc., and prior to March 8, 2004 traded on the
Nasdaq SmallCap Market. The Company's common stock trades under the symbol
"ERTH.PK." For the periods indicated, the following table presents the range of
high and low closing sale prices for the Company's common stock.
FIRST SECOND THIRD FOURTH TOTAL YEAR
----------- ----------- ----------- ----------- -----------
2003
Market price per common share
High .................... $ 7.80 $ 7.08 $ 5.64 $ 4.56 $ 7.80
Low ..................... 4.20 4.32 3.72 1.33 1.33
2002
Market price per common share
High .................... $ 24.60 $ 16.80 $ 12.96 $ 9.60 $ 24.60
Low ..................... 13.80 4.32 6.00 6.96 4.32
The closing sale prices for the Company's common stock reflect, where
applicable, the one-for-twelve reverse stock split of the Company's common stock
effective October 31, 2003.
The number of stockholders of record of the Company's common stock at
March 31, 2004 was 1,182. At March 31, 2004, Mr. Essam Khashoggi, directly or
indirectly, owned approximately 35% of the outstanding common stock of the
Company.
The Company is a developmental stage company and does not intend to
declare or pay cash dividends on its common stock in the foreseeable future.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below should be read in conjunction
with the Company's Financial Statements and Notes thereto and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this Annual Report on Form 10-K.
SELECTED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOVEMBER 1,
1992
(INCEPTION)
FOR THE YEAR ENDED DECEMBER 31 THROUGH
-------------------------------------------------------------------- DECEMBER 31,
2003 2002 2001 2000 1999 2003
--------- --------- --------- --------- --------- ---------
STATEMENT OF OPERATIONS DATA
Research and development expenses . $ 9,547 $ 26,890 $ 47,148 $ 37,265 $ 30,471 $ 213,703
General and administrative expenses 5,786 9,590 9,634 6,843 11,872 70,401
Depreciation and amortization ..... 380 3,099 5,874 5,704 4,644 22,841
Gain on sale of property and
equipment ..................... (452) (441) -- -- -- (893)
Interest expense (income), net .... 1,791 132 (356) (1,264) (3,448) (2,193)
Related party patent expenses ..... -- -- -- 362 645 8,693
Debenture conversion cost ......... 166 321 -- -- -- 487
Net loss .......................... 18,517 39,591 62,302 48,912 44,188 314,351
Preferred dividends ............... -- -- -- -- -- 9,927
Net loss available to common
stockholders .................. 18,517 39,591 62,302 48,912 44,188 324,277
Average shares outstanding ........ 13,267 11,277 9,353 8,452 8,337 8,436
BALANCE SHEET DATA
Cash and cash equivalents ......... $ 1,902 $ 111 $ 828 $ 7,792 $ 26,413
Short-term investments ............ -- -- -- -- 8,971
Working capital (deficit) ......... (7,922) (8,315) (6,941) 2,107 32,886
Total assets ...................... 2,287 18,024 19,886 48,474 87,199
Convertible debentures, accounts
payable to related party,
accrued interest and accrued
dividends ..................... -- 10,190 -- 266 1,386
Deficit accumulated during
development stage ............. (314,351) (295,834) (256,243) (193,941) (145,029)
Stockholders' equity (deficit) .... (12,269) (3,473) 11,536 42,296 80,686
Shares outstanding ................ 14,129 12,055 9,860 8,709 8,337
PER COMMON SHARE
Basic and diluted loss per share .. $ 1.40 $ 3.51 $ 6.66 $ 5.79 $ 5.30 $ 38.44
11
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the Selected
Financial Data and the Company's Consolidated Financial Statements and Notes
thereto included elsewhere in this Annual Report on Form 10-K. Such consolidated
financial statements and information have been prepared to reflect the
historical operations, assets and liabilities of the Company from the date of
the Company's organization on November 1, 1992 through December 31, 2003.
FORWARD-LOOKING STATEMENTS
Information in this Annual Report on Form 10-K including but not limited to
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995, as amended. These statements
may be identified by the use of forward-looking terminology including but not
limited to "may," "will," "expect," "anticipate," "estimate," or "continue," or
the negative thereof or other comparable terminology. Any one factor or
combination of factors could cause the Company's actual operating performance or
financial results to differ from those anticipated by management that are
described herein. Factors influencing the Company's operating performance and
financial results include, but are not limited to, changes in the general
economy, the availability of financing, governmental regulations concerning, but
not limited to, environmental issues, and other risks and unforeseen
circumstances affecting the Company's business which may be discussed elsewhere
in this Annual Report on Form 10-K.
CRITICAL ACCOUNTING ASSUMPTIONS
Going Concern Basis. The consolidated financial statements have been
prepared on a going concern basis, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of business. During the
period from November 1, 1992 (inception) to December 31, 2003, the Company has
incurred a cumulative net loss of $314,350,681 and has a working capital deficit
of $7,922,339 at December 31, 2003. These factors, along with others, may
indicate that the Company will be unable to continue as a going concern for a
reasonable period of time. The Company will have to raise additional funds to
meet its current obligations and to cover operating expenses through the year
ending December 31, 2004. If the Company is not successful in raising additional
capital it may not be able to continue as a going concern for a reasonable
period of time. Management plans to address this need by raising cash through
either the issuance of debt or equity securities. In addition, the Company
expects cash to be generated in 2004 through royalty payments from licensees.
Another possible source of funds is the sale or transfer of the commercial
production line in Goettingen, Germany to an operating partner. However, the
Company can not assure that additional financing will be available to it, or, if
available, that the terms will be satisfactory, that it will receive any royalty
payments in 2004, or that it will be able to negotiate mutually agreeable terms
for the transfer of its commercial production line to an operating partner.
Management will also continue in its efforts to reduce expenses, but can not
assure that it will be able to reduce expenses below current levels. The
consolidated financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts and
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern.
12
Estimated Net Realizable Value of Property and Equipment. The Company has
been engaged in the development of manufacturing equipment to validate
acceptance of EarthShell products and their pricing. To this end, the Company
has previously developed manufacturing lines in Owings Mills, Maryland, Goleta,
California and in Goettingen, Germany. The Company evaluates the recoverability
of property and equipment whenever events or changes in circumstances indicate
that the carrying value of an asset may not be recoverable. If there is an
indication that the carrying value of an asset may not be recoverable and the
estimated future cash flows (undiscounted and without interest charges) from the
use of the asset are less than the carrying value, a write-down is recorded to
reduce the related asset to its estimated fair value.
The Company entered into a strategic relationship with Sweetheart in late
1997 whereby the Company financed and built production lines at Sweetheart's
Owings Mills, Maryland manufacturing facility to demonstrate that its hinged-lid
containers could be produced commercially for McDonald's. The Company worked
closely with Sweetheart and McDonald's to create an acceptable product design,
develop a commercially viable operation and meet required performance standards.
In the fourth quarter of 2001, the company wrote down $12.3 million of the
Owings Mills property and equipment to reflect the net realizable value of the
equipment and machinery based on a quotation from a third party. During the
first half of 2002, production at the Owings Mills facility ceased as Sweetheart
contemplated acquisition of new, updated production lines. The Company
negotiated with Sweetheart and certain equipment manufacturers to assess their
interest in utilizing portions of the Company's existing production lines and
infrastructure in Owings Mills; however, definitive agreements were not reached
and the Company is unable to determine the amount, if any, of compensation it
might receive in disposing of its production lines in Owings Mills. As a result,
the Company wrote down the remaining $7.5 million of the equipment at Owings
Mills during the year ended 2002. As of December 31, 2002, the Company's Owings
Mills production lines was carried on its balance sheet at a net book value of
zero, and as of December 31, 2003 all of the Owings Mills equipment has been
sold or scrapped.
The commercial production line in Goettingen, Germany was originally
financed and constructed by the Company for the Company's joint venture with
Huhtamaki. During 2001, $1.2 million of the Goettingen line was written off to
reflect equipment that had no further application in the product development
cycle. During the third quarter of 2002 the Company concluded, after obtaining
quotations from various machinery suppliers for an identical line, that $1.7
million of the cost of the line would not be recoverable and therefore the
carrying value of the line was written down by this amount, of which $1.6
million was recorded in the third quarter of 2002 and the remaining $0.1 million
was recorded in the fourth quarter of 2002. With the conclusion of the joint
venture with Huhtamaki, the Company is seeking other operating partners to
purchase the production line. However, because the Company is unable to
determine with certainty the proceeds that will be realized upon sale of the
equipment, the Company wrote the line down to $1 as of December 31, 2003 and
reclassified it to the long-term asset account "Equipment held for sale."
RESULTS OF OPERATIONS
Year Ended December 31, 2003 Compared with the Year Ended December 31, 2002
The Company's net loss decreased $21.1 million to $18.5 million from $39.6
million for the year ended December 31, 2003 compared to the year ended December
31, 2002, respectively.
Research and Development Expenses. Total research and development expenses
are comprised of Related party license fee and research and development expenses
and Other research and development expenses. Total research and development
expenditures for the development of EarthShell Packaging(R) decreased $17.4
million to $9.5 million from $26.9 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively.
o Related party license fee and research and development expenses are
comprised of the $100,000 minimum monthly licensing fee for the use
of the EarthShell technology and for technical services, both of
which were payable to EKI, a stockholder of the Company, or Biotec,
a wholly owned subsidiary of EKI. It should be noted that payment of
these related party expenses has been deferred pursuant to
subordination agreements entered into by the EKI entities in
connection with the convertible debenture financing concluded in
March of 2003. Related party license fee and research and
development expenses decreased $0.2 million to $1.3 million from
$1.5 million for the year ended December 31, 2003 compared to the
year ended December 31, 2002, respectively. The decrease was
entirely due to a decrease in technical services provided to the
Company by Biotec.
13
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production, as well as impairment charges on manufacturing property
and equipment constructed for demonstration production purposes.
Other research and development expenses decreased $17.2 million to
$8.2 million from $25.4 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively. The
decrease in other research and development expenses was primarily
due to concluding the demonstration manufacturing of hinged-lid
containers in Owings Mills, Maryland at the end of the second
quarter of 2002. While the majority of the expenses incurred in 2002
related to the Owings Mills demonstration manufacturing, it also
included expenses related to the commencement of demonstration
manufacturing of bowls and plates in Goleta, California. Other
research and development expenses incurred in 2003 primarily related
to the ongoing demonstration manufacturing in Goleta through
mid-April and to the start-up in mid-May of a new manufacturing line
for plates and bowls built and financed by Detroit Tool and
Engineering Company (DTE) at their Lebanon, Missouri facility. In
early August 2003, the company discontinued its day-to-day support
of manufacturing activities at DTE. In keeping with its business
model, the Company will hereafter focus primarily on the licensing
of its foam analog material and other technologies, and all future
manufacturing and production will be the responsibility of current
or new licensees as they install and run equipment to produce
EarthShell Packaging(R)in their own facilities. The decrease in
other research and development expenses was also due to a $5.8
million reduction in property and equipment impairment charges, to
$4.0 million in 2003 from $9.8 million in 2002.
Other General and Administrative Expenses. Other general and
administrative expenses are comprised of personnel costs, travel and direct
overhead for marketing, finance and administration. Total general and
administrative expenses decreased $3.8 million to $5.8 million from $9.6 million
for the year ended December 31, 2003 compared to the year ended December 31,
2002, respectively. This was primarily the result of efforts to significantly
reduce general and administrative expenses in 2003, which resulted in reductions
in the following expense categories: legal fees, including patent prosecution
and maintenance fees, by $0.9 million, personnel costs by $0.7 million,
professional fees and services by $0.4 million, travel costs by $0.3 million,
facility costs by $0.3 million and business insurance costs by $0.2 million. In
addition, in the second quarter of 2003 the Company began a program to satisfy
vendors for outstanding invoices and recognized gains from settling various old
trade accounts payable at a discount. As a result of negotiations, in 2003 the
Company settled and paid outstanding accounts payable of approximately $1.5
million at a discount of approximately $0.8 million.
Depreciation and Amortization Expense. Depreciation and amortization
expense decreased $2.7 million to $0.4 million from $3.1 million for the year
ended December 31, 2003 compared to the year ended December 31, 2002,
respectively. The decrease in depreciation expense is primarily attributable to
the decrease in property and equipment as a result of the impairment of
demonstration manufacturing property and equipment in 2002.
Interest Income. Interest income totaled $0.1 million for each of the
years ended December 31, 2003 and December 31, 2002.
Interest Expense. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense increased $0.3 million to $0.4
million from $0.1 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively. The
increase was due to an increase in accrued interest payable on
outstanding loans made to the Company by EKI from September 2002
through January 2003 that were outstanding throughout all of 2003,
accretion in 2003 of the discount related to the warrants issued in
conjunction with the March 2003 financing transactions, plus accrued
interest payable on amounts owed to EKI for monthly licensing fees
that were not paid in accordance with the terms of the subordination
agreements entered into in connection with the 2006 Debentures (see
Related Party Transactions).
14
Although the outstanding loans and monthly licensing fees will
accrue approximately $0.4 million in annual interest expense,
payment of the interest is subordinated to the 2006 Debentures.
Therefore, the related party interest expense will continue to
accrue but will not be paid in cash until the 2006 Debentures have
been converted or the obligation satisfied in full.
o Other interest expense increased $1.2 million to $1.4 million from
$0.2 million for the year ended December 31, 2003 compared to the
year ended December 31, 2002, respectively. Other interest expense
for 2003 is primarily comprised of accretion of the discount on the
2006 Debentures and a beneficial conversion charge in the amount of
$0.4 million due to a change in the 2007 Debentures conversion
price. In addition, Other interest expense for 2003 also included
accretion of the discount on the 2007 Debentures and accrued
interest payable on the 2006 and 2007 Debentures. Other interest
expense for 2002 was comprised of accretion of the discount and
accrued interest payable on the 2007 Debentures. Interest expense
from accretion of the discount and accrued interest payable for the
2006 Debentures will be approximately $0.8 million per year until
they are repaid or are converted into common stock.
Other Income. Other income was $0.4 million for the year ended December
31, 2003. This represents the net gain realized in the third quarter of 2003
from reducing the balance of the warrant obligation to its estimated fair value
of zero. Management believes the estimated fair value of the warrant at December
31, 2003 is zero. The warrant obligation was initially recorded in connection
with the March 2003 financing transactions (see Convertible Debentures).
Loss on Extinguishment of Debentures. Loss on extinguishment of debentures
was $1.7 million for the year ended December 31, 2003. In connection with the
March 2003 financing transactions, the Company prepaid $5.2 million aggregate
principal amount of the 2007 Debentures, resulting in a prepayment penalty of
approximately $0.2 million. The Company also issued to the holders of the
prepaid 2007 Debentures 52,083 shares of common stock, valued at approximately
$0.2 million based upon the closing price of the Company's common stock of $4.56
per share on March 5, 2003. In addition, one of the holders of the 2007
Debentures exchanged $2.0 million aggregate principal amount of 2007 Debentures
for $2.0 million aggregate principal amount of 2006 Debentures. In connection
with the prepayment and exchange transactions, the Company incurred cash
transaction costs of approximately $0.3 million, excluding the prepayment
penalty. In addition, the Company incurred a charge of approximately $0.9
million for the prorated portion of the original discount attributed to the $7.2
million of the 2007 Debentures repaid and exchanged. Therefore, the Company
recognized a $1.7 million loss upon extinguishment of the 2007 debentures
through the prepayment and exchange.
Gain on Sale of Property and Equipment. Gain on the sale of property and
equipment increased $0.1 million to $0.5 million from $0.4 million for the year
ended December 31, 2003 compared to the year ended December 31, 2002,
respectively. The gain in both 2003 and 2002 represents the excess of proceeds
received from the sale of non-essential machine shop equipment and excess office
furniture and equipment over their net book value. In addition, 2003 also
includes proceeds received from the sale of production line equipment that was
previously impaired and therefore had a net book value of zero.
Debenture Conversion Cost. Debenture Conversion Cost decreased $0.1
million to $0.2 million from $0.3 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively. The expense
represents the prorated portion of the original discount attributed to the 2007
Debentures whose conversion was forced by the Company in the respective periods.
Year Ended December 31, 2002 Compared with the Year Ended December 31, 2001
The Company's net loss decreased $22.7 million to $39.6 million from $62.3
million for the year ended December 31, 2002 compared to the year ended December
31, 2001, respectively.
Research and Development Expenses. Total research and development expenses
are comprised of Related party license fee and research and development expenses
and Other research and development expenses. Total research and development
expenditures for the development of EarthShell Packaging(R) decreased $20.2
million to $26.9 million from $47.1 million for the year ended December 31, 2002
compared to the year ended December 31, 2001, respectively.
o Related party license fee and research and development expenses are
comprised of the $100,000 minimum monthly licensing fee for the use
of the EarthShell technology and for technical services, both of
which were payable to EKI, a stockholder of the Company, or Biotec,
a wholly owned subsidiary of EKI. Related party research and
development expenses totaled $1.5 million for each of the years
ended December 31, 2002 and December 31, 2001.
15
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production, as well as impairment charges on manufacturing property
and equipment constructed for demonstration production purposes.
Other research and development expenses decreased $20.3 million to
$25.4 million from $45.7 million for the year ended December 31,
2002 compared to the year ended December 31, 2001, respectively. The
decrease in other research and development was primarily due to
concluding the demonstration manufacturing of hinged-lid containers
in Owings Mills, Maryland at the end of the second quarter of 2002.
This decrease was partially offset by the commencement of
demonstration manufacturing of bowls and plates in Goleta,
California. The decrease in other research and development expenses
was also due to a reduction in impairment charges on property and
equipment; impairment charges were $9.8 million for the year ended
December 31, 2002 versus $19.4 million for the year ended December
31, 2001.
The Company entered into a strategic relationship agreement with
Sweetheart in late 1997 whereby the Company financed and built
production lines at Sweetheart's Owings Mills, Maryland
manufacturing facility to demonstrate that its hinged-lid container
products could be produced commercially for McDonald's. The Company
worked closely with Sweetheart and McDonald's to create an
acceptable product design, develop a commercially viable operation
and meet required performance standards. Originally the Company
intended to transfer the production lines at Owings Mills to
Sweetheart.
In the fourth quarter of 2001, the Company wrote down $12.3 million
of the Owings Mills property and equipment to reflect the net
realizable value of the equipment and machinery based on a quotation
from a third party. During the first half of 2002 production at the
Owings Mills facility ceased as Sweetheart contemplated acquisition
of new, updated production lines. The Company negotiated with
Sweetheart and certain equipment manufacturers to assess their
interest in utilizing portions of the Company's existing production
lines and infrastructure in Owings Mills; however, definitive
agreements were not reached and the Company was unable to determine
the amount, if any, of compensation it might receive in disposing of
its production lines in Owings Mills. As a result, the Company wrote
down the remaining $7.5 million of the equipment at Owings Mills
during the year ended 2002. As of December 31, 2002 the Company's
Owings Mills production lines were being carried on its balance
sheet at a net book value of zero.
The commercial production line in Goettingen, Germany was originally
financed and constructed by the Company for the Company's joint
venture with Huhtamaki. During 2001, $1.2 million of the Goettingen
line was written off to reflect equipment that had no further
application in the product development cycle. During the third
quarter of 2002 the Company concluded, after obtaining quotations
from various machinery suppliers for an identical line, that $1.7
million of the cost of the line will not be recoverable and
therefore the carrying value of the line was written down by this
amount, of which $1.6 million was recorded in the third quarter of
2002 and the remaining $0.1 million was recorded in the fourth
quarter of 2002.
During the fourth quarter of 2001 and the fourth quarter of 2002,
$5.9 million and $0.5 million, respectively, of equipment at the
Company's product development center was written off because it had
no further application in the product development activities at that
time.
Other General and Administrative Expenses. Other General and
Administrative Expenses are comprised of personnel costs, travel and direct
overhead for marketing, finance and administration. Other general and
administrative expenses were $9.6 million for both the year ended December 31,
2002 and the year ended December 31, 2001. Patent prosecution and maintenance
fees remained flat year over year. Reductions in headcount and legal expenses
were offset by an increase in insurance and Nasdaq fees, as well as increases in
investor and public relations programs.
Depreciation and Amortization Expense. Depreciation and amortization
expense decreased $2.8 million to $3.1 million from $5.9 million for the year
ended December 31, 2002 compared to the year ended December 31, 2001,
respectively. The decrease in depreciation expense is primarily attributable to
the decrease in fixed assets as a result of the impairment of property and
equipment to net realizable value during both 2002 and 2001.
16
Interest Income. Interest income decreased $0.3 million to $0.1 million
from $0.4 million for the year ended December 31, 2002 compared to the year
ended December 31, 2001, respectively. The decrease was the result of lower cash
balances available for investment for the comparative years.
Interest Expense. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense was $0.1 million for the year ended
December 31, 2002. This represents accrued interest payable on
short-term working capital loans made to the Company by EKI
beginning in September 2002.
o Other interest expense was $0.2 million for the year ended December
31, 2002. This represents accretion of the discount and accrued
interest payable on the 2007 Debentures issued in August 2002.
Gain on Sale of Property and Equipment. Gain on the sale of property and
equipment was $0.4 million for the year ended December 31, 2002. The gain was
primarily due to the Company selling equipment no longer required to meet
objectives, most of which was fully depreciated.
Debenture Conversion Cost. Debenture Conversion Cost was $0.3 million for
the year ended December 31, 2002. This expense represents the prorated portion
of the original discount attributed to the $1.0 million of 2007 Debentures whose
conversion was forced by the Company in the third quarter of 2002.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow. The Company's principal uses of cash for the year ended
December 31, 2003 were to fund operations and pay accounts payable and accrued
expenses. Net cash used in operations was $15.7 million and $23.0 million for
the years ended December 31, 2003 and 2002, respectively. Net cash provided by
(used in) investing activities was $4.0 million and ($2.3) million for the years
ended December 31, 2003 and 2002, respectively. Net cash provided by financing
activities was $13.5 million and $24.6 million for the years ended December 31,
2003 and 2002, respectively. As of December 31, 2003, the Company had cash and
related cash equivalents totaling $1.9 million.
Capital Requirements. Due to the fact that construction of the initial
commercial production lines was largely completed in 2002 and the Company
decided to discontinue all demonstration manufacturing activities in 2003, the
Company only made one minor capital expenditure for the year ended December 31,
2003. The Company does not expect to make significant capital expenditures in
the year 2004.
Contractual Obligations. The following table summarizes the Company's
known obligations to make future payments pursuant to certain contracts as of
December 31, 2003, as well as an estimate of the timing in which these
obligations are expected to be satisfied:
PAYMENTS DUE BY PERIOD
-----------------------------------------------
CONTRACTUAL OBLIGATIONS LESS THAN 1 - 3
TOTAL 1 YEAR YEARS
------------ ------------ ------------
Long-term debt - principal payments only $ 11,394,108 $ 6,800,000 $ 4,594,108
Capital leases -- -- --
Operating leases -- -- --
Other long-term liability 83,333 50,000 33,333
------------ ------------ ------------
Totals $ 11,477,441 $116,850,000 $ 4,627,441
============ ============ ============
Sources of Capital. As part of the Company's initial public offering on
March 27, 1998, the Company issued 877,193 shares of common stock, for which it
received net proceeds of $206 million. On April 18, 2000 and January 4, 2001,
the Company filed shelf registrations statements for 416,667 and 1,250,000
shares, respectively, of the Company's common stock. During the years ended
December 31, 2002, 2001 and 2000 the Company sold approximately 0.1 million, 1.1
million and 0.4 million shares of common stock in private transactions under
such registration statements and received net proceeds from such sales of
approximately $2.3 million $30.6 million and $10.5 million, respectively. All
shares available under such registration statements had been sold as of December
2002.
17
In December of 2001 the Company filed an additional shelf registration
statement providing for the sale of up to $50 million of securities, including
secured or unsecured debt securities, preferred stock, common stock, and
warrants. These securities could be offered, separately or together, in distinct
series, and amounts, at prices and on terms to be set forth in the prospectus
contained in the registration statement, and in subsequent supplements to the
prospectus. During the year ended December 31, 2002, the Company sold 1.9
million shares of common stock under such registration statement and received
net proceeds from such sales of $19.6 million.
On August 12, 2002, the Company issued $10 million in aggregate principal
amount of convertible debentures, due August 2007, (the "2007 Debentures") and
warrants to purchase 0.2 million shares of common stock to institutional
investors for proceeds of $10.0 million. The terms of the debentures required
the proceeds be held in restricted cash accounts linked to irrevocable letters
of credit in favor of each debenture holder such that unrestricted access to the
proceeds from the sale of the debentures generally occurred only upon conversion
of the debentures into shares of the Company's common stock. These debentures
bore interest at a rate of 1.5% per annum. The holders of these debentures had
the right to convert the debentures into the Company's common stock at an
initial conversion price of $15.60 per share, which has been reduced to $6.00
per share as a result of anti-dilution adjustments. The proceeds from the
debentures were held in restricted accounts linked to irrevocable letters of
credit in favor of the debenture holders such that unrestricted access to the
proceeds from the sale of the debentures generally occurred only upon conversion
of the debentures into shares of the Company's common stock. In addition to the
holders' conversion option, under certain circumstances the Company had the
right to force conversion of up to $500,000 of the debentures per week at a 15%
discount to the market price of the Company's stock. Subject to certain
conditions set forth in the debentures, the debentures could be prepaid upon
twenty business days notice for 104% of the outstanding principal balance of the
debentures. During the third quarter of 2002, the Company forced conversion of
$1.0 million principal amount of the debentures for 168,696 shares of common
stock, resulting in the release to the Company of $1.0 million of restricted
cash. Subsequent to December 31, 2002, the Company forced conversion of an
additional $1.3 million principal amount of the debentures and debenture holders
voluntarily converted $0.5 million principal amount of the debentures, for a
total of 353,985 shares of common stock, resulting in the release to the Company
of $1.8 million of restricted cash. In March 2003, as part of a new convertible
debenture financing, the Company prepaid $5.2 million principal amount of the
debentures. In addition, one of the holders of the debentures exchanged $2.0
million aggregate principal amount of these debentures for $2.0 million
aggregate principal amount of 2006 Debentures and 78,989 shares of common stock.
The exchange resulted in the release to the Company of $2.0 million of
restricted cash, as the 2006 Debentures are not secured by cash. There are no
outstanding 2007 Debentures as of December 31, 2003.
On March 5, 2003, the Company issued to a group of institutional investors
416,667 shares of common stock and $10.55 million in aggregate principal amount
of secured convertible debentures due in March 2006 (the "2006 Debentures"), for
which the Company received proceeds of approximately $9.0 million, net of
financing costs of approximately $1.5 million. The 2006 Debentures bear interest
at a rate of 2.0% per annum, payable quarterly in arrears on each January 31,
April 30, July 31 and October 31. The debentures are secured by the Company's
rights, title and interest to the technology and trademarks covered by the EKI
License Agreement, including all process and product improvements of the
Company, the Company's right to use and to sublicense the technology, and all
license fees, royalties and/or other forms of compensation due to the Company
from sublicenses under existing or future sublicenses. The holders of the 2006
Debentures have the right to convert such debentures into the Company's common
stock at a conversion price of $6.00 per share. While the 2006 Debentures are
outstanding, the conversion price is subject to adjustment in certain instances,
such as a result of stock dividends and splits, distributions of property to
common stockholders, the sale of substantially all of the Company's assets, the
consummation of a merger, or sales of common stock or common stock equivalents
for per share prices lower than the conversion price in effect. In addition to
the holders' conversion option, after the first anniversary of the issuance of
the 2006 Debentures the Company has the right to force conversion of all or a
portion of the outstanding principal amount of the 2006 Debentures if certain
conditions are met, including a requirement that the closing price of the common
stock has been equal to or greater than 300% of the conversion price for at
least the 10 consecutive days immediately preceding the conversion. The
principal amount of the 2006 Debentures is due and payable on March 5, 2006;
however, earlier repayment may occur if the Company receives cash proceeds in
excess of $2.65 million (the "Excess Amount") from the sale of debt or equity
securities, equipment sales to unrelated third parties, operating revenues, or
any cash that becomes available to the Company as a result of a reduction in a
$3.5 million letter of credit the Company issued to a third party in 1998. If
the Excess Amount arises, the Company can elect to distribute one-third of such
Excess Amount to EKI in payment of amounts due to EKI under the License
Agreement or the Biotec Agreement that have been subordinated to the 2006
Debentures, and one-third of such Excess Amount , with the consent of each
applicable debenture holder, as a 102% prepayment of principal and interest of
the 2006 Debentures.
18
In connection with the March 2003 financing transactions, the Company
issued 54,167 shares of common stock to the lead purchaser of the 2006
Debentures and two warrants to a placement agent, both of whom received the
instruments as compensation for their services rendered in connection with the
transaction. The first of the two warrants is immediately exercisable by the
placement agent to purchase 28,810 shares of the Company's common stock for
$10.08 per share and expires in March 2006. The second of the two warrants is
immediately exercisable by the placement agent to purchase $1.055 million in
aggregate principal amount of the 2006 Debentures and 416,667 shares of the
Company's common stock, except if, prior to exercise of the warrant, all of the
2006 Debentures have been redeemed, repurchased or converted, in which case the
portion of the warrant exercisable into the 2006 Debentures becomes exercisable
into common stock as if the 2006 Debentures included in the warrant had been
converted to common stock. The exercise price of the convertible debenture
portion of the warrant is $1,200 for each $1,000 of principal and is subject to
adjustment consistent with the provisions of the 2006 Debentures. The exercise
price of the common stock portion of the warrant is $7.20 per share. This
warrant also expires in March 2006.
In 2003, $5.75 million principal amount of the 2006 Debentures was
converted into 958,334 shares of common stock.
At December 31, 2003, the outstanding principal balance of 2006 Debentures
was $6.8 million. The remaining shares under the December 2001 shelf
registration described above have been used to secure shares potentially
issuable upon conversion of the 2006 Debentures.
At December 31, 2003, the Company was in compliance with all covenants of
the 2006 Debentures. However, on March 8, 2004, the Company's common stock was
delisted from the Nasdaq Smallcap Market because the Company's market
capitalization failed to meet the minimum required standard. In addition, the
Company did not make interest payments related to the 2006 Debentures as
required on January 31, 2004. These actions put the Company in non-compliance
with its covenants under the 2006 Debentures. Management is currently
negotiating with the debenture holders for appropriate relief or waiver of these
covenants. One of the debenture holders has notified the Company in writing that
they are in default and has requested that the Company repurchase the entire
principal amount of the 2006 Debentures that they hold at the price specified in
the debenture, along with any accrued and unpaid interest. Because the Company
can not assure that it will be able to negotiate appropriate relief or a waiver
of the applicable covenants, the entire outstanding principal amount of the 2006
Debentures have been classified as current liabilities as of December 31, 2003.
(See Subsequent Events).
During 2002 and 2003, the Company's largest shareholder, EKI, made various
simple interest working capital loans to the Company. These loans bear interest
at a rate of 7% or 10% per annum, and are payable on demand. As of December 31,
2003, the outstanding principal balance of these loans was $2,755,000. In
connection with the March 2003 convertible debenture financing, the remaining
outstanding balance of these loans was subordinated to the 2006 Debentures, with
strict covenants governing their repayment. In addition, EKI and Biotec agreed
to subordinate certain payments to which they were otherwise entitled under the
Biotec License Agreement (other than their respective percentages of any
royalties received by the Company) to the satisfaction of the Company's payment
obligations under the 2006 Debentures. They further agreed not to assert any
claims against the Company for breaches of the Biotec License Agreement (other
than the assertion of certain equitable remedies to enjoin the Company from, for
example, selling products outside its field of use) until such time as the
Company's obligations under the 2006 Debentures are satisfied in full. EKI and
Biotec also agreed to allow the Company to pledge their respective interests in
the EKI and Biotec License Agreements to secure the Company's obligations under
the 2006 Debentures, and certain additional concessions were made by EKI and
Biotec to permit the Company greater flexibility in selling its rights under the
EKI and Biotec License Agreements to third parties in an insolvency context.
These rights terminate upon the satisfaction in full of the obligations under
the 2006 Debentures. In consideration for its willingness to subordinate the
payments and advances that are owed to it, in March 2003 the Company issued to
EKI a warrant, expiring in ten years, to acquire 83,333 shares of the Company's
common stock for $6.00 per share.
The Company will have to raise additional funds to meet its current
obligations and to cover operating expenses through the year ending December 31,
2004. If the Company is not successful in raising additional capital it may not
be able to continue as a going concern for a reasonable period of time.
Management plans to address this need by raising cash through either the
issuance of debt or equity securities. In addition, the Company expects cash to
be generated in 2004 through royalty payments from licensees. Another possible
source of funds is the sale or transfer of the commercial production line in
Goettingen, Germany to an operating partner. However, the Company can not assure
that additional financing will be available to it, or, if available, that the
terms will be satisfactory, that it will receive any royalty payments in 2004,
or that it will be able to negotiate mutually agreeable terms for the transfer
of its commercial production line to an operating partner. Management will also
continue in its efforts to reduce expenses, but can not assure that it will be
able to reduce expenses below current levels.
19
Off-Balance Sheet Arrangements. The Company does not have any off-balance
sheet arrangements as of December 31, 2003 and has not entered into any
transactions involving unconsolidated, limited purpose entities.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's treasury function controls all decisions and commitments
regarding cash management and financing arrangements. Treasury operations are
conducted within a framework that has been authorized by the board of directors.
The Company is exposed to interest rate risk on its fixed rate long-term
working capital loans to EKI and its fixed rate long-term convertible debenture
obligations. As of December 31, 2003, these long-term fixed rate debt
obligations totaled approximately $9.555 million. The working capital loans bear
interest at a fixed rate of 10% per annum. The convertible debentures bear
interest at a fixed rate of 2.0% per annum. While generally an increase in
market interest rates will decrease the value of this debt, and decreases in
rates will have the opposite effect, we are unable to estimate the impact that
interest rate changes will have on the value of the substantial majority of this
debt as there is no active public market for this debt.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Index to Consolidated Financial Statements and Schedules.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
As reported in a Form 8-K dated June 26, 2003, on June 26, 2003, the
Company received a letter from Deloitte and Touche LLP ("D&T") in which D&T
resigned as the Company's independent public accountants.
D&T's audit reports on the Company's financial statements for the fiscal
years ended December 31, 2002 and 2001 (the "Reports") did not contain any
adverse opinion or disclaimer of opinion, nor were they qualified or modified as
to uncertainty, audit scope, or accounting principles, except that such reports
contained an explanatory paragraph concerning the Company's ability to continue
as a going concern.
During the years ended December 31, 2002 and 2001 and through June 26,
2003, there were no disagreements between the Company and D&T on any matter of
accounting principles or practices, financial statement disclosure, or auditing
scope or procedure, which disagreements, if not resolved to the satisfaction of
D&T would have caused it to make reference to the subject matter of such
disagreements in connection with its Reports; and there were no reportable
events, as defined in Item 304(a)(1)(v) of Regulation S-K except with respect to
the year ended December 31, 2002, as to which D&T sent a letter to the Company's
Audit Committee during the last week in June in conjunction with its
resignation, which letter was backdated to April 29, 2003, advising the Audit
Committee of four reportable conditions in the Company's internal controls noted
during the course of the audit for the year ended December 31, 2002, as follows:
(1) a formal process to close accounting periods prior to the production of
financial information did not exist, (2) some of the accounting records
maintained by the Company did not adequately support amounts recorded in the
financial statements, (3) purchase cutoff prodcedures were inadequate, and (4)
the Company's accounting personnel did not have the appropriate qualifications
and training to fulfill their assigned functions. While the Company believes
that certain of the matters reported to the Audit Committee by D&T regarding the
year ended December 31, 2002 were untimely, overstated, or inaccurate, it
believes that each of the issues raised has already been addressed to the
satisfaction of the Audit Committee.
The Company engaged Farber & Hass, LLP as its new independent accountants
as of July 31, 2003.
20
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. The Company's Chief
Executive Officer and Chief Financial Officer have evaluated the effectiveness
of the Company's disclosure controls and procedures (as such term is defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the
period covered by this Report (the "Evaluation Date"). Based on such evaluation,
such officers have concluded that, as of the Evaluation Date, the Company's
disclosure controls and procedures are effective in alerting them on a timely
basis to material information relating to the Company required to be included in
the Company's periodic filings under the Exchange Act.
(b) Changes in Internal Control Over Financial Reporting. No changes in
the Company's internal control over financial reporting have come to
management's attention during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item will be contained in the Company's
Proxy Statement for its 2004 annual meeting of stockholders, which will be filed
on or before April 29, 2004 and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will be contained in the Company's
Proxy Statement for its 2004 annual meeting of stockholders, which will be filed
on or before April 29, 2004 and is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by this item will be contained in the Company's
Proxy Statement for its 2004 annual meeting of stockholders, which will be filed
on or before April 29, 2004 and is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item will be contained in the Company's
Proxy Statement for its 2004 annual meeting of stockholders, which will be filed
on or before April 29, 2004 and is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item will be contained in the Company's
Proxy Statement for its 2004 annual meeting of stockholders, which will be filed
on or before April 29, 2004 and is incorporated herein by reference.
21
PART IV
ITEM 15. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K
(A) INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
1. CONSOLIDATED FINANCIAL STATEMENTS:
Independent Auditors' Reports .................................................................... F-2
Consolidated Balance Sheets as of December 31, 2003, and 2002..................................... F-3
Consolidated Statements of Operations for the years ended December 31, 2003, 2002, 2001, and
for the period from November 1, 1992 (inception) through December 31, 2003........................ F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 2003,
2002, 2001, 2000, 1999, 1998, 1997, 1996, 1995, 1994 and 1993..................................... F-5
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002, 2001, and
the period from November 1, 1992 (inception) through December 31, 2003............................ F-6
Notes to the Consolidated Financial Statements.................................................... F-9
2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES:
All schedules have been omitted because they are not required, not
applicable, or the information required to be set forth therein is
included in the Company's Consolidated Financial Statements or the
Notes therein.
(B) REPORTS ON FORM 8-K
The Company filed two reports on Form 8-K during the quarter ended
December 31, 2003. Information regarding the items reported on is as follows:
DATE ITEM REPORTED ON
--------------------------------------------------------------------------------
October 17, 2003 Press release of the Company dated October 20,
2003, regarding a reverse stock split.
December 1, 2003 Press release of the Company dated December 3,
2003, regarding filing of a Form S-3 to
register shares of its common stock and that it
was not in compliance with one of the Nasdaq's
minimum listing requirements.
(C) EXHIBITS
3.1 Certificate of Incorporation of the Company.(1)
3.2 Bylaws of the Company.(1)
3.3 Certificate of Designation, Preferences Relative,
Participating, Optional and Other Special Rights of the
Company's Series A Cumulative Senior Convertible Preferred
Stock.(1)
3.4 Amended and Restated Certificate of Incorporation of the
Company.(1)
3.5 Amended and Restated Bylaws of the Company.(1)
4.1 Specimen certificate of Common Stock.(1)
4.3 Form of Warrant to purchase Common Stock dated August 12,
2002.(9)
4.4 Form of Note under Loan Agreement dated as of September 9,
2002 between the Company and E. Khashoggi Industries, LLC.(11)
4.5 Form of Secured Convertible Debenture due March 5, 2006.(13)
4.6 Intellectual Property Security Agreement dated as of March 5,
2003 among the Company, E. Khashoggi Industries, LLC and the
investors signatory thereto.(13)
4.7 Waiver and Amendment to Debentures and Warrants dated as of
March 5, 2003 among the Company and the purchasers identified
on the signature pages thereto.(13)
4.8 Exchange Agreement dated as of March 5, 2003 between the
Company and the institutional investor signatory thereto.(13)
10.1 Amended and Restated License Agreement dated February 28, 1995
by and between the Company and E. Khashoggi
Industries("EKI").(2)
10.2 Registration Rights Agreement dated as of February 28, 1995 by
and between the Company and EKI, as amended.(1)
10.3 EarthShell Container Corporation 1994 Stock Option Plan.(1)
22
10.4 EarthShell Container Corporation 1995 Stock Incentive Plan.(1)
10.5 Form of Stock Option Agreement under the EarthShell Container
Corporation 1994 Stock Option Plan.(1)
10.6 Form of Stock Option Agreement under the EarthShell Container
Corporation 1995 Stock Incentive Plan.(1)
10.7 Warrant to Purchase Stock issued July 2, 1996 by the Company
to Imperial Bank.(1)
10.8 Amended and Restated Technical Services and Sublease Agreement
dated October 1, 1997 by and between the Company and EKI.(1)
10.9 Amended and Restated Agreement for Allocation of Patent Costs
dated October 1, 1997 by and between the Company and EKI.(1)
10.10 Warrant to Purchase Stock issued October 6, 1997 by the
Company to Imperial Bank.(1)
10.11 Warrant to Purchase Stock dated December 31, 1997 by the
Company to Imperial Bank.(1)
10.12 Letter Agreement re Haas/BIOPAC Technology dated February 17,
1998 by and between the Company and EKI.(1)
10.13 Second Amendment to 1995 Stock Incentive Plan of the
Company.(1)
10.14 Amendment No. 2 to Registration Rights Agreement dated as of
September 16, 1993.(1)
10.15 Amendment No. 2 to Registration Rights Agreement dated
February 28, 1995.(1)
10.16 Employment Agreement dated April 15, 1998 by and between the
Company and Vincent J. Truant.(3)
10.17 First Amendment dated June 2, 1998 to the Amended and Restated
License Agreement by and between the Company and E. Khashoggi
Industries("EKI").(4)
10.18 First Amendment to 1995 Stock Incentive Plan of the
Company.(5)
10.19 Third Amendment to 1995 Stock Incentive Plan of the
Company.(6)
10.20 Fourth Amendment to 1995 Stock Incentive Plan of the
Company.(6)
10.21 Lease Agreement dated August 23, 2000 by and between the
Company and Heaver Properties, LLC.(7)
10.22 Settlement Agreement with Novamont dated August 3, 2001.(8)
10.23 Amendment to Common Stock Purchase Agreement dated March 28,
2001.(8)
10.24 Securities Purchase Agreement dated as of August 12, 2002
between the Company and the investors signatory thereto.(9)
10.25 Amendment #1 to Employment Agreement dated as of May 15, 2002
by and between the Company and Vince Truant.(10)
10.26 Loan Agreement dated as of September 9, 2002 between the
Company and E. Khashoggi Industries, LLC.(11)
10.27 Second Amendment dated 29 July, 2002 to Amended and Restated
License Agreement between E. Khashoggi Industries, LLC and the
Company.(12)
10.28 License and Information Transfer Agreement dated 29 July, 2002
between the Biotec Group and the Company.(12)
10.29 Loan and Securities Purchase Agreement dated as of March 5,
2003 between the Company and the investors signatory
thereto.(13)
10.30 Sublicense Agreement dated February 20, 2004 by and between
the Company and Hood Packaging Corporation.
10.31 Operating and Sublicense Agreement dated October 3, 2002 by
and between the Company and Sweetheart Cup Company, Inc.
23
10.32 First Amendment to Operating and Sublicense Agreement dated
July 2003 by and between the Company and Sweetheart Cup
Company, Inc.
10.33 Lease Agreement dated July 2003 between the Company and
Sweetheart Cup Company, Inc.
10.34 First Amendment to Lease Agreement dated December 16, 2003
between the Company and Sweetheart Cup Company, Inc.
14.4 EarthShell Corporation Code of Ethics for Directors, Officers
and Employees
16.1 Letter from Deloitte & Touche LLP to the Securities and
Exchange Commission dated July 9, 2003, regarding change in
certifying accountant. (18)
23.1 Independent Auditor's consent
23.2 Independent Auditor's consent
31.1 Certification of the CEO pursuant to Rules 13a-14 and 15d-14
under the Exchange Act, as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2 Certification of the CFO pursuant to Rules 13a-14 and 15d-14
under the Exchange Act, as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
-------------
(1) Previously filed, as an exhibit to the Company's Registration Statement on
Form S-1 and amendments thereto, File no. 333-13287, and incorporated
herein by reference.
(2) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended March 31, 1998, and incorporated herein by
reference.
(3) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended June 30, 1998, and incorporated herein by
reference.
(4) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended September 30, 1998, and incorporated herein by
reference.
(5) Previously filed as an exhibit to the Company's annual report on Form
10-K, for the fiscal year ended December 31, 1998, and incorporated herein
by reference.
(6) Previously filed as part of the Company's definitive proxy statement on
Schedule 14A, file no. 000-23567, for its 1999 annual meeting of
stockholders, and incorporated herein by reference.
(7) Previously filed as an exhibit to the Company's annual report on Form
10-K, for the fiscal year ended December 31, 2000, and incorporated herein
by reference.
(8) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended June 30, 2001, and incorporated herein.
24
(9) Previously filed as an exhibit to the Company's current report on Form 8-K
dated August 12, 2002, and incorporated herein by reference.
(10) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q for the quarter ended June 30, 2002, and incorporated herein by
reference.
(11) Previously filed as an exhibit to the Company's current report on Form 8-K
dated September 17, 2002, and incorporated herein by reference.
(12) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q for the quarter ended September 30, 2002, and incorporated herein by
reference.
(13) Previously filed as an exhibit to the Company's current report on Form 8-K
dated March 5, 2003, and incorporated herein by reference.
25
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, on April 13, 2004.
EARTHSHELL CORPORATION
By: /s/ Simon K. Hodson
------------------------------------
Simon K. Hodson
Vice Chairman of the Board and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Essam Khashoggi Chairman of the Board April 13, 2004
------------------------------
Essam Khashoggi
Vice Chairman of the Board and Chief
Executive Officer (Principal Executive April 13, 2004
/s/ Simon K. Hodson Officer)
------------------------------
Simon K. Hodson
Chief Financial Officer and Secretary April 13, 2004
/s/ D. Scott Houston (Principal Financial Officer)
------------------------------
D. Scott Houston
Controller April 13, 2004
/s/ Michael P. Hawks (Principal Accounting Officer)
------------------------------
Michael P. Hawks
/s/ John Daoud Director April 13, 2004
------------------------------
John Daoud
/s/ Layla Khashoggi Director April 13, 2004
------------------------------
Layla Khashoggi
/s/ Hamlin Jennings Director April 13, 2004
------------------------------
Hamlin Jennings
/s/ Walker Rast Director April 13, 2004
------------------------------
Walker Rast
/s/ George Roland Director April 13, 2004
------------------------------
George Roland
26
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Index to Consolidated Financial Statements and Schedules............................................... F-1
Independent Auditors' Reports ......................................................................... F-2
Consolidated Balance Sheets as of December 31, 2003 and 2002........................................... F-3
Consolidated Statements of Operations for the years ended December 31, 2003, 2002, and 2001, and
for the period from November 1, 1992 (inception) through December 31, 2003............................. F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 2003, 2002,
2001, 2000, 1999, 1998, 1997, 1996, 1995, 1994, and 1993............................................... F-5
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002, and 2001, and
for the period from November 1, 1992 (inception) through December 31, 2003............................. F-6
Notes to Consolidated Financial Statements............................................................. F-9
Consolidated Financial Statement Schedules:
None.
All schedules have been omitted because they are not required, not
applicable, or the information required to be set forth therein is included in
the Company's Consolidated Financial Statements or the Notes therein.
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
EarthShell Corporation:
We have audited the accompanying consolidated balance sheet of
EarthShell Corporation (a development stage enterprise) (the "Company") as of
December 31, 2003, and the related consolidated statements of operations,
stockholders' (deficit) equity, and cash flows for the year then ended, and for
the period from November 1, 1992 (inception) through December 31, 2003. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit. The Company's financial statements as of and for the year ended
December 31, 2002, and for the period from November 1, 1992 (inception) through
December 31, 2002 were audited by other auditors whose report, dated April 29,
2003, expressed an unqualified opinion on those statements and included an
explanatory paragraph relating to the Company's ability to continue as a going
concern. The financial statements for the period from November 1, 1992
(inception) through December 31, 2002 total a net loss of $295,833,940. The
other auditor's report has been furnished to us, and our opinion, insofar as it
relates to the amounts included for such prior period, is based solely on the
report of such other auditors.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, based on our audit and the report of other auditors,
such consolidated financial statements present fairly, in all material respects,
the financial position of the Company as of December 31, 2003, and the results
of its operations and its cash flows for the year then ended, and for the period
from November 1, 1992 (inception) through December 31, 2003, in conformity with
accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. The Company is a
development stage enterprise engaged in the commercialization of foodservice
disposable packaging with the environment in mind. As discussed in the notes to
the consolidated financial statements, during the period from November 1, 1992
(inception) to December 31, 2003, the Company has incurred a cumulative net loss
of approximately $314,000,000 and has a working capital deficit of $7,900,000 at
December 31, 2003. In addition, in March 2004 the Company was delisted from the
NASDQ Smallcap Market and did not make the January 2004 interest payments on its
2006 Debentures, which has caused the Company to be in default on the 2006
Debentures. These matters raise substantial doubt about the Company's ability to
continue as a going concern. Management's plans concerning these matters are
also described in the notes to the consolidated financial statements. The
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
/s/ Farber & Hass LLP
Camarillo, California
March 23, 2004
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
EarthShell Corporation:
We have audited the accompanying consolidated balance sheet of EarthShell
Corporation (a development stage enterprise) (the "Company") as of December 31,
2002, and the related consolidated statements of operations, stockholders'
(deficit) equity, and cash flows for each of the two years in the period ended
December 31, 2002 and for the period from November 1, 1992 (inception) through
December 31, 2002 (not separately presented herein). These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of the Company as of December 31,
2002, and the results of its operations and its cash flows for each of the two
years in the period ended December 31, 2002 and for the period from November 1,
1992 (inception) through December 31, 2002, in conformity with accounting
principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. The Company is a
development stage enterprise engaged in the commercialization of foodservice
disposable packaging with the environment in mind. As discussed in the notes to
the consolidated financial statements, during the period from November 1, 1992
(inception) to December 31, 2002, the Company has incurred a cumulative net loss
of $295,833,940 and has a working capital deficit at December 31, 2002. These
matters raise substantial doubt about the Company's ability to continue as a
going concern. Management's plans concerning these matters are also described in
the notes to the consolidated financial statements. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Los Angeles, California
April 29, 2003 (April 13, 2004 as to the one-for-twelve reverse stock split of
the Company's common stock)
F-2
EARTHSHELL CORPORATION
(A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
--------------------------------
2003 2002
--------------------------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents .................................... $ 1,901,639 $ 111,015
Restricted cash .............................................. -- 12,500,000
Prepaid expenses and other current assets .................... 323,680 570,802
--------------------------------
Total current assets ...................................... 2,225,319 13,181,817
PROPERTY AND EQUIPMENT, NET ..................................... 61,794 4,476,174
EQUIPMENT HELD FOR SALE ......................................... 1 --
INVESTMENT IN JOINT VENTURE ..................................... -- 366,012
--------------------------------
TOTALS .......................................................... $ 2,287,114 $ 18,024,003
================================
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Accounts payable and accrued expenses ........................ $ 4,853,413 $ 7,904,957
Payable to related party ..................................... -- 578,779
Accrued purchase commitment .................................. -- 3,500,000
Notes payable to related party ............................... -- 1,745,000
Convertible debentures, net of discount of $1,505,755 and
$1,232,047 as of December 31, 2003 and 2002, respectively . 5,294,245 7,767,953
--------------------------------
Total current liabilities ................................. 10,147,658 21,496,689
PAYABLES TO RELATED PARTY ....................................... 1,839,108 --
NOTES PAYABLE TO RELATED PARTY, NET OF DISCOUNT OF $219,210 ..... 2,535,790 --
OTHER LONG-TERM LIABILITY ....................................... 33,333 --
--------------------------------
Total liabilities ......................................... 14,555,889 21,496,689
--------------------------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' DEFICT
Preferred Stock, $.01 par value, 10,000,000 shares authorized;
9,170,000 Series A shares designated; no shares
issued and outstanding as of December 31, 2003 and 2002 ... -- --
Common stock, $.01 par value, 25,000,000 shares authorized;
14,128,966 and 12,054,637 shares issued and outstanding as
of December 31, 2003 and 2002, respectively ............... 141,290 120,546
Additional paid-in common capital ............................ 302,033,746 292,257,340
Deficit accumulated during the development stage ............. (314,350,681) (295,833,940)
Accumulated other comprehensive loss ......................... (93,130) (16,632)
--------------------------------
Total stockholders' deficit ............................... (12,268,775) (3,472,686)
--------------------------------
TOTALS .......................................................... $ 2,287,114 $ 18,024,003
================================
See Notes to Consolidated Financial Statements.
F-3
EARTHSHELL CORPORATION
(A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED STATEMENTS OF OPERATIONS
NOVEMBER 1, 1992
YEAR ENDED DECEMBER 31, (INCEPTION)
---------------------------------------------------- THROUGH DECEMBER 31,
2003 2002 2001 2003
------------------------------------------------------------------------
Operating Expenses
Related party license fee and research and
development expenses............................ $ 1,312,374 $ 1,488,070 $ 1,465,250 $ 71,191,282
Other research and development expenses........... 8,234,416 25,401,869 45,683,165 142,512,071
Related party general and administrative expenses
(reimbursements)................................ (4,074) (24,444) (24,444) 2,187,540
Other general and administrative expenses......... 5,790,473 9,614,037 9,658,116 68,213,158
Depreciation and amortization..................... 379,949 3,099,367 5,874,144 22,841,379
Related party patent expenses..................... -- -- -- 8,693,105
Gain on sales of property and equipment........... (451,940) (441,413) -- (893,353)
------------------------------------------------------------------------
Total operating expenses....................... 15,261,198 39,137,486 62,656,231 314,745,182
Other (Income) Expenses
Interest income................................... (95,176) (134,391) (355,520) (10,904,809)
Related party interest expense.................... 445,628 66,599 -- 5,282,958
Other interest expense............................ 1,440,118 199,880 -- 3,428,736
Other income...................................... (399,701) -- -- (399,701)
Loss on extinguishment of debentures.............. 1,697,380 -- -- 1,697,380
Debenture conversion cost......................... 166,494 320,970 -- 487,464
------------------------------------------------------------------------
Loss Before Income Taxes............................. 18,515,941 39,590,544 62,300,711 314,337,210
Income Taxes......................................... 800 800 800 13,471
------------------------------------------------------------------------
Net Loss............................................. 18,516,741 39,591,344 62,301,511 314,350,681
Preferred Dividends.................................. -- -- -- 9,926,703
------------------------------------------------------------------------
Net Loss Available to Common Stockholders............ $18,516,741 $39,591,344 $62,301,511 $324,277,384
========================================================================
Basic and Diluted Loss Per Common Share.............. $ 1.40 $ 3.51 $ 6.66 $ 38.44
Weighted Average Number of Common Shares Outstanding. 13,266,668 11,277,170 9,352,641 8,435,523
See Notes to Consolidated Financial Statements.
F-4
EARTHSHELL CORPORATION
(A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY
CUMULATIVE CONVERTIBLE
PREFERRED STOCK ADDITIONAL
SERIES A PAID-IN COMMON STOCK
----------------------------------- PREFERRED --------------------------
SHARES AMOUNT CAPITAL SHARES AMOUNT
--------------------------------------------------------------------------------------------
ISSUANCE OF COMMON STOCK
AT INCEPTION ................. -- -- -- 6,877,500 $ 3,150
Sale of preferred stock,
net .......................... 6,988,850 $ 267 $ 24,472,734 -- --
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1993 ......................... 6,988,850 267 24,472,734 6,877,500 3,150
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1994 ......................... 6,988,850 267 24,472,734 6,877,500 3,150
Contribution to equity .......... -- -- -- -- --
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1995 ......................... 6,988,850 267 24,472,734 6,877,500 3,150
Contribution to equity .......... -- -- -- -- --
Issuance of stock
warrants ..................... -- -- -- -- --
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1996 ......................... 6,988,850 267 24,472,734 6,877,500 3,150
Compensation related to
stock options,
warrants and stock
grants ....................... -- -- -- -- --
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1997 ......................... 6,988,850 267 24,472,734 6,877,500 3,150
262 to 1 stock split............. 5,557 (5,557) -- 65,625 (65,625)
Conversion of preferred
stock into common
stock ........................ (6,988,850) (5,824) 582,404 5,824 24,467,177
Issuance of common stock ........ -- -- -- 877,193 8,772
Preferred stock dividends ....... -- -- -- -- --
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1998 ......................... -- -- -- 8,337,097 83,371
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1999 ......................... -- -- -- 8,337,097 83,371
Issuance of common stock ........ -- -- -- 371,431 3,714
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2000 ......................... -- -- -- 8,708,528 87,085
Issuance of common stock ........ -- -- -- 1,126,727 11,267
Compensation related to
stock options,
warrants and stock
grants ....................... -- -- -- 25,000 250
Net loss ........................ -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2001 ......................... -- -- -- 9,860,255 98,602
Issuance of common stock ........ -- -- -- 2,025,686 20,257
Common stock warrants
issued in connection
with convertible
debentures ................... -- -- -- -- --
Conversion of
convertible
debentures to common
stock ........................ -- -- -- 168,696 1,687
Debenture conversion
costs ........................ -- -- -- -- --
Net loss ........................
Foreign currency
translation adjustment ....... -- -- -- -- --
Comprehensive loss .............. -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2002 ......................... -- -- -- 12,054,637 120,546
Issuance of common stock ........ -- -- -- 137,264 1,373
Common stock and common
stock warrants issued
in connection with
issuance of
convertible debentures ....... -- -- -- 624,747 6,248
Conversion of
convertible
debentures to common
stock ........................ -- -- -- 1,312,318 13,123
Debenture conversion
costs ........................ -- -- -- -- --
Net loss ........................ -- -- -- -- --
Foreign currency
translation
adjustment ................... -- -- -- -- --
Comprehensive loss .............. -- -- -- -- --
--------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2003 ......................... -- $ -- $ -- 14,128,966 $ 141,290
============================================================================================
DEFICIT
ADDITIONAL ACCUMULATED ACCUMULATED
PAID-IN DURING OTHER
COMMON DEVELOP- COMPREHENSIVE
CAPITAL MENT STAGE LOSS TOTALS
-------------------------------------------------------------------------------------
ISSUANCE OF COMMON STOCK
AT INCEPTION .................... $ 6,850 -- -- $ 10,000
Sale of preferred stock,
net ............................. -- -- -- 24,473,001
Net loss ........................... -- $ (7,782,551) -- (7,782,551)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1993 ............................ 6,850 (7,782,551) -- 16,700,450
Net loss ........................... -- (16,582,080) -- (16,582,080)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1994 ............................ 6,850 (24,364,631) -- 118,370
Contribution to equity ............. 1,117,723 -- -- 1,117,723
Net loss ........................... -- (13,914,194) -- (13,914,194)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1995 ............................ 1,124,573 (38,278,825) -- (12,678,101)
Contribution to equity ............. 650,000 -- -- 650,000
Issuance of stock
warrants ........................ 246,270 -- -- 246,270
Net loss ........................... -- (16,950,137) -- (16,950,137)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1996 ............................ 2,020,843 (55,228,962) -- (28,731,968)
Compensation related to
stock options,
warrants and stock
grants .......................... 3,156,659 -- -- 3,156,659
Net loss ........................... -- (18,992,023) -- (18,992,023)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1997 ............................ 5,177,502 (74,220,985) -- (44,567,332)
262 to 1 stock split................ -- -- -- --
Conversion of preferred
stock into common
stock ........................... -- -- --
Issuance of common stock ........... 205,979,984 -- -- 205,988,756
Preferred stock dividends .......... (9,926,703) -- -- (9,926,703)
Net loss ........................... -- (26,620,052) -- (26,620,052)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1998 ............................ 225,632,335 (100,841,037) -- 124,874,669
Net loss ........................... -- (44,188,443) -- (44,188,443)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
1999 ............................ 225,632,335 (145,029,480) -- 80,686,226
Issuance of common stock ........... 10,518,074 -- -- 10,521,788
Net loss ........................... -- (48,911,605) -- (48,911,605)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2000 ............................ 236,150,409 (193,941,085) -- 42,296,409
Issuance of common stock ........... 30,542,773 -- -- 30,554,040
Compensation related to
stock options,
warrants and stock
grants .......................... 986,869 -- -- 987,119
Net loss ........................... -- (62,301,511) -- (62,301,511)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2001 ............................ 267,680,051 (256,242,596) -- 11,536,057
Issuance of common stock ........... 21,881,459 -- -- 21,901,716
Common stock warrants
issued in connection
with convertible
debentures ...................... 1,521,046 -- -- 1,521,046
Conversion of
convertible
debentures to common
stock ........................... 998,313 -- -- 1,000,000
Debenture conversion
costs ........................... 176,471 -- -- 176,471
Net loss ........................... (39,591,344) (39,591,344)
Foreign currency
translation adjustment .......... -- -- $ (16,632) (16,632)
---------------------
Comprehensive loss ................. -- -- -- (39,607,976)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2002 ............................ 292,257,340 (295,833,940) (16,632) (3,472,686)
Issuance of common stock ........... 811,267 -- -- 812,640
Common stock and common
stock warrants issued
in connection with
issuance of
convertible debentures .......... 2,921,594 -- -- 2,927,842
Conversion of
convertible
debentures to common
stock ........................... 7,536,877 -- -- 7,550,000
Debenture conversion
costs ........................... (1,493,332) -- -- (1,493,332)
Net loss ........................... -- (18,516,741) -- (18,516,741)
Foreign currency
translation
adjustment ...................... -- -- (76,498) (76,498)
---------------------
Comprehensive loss ................. -- -- -- (18,593,239)
-------------------------------------------------------------------------------------
BALANCE, DECEMBER 31,
2003 ............................ $ 302,033,746 $(314,350,681) $ (93,130) $ (12,268,775)
====================================================================================
See Notes to Consolidated Financial Statements.
F-5
EARTHSHELL CORPORATION
(A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED STATEMENTS OF CASH FLOWS
NOVEMBER 1,
1992
(INCEPTION)
YEAR ENDED DECEMBER 31, THROUGH
--------------------------------------------------------- DECEMBER 31,
2003 2002 2001 2003
----------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ....................................... $ (18,516,741) $ (39,591,344) $ (62,301,511) $(314,350,681)
Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation and amortization ............... 379,949 3,099,367 5,874,144 22,841,379
Amortization and accretion of debenture issue
costs .................................... 955,574 144,500 -- 1,371,351
Debenture conversion costs .................. 166,494 320,970 -- 487,464
Gain on change in fair value of warrant
obligation ............................... (399,701) -- -- (399,701)
Loss on extinguishment of debentures ........ 1,697,380 -- -- 1,697,380
Beneficial conversion value due to change in
debentures conversion price .............. 360,000 -- -- 360,000
Loss on sale, disposal or impairment
of property and equipment ................ 3,548,059 9,340,375 19,386,412 50,761,599
Equity in the losses of joint venture ....... 392,116 20,263 37,153 541,542
Accrued purchase commitment ................. (1,855,000) 3,500,000 -- 1,645,000
Compensation related to issuance of stock,
stock options and warrants to directors,
consultants and officers ................. -- -- 987,119 4,848,641
Net loss on sale of investments ............. -- -- -- 32,496
Accretion of discounts on investments ....... -- -- -- (410,084)
Other non-cash items ........................ 50,198 -- -- 50,198
Changes in operating assets and liabilities
Prepaid expenses and other current assets ... 264,153 9,670 (87,583) (306,649)
Accounts payable and accrued expenses ....... (2,339,720) (444,851) 2,438,911 4,706,951
Payable to related party .................... 1,214,683 578,779 (266,312) 1,839,108
Accrued purchase commitment ................. (1,645,000) -- -- (1,645,000)
Other long-term liability ................... 33,333 -- -- 33,333
----------------------------------------------------------------------------------
Net cash used in operating activities .... (15,694,223) (23,022,271) (33,931,667) (225,895,673)
==================================================================================
F-6
NOVEMBER 1,
1992
(INCEPTION)
YEAR ENDED DECEMBER 31, THROUGH
--------------------------------------------------------- DECEMBER 31,
2003 2002 2001 2003
----------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of restricted time deposit in
connection with purchase commitment ......... -- -- -- (3,500,000)
Proceeds from release of restricted time deposit
upon settlement of purchase commitment ...... 3,500,000 -- -- 3,500,000
Purchase of investments U.S. government
securities .................................. -- -- -- (52,419,820)
Proceeds from sales and redemptions of
investments ................................. -- -- -- 52,797,408
Proceeds from sales of property and equipment .. 487,691 477,566 -- 1,262,927
Investment in joint venture .................... (26,104) -- -- (541,542)
Purchases of property and equipment ............ (1,320) (2,802,371) (3,586,020) (75,799,435)
----------------------------------------------------------------------------------
Net cash provided by (used in) investing
activities ............................. 3,960,267 (2,324,805) (3,586,020) (74,700,462)
==================================================================================
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of common stock ......... -- 21,901,716 30,554,040 284,852,820
Common stock issuance costs .................... -- -- -- (15,178,641)
Proceeds from issuance of common stock and
convertible debentures, net of issuance costs
and discounts amounting to approximately $3.4
million ..................................... 8,711,844 -- -- 8,711,844
Proceeds from issuance of convertible debentures -- 10,000,000 -- 10,000,000
Purchase of restricted time deposit in
connection with issuance of convertible
debentures .................................. -- (10,000,000) -- (10,000,000)
Proceeds from release of restricted time deposit
upon conversion of convertible debentures
into common stock ........................... 1,800,000 1,000,000 -- 2,800,000
Proceeds from release of restricted time deposit
upon exchange of convertible debentures ..... 2,000,000 -- -- 2,000,000
Proceeds from release of restricted time deposit
for repayment of convertible debentures ..... 5,200,000 -- -- 5,200,000
Repayment of convertible debentures ............ (5,200,000) -- -- (5,200,000)
Proceeds from issuance of notes payable to
related party ............................... 1,010,000 4,825,000 -- 20,105,000
Repayment of notes payable to related
party ...................................... -- (3,080,000) -- (15,325,651)
Proceeds from drawings on line of credit with
bank ........................................ -- -- -- 14,000,000
Repayment of line of credit with bank .......... -- -- -- (14,000,000)
Preferred dividends paid ....................... -- -- -- (9,926,703)
Proceeds from issuance of preferred stock ...... -- -- -- 25,675,000
Preferred stock issuance costs ................. -- -- -- (1,201,999)
----------------------------------------------------------------------------------
Net cash provided by financing activities 13,521,844 24,646,716 30,554,040 302,511,670
Effect of exchange rate changes on cash and cash
equivalents ................................. 2,736 (16,632) -- (13,896)
----------------------------------------------------------------------------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,790,624 (716,992) (6,963,647) 1,901,639
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD . 111,015 828,007 7,791,654 --
----------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF PERIOD ....... $ 1,901,639 $ 111,015 $ 828,007 $ 1,901,639
==================================================================================
F-7
NOVEMBER 1,
1992
(INCEPTION)
YEAR ENDED DECEMBER 31, THROUGH
--------------------------------------------------------- DECEMBER 31,
2003 2002 2001 2003
----------------------------------------------------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for
Income taxes ................................ $ 800 $ 800 $ 800 $ 12,671
Interest .................................... 111,353 21,058 -- 3,160,651
Common stock warrants issued in connection with
convertible debentures ...................... 745,562 1,521,046 -- 2,572,776
Conversion of convertible debentures into common
stock ....................................... 7,550,000 1,000,000 -- 8,550,000
Transfer of property from EKI .................. -- -- -- 28,745
Conversion of preferred stock into common stock -- -- -- 69,888
Interest paid in common stock .................. 95,339 -- -- 95,339
Commission paid in common stock ................ 29,500 -- -- 29,500
Common stock issued to service providers in
connection with the March 2003 financing .... 484,500 -- -- 484,500
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
In 2003, warrants for the purchase of $1.055 million in aggregate
principal amount of convertible debentures and 70,477 shares of common stock
were issued in connection with the issuance of convertible debentures. The
estimated fair value of the warrants of $442,040, based upon the Black-Scholes
method of valuation, was recorded as an original issue discount thereby reducing
the carrying value of the convertible debentures and as an increase in
additional paid-in common capital.
In 2003, warrants for the purchase of 83,333 shares of common stock were
issued to EKI, in connection with the issuance of convertible debentures, in
consideration for its willingness to subordinate amounts owed to it. The
estimated fair value of the warrants of $303,522, based upon the Black-Scholes
method of valuation, was recorded as an original issue discount thereby reducing
the carrying value of the notes payable to EKI and as an increase in additional
paid-in common capital.
In 2003, 137,264 shares of common stock were issued to satisfy accounts
payable and accrued interest payable of $812,640.
In 2002, warrants for the purchase of 208,333 shares of common stock were
issued in connection with the issuance of convertible debentures. The estimated
fair value of the warrants of $1,521,046, based upon the Black-Scholes method of
valuation, was recorded as an original issue discount thereby reducing the
carrying value of the convertible debentures and as an increase in additional
paid-in common capital.
In 2001, 25,000 shares of common stock were granted to consultants and
officers with a fair market value on the date of grant of $792,353.
In 2001, 10,833 stock options were granted to consultants. The Company
recorded $194,766 of expense in conjunction with these transactions.
See Notes to Consolidated Financial Statements.
F-8
EARTHSHELL CORPORATION
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
BASIS OF PRESENTATION AND NATURE OF OPERATIONS
EarthShell Corporation was incorporated in Delaware on November 1, 1992 as
a subsidiary of E. Khashoggi Industries, LLC (together with its predecessor
entities, "EKI"). Beginning in January 2002, the consolidated financial
statements of EarthShell Corporation include the accounts of its wholly-owned
subsidiary, PolarCup EarthShell GmbH. All significant intercompany balances and
transactions have been eliminated in consolidation. Both EarthShell Corporation
and its subsidiary (collectively "EarthShell" or the "Company") are development
stage enterprises. In connection with the formation of the Company, the Company
entered into an Amended and Restated License Agreement (the "License Agreement")
for certain technology developed by EKI, exclusively for use in connection with
the manufacture and sale of selected disposable food and beverage containers for
use in the foodservice industry. Investments in affiliated companies with a 20%
to 50% ownership interest where control does not exist are accounted for using
the equity method. The accompanying consolidated financial statements reflect
only the costs and expenses related to the application of the technology under
development since the Company's formation on November 1, 1992.
The accompanying consolidated financial statements have been prepared on a
going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. During the period
from November 1, 1992 (inception) to December 31, 2003, the Company has incurred
a cumulative net loss of $314,350,681 and has a working capital deficit of
$7,922,339 at December 31, 2003. These factors, along with others, may indicate
that the Company will be unable to continue as a going concern for a reasonable
period of time.
The Company will have to raise additional funds to meet its current
obligations and to cover operating expenses through the year ending December 31,
2004. If the Company is not successful in raising additional capital it may not
be able to continue as a going concern for a reasonable period of time.
Management plans to address this need by raising cash through either the
issuance of debt or equity securities. In addition, the Company expects cash to
be generated in 2004 through royalty payments from licensees. Another possible
source of funds is the sale or transfer of the commercial production line in
Goettingen, Germany to an operating partner. However, the Company can not assure
that additional financing will be available to it, or, if available, that the
terms will be satisfactory, that it will receive any royalty payments in 2004,
or that it will be able to negotiate mutually agreeable terms for the transfer
of its commercial production line to an operating partner. Management will also
continue in its efforts to reduce expenses, but can not assure that it will be
able to reduce expenses below current levels.
The consolidated financial statements do not include any adjustments
relating to the recoverability and classification of recorded asset amounts or
the amounts and classification of liabilities that might be necessary should the
Company be unable to continue as a going concern.
Management has made estimates and assumptions in the preparation of these
consolidated financial statements that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the consolidated financial statements and the reported amounts of expenses
during the reporting period. Actual results could differ from those estimates.
In January 2004, the Company announced that it was not in compliance with
a Nasdaq SmallCap Market minimum requirement. On March 8, 2004 the Company's
common stock was delisted by the Nasdaq SmallCap Market and trading was moved to
the over-the-counter (OTC) Pink Sheets Electronic Quotation Service. The stock
trades under the symbol "ERTH.PK."
F-9
LOSS PER COMMON SHARE
Basic loss per common share is computed by dividing net loss available to
common stockholders by the weighted-average number of common shares outstanding
during the period. Diluted loss per common share is computed by dividing net
loss available to common stockholders by the weighted-average number of common
shares outstanding plus an assumed increase in common shares outstanding for
potentially dilutive securities, which consist of options and warrants to
acquire common stock and convertible debentures. Net loss as reported is
adjusted for preferred dividends. Potentially dilutive shares are excluded from
the computation in loss periods, as their effect would be antidilutive. The
dilutive effect of options and warrants to acquire common stock is measured
using the treasury stock method. The dilutive effect of convertible debentures
is measured using the if converted method. Basic and diluted loss per common
share is the same for all periods presented because the impact of potentially
dilutive securities is anti-dilutive. The dilutive effect of potentially
dilutive securities was 54 shares, 38,596 shares, and 38,884 shares for the
years ended at December 31, 2003, 2002 and 2001, respectively.
OPERATIONS AND FINANCING
The Company was engaged in initial concept development from 1993 to 1998.
During this period, the Company focused on enhancing the material science
technology licensed from EKI, initial development of the Company's foam
packaging products (primarily, its hinged-lid sandwich containers, which are
referred to as "hinged-lid containers"), and the development of relationships
with key licensees and end-users.
Since 1998, the Company has been primarily engaged in commercial
validation of EarthShell Packaging for plates, bowls, hinged-lid containers, and
sandwich wraps, and other market development activities. During this stage, the
Company has worked to demonstrate the commercial viability of its business model
by optimizing product design, garnering support from key members of the
environmental community, expanding validation of the environmental profile
through third party evaluations, developing commercially viable manufacturing
processes, establishing and refining licensing arrangements with the Company's
licensees, and validating product performance and price acceptance through
commercial contracts with influential purchasers in key segments of the
foodservice market. In cooperation with its operating partners, the Company
financed and built initial commercial demonstration production capacity and has
sold limited quantities of plates, bowls, and hinged-lid containers. In 2003,
the Company ceased commercial demonstration production activity and is relying
on its equipment and manufacturing partners to demonstrate and to guarantee the
long-term manufacturability of EarthShell Packaging(R).
As demonstration of the business fundamentals to licensees is
accomplished, the Company expects that its operating partners will build
production capacity. The Company intends to expand the use of EarthShell
Packaging in the U.S. and in international markets through agreements with
additional licensees. By leveraging the infrastructure of its licensees, the
Company believes the go-to-market strategy will accelerate the market
penetration of EarthShell Packaging.
Currently, the Company's strategic relationships include Detroit Tool and
Equipment ("DTE"), Sweetheart Cup Company Inc. ("Sweetheart"), and Hood
Packaging Corporation, all in the U.S. The Company has not recorded any revenues
from operations since its inception, and proceeds from sales of plates, bowls
and hinged-lid containers to date have been insignificant and have been recorded
as an offset to the costs of its demonstration manufacturing operations.
As part of the Company's initial public offering on March 27, 1998, the
Company issued 877,193 shares of common stock, for which it received net
proceeds of $206 million. On April 18, 2000 and January 4, 2001, the Company
filed S-3 shelf registration statements for 416,667 and 1,250,000 shares,
respectively, of the Company's common stock. During the years ended December 31,
2002, 2001, and 2000 the Company sold approximately 0.1 million, 1.1 million and
0.4 million shares of common stock under such registration statements and
received net proceeds from such sales of approximately $2.3 million, $30.6
million and $10.5 million, respectively. All shares available under such
registration statements had been sold as of December 2002.
In December of 2001, the Company filed an additional shelf registration
statement providing for the sale of up to $50 million of securities, including
secured or unsecured debt securities, preferred stock, common stock, and
warrants. These securities could be offered, separately or together, in distinct
series, and amounts, at prices and terms to be set forth in the prospectus
contained in the registration statement, and in subsequent supplements to the
prospectus. During the year ended December 31, 2002, the Company sold 1.9
million shares of common stock under such registration statement and received
net proceeds from such sales of $19.6 million.
F-10
On August 12, 2002, the Company issued $10.0 million in aggregate
principal amount of convertible debentures, due August 2007, (the "2007
Debentures") and warrants to purchase 0.2 million shares of common stock to
institutional investors for proceeds of $10.0 million (see Convertible
Debenture). The terms of the debentures required the proceeds be held in
restricted cash accounts linked to irrevocable letters of credit in favor of
each debenture holder such that unrestricted access to the proceeds from the
sale of the debentures generally occurred only upon conversion of the debentures
into shares of the Company's common stock (see Restricted Cash). In 2002 and
2003, $2.8 million of the debentures were converted to common stock. In March
2003, the Company issued $10.55 million in aggregate principal amount of
convertible debentures, due March 2006 (the "2006 Debentures"), and 0.5 million
shares of common stock to a group of institutional investors for net proceeds of
approximately $9.0 million. In connection with this transaction, the Company
repaid $5.2 million of the remaining balance of the 2007 Debentures, and
exchanged $2.0 million of the 2007 Debentures for the 2006 Debentures. This
transaction provided the Company with net proceeds of approximately $11.0
million. The Company's use of these proceeds was subject to a number of
restrictions. In 2003, $5.75 million of the 2006 Debentures were converted to
common stock. The remaining shares under the December 2001 shelf registration
described above have been used to secure shares potentially issuable upon
conversion of the remainder of the 2006 Debentures.
During 2002 and 2003, the Company's largest shareholder, EKI, made various
simple interest working capital loans to the Company. These loans bear interest
at a rate of 7% or 10% per annum, and are payable on demand. As of December 31,
2003, the outstanding principal balance of these loans was $2,755,000. In
connection with the March 2003 convertible debenture financing the remaining
outstanding balance of these loans was subordinated to the 2006 Debentures, with
strict covenants governing their repayment. (See Related Party Transactions).
RECENT ACCOUNTING PRONOUNCEMENTS
The FASB recently issued the following statements:
In April 2002, the FASB issued 145 "Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." This
Statement rescinds SFAS 4, Reporting Gains and Losses from Extinguishment of
Debt and an amendment of that statement, SFAS 64, Extinguishments of Debt Made
to Satisfy Sinking-Fund Requirements. The rescission of these Statements alters
the financial reporting requirements from gains and losses resulting from the
extinguishments of debt. These gains or losses should now be reported before
extraordinary items, unless the two requirements for extraordinary items are
met. This statement also rescinds SFAS 44, Accounting for Intangible Assets of
Motor Carriers and amends SFAS 13, Accounting for Leases, to eliminate an
inconsistency between the required accounting for sale-leaseback transactions
and the required accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions. This statement also
amends other existing authoritative pronouncements to make various technical
corrections, clarify meanings, or describe their applicability under changed
conditions. The provisions of this statement related to the rescission of
Statement 4 shall be applied in fiscal years beginning after May 15, 2002. Any
gain or loss on extinguishments of debt that was classified as an extraordinary
item in prior periods presented that does not meet the criteria in Opinion 30
for classification as an extraordinary shall be reclassified. The provision of
this Statement related to Statement 13 shall be effective for transactions
occurring after May 15, 2002.
In June of 2002, the FASB issued SFAS 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which nullifies EITF Issue 94-3.
SFAS 146 is effective for exit and disposal activities that are initiated after
December 31, 2002 and requires that a liability for a cost associated with an
exit or disposal activity be recognized when the liability is incurred, in
contrast to the date of an entity's commitment to an exit plan, as required by
EITF Issue 94-3. The Company adopted the provisions of SFAS 146 effective
January 1, 2003.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure." This Statement amends
SFAS No. 123, "Stock-Based Compensation," to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. In addition, this Statement amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The alternative methods of transition of SFAS 148 are effective for
fiscal years ending after December 15, 2002. The Company follows APB 25 in
accounting for its employee stock options. The disclosure provision of SFAS 148
is effective for years ending after December 15, 2002 and has been incorporated
into these consolidated financial statements and accompanying footnotes.
F-11
In January 2003 the Financial Accounting Standards Board ("FASB") issued
Interpretation 46 "Consolidation of Variable Interest Entities, an
interpretation of ARB No. 51". This Interpretation requires a Company to
consolidate the financial statements of a "Variable Interest Entity" ("VIE"),
sometimes also known as a "special purpose entity", even if the entity does not
hold a majority equity interest in the VIE. The Interpretation requires that if
a business enterprise has a "controlling financial interest" in a VIE, the
assets, liabilities, and results of the activities of the VIE should be included
in consolidated financial statements with those of the business enterprise, even
if it holds a minority equity position. This Interpretation was effective
immediately for all VIE's created after January 31, 2003; for the first fiscal
year or interim period beginning after June 15, 2003 for VIE's in which a
Company holds a variable interest that it acquired before February 1, 2003. In
December 2003, the FASB issued a revision to FIN 46 ("FIN46R") to clarify some
of the provisions of FIN 46. The Company currently has no entities which have
the characteristics of a variable interest entity. Furthermore, the Company's
adoption of the remaining provisions of FIN 46R in the quarter ending March 31,
2004 did not have an impact on the Company's financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
Statement establishes standards for how an issuer of debt classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify certain financial instruments as
a liability (or an asset in some circumstances) instead of equity. The Statement
is effective for financial instruments entered into or modified after May 31,
2003, and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. The Company adopted this Statement on July 1,
2003.
The Company does not believe that any of these recent accounting
pronouncements have had or will have a material impact on their financial
position or results of operations.
OTHER COMPREHENSIVE INCOME
The Company has reflected the provisions of SFAS No. 130, "Reporting
Comprehensive Income", in the accompanying consolidated financial statements for
all periods presented. The accumulated comprehensive loss and other
comprehensive loss as reflected in the accompanying consolidated financial
statements, respectively, consists of foreign currency translation adjustments.
FOREIGN CURRENCY TRANSLATION
Assets and liabilities of the Company's foreign subsidiary, PolarCup
EarthShell GmbH, are translated into United States dollars at the exchange rate
in effect at the close of the period, and revenues and expenses are translated
at the weighted average exchange rate during the period. The aggregate effect of
translating the financial statements of PolarCup EarthShell GmbH is included as
a separate component of stockholders' equity. Foreign exchange gains/losses have
been insignificant.
REVERSE STOCK SPLIT
Effective as of October 31, 2003, the Company's Board of Directors
("Board") approved an amendment to the Company's Certificate of Incorporation to
effect a reverse split of the Company's common stock. This action by the Board
followed approval by 88% of the stockholders of a proposal at the 2003 Annual
Meeting of the Company that authorized the Board to take such action. The
decision by the Board was prompted by the need to maintain compliance with
certain covenants of the Company's 2006 debentures that require the Company to
retain its listing on a national market.
After careful analysis, the Board approved the final ratio for the split
at one-for-twelve (1:12), whereby each twelve shares of the company's issued and
outstanding common stock was automatically converted into one share of new
common stock. The percentage of the Company's stock owned by each shareholder
remained the same. No fractional shares were issued, and instead, the Company's
transfer agent aggregated and sold any fractional shares on the open market and
distributed the pro rata share of the cash proceeds to the holders of fractional
share interests.
The reverse split has been retroactively reflected in these financial
statements.
In conjunction with the reverse split, the authorized shares of common
stock were reduced from 200 million to 25 million as of October 31, 2003.
F-12
DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company has financial instruments, none of which are held for trading
purposes. The Company estimates that the fair value of all financial instruments
at December 31, 2003 and 2002, as defined in FASB 107, does not differ
materially from the aggregate carrying values of its financial instruments
recorded in the accompanying balance sheet. The estimated fair value amounts
have been determined by the Company using available market information and
appropriate valuation methodologies. However, the fair value of payables to
related parties and notes payable to related party cannot be determined due to
their related party nature. In addition, it is impractical for the Company to
estimate the fair value of the convertible debentures because a market for such
debentures does not readily exist. Considerable judgment is required in
interpreting market data to develop the estimates of fair value, and
accordingly, the estimates are not necessarily indicative of the amounts that
the Company could realize in a current market exchange.
CONCENTRATION OF RISK - FINANCIAL INSTRUMENTS
Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of Cash and Cash Equivalents.
The Company places its excess cash in reputable financial institutions
($1,861,538) and in high quality money market fund deposits ($39,801). Cash
deposits in excess of those federally insured amounted to $1,753,523 at December
31, 2003. Money market fund deposits are subject to market fluctuations and
there is no guarantee as to their ultimate value.
RECLASSIFICATIONS
Certain items in the 2002 and 2001 financial statements have been
reclassified to conform to the 2003 presentation.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash, funds invested in money market
funds and cash invested temporarily in various instruments with maturities of
three months or less at the time of purchase. The money market fund deposits
have an investment objective to provide high current income to the extent
consistent with the preservation of capital and the maintenance of liquidity
and, therefore, are subject to minimal risk.
RESTRICTED CASH
At March 30, 1998, a certificate of deposit for $3.5 million was opened as
collateral for the letter of credit related to the Company's obligation under a
letter agreement between the Company's majority stockholder, EKI, and the
Company relating to a patent purchase agreement between EKI and a third party,
as discussed in the Commitments note, and was classified as restricted cash on
the December 31, 2002 balance sheet. The $3.5 million certificate of deposit was
reflected as a current asset in the December 31, 2002 balance sheet since the
obligation would become payable on or about December 31, 2003. With the
negotiation and payment of the reduced obligation amount in the fourth quarter
of 2003, both the letter of credit and certificate of deposit were released.
Therefore, no cash remains restricted for this obligation as of December 31,
2003. (See Commitments).
In August 2002, proceeds from the issuance of $10.0 million of the 2007
Debentures (see Convertible Debentures note) were used to purchase restricted
cash deposits to secure irrevocable letters of credit in favor of the debenture
holders. Unrestricted access to the proceeds of the debentures occurred
generally only upon conversion of the debentures into shares of the Company's
common stock, accompanied by pro rata reductions in the letters of credit. At
December 31, 2002, $9.0 million of the proceeds were used to secure the
irrevocable letters of credit. In 2003, the Company prepaid $5.2 million and
restructured $2.0 million of these secured convertible debentures, while the
remaining $1.8 million were converted to common stock. At December 31, 2003,
there were no 2007 Debentures outstanding.
PREPAID EXPENSES AND OTHER CURRENT ASSETS
The following is a summary of prepaid expenses and other current assets at
December 31:
2003 2002
-------- --------
Recoverable foreign taxes-VAT.................. $158,491 $ 7,408
Prepaid expenses and other current assets ..... 165,189 563,394
-------- --------
Total Prepaid Expenses and Other Current Assets $323,680 $570,802
======== ========
F-13
EVALUATION OF LONG-LIVED ASSETS
The Company evaluates the recoverability of long-lived assets whenever
events or changes in circumstances indicate that the carrying value of an asset
may not be recoverable. If there is an indication that the carrying value of a
long-lived asset may not be recoverable and the estimated future cash flows
(undiscounted and without interest charges) from the use of the asset are less
than the carrying value, a write-down is recorded to reduce the related asset to
its estimated fair value (see Property and Equipment).
PROPERTY AND EQUIPMENT AND EQUIPMENT HELD FOR SALE
Property and equipment are carried at cost. Depreciation and amortization
is provided for using the straight-line method for financial reporting purposes
based upon the estimated useful lives of the assets which range from three to
seven years. The cost of assets sold or retired and the related amounts of
accumulated depreciation are eliminated from the accounts and the resulting gain
or loss is included in income. As described further below, the Company wrote
down property and equipment related to commercialization of the EarthShell
Packaging products technology by $4.0 million in 2003, $9.8 million in 2002, and
$19.4 million in 2001. The impairment charges were expensed to "Other research
and development" in the accompanying Statements of Operations.
The cost and accumulated depreciation of property and equipment and
equipment held for sale at December 31 were as follows:
2003 2002
----------- -----------
Commercial Manufacturing Equipment
Goettingen, Germany ........................ $ -- $ 4,000,000
Other Property and Equipment
Product Development Center ................. 1,175,394 2,077,438
Office Furniture and Equipment ............. 356,339 742,931
Leasehold improvements ..................... -- 521,187
----------- -----------
1,531,733 3,341,556
Total cost .................................... 1,531,733 7,341,556
Less: accumulated depreciation and amortization (1,469,939) (2,865,382)
----------- -----------
Property and equipment--net ................... $ 61,794 $ 4,476,174
=========== ===========
Equipment held for sale ....................... $ 1 --
=========== ===========
The commercial production line in Goettingen, Germany was financed and
constructed by the Company for the Company's joint venture (see Investment in
Joint Venture) with Huhtamaki. During 2001, $1.2 million of the Goettingen line
was written off to reflect equipment that had no further application in the
product development cycle. During the third quarter of 2002 the Company
concluded, after obtaining quotations from various machinery suppliers for an
identical line, that $1.7 million of the cost of the line will not be
recoverable and therefore the carrying value of the line was written down by
this amount, of which $1.6 million was recorded in the third quarter of 2002 and
the remaining $0.1 million was recorded in the fourth quarter of 2002. At
December 31, 2003, the Company is negotiating to sell the line to a party who
would become a licensee with rights to produce foodservice disposables. However,
because the Company is unable to determine with certainty the proceeds that will
be realized upon sale of the equipment, the Company wrote the line down to $1 as
of December 31, 2003 and reclassified it to the long-term asset account
"Equipment held for sale." The $4.0 million impairment charge was expensed to
"Other research and development" in the accompanying Statements of Operations.
If the equipment is sold, the Company will recognize a gain equal to the
proceeds received for the equipment.
The Company entered into a strategic relationship agreement with
Sweetheart in late 1997 whereby the Company financed and built production lines
at Sweetheart's Owings Mills, Maryland manufacturing facility to demonstrate
that its hinged-lid containers could be produced commercially for McDonald's.
The Company worked closely with Sweetheart and McDonald's to create an
acceptable product design and meet required performance standards. Since 1997
the Company had intended to transfer the production lines at Owings Mills to
Sweetheart. During 1999 and 2000 the Company consolidated its space in Owings
Mills. In December 2000, management determined that the manufacturing
configuration of the equipment at Owings Mills would have to be modified
somewhat and additional process improvements implemented to accommodate product
design changes and to achieve the design capacity of the plant. The
reconfiguration of the lines was expected to result in a simplified
manufacturing process. As a result of the planned modifications, the Company
impaired $11.0 million of assets located at Owings Mills during the fourth
quarter of 2000, approximately $0.7 million during the second quarter of 2000
and approximately $0.3 million during the first quarter of 2000. In the fourth
quarter of 2001, the Company wrote down $12.3 million of property and equipment
at Owings Mills to reflect the net realizable value of the equipment and
machinery based on a quotation from a third party. During the first half of
2002, production at the Owings Mills facility ceased as Sweetheart contemplated
construction of new, updated production lines. As a result, the Company wrote
down the remaining $7.5 million of the equipment at Owings Mills during the year
ended 2002; $0.3 million in the third quarter and $7.2 million in the fourth
quarter. As of December 31, 2002, the Company's Owings Mills production lines
were carried on its balance sheet at a net book value of zero. In 2003, all of
the Owings Mills equipment was either sold or disposed of.
F-14
During the fourth quarter of 2001 and the fourth quarter of 2002, $5.9
million and $0.5 million, respectively, of equipment at the Company's product
development center was written off because it had no further application in the
product development cycle.
As the Company sold non-essential machine shop equipment and excess office
furniture and equipment in 2003, the related cost and accumulated depreciation
were removed from the applicable asset account and accumulated depreciation,
respectively. At the expiration of the leases at the Company's Santa Barbara and
Goleta, California facilities in 2003, all leasehold improvements were fully
amortized. Due to the relocation to new office space in Santa Barbara, the
Company removed the fully amortized leasehold improvements from both the
Leasehold improvements and accumulated amortization accounts.
INVESTMENT IN JOINT VENTURE
On May 24, 1999, the Company entered into a joint venture agreement with
Huhtamaki to commercialize EarthShell Packaging throughout Europe, Australia,
New Zealand, and, on a country by country basis, Asia. The Company and Huhtamaki
formed Polarcup EarthShell ApS ("PolarCup"), a Danish holding company, for the
purpose of establishing operating companies to manufacture, market, sell and
distribute EarthShell Packaging.
The Company contributed approximately 10,000 Euros as nominal share
capital and 500,000 Euros for start-up capital. The Company paid for the
development of the initial commercial production line to be located at the
Huhtamaki facility at Goettingen, Germany (see Property and Equipment). In
January 2004, the Company announced the conclusion of its joint venture
structure with Huhtamaki. During 2003, 2002, and 2001 the Company recorded its
equity in the losses of the joint venture of $392,117, $20,263, and $37,153,
respectively, including the write off of its remaining investment as of December
31, 2003.
RELATED PARTY TRANSACTIONS
In connection with the formation of the Company, the Company entered into
a License Agreement (the "License Agreement") with EKI, a stockholder of the
Company. Pursuant to the license agreement, as amended, the Company has an
exclusive, worldwide, royalty-free license to use and license the EKI technology
to manufacture and sell disposable, single-use containers for packaging or
serving food or beverages intended for consumption within a short period of time
(less than 24 hours) and to use certain trademarks owned by EKI in connection
with the products covered under the License Agreement. The license continues to
be in effect during the life of the patents licensed under the License Agreement
covering the technologies. Patents currently issued do not begin to expire until
2012 and provide some protection through 2020. Pending patents, if granted,
would extend protection through 2022. On July 29, 2002, the License Agreement
was amended to expand the field of use for the EarthShell technology to include
noodle bowls used for packaging instant noodles. The Company will pay to EKI 50%
of any royalty or other consideration it receives in connection with the sale of
products within this particular field of use. In addition, on July 29, 2002 the
Company entered into a License & Information Transfer Agreement with Biotec, a
wholly owned subsidiary of EKI, to utilize the Biotec technology for foodservice
applications, including the food wraps used in foodservice applications (the
"Biotec Agreement"). Effective January 1, 2001, EKI had previously granted to
the Company priority rights to license certain product applications on an
exclusive basis from Biotec in consideration for the Company's payment of a
$100,000 monthly licensing fee to Biotec. In addition, in consideration of the
monthly payment, Biotec agreed to render technical services to the Company at
Biotec's cost plus 5%. The licensing fee and services arrangements were
continued in the Biotec Agreement. Under the terms of the Biotec Agreement,
Biotec is entitled to receive 25% of any royalties or other consideration that
the Company receives in connection with the sale of products utilizing the
Biotec technology. As part of the new convertible debenture financing completed
in March 2003 (see Convertible Debentures), payment of amounts due to EKI under
the License Agreement or the Biotec Agreement have been subordinated to the 2006
Debentures with strict covenants governing their repayment. However, any amounts
deferred pursuant to this subordination requirement shall accrue interest at the
rate of 10% per annum until paid. For the years ended December 31, 2003, 2002
and 2001, the Company paid or accrued to EKI $1,355,693, $1,488,070 and
$1,465,250, respectively, under the License Agreement and Biotec Agreement,
consisting of the $100,000 per month licensing fee, materials and services
provided by EKI, which vary based on the Company's given requirements, and
interest payable on outstanding balances.
F-15
From July 1, 1994 through December 31, 2000 the Company and EKI operated
under various agreements pursuant to which the Company paid EKI for certain
technical services and by which the Company subleased office space from EKI for
$5,600 per month. Technical services consisted of direct project labor hours
incurred by EKI personnel at specified hourly billing rates and direct expenses
incurred on approved projects. Effective January 1, 2001, the Company and EKI
ceased operating under these agreements, the Company hired directly from EKI the
scientific, technical and administrative personnel it required for its
operations and assumed direct responsibility for the lease obligations related
to the office and laboratory space the Company was subleasing from EKI in Santa
Barbara, California. The Company did not assume any accrued compensation
obligations in connection with the transfer of the employees, and EKI remained
obligated to pay all accrued vacation and severance liabilities. The Company
entered into a new lease for the Santa Barbara office (cancelable on six-months'
notice) beginning April 1, 2001. In each of 2003, 2002 and 2001, EKI paid the
Company $4,074, $24,444, and $24,444, respectively, for the use of office space
in the Company's Santa Barbara office. Effective March 1, 2003, EKI no longer
sublets any space from the Company.
On January 1, 2001, the Company also purchased from EKI certain operating
equipment and machinery, furniture, supplies and tools to facilitate the
transfer of the EKI employees to the Company. The Company paid $900,000 for the
assets, which approximated net book value.
In the year ended December 31, 2000 and prior periods, the Company
reimbursed EKI for the costs and expenses incurred in filing, prosecuting,
acquiring and maintaining certain patents and patent applications relating to
the technology licensed to the Company under the License Agreement under an
Amended and Restated Agreement for the Allocation of Patent Costs (the "Patent
Agreement"). Legal fees of $362,244 were paid to or on behalf of EKI during 2000
under the Patent Agreement. Effective January 1, 2001, EarthShell assumed direct
responsibility to manage and maintain the patent portfolio underlying the
License Agreement with EKI and to pay directly all related costs.
At December 31, 2003 and 2002, the amounts payable to EKI under the
various agreements, for materials and services provided, and for interest on
outstanding balances were $1.5 million and $0.6 million, respectively.
On September 9, 2002, the Company entered into a Loan Agreement with EKI
whereby EKI agreed to extend certain loans to the Company at EKI's sole
discretion. Loans made under the Loan Agreement plus accrued interest are due
and payable on the first to occur of i) receipt by the Company of proceeds from
a qualified financing or ii) 30 days. During 2002, the Company received $4.8
million in loans from EKI, at interest rates of 7% or 10% per annum. At December
31, 2002, outstanding loans and related interest payable to EKI were $1.745
million and $0.159 million, respectively. In January 2003, the Company received
an additional $1.01 million in short-term loans from EKI, at interest rates of
10% per annum. As part of the new convertible debenture financing completed in
March 2003 (see Convertible Debentures), repayment of loans totaling $2.755
million have been subordinated to the new debentures with strict covenants
governing their repayment. In March 2003, the Company issued to EKI a warrant to
purchase 83,333 shares at $6.00 per share in connection with the subordination
of loans of $2.755 million made to the Company and the elimination of the
conversion feature. At December 31, 2003, outstanding loans and related interest
payable to EKI were $2.755 million and $0.323 million, respectively.
F-16
ACCOUNTS PAYABLE AND ACCRUED EXPENSES
The following is a summary of accounts payable and accrued expenses at
December 31:
2003 2002
---------- ----------
Accounts payable and other accrued expenses $3,603,340 $5,767,482
Accrued property taxes .................... 655,000 500,586
Accrued salaries, wages and benefits ...... 338,402 538,189
Accrued legal fees ........................ 256,671 1,098,700
---------- ----------
Total Accounts Payable and Accrued Expenses $4,853,413 $7,904,957
========== ==========
CONVERTIBLE DEBENTURES
On August 12, 2002, the Company issued $10.0 million in aggregate
principal amount of the 2007 Debentures to institutional investors. These
debentures bore interest at a rate of 1.5% per annum, payable quarterly in
arrears on each January 31, April 30, July 31 and October 31. The holders of
these debentures had the right to convert the debentures into the Company's
common stock at an initial conversion price of $15.60 per share, which was
reduced to $8.40 per share in November 2002 and then to $6.00 per share in March
2003 as a result of anti-dilution adjustments. Based on the conversion price
relative to the fair market value of the common stock at the date of issue, the
debentures were deemed to have no beneficial conversion feature. In March 2003,
the conversion price of the 2007 Debentures was adjusted downward, resulting in
a beneficial conversion charge of $360,000 that is included in Other interest
expense in the Statements of Operations. The proceeds from the debentures were
held in restricted accounts linked to irrevocable letters of credit in favor of
the debenture holders such that unrestricted access to the proceeds from the
sale of the debentures generally occurred only upon conversion of the debentures
into shares of the Company's common stock (see Restricted Cash). In addition to
the holders' conversion option, under certain circumstances the Company had the
right to force conversion of up to $500,000 of the debentures per week at a 15%
discount to the market price of the Company's stock. Subject to certain
conditions set forth in the debentures, the debentures could be prepaid upon
twenty business days notice for 104% of the outstanding principal balance of the
debentures. During the third quarter of 2002, the Company forced conversion of
$1.0 million principal amount of the debentures for 168,696 shares of common
stock, resulting in the release to the Company of $1.0 million of restricted
cash. During 2003, the Company forced conversion of an additional $1.3 million
principal amount of the debentures and debenture holders voluntarily converted
$0.5 million principal amount of the debentures, for a total of 353,985 shares
of common stock, resulting in the release to the Company of $1.8 million of
restricted cash.
In connection with the issuance of the 2007 Debentures, the Company issued
to the debenture holders warrants to purchase 208,333 shares of the Company's
common stock at $14.40 per share (see Stock Warrants). A value of $1,521,046 was
ascribed to the warrants and recorded as an original issue discount based on the
Black-Scholes method of valuation. During 2002, non-cash interest expense of
$144,500 and debenture conversion costs of $320,970 were recognized in the
Statements of Operations to reflect amortization of the original issue discount
associated with the warrants and to reflect the 15% discount to the market price
of the Company's common stock resulting from the forced conversions of the 2007
Debentures. During 2003, non-cash interest expense of $74,927 was recognized in
the Statements of Operations to reflect amortization of the original issue
discount associated with the warrants. In addition, $59,747 of the original
issue discount associated with the debentures voluntarily converted was charged
to additional paid in common capital.
In March 2003, as part of a new convertible debenture financing, the
Company prepaid $5.2 million principal amount of the 2007 Debentures, resulting
in a prepayment penalty of $208,000. The Company also issued to the holders of
the 2007 Debentures, 52,083 shares of common stock, valued at $237,500 based
upon the closing price of the Company's common stock on the Nasdaq SmallCap
Market of $4.56 per share on March 5, 2003. In addition, one of the holders of
the 2007 Debentures exchanged $2.0 million aggregate principal amount of 2007
Debentures for $2.0 million aggregate principal amount of 2006 Debentures and
78,989 shares of common stock valued at approximately $360,000 based upon the
closing price of the Company's common stock of $4.56 per share on March 5, 2003.
In connection with the prepayment and exchange transactions, the Company
incurred cash transaction costs of approximately $296,000, excluding the
prepayment penalty. The Company recognized a $1.7 million loss upon
extinguishment of the 2007 Debentures through the prepayment and exchange. The
exchange of $2.0 million of the 2007 Debentures for 2006 Debentures resulted in
the release to the Company of $2.0 million of restricted cash. There are no
outstanding 2007 Debentures as of December 31, 2003.
F-17
On March 5, 2003, the Company issued to a group of institutional investors
416,667 shares of common stock and $10.55 million in aggregate principal amount
of secured convertible debentures due in March 2006 (the "2006 Debentures"), for
which the Company received proceeds of approximately $9.0 million, net of
financing costs of approximately $1.5 million. The 2006 Debentures bear interest
at a rate of 2.0% per annum, payable quarterly in arrears on each January 31,
April 30, July 31 and October 31. The debentures are secured by the Company's
rights, title and interest to the technology and trademarks covered by the EKI
License Agreement, including all process and product improvements of the
Company, the Company's right to use and to sublicense the technology, and all
license fees, royalties and/or other forms of compensation due to the Company
from sublicenses under existing or future sublicenses. The holders of the 2006
Debentures have the right to convert such debentures into the Company's common
stock at a conversion price of $6.00 per share. While the 2006 Debentures are
outstanding, the conversion price is subject to adjustment in certain instances,
such as a result of stock dividends and splits, distributions of property to
common stockholders, the sale of substantially all of the Company's assets, the
consummation of a merger, or sales of common stock or common stock equivalents
for per share prices lower than the conversion price in effect. In addition to
the holders' conversion option, after the first anniversary of the issuance of
the 2006 Debentures the Company has the right to force conversion of all or a
portion of the outstanding principal amount of the 2006 Debentures if certain
conditions are met, including a requirement that the closing price of the common
stock has been equal to or greater than 300% of the conversion price for at
least the 10 consecutive days immediately preceding the conversion. The
principal amount of the 2006 Debentures is due and payable on March 5, 2006;
however, earlier repayment may occur if the Company receives cash proceeds in
excess of $2.65 million (the "Excess Amount") from the sale of debt or equity
securities, equipment sales to unrelated third parties, operating revenues, or
any cash that becomes available to the Company as a result of a reduction in a
$3.5 million letter of credit the Company issued to a third party in 1998. If
the Excess Amount arises, the Company can elect to distribute one-third of such
Excess Amount to EKI in payment of amounts due to EKI under the License
Agreement or the Biotec Agreement that have been subordinated to the 2006
Debentures, and one-third of such Excess Amount , with the consent of each
applicable debenture holder, as a 102% prepayment of principal and interest of
the 2006 Debentures.
In accordance with Accounting Principles Board Opinion No. 14, "Accounting
for Convertible Debt and Debt Issued with Stock Purchase Warrants," the Company
allocated the net proceeds of $9.0 million to the 2006 Debentures and the common
stock based upon their relative fair values. A discount on the 2006 Debentures
of $3.4 million and a discount on the common stock of $604,000 resulted from the
fair value allocation. Based on the conversion price of the 2006 Debentures
relative to the fair market value for a share of the Company's common stock at
the date of issue, the 2006 Debentures were deemed to have no beneficial
conversion feature. If subsequent to the issuance date the conversion price of
the 2006 Debentures is adjusted downward, the value of the conversion feature
will be re-measured to determine if any beneficial conversion value should be
recorded as of the date the conversion price is adjusted. There have been no
adjustments to the conversion price of the 2006 Debentures. The principal amount
of the 2006 Debentures of $10.55 million was recorded as a noncurrent liability,
net of the $3.4 million discount. The total discount of $3.4 million, which is
being amortized to interest expense over the 36-month term of the 2006
Debentures using the effective interest method, may be subject to downward
adjustments to the extent partial conversions of the 2006 Debentures occur.
These adjustments, if required, would reduce the discount and reduce additional
paid-in capital.
In addition to the $1.5 million of financing costs, the Company also
incurred approximately $646,000 of non-cash costs attributable to 54,167 shares
of common stock issued to the lead purchaser of the 2006 Debentures and two
warrants issued to a placement agent, both of whom received the instruments as
compensation for their services rendered in connection with the transaction. The
fair value of the 54,167 shares of common stock issued to the lead purchaser was
determined to be $247,000, based on the closing price of $4.56 per share of the
Company's common stock on the Nasdaq SmallCap Market on March 5, 2003. The fair
value of approximately $42,000 of the first of the two warrants issued to the
placement agent, which expires in March 2006 and is immediately exercisable by
the placement agent to purchase 28,810 shares of the Company's common stock for
$10.08 per share, was estimated using the Black Scholes option-pricing model and
is reflected in the accompanying financial statements as an increase in
additional paid-in capital and as a component of the $4.0 million aggregate
discount on the 2006 Debentures and common stock issued in the March 2003
transaction. The second of the two warrants issued to the placement agent, which
expires in March 2006, is immediately exercisable by the placement agent to
purchase $1.055 million in aggregate principal amount of the 2006 Debentures and
41,667 shares of the Company's common stock, except if, prior to exercise of the
warrant, all of the 2006 Debentures have been redeemed, repurchased or
converted, in which case the portion of the warrant exercisable into the 2006
Debentures becomes exercisable into common stock as if the 2006 Debentures
included in the warrant had been converted to common stock. The exercise price
of the convertible debenture portion of the warrant is $1,200 for each $1,000 of
principal and is subject to adjustment consistent with the provisions of the
2006 Debentures. The exercise price of the common stock portion of the warrant
is $7.20 per share. The estimated fair value of this warrant was reflected in
the financial statements as a warrant obligation and as a component of the $4.0
million aggregate discount on the 2006 Debentures and common stock issued in the
March 2003 financing transaction. At September 30, 2003, the Company evaluated
the current value of this warrant, considering the Company's current cash flow
projections, continued operating losses, the prospects of raising additional
equity capital, the significant excess of the conversion price to the current
stock price and the volatility in the Company's stock price. Based upon these
factors, the Company determined that the warrant had no value as of September
30, 2003 and December 31, 2003 and therefore reduced the balance of the warrant
obligation to zero as of September 30, 2003, resulting in a $0.5 million gain
that is reflected in "Other (income) expense" in the Statements of Operations.
F-18
The issuance of the 2006 Debentures, prepayment of the 2007 Debentures
(from restricted cash) and the debenture exchange provided the Company with
aggregate net proceeds of approximately $11.0 million.
In 2003, $5.75 million principal amount of the 2006 Debentures was
converted into 958,334 shares of common stock resulting in the approximately
$4.4 million carrying amount of the 2006 Debentures being transferred to common
stock.
At December 31, 2003, the outstanding principal balance of 2006 Debentures
was $6.8 million, which is reflected on the accompanying balance sheet net of an
unamortized discount of approximately $1.5 million.
At December 31, 2003, the Company was in compliance with all covenants of
the 2006 Debentures. However, on March 8, 2004, the Company's common stock was
delisted from the Nasdaq Smallcap Market because the Company's market
capitalization failed to meet the minimum required standard. In addition, the
Company did not make interest payments related to the 2006 Debentures as
required on January 31, 2004. These actions put the Company in non-compliance
with its covenants under the 2006 Debentures. Management is currently
negotiating with the debenture holders for appropriate relief or waiver of these
covenants. One of the debenture holders has notified the Company in writing that
they are in default and has requested that the Company repurchase the entire
principal amount of the 2006 Debentures that they hold at the price specified in
the debenture, along with any accrued and unpaid interest. Because the Company
can not assure that it will be able to negotiate appropriate relief or a waiver
of the applicable covenants, the entire outstanding principal amount of the 2006
Debentures has been classified as a current liability as of December 31, 2003.
(See Subsequent Events)
In connection with the March 2003 financing transactions, EKI agreed to
subordinate the repayment of its outstanding loans totaling $2.755 million to
the Company's payment obligations under the 2006 Debentures. In addition, EKI
and Biotec agreed to subordinate certain payments to which they were otherwise
entitled under the Biotec License Agreement (other than their respective
percentages of any royalties received by the Company) to the satisfaction of the
Company's payment obligations under the 2006 Debentures. They further agreed not
to assert any claims against the Company for breaches of the Biotec License
Agreement (other than the assertion of certain equitable remedies to enjoin the
Company from, for example, selling products outside its field of use) until such
time as the Company's obligations under the 2006 Debentures are satisfied in
full. EKI and Biotec also agreed to allow the Company to pledge their respective
interests in the EKI and Biotec License Agreements to secure the Company's
obligations under the 2006 Debentures, and certain additional concessions were
made by EKI and Biotec to permit the Company greater flexibility in selling its
rights under the EKI and Biotec License Agreements to third parties in an
insolvency context. These rights terminate upon the satisfaction in full of the
obligations under the 2006 Debentures. In consideration for its willingness to
subordinate the payments and advances that are owed to it, in March 2003 the
Company issued to EKI a warrant, expiring in ten years, to acquire 83,333 shares
of the Company's common stock for $6.00 per share. The fair value of the warrant
was estimated to be approximately $303,522 using the Black-Scholes option
pricing model and was recorded as a discount on the outstanding loans.
COMMITMENTS
In September 2003, the Company leased 4,000 square feet of office and
research and development space in Santa Barbara, California, under a lease that
expired on December 31, 2003. In January 2004, the lease was extended through
April 2004. The Company's monthly lease payment with respect to this space is
$5,000. In addition, the Company leases 3,353 square feet of office space in
Lutherville, Maryland, on a month to month basis. The Company's monthly lease
payment with respect to this space is $5,780. Future minimum lease payments
required under these leases as of December 31, 2003 are $0. Rental expenses for
the years ended December 31, 2003, 2002 and 2001 amounted to $558,195, $927,386
and $980,978, respectively.
F-19
During 1998, EKI entered into certain agreements with an equipment
manufacturer providing for the purchase by EKI of certain technology applicable
to starch-based disposable packaging. EKI licenses such technology to the
Company on a royalty-free basis pursuant to the License Agreement. In connection
with the purchase, and pursuant to the terms of a letter agreement with EKI, the
Company agreed to pay the seller of the technology $3.5 million on or about
December 31, 2003, which obligation is secured by a letter of credit (see
Restricted Cash). In the fourth quarter of 2002, the Company established a
liability for the $3.5 million commitment as of December 31, 2002 ("Accrued
Purchase Commitment") and recorded a corresponding expense to "Other research
and development" in the Statements of Operations. In the fourth quarter of 2003,
the Company negotiated a reduction of the obligation to $1.6 million. Upon
payment of the reduced obligation amount in the fourth quarter of 2003, the
seller simultaneously released the letter of credit. Therefore, as of December
31, 2003, the Accrued Purchase Commitment has been fulfilled and the excess $1.8
million recorded in 2002 was recorded as an offset to "Other research and
development" in the 2003 Statements of Operations.
In addition, the Company is required to pay the seller $3.0 million over
the five-year period commencing January 1, 2004 if EKI, the Company or their
licensees make active use of the technology and have not purchased, by December
31, 2003, at least $35.0 million of equipment from the seller. As of December
31, 2003, the Company and its licensees have neither actively used the
technology nor purchased equipment from the seller. The Company does not plan to
make active use of the technology during the year ending December 31, 2004. EKI
has agreed to indemnify the Company to the extent the Company is required to pay
any portion of this $3.0 million obligation solely as a result of EKI's or its
licensees' active use of such patents and related technology (other than use by
the Company or its sublicensees). The $3.0 million obligation to the seller of
the technology is subject to reduction in an amount equal to 5% of the purchase
price of any equipment purchased from the seller by EKI, the Company or their
sublicensees during the five-year period commencing January 1, 2004.
CUMULATIVE CONVERTIBLE PREFERRED STOCK
The cumulative convertible preferred stock was issued in 1993 and remained
outstanding until it was converted into shares of common stock in 1998.
During 1993, the Company completed a private placement of preferred stock
totaling $26,675,000, with net proceeds to the Company totaling $24,473,001.
Under the Series A Cumulative Senior Convertible Preferred Stock Purchase
Agreement, the Company issued 6,988,850 shares of Series A cumulative senior
convertible preferred stock at $3.82 per share. Dividends, when declared, were
payable on a quarterly basis at 8% per annum. At December 31, 1996, and December
31, 1997 cumulative undeclared dividends totaled $7,016,000 and $9,149,890,
respectively. Each share of preferred stock was convertible into one share of
common stock. Subject to the right of the holders of the preferred stock to
convert their shares into common stock, the Company had the right to redeem the
preferred stock at a price of $3.87 per share between September 30, 1997 and
September 30, 1998 and at a price of $3.82 per share after September 30, 1998.
After three years from the issuance, registration rights enabled the preferred
stockholders to cause the Company to effect two registration statements for the
common stock into which their shares of preferred stock are convertible.
Preferred stockholders had the right to vote with the common stock as if the
preferred stock had converted to common stock of the Company. Preferred
stockholders had the right to elect one member to the Board of Directors.
To facilitate the sale by stockholders of Series A preferred stock in the
Company's March 1998 initial public offering of common stock, 3,993,404 shares
of the 6,988,850 shares of outstanding Series A preferred stock were converted
to 3,993,404 shares of common stock. A portion of the converted shares was sold
in the initial public offering by stockholders. In April 1998, the Board of
Directors declared a cash dividend to preferred stockholders of $1.40 per share
based on the dividend rate of 8% per annum on the liquidation preference of the
shares. The total dividends paid were $9,725,201. By notice dated May 13, 1998,
the Company called for redemption, effective July 14, 1998, of the remaining
2,995,446 shares of Series A preferred stock. In August 1998, the Board of
Directors declared a cash dividend to former preferred stockholders of $.0033
per share based on the dividend rate of 8% per annum of the liquidation
preference pursuant to the Certificate of Designation, Preferences Relative,
Participating, Optional and Other Special Rights for Series A Cumulative Senior
Convertible Preferred Stock, which provided for dividends to accrue until the
time of conversion, together with interest thereon at the rate of 8% per annum
from the date of conversion until the date of payment. Total dividends and
interest paid to the remaining Series A preferred stockholders was $201,502. As
of September 30, 1998, all outstanding shares of Series A preferred stock had
been converted to common stock.
F-20
RETIREMENT BENEFITS
The Company established a qualified 401(k) plan for all of its employees
in 1998. The 401(k) plan allows employees to contribute, on a tax-deferred
basis, up to fifteen percent of their annual base compensation subject to
certain regulatory and plan limitations. The Company uses a discretionary
matching formula that matches one half of the employee's 401(k) deferral up to a
maximum of six percent of annual base compensation. The 401(k) employer match
was $44,057 in 2003, $74,853 in 2002, and $114,746 in 2001.
STOCK OPTIONS
In 1994 the Company established the EarthShell Corporation 1994 Stock
Option Plan (the "1994 Plan"). In 1995 the Company subsequently established the
EarthShell Corporation 1995 Stock Incentive Plan (the "1995 Plan") which
effectively superseded the 1994 Plan for options issued on or after the date of
the 1995 Plan's adoption. The 1994 and 1995 Plans as amended (the "Plans")
provide that the Company may grant an aggregate number of options for up to
833,333 shares of common stock to employees, directors and other eligible
persons as defined by the Plans. Options issued to date under the Plans
generally vest over varying periods from 0 to 5 years and generally expire 10
years from the date of grant.
Stock option activity for 2003, 2002 and 2001 is as follows:
2003 2002 2001
------------------------------------------------------------------------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------------------------------------------------------------------------------------------
Outstanding at beginning of year.... 320,924 $50.49 231,333 $ 73.44 193,552 $87.12
Granted.......................... 121,699 4.87 168,811 34.44 60,000 38.64
Cancelled........................ (43,748) 34.02 (73,105) 74.52 (22,219) 98.28
Expired.......................... (13,963) 42.14 (6,115) 189.24 -- --
------------------------------------------------------------------------------------------
Outstanding at end of year.......... 384,912 38.24 320,924 50.49 231,333 73.44
==========================================================================================
Options exercisable at year-end..... 155,228 $61.70 162,476 $ 63.72 188,208 $73.44
==========================================================================================
The following table summarizes information about stock options outstanding
at December 31, 2003:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------------------------------------------------------------------------
NUMBER WEIGHTED-AVERAGE
OUTSTANDING REMAINING NUMBER
EXERCISE AT CONTRACTUAL WEIGHTED-AVERAGE EXERCISABLE WEIGHTED-AVERAGE
PRICES 12/31/03 LIFE EXERCISE PRICE AT 12/31/03 EXERCISE PRICE
----------------------------------------------------------------------------------------------------------------------------
$ 4.20 4,167 9.84 $ 4.20 2,083 $ 4.20
4.80 104,166 9.73 4.80 - -
5.64 11,283 4.43 5.64 8,683 5.64
15.00 8,334 2.19 15.00 8,334 15.00
16.68 8,332 3.41 16.68 8,332 16.68
36.00 128,334 8.08 36.00 7,500 36.00
44.04 27,145 7.17 44.04 27,145 44.04
45.36 6,249 1.36 45.36 6,249 45.36
45.60 6,249 2.35 45.60 6,249 45.60
60.00 43,750 5.8 60.00 43,750 60.00
91.56 23,471 2.05 91.56 23,471 91.56
128.28 4,166 .37 128.28 4,166 128.28
182.40 2,183 3.90 182.40 2,183 182.40
252.00 7,083 4.42 252.00 7,083 252.00
-------------------------------------------------------------------------------------------------------------
384,912 7.14 $ 38.24 155,228 $ 61.70
=============================================================================================================
F-21
The Company accounts for the Plans in accordance with the provisions of
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," and complies with the disclosure provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock- Based
Compensation." Under APB Opinion No. 25, compensation expense is based on the
difference, if any, on the date of grant, between the fair value of the
Company's common stock and the exercise price of the option. For disclosure
purposes, to measure stock-based compensation in accordance with SFAS No. 123,
"Accounting for Stock-Based Compensation", the fair value of each option grant
is estimated on the date of grant using the Black-Scholes option-pricing model.
The fair value of each option grant will be amortized as pro forma compensation
expense over the vesting period of the options. The following table sets forth
the assumptions used and the pro forma net loss and loss per share resulting
from applying SFAS No. 123:
YEAR ENDED, YEAR ENDED, YEAR ENDED,
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2003 2002 2001
--------------------------------------------------------
Net Loss as reported ..................................................... $ 18,516,741 $ 39,591,344 $ 62,301,511
Deduct: Stock-based employee compensation expense included in reported net
loss, net of tax ...................................................... -- -- --
Add: Total stock-based employee compensation determined under fair value
based method for all awards, net of tax ............................... 776,018 2,136,323 2,635,623
--------------------------------------------------------
Pro forma net loss ....................................................... $ 19,292,759 $ 41,727,667 $ 64,937,134
Net loss per common share
As reported ........................................................... $ 1.40 $ 3.51 $ 6.66
Pro forma ............................................................. 1.45 3.70 6.94
Weighted average risk-free interest rate ................................. 4.53% 4.54% 5.06%
Weighted average expected life in years .................................. 9.5 9.6 7.9
Volatility ............................................................... 102% 182% 113%
Weighted average fair value of options granted during the year ........... $ 3.99 $ 11.91 $ 32.36
STOCK WARRANTS
On June 7, 1996, in consideration of a $3,000,000 line of credit financing
arrangement, the Company issued a warrant which entitled the lender to purchase
common shares equal to $150,000 divided by the price per share of the Company's
common stock in the initial public offering of $252 per share. The warrant was
not exercised and expired on June 7, 2001.
On November 15, 1996, the line of credit was increased to $9,000,000 and
an additional warrant was issued which entitled the lender to purchase 1,623
shares of common stock for $277.20 per share. The warrant was not exercised and
expired on November 15, 2003.
On October 6, 1997, the line of credit was increased to $13,000,000 and an
additional warrant was issued which entitled the lender to purchase $250,000 in
common stock at a price per share equal to 110% of the initial public offering
price. This warrant expires on October 6, 2004.
On December 31, 1997, the line of credit was increased to $14,000,000 and
an additional warrant was issued which entitled the lender to purchase $50,000
in common stock at a price per share equal to 110% of the initial public
offering price. This warrant expires on December 31, 2004. The warrants issued
in 1997 were valued at $59,898 based upon an option pricing model.
On October 26, 2000, as partial consideration for a financing agreement
where the minimum trading prices were below $36.00 per share, the Company issued
warrants to purchase 69,186 shares of common stock at an exercise price of 115%
of the purchase price per share of the common stock issued and sold in respect
of such drawdown period. During 2001, 1,667 warrants were exercised at a price
of $17.33 per common share in respect to the warrants described. On March 20,
2002 the Company terminated this financing agreement and reduced the warrant
exercise prices in consideration. The exercise price of the remaining 67,519
warrants were re-priced to $3.00 per share and were subsequently exercised
during 2002.
F-22
On April 5, 2002, the Company entered into a common stock purchase
agreement (the "Purchase Agreement") with certain investors (the "Purchasers")
for an aggregate of 291,667 shares of EarthShell common stock for aggregate
consideration of $4,025,000. Under the Purchase Agreement, the Purchasers were
issued warrants to purchase up to an additional 145,833 shares of the Company's
common stock at a price equal to $13.80 per share during the thirty day period
following the closing of the Purchase Agreement. These warrants have expired.
In connection with the issuance of the convertible debentures on August
12, 2002 (see Convertible Debentures), the Company issued to the debenture
holders warrants to purchase 208,333 shares of the Company's common stock at
$14.40 per share. A value of $1,521,046 was ascribed to the warrants and
recorded as an original issue discount based on the Black-Scholes method of
valuation. The exercise price and number of common shares issuable upon exercise
of the warrants are subject to adjustment under certain circumstances, such as
the occurrence of stock dividends and splits, distributions of property or
securities other than common stock, equity issuances for less than the warrant
exercise price and a change in control of the Company. Originally, with any
adjustment to the warrant exercise price, the number of shares issuable were to
be increased or decreased such that the aggregate exercise price remained fixed
at $3,000,000. As of December 31, 2002, 357,143 shares of common stock were
issuable upon exercise of the warrants for $8.40 per share. In March 2003, in
connection with the issuance of the 2006 Debentures, the exercise price of the
warrants was reduced to $6.00 per share, but the number of shares of common
stock issuable upon exercise remained fixed at 357,143. At the same time, the
warrant agreement was amended such that any subsequent reduction in the exercise
price of the warrants will not result in any increase in the number of shares of
common stock issuable under the warrants. The warrants expire on August 12,
2007.
In connection with the issuance of the convertible debentures in March
2003 (see Convertible Debentures), the Company issued to the placement agent
warrants to purchase $1.055 million in aggregate principal amount of the 2006
Debentures at $1,200 per $1,000 of principal amount, 28,810 shares of the
Company's common stock at $10.08 per share, and 41,667 shares of the Company's
common stock at $7.20 per share. A value of $484,500 was ascribed to the
warrants and recorded as an original issue discount based on the Black-Scholes
method of valuation. The exercise price and number of common shares issuable
upon exercise of the warrants are subject to adjustment under certain
circumstances, such as the occurrence of stock dividends and splits,
distributions of property or securities other than common stock and a change in
control of the Company. The warrants expire in March 2006.
On March 5, 2003, the Company issued to EKI a warrant to purchase 83,333
shares at $6.00 per share in connection with the subordination of loans of
$2.755 million made to the Company and the elimination of the conversion
feature. The warrants expire on March 4, 2010.
INCOME TAXES
Deferred income tax assets and liabilities are computed annually for
differences between the financial statement and income tax bases of assets and
liabilities. Such deferred income tax asset and liability computations are based
on enacted tax laws and rates applicable to periods in which the differences are
expected to reverse. Valuation allowances are established, when necessary, to
reduce deferred income tax assets to the amounts expected to be realized. Income
tax expense is the tax payable or refundable for the period plus or minus the
change during the period in deferred income tax assets and liabilities.
F-23
Deferred income taxes result from temporary differences in the recognition
of revenues and expenses for financial and tax reporting purposes. At December
31, 2003 and 2002, deferred income tax assets were comprised primarily of the
following:
2003 2002
---------------------------------
Federal:
Depreciation ....................... $ 6,510,014 $ 5,335,487
Capitalized operating expenses ..... 3,198,684 6,480,950
Deferred compensation .............. 1,091,917 1,091,917
Deferred contributions ............. 361,117 360,955
Accrued vacation ................... 110,415 141,408
Other reserves ..................... 20,945 33,442
Accrued purchase commitment ........ -- 1,190,000
Net operating loss carryforward .... 92,580,034 82,550,118
---------------------------------
103,873,126 97,184,277
=================================
State:
Capitalized research and development 9,813,976 9,633,296
Depreciation ....................... 1,927,489 1,552,355
Capitalized operating expenses ..... -- 576,499
Accrued purchase commitment ........ -- 346,229
Deferred compensation .............. 323,296 317,692
Deferred contributions ............. 106,920 105,020
Accrued vacation ................... 32,692 41,142
Other reserves ..................... 6,201 9,730
Net operating loss carryforward .... 12,649,869 10,156,366
---------------------------------
24,860,443 22,738,329
---------------------------------
Deferred tax asset .................... 128,733,569 119,922,606
Valuation allowance ................... (128,733,569) (119,922,606)
---------------------------------
Net deferred tax asset ............. $ -- $ --
=================================
The valuation allowance increased by $8,810,963, $20,523,501 and
$8,014,321 during the years ended December 31, 2003, 2002, and 2001,
respectively, as a result of changes in the components of the deferred income
tax items.
For federal income tax purposes, the Company has net operating loss
carryforwards of $272,294,219 as of December 31, 2003 that expire through 2023.
For state income tax purposes, the Company has California net operating loss
carryforwards of $46,883,091 as of December 31, 2003 that expire through 2014,
and Maryland net operating loss carryforwards of $121,505,765 that follow the
federal treatment and expire through 2023.
Income tax expense for 2003, 2002, and 2001 consists of the minimum state
franchise tax.
SUBSEQUENT EVENTS
On March 8, 2004, the Company's common stock was delisted from the Nasdaq
Smallcap Market because the Company's market capitalization failed to meet the
minimum required standard. In addition, the Company did not make interest
payments related to the 2006 Debentures as required on January 31, 2004. These
actions put the Company in non-compliance with its covenants under the 2006
Debentures. Management is currently negotiating with the debenture holders for
appropriate relief or waiver of these covenants. One of the debenture holders
has notified the Company in writing that they are in default and has requested
that the Company repurchase the entire principal amount of the 2006 Debentures
that they hold at the price specified in the debenture, along with any accrued
and unpaid interest. Because the Company can not assure that it will be able to
negotiate appropriate relief or a waiver of the applicable covenants, the entire
outstanding principal amount of the 2006 Debentures has been classified as a
current liability as of December 31, 2003.
F-24
QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
FIRST SECOND THIRD FOURTH TOTAL YEAR
---------------------------------------------------------------------------------
2003
Related party research and development $ 353,800 $ 304,667 $ 353,907 $ 300,000 $ 1,312,374
Other research and development 1,896,986 1,707,507 1,287,516 3,342,407 8,234,416
Other general and administrative 1,853,702 1,193,342 1,361,900 1,381,529 5,790,473
Net loss common shareholders $ 6,770,727 $ 3,608,184 $ 2,920,797 $ 5,217,033 $18,516,741
Basic and diluted loss per common share $ 0.55 $ 0.28 $ 0.21 $ 0.37 $ 1.40
Weighted average common shares outstanding 12,358,967 13,013,462 13,595,973 14,013,965 13,266,668
2002
Related party research and development $ 300,000 $ 468,313 $ 300,000 $ 419,757 $ 1,488,070
Other Research and development 6,667,159 3,809,063 2,941,860 11,983,787 25,401,869
Other general and administrative 2,477,474 2,122,397 2,372,488 2,641,678 9,614,037
Net loss common shareholders $10,212,738 $ 7,159,409 $ 6,785,374 $15,433,823 $39,591,344
Basic and diluted loss per common share $ 0.99 $ 0.64 $ 0.59 $ 1.29 $ 3.51
Weighted average common shares outstanding 10,364,811 11,147,808 11,541,668 11,941,306 11,277,170
F-25