UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

Commission File Number 001-15063

 

Endocare, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware		33-0618093
(State of incorporation)		(I.R.S. Employer Identification No.)
201 Technology, Irvine, CA (Address of principal executive offices)		92618 (Zip Code)

 

Registrant’s telephone number, including area code: (949) 450-5400

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 par value

Rights to Purchase Shares of Series A Junior Participating Preferred Stock

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ

 

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. (1) Yes þ No o (2) Yes þ No o

 

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 the 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. þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

 

The aggregate market value of the common stock of the Registrant held by non-affiliates as of June 30, 2008 was approximately $43,542,270 (based on the last sale price for shares of the Registrant’s common stock as reported on The NASDAQ Capital Market for that date). Shares of common stock held by each executive officer, director and holder of 10 percent or more of the outstanding common stock have been excluded in that such persons may be deemed affiliates. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of management or policies of the Registrant, or that such person is controlled by or under common control with the Registrant.

 

There were 11,811,451 shares of the Registrant’s common stock issued and outstanding as of February 28, 2009.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain exhibits filed with our prior registration statements, proxy statement and Forms 10-K, 8-K and 10-Q are incorporated herein by reference into Part IV of this Annual Report on Form 10-K.

 

 

Endocare, Inc.

 

Form 10-K

 

For the Fiscal Year Ended December 31, 2008

 

TABLE OF CONTENTS

 

 

This Annual Report on Form 10-K may contain forward-looking statements that involve risks and uncertainties. Such statements typically include, but are not limited to, statements containing the words “believes,” “intends,” “anticipates,” “expects,” “hopes,” “estimates,” “should,” “could,” “may,” “plans,” “planned” and words of similar import. Our actual results could differ materially from any such forward-looking statements as a result of the risks and uncertainties, including but not limited to those set forth below in “Risks Factors” and in other documents we file from time to time with the Securities and Exchange Commission, including our Quarterly Reports on Form 10-Q. Any such forward-looking statements reflect our management’s opinions only as of the date of this Annual Report on Form 10-K, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements. Readers should carefully review the risk factors set forth below in “Risks Factors” and in other documents we file from time to time with the Securities and Exchange Commission, including our Quarterly Reports on Form 10-Q.

 

AutoFreeze^®, CGC^tm, Cryocare^®, Cryocare CS^®, Cryocare SL^®, Cryocare Surgical System^®, CryoDisc^®, CryoGrid^tm, CryoGuide^®, Direct Access^®, Endocare^tm, FastTrac^®, Primary Cryo^®, Integrated Ultrasound^tm, SmartTemp^tm, Targeted Cryoablation of the Prostate TCAP^®, TCAP^®, Tempprobe^®, Urethral Warmer^tm, R-Probe^tm, V-Probe^®, Cryocare CN2^tm, PerCryo^®, and CryoProbe CN2^tm are our trademarks; and, Endocare^®, Renal Cryo^®, Salvage Cryo^®, Focal Cryo^®, Ice Knife^tm and Primary Cryo^® are our servicemarks. This Annual Report on Form 10-K may also include trademarks and trade names owned by other parties, and all other trademarks and trade names mentioned in this Annual Report on Form 10-K are the property of their respective owners.

 

 

Overview

 

Endocare is a specialty medical device company focused on improving patients’ lives through the development, manufacturing and distribution of health care products for cryoablation. Our strategy in the prostate and renal cancer markets is to further develop and increase the acceptance of our technology in the interventional radiology and oncology markets for treatment of liver and lung tumors as well as palliative intervention (treatment of pain associated with metastases), while achieving penetration across additional markets with our proprietary cryoablation technology. The term “cryoablation” refers to the creation inside the body of extremely low freezing temperatures which causes the destruction of cells within tissue and tumors, for therapeutic purposes. The term “cryoablation technology” refers to technology relating to the use of ice in surgical procedures, including cryoablation procedures.

 

Today, our FDA-cleared Cryocare Surgical System is used in the treatment of prostate and renal cancer. Because of our initial concentration on prostate and renal cancer, the majority of our sales and marketing resources are directed toward the promotion of our technology to urologists. We also employ a dedicated sales team focused on the interventional radiology market in which our products are used to treat renal, liver and lung cancer and for palliative intervention. In addition to selling our cryoablation disposable products to hospitals and mobile service companies, we contract directly with hospitals for the use of our Cryocare Surgical System and disposable products on a fee-for-service basis. We intend to continue to identify and develop new markets for our cryoablation products and technologies, particularly in the area of tumor ablation.

 

We were incorporated under the laws of the State of Delaware in May 1994. We maintain our principal executive offices at 201 Technology Drive, Irvine, California 92618, and our telephone number at that address is (949) 450-5400. Information regarding our financial condition and results of operations can be found in a separate section of this proxy statement/prospectus, beginning on page F-2. We previously owned Timm Medical Technologies, Inc., a company focused on erectile dysfunction products. We sold Timm Medical to UK-based Plethora Solutions Holdings plc on February 10, 2006.

 

Recent Events

 

On November 10, 2008, Endocare and privately held Galil Medical, Ltd. (Galil) entered into the Merger Agreement, pursuant to which Orange Acquisition Ltd, (a newly-formed wholly owned subsidiary of Endocare)

will merge with and into Galil, with Galil continuing after the merger as the surviving company and a wholly owned subsidiary of Endocare. This merger is referred to in this Annual Report on Form 10-K as the “Merger.” The Merger will be effected via the exchange of Endocare common stock and stock options for Galil’s outstanding ordinary shares and options.

 

At the effective time of the Merger, it is expected that 11,092,330 shares of Endocare common stock will be issued in the Merger. The exact conversion ratio cannot be calculated until immediately prior to the effective time of the Merger, but it is expected that approximately 33.0 ordinary shares of Galil will be converted into one share of Endocare common stock. Immediately following the effective time of the Merger and attributing ownership to Galil’s shareholders of the Endocare common stock to be deposited into the escrow (the Escrow Shares), Galil’s shareholders will own approximately 48.0%, and Endocare’s stockholders will own approximately 52.0%, of Endocare’s common stock, without giving effect to the shares issuable pursuant to the concurrent financing described below. The Merger will have no effect on the number of shares of common stock of Endocare owned by existing Endocare stockholders. Subject to receipt of regulatory approvals, including the closing of the pending investigation by the Federal Trade Commission (the “FTC”), and approvals by Endocare stockholders and Galil shareholders, we are seeking to close the Merger in the second quarter of 2009.

 

Concurrent with the execution of the Merger Agreement, Endocare and certain existing institutional accredited stockholders of Endocare and Galil entered into the Stock Purchase Agreement, relating to the private placement by Endocare of 16,250,000 shares of Endocare common stock at a purchase price of $1.00 per share. The offering gross proceeds to Endocare from this financing are expected to be $16,250,000. This financing is referred to in this Annual Report on Form 10-K as the “Financing.” The closing of the Financing is subject to the concurrent closing of the Merger and certain other conditions, including the sale of shares with a minimum aggregate purchase price of $12,000,000 and that Endocare’s common stock remains listed on the NASDAQ Capital Market or the Over-The-Counter Bulletin Board. Upon consummation of the Merger and the Financing, and attributing ownership to Galil’s shareholders of the Escrow Shares, Endocare stockholders will own approximately 38.5% of Endocare’s outstanding common stock and the former shareholders of Galil will own approximately 61.5% of Endocare’s outstanding common stock. Primarily as a result of this factor, the Merger will be accounted for as a reverse acquisition and equity recapitalization in accordance with U.S. generally accepted accounting principles. Under this method of accounting, after completion of the Merger and the Financing, Endocare will be treated as the “acquired” company for financial accounting and reporting purposes, and the combined entity’s results of operations prior to completion of the Merger will be those of Galil. We are obligated to pay a transaction fee of $800,000 and a percentage of the Financing proceeds (estimated to be approximately $265,000) to our financial advisor and placement agent upon the closing of the Merger and Financing.

 

Consummation of the Merger is subject to certain closing conditions, including, among other things, approval by Endocare stockholders and those of Galil. As a condition to the parties entering into the Merger Agreement, certain of Galil stockholders who in the aggregate own approximately 97.5% of Galil stock on an as if converted to common stock basis, have entered into voting agreements whereby they have agreed to vote in favor of the transactions contemplated by the Merger Agreement subject to the terms of the voting agreements.

 

The Merger Agreement terminates pursuant to its terms if the Merger has not occurred on or prior to June 30, 2009, unless the parties agree otherwise. The Merger Agreement contains certain other termination rights for both Endocare and Galil, including each party’s right to terminate the Merger Agreement in the event the other party’s available cash drops below $1.0 million for more than ten business days. Upon termination of the Merger Agreement for specified breaches and certain similar circumstances, either party may be required to pay the other party a termination fee of $900,000 and, in some circumstances, reimburse the other party for expenses incurred in connection with the Merger, up to a maximum of $850,000.

 

The Merger Agreement and Stock Purchase Agreement, which have been filed as exhibits to this Annual Report on Form 10-K, have been included as exhibits to provide you with information regarding the terms of the transactions described therein and are not intended to provide any other factual information or disclosure about Endocare, Galil or the investors in the Financing. The representations, warranties and covenants contained in the Merger Agreement and Stock Purchase Agreement were made only for purposes of such agreements and as of a specific date, were solely for the benefit of the parties to such agreements, may be subject to limitations agreed upon by the contracting parties,

including being qualified by disclosure schedules made for the purposes of allocating contractual risk between the parties thereto instead of establishing these matters as facts, and may be subject to standards of materiality applicable to the contracting parties that differ from those applicable to investors. Moreover, information concerning the subject matter of the representations and warranties may change after the dates of the Merger Agreement and the Stock Purchase Agreement, which subsequent information may or may not be fully reflected in Endocare’s public disclosures. Investors are not third-party beneficiaries under the Merger Agreement or the Stock Purchase Agreement and, in light of the foregoing reasons, should not rely on the representations, warranties and covenants or any descriptions thereof as characterizations of the actual state of facts or condition of Endocare, Galil, Orange Acquisitions, Ltd., the investors in the Financing or any of their respective subsidiaries or affiliates. Information regarding Endocare is provided elsewhere in this Annual Report on Form 10-K and Endocare’s other SEC filings, which are available at www.endocare.com and on the SEC’s website at www.sec.gov.

 

Advent of Cryoablation

 

Throughout the past two decades, the medical community has moved increasingly toward minimally invasive treatments for destroying cancerous tumors. This shift has been prompted by a variety of medical innovations including (1) major advancements in our ability to image or “see inside” the body using visualization technologies; (2) ablative technologies such as cryoablation, which can be performed from outside the body percutaneously, and (3) more precise methods for diagnosing, characterizing and targeting tumors inside the body.

 

Endocare is a pioneer of modern cryoablation, a minimally invasive procedure that freezes tissue to destroy tumor cells. Cryoablation was first developed in the 1960s and focused on the prostate cancer market. The early cryoablation technology, which used “cold probes,” or cryoprobes, was explored as a method to kill prostate tissue but was limited by imprecise targeting techniques and the inability to control the amount of tissue frozen during the procedure.

 

In more recent years, progress in ultrasound imaging and the advent of the Endocare Cryocare Surgical System and later Cryocare CS^tm Surgical System prompted the further evolution of cryoablation. Ultrasound allows a physician to guide the cryoprobes to the targeted tissue where the freezing system can be activated and the growth of ice around the diseased tissue can be more precisely controlled and monitored.

 

Existing Markets for Cryoablation

 

Endocare initially focused on developing treatments for prostate cancer. Incidence of prostate cancer has grown since 1980 and that disease is now the second most common cause of cancer-related deaths among men in the United States. The American Cancer Society in 2008 estimated there would be approximately 186,000 new cases of prostate cancer diagnosed and approximately 28,000 deaths associated with the disease in the United States during 2008. Prostate cancer incidence and mortality increase with age. Prostate cancer is found most often in men who are over the age of 50. According to the American Cancer Society, about 64 percent of men diagnosed with prostate cancer are age 65 or older. Incidence rates are higher in African American men. In addition to age and race, other risk factors are linked to prostate cancer, such as genetics, diet and exposure to environmental toxins.

 

Recently, we have added a new focus: the growing renal, or kidney, cancer market. The American Cancer Society estimates that approximately 54,000 people are diagnosed with renal cancer each year. Recent data, including five-year outcomes presented by The Cleveland Clinic for laparoscopic renal cryoablation and a Mayo Clinic study presented at the Radiological Society of North America conference in November 2007, have demonstrated the effectiveness of cryoablation in the destruction of renal tumors leading to increased cancer-free rates for patients when performed as a percutaneous procedure (without making an incision). Based on a recommendation from the American Medical Association, Medicare in 2007 created a clinical reimbursement code for percutaneous renal cryoablation.

 

Other treatments that make up our competition in the prostate and renal cancer markets generally include surgery, radiation (both external beam and seed, or brachytherapy) and other ablative treatments. Cryoablation is a minimally invasive procedure the urologists can perform independently. For radiation therapies, urologists must refer a patient for treatment to a radiation oncologist. Cryoablation offers the urologist both the opportunity to maintain continuity of patient care and to generate additional revenue, while providing clinical results on par with or superior to other treatment modalities.

Potential Future Markets

 

Endocare hopes to place a renewed emphasis on four other cancer markets within our currently FDA-cleared indications for use: liver metastases, lung, a broad market called palliative intervention, which includes tumors that have metastasized to such areas of the body as the bones, and an expansion of the prostate cancer market called focal or partial gland treatment.

 

According to American Cancer Society estimates, in the United States approximately 215,000 people a year will be diagnosed with lung cancer and approximately 21,000 will be diagnosed with liver cancer.

 

The bone cancer market, which is estimated to be 100,000 patients annually, is considered an important opportunity because of recent studies led by physicians at The Mayo Clinic. Initial results indicate that cryoablation could play a significant role in the treatment of these patients because it first destroys these metastasized tumors, but in so doing it also relieves the often debilitating and excruciating pain caused by the cancer. Based on the positive results of an initial study at The Mayo Clinic in the use of cryoablation as a treatment to relieve bone pain, the National Cancer Institute of the National Institutes of Health is supporting a multi-center study comparing the pain-reducing palliative effects of cryoablation and radiation therapy for patients who are experiencing focal pain from cancer that has metastasized to their bones. The prospective, randomized study, called Cryoablation And Radiation Effectiveness (CARE) for Bone Pain is evaluating the efficacy of percutaneous cryoablation compared to external beam radiation therapy as measured by pain relief, quality of life, analgesic use and complication rates.

 

We are working with some of the nation’s leading urologists and interventional radiologists in advancing a technique called focal or partial prostate gland treatment. Focal cryoablation is a prostate cancer treatment in which the ablation is confined to the known tumor location, thereby sparing surrounding tissue and avoiding side effects such as impotence or incontinence in the majority of patients. Much like the evolution that took place 30 years ago in the treatment of breast cancer in women, men’s health professionals are asking themselves if it is necessary to remove or destroy the entire prostate when the disease may be confined to only a portion of that gland. New diagnostic methods and the precision of ablative technologies such as our Cryocare CS^tm Surgical System have convinced leading physicians that focal cryoablation should become an important option for many men facing prostate cancer.

 

Endocare Cryoablation Technology Development

 

We have sought to develop our technology over time to increase the safety and efficacy of our products. In 1996, we developed our first generation eight-probe argon-based cryoablation system. Argon allows for room temperature gas to safely pass through the cryoprobe to create a consistent highly sculpted ablation zone. In 1997, we incorporated temperature-monitoring software to allow for continual feedback from the thermocouple tips. In 1998, we launched our CryoGuide intraoperative planning software, which allowed physicians better planning and targeting technology for use during a procedure. In 2000, we launched our 2.4 mm DirectAccess CryoProbe and CryoGrid which we believe shortened the time necessary to perform a procedure and added to the safety and ease of the procedure. In 2002, we developed and launched AutoFreeze, our innovative software technology that provides computer-controlled automated freeze/thaw cycles. In 2003, we launched our second generation Cryocare Surgical System, which we refer to as “Cryocare CS,” which integrated all the past and latest technology, including an on-board, integrated ultrasound device, into one complete system.

 

At the Annual Meeting of the American Urological Association in May 2006, we introduced the first variable cryoablation probe, referred to as the V-Probe. The V-Probe provides physicians the ability to “sculpt” different sized ablation zones to encompass tumors and tissue based on individual patient anatomy and needs. As previously announced, we currently are in the planning and design stage for the development of a nitrogen-based cryoablation system, which we refer to as the “Cryocare CN2 System.” Once development is complete, we expect to market the Cryocare CN2 System primarily to our interventional radiology and oncology customers and to customers in international markets where argon gas is not widely available.

Our System Solution: Cryocare CS

 

We believe Cryocare CS is the most sophisticated prostate cryoablation system currently available and combines the latest technology to enhance the speed and effectiveness of the procedure. Exclusive features of the Cryocare CS include an on-board training module, integrated color Doppler ultrasound designed specifically for the needs of prostate cryoablation, CryoGuide our patented intraoperative planning module, and AutoFreeze our patented treatment software that provides computer-controlled automated freeze/thaw cycles based upon target endpoint temperatures and continual feedback from the thermocouple tips.

 

The argon gas-based Cryocare CS accommodates up to eight independently operated cryoprobes and six thermocouples to allow physicians to monitor temperatures of tissue adjacent to the prostate in real-time. Our proprietary suite of cryoprobes is engineered to consistently produce sculpted ice conforming to the unique anatomy of the prostate. Our vacuum-insulated DirectAccess CryoProbes help deliver lethal ice in a controllable and repeatable fashion. Our CryoGrid, which is similar to a brachytherapy grid, is affixed to the ultrasound stepper and aids the physician with placement of the cryoprobes so that ice formation and lethal temperatures occur where necessary to destroy cancerous tissue but do not affect areas where tissue damage could cause harm.

 

Key Clinical Advantages of Our Cryocare CS System

 

Cryocare CS provides the following potential clinical advantages relative to other principal treatment options for prostate cancer:

 

 

Marketing and Strategy

 

Cryoablation Products

 

Endocare’s objective in urology is to establish cryoablation as a primary treatment option for prostate and renal cancers. Our earlier commercial efforts were focused on direct-sales to hospitals and distributor sales of systems to third party service providers who would provide systems and technicians to hospitals where cryoablation procedures were performed.

 

In 2003, we redirected our urology strategy away from attempting to drive acceptance of cryoablation through sales of capital equipment into the urology market. Our primary objective for the urology portion of our business is now to grow market share, measured in terms of procedures and revenues, by establishing cryoablation as a primary treatment option for prostate and renal cancers. In 2004, 2005 and 2006, we derived a significant percentage of our revenues from recurring sales of disposable products used with the Cryocare Surgical System.

 

A cryoablation procedure requires the necessary sterile disposable products that are usually provided in the form of a kit. In addition to the cryoablation disposable products component, there is a service component. This service component consists of transportation and provision of equipment used in the procedure, plus the services of a technician to assist the urologist with use and monitoring of this equipment. In addition to the use of a Cryocare Surgical System, an ultrasound device is needed for visual monitoring of the prostate and ice formation, unless our Cryocare CS is used, since the Cryocare CS includes an on-board, integrated ultrasound unit. Tanks of argon and

helium gas are needed for freezing and warming during the procedure. Frequently, this equipment is not stored on site but is mobilized and brought into the hospital for procedures by an independent third party who performs the service component of the procedure.

 

For urology procedures we typically sell the cryoablation disposable products to hospitals either as part of a procedure fee or separately, that is, without the service component. We also continue to sell our Cryocare Surgical Systems both to hospitals and service providers. For interventional radiology we will often place a system with a new customer under our placement program and sell cryoprobes directly to the hospitals or enter into an agreement to provide cryoablation services to the hospital, which includes providing the equipment, technicians and cryoablation disposable products necessary to perform the procedures. These agreements generally include the services of a third party provider contracted by us or the hospital to provide these services.

 

An important challenge we face in the prostate cancer market is to educate physicians and then to overcome any initial reluctance on the part of urologists so that they are able to incorporate cryoablation as a primary treatment option. Many times a physician’s initial reluctance may be based on her or his experiences or perception of the clinical failures experienced during earlier efforts to introduce the technology by other companies. See above under “Advent of Cryoablation.” In addition, we compete with other therapies that have proven effective in treating prostate cancer. Over 30 years of clinical data exist documenting the safety and efficacy of radical prostatectomy for prostate cancer. There are 20 years of clinical data supporting use of various forms of radiation treatment options such as brachytherapy and beam radiation treatments, which we estimate are used to treat over one third of all prostate cancer cases each year in the United States.

 

We believe cryoablation has clinical advantages for many patients over both the current most popular forms of treatment. While there are long-term clinical data available on radical prostatectomy, this treatment approach, typical of surgery in general, is characterized by a long recovery period combined with a relatively high incidence of side effects, including impotence and urinary incontinence. The appeal of radiation as a treatment alternative, particularly to patients, is that it is less invasive than surgery. Like radiation, cryoablation is less invasive and therefore has potentially fewer side effects than radical prostatectomy. Unlike radiation treatments, however, cryoablation treatments can be repeated on the same patient. In fact, our initial clinical successes in prostate cancer treatment were in treating patients who had failed radiation therapy. We also believe that cryoablation has significant economic benefits for payers. These benefits include shorter hospital stays for recovery and shorter procedure time as compared to radical prostatectomy, long term hormone treatment or radiation therapies, resulting in reduced expense to the payer.

 

Key elements in our strategy for overcoming the challenges we face in establishing cryoablation as a primary treatment option for prostate cancer are:

 

 

Because of our initial concentration on prostate cancer, the majority of our sales and marketing resources are directed towards the promotion of cryoablation technology to urologists for the treatment of prostate and renal cancers. However, we are also expanding the reach of our technology across a number of other markets, including ablation of tumors in the lung and liver, as well as for palliative intervention (treatment of pain associated with metastases). Procedures for treatment of these cancers are typically performed percutaneously, using CT scanning technology, and are provided by interventional radiologists. In order to better understand and address the distinct needs of this new market, we have formed a dedicated sales team to work in developing these opportunities for application of our cryoablation technology.

 

Key elements in our strategy to establish new markets for cryoablation treatment of tumors, specifically in the interventional radiology and radiation oncology markets, are:

 

 

Products

 

We currently market the following products:

 

Prostate and Renal Cancer:

 

 

Additional Cryoablation Markets:

 

 

Raw Materials

 

We rely on third party suppliers to provide certain critical components for all of our product lines. In certain cases, the suppliers are our sole source of supply for these components. Our policy is to enter into long-term supply agreements that require suppliers to maintain adequate inventory levels and which contain other terms and conditions designed to protect us against unforeseen interruptions in their production. We endeavor to maintain adequate stock levels at our own locations to ensure an uninterrupted source of supply. We typically seek to establish secondary sources of supply or other manufacturing alternatives. Nevertheless, despite these efforts, it is possible that we may experience an interruption in supply of one or more of our critical components resulting in backorders to our customers. However, we believe that we could locate alternative sources of supply upon such terms and within such a timeframe as would not result in a material adverse effect on our business.

 

Patents and Intellectual Property

 

As of December 31, 2008, we have rights to 51 issued United States patents relating to cryoablation technology. Included within these 51 issued United States patents are 7 patents in which we have licensed-in

rights. The remainder of the patents are assigned to us. Most of these patents relate to our cryoprobe technology for creating the freeze zone and precisely controlling the shape of the freeze zone produced by the cryoprobes. Additionally, certain patents relate to our computer guided system for assisting surgeons in properly placing cryoprobes in a patient, a computer-controlled cryoablation apparatus and method, a cryoablation integrated control and monitoring system and urethral warming technology. We also have rights to 14 pending United States patent applications relative to cryoablation technology. Additionally, we have rights to 57 foreign patents and pending foreign patent applications in this technology area. The earliest of our patents do not expire until 2011. Most of the earliest patents in our core technology area do not expire until about 2016.

 

Our policy is to secure and protect intellectual property rights relating to our technology through patenting inventions and licensing others when necessary. While we believe that the protection of patents and licenses is important to our business, we also rely on trade secrets, know-how and continuing technological innovation to maintain our competitive position. Given our technology and patent portfolio, we do not consider the operation of our business to be materially dependent upon any one patent, group of patents or single technological innovation.

 

Our policy is to sell our products under trademarks and to secure trademark protection in the United States and elsewhere where we deem such protection important.

 

No assurance can be given that our processes or products will not infringe patents or other intellectual property rights of others or, if they are held to infringe, that any license required would be made available under any such patents or intellectual property rights, on terms acceptable to us or at all. In the past, we have received correspondence alleging infringement of intellectual property rights of third parties. No assurance can be given that any relevant claims of third parties would not be upheld as valid and enforceable, and therefore we could be prevented from practicing the subject matter claimed or could be required to obtain licenses from the owners of any such intellectual property rights to avoid infringement.

 

We seek to preserve the confidentiality of our technology by entering into confidentiality agreements with our employees, consultants, customers and key vendors and by other means. No assurance can be given, however, that these measures will prevent the unauthorized disclosure or use of such technology.

 

Research Strategy

 

Our research goal is to develop innovative cryoablation technology that dramatically improves patient outcomes. Our primary focus is on developing devices for the treatment of prostate, kidney, lung and liver tumors and for palliative intervention. To that end, we endeavor to develop innovations that improve the safety and efficacy of our Cryocare Surgical System, as well as to explore new applications for use of our technology platform in the body.

 

We spent approximately $2.8 million, $2.6 million and $2.3 million for the years ended, 2006, 2007 and 2008, respectively, on research and development activities from continuing operations.

 

Sales

 

We sell our products primarily to hospitals and third party service providers and have both domestic and international customers. One of our customers, Advanced Medical Partners, Inc., a subsidiary of HealthTronics, Inc., accounted for 28.8 percent, 42.1 percent and 37.0 percent of our total revenues for each of the years ended 2006, 2007 and 2008, respectively. The following products and services account for 15 percent or more of total revenues from continuing operations for each of the years ended December 31, 2006, 2007 and 2008.

 

 

 

 

We currently sell our cryoablation products domestically through our direct sales force, which as of December 31, 2008 consisted of 40 people, consisting of 34 sales representatives and sales managers and 6 cryoablation field technicians. Our strategy is to continue to introduce the clinical benefits of cryoablation to new physicians as well as educating physicians already performing cryoablation so that they are able to increasingly incorporate cryoablation into their practice. We also intend to create patient demand by providing education regarding the benefits of cryoablation therapy versus alternative treatment options and by using national advertising and other programs targeted directly at prostate cancer patients.

 

Internationally, our cryoablation products are sold primarily through independent distributors. Our international sales from continuing operations represented approximately 5.8 percent, 7.2 percent and 8.1 percent of our total revenue for each of the years ended 2006, 2007 and 2008, respectively.

 

We derived our revenues from continuing operations from the following geographic regions for each of the years ended December 31, 2006, 2007 and 2008, based on shipping destination:

 

 

Reimbursement

 

We sell our Cryocare Surgical System and related disposable products to hospitals and third party service companies that provide services to hospitals. While patients occasionally pay for cryoablation procedures directly, most patients depend upon third-party payers to pay for their procedures, including Medicare, Medicaid, Tricare and other federal health care programs, as well as private insurers.

 

Accordingly, our revenue is dependent upon third-party reimbursement, particularly Medicare, since the majority of patients receiving prostate cryoablation treatments using our products are Medicare beneficiaries. The mix of public/private payers for other cryoablation procedures varies by type of procedure.

 

Medicare reimbursement for cryoablation procedures using our products as a primary treatment alternative for localized prostate cancer began in July 1999. Effective July 2001, Medicare coverage was approved for secondary cryoablation treatment of prostate cancer patients who have failed radiation therapy.

 

When Medicare-reimbursed services are provided on an inpatient basis, the hospital is reimbursed under the Medicare prospective payment system, based on the applicable diagnosis related group. A single payment covers all facility services.

 

Outpatient reimbursement for cryoablation procedures for Medicare beneficiaries is in accordance with the Hospital Outpatient Prospective Payment System, or HOPPS. Under HOPPS, the hospital is paid on a per procedure basis, based on the ambulatory payment classification for the procedure. The payment to the hospital includes the per procedure share of the cost for any depreciable equipment, such as our Cryocare Surgical System, and the provision of disposable devices, such as our temperature probes and cryoprobes.

 

Clinical studies are in process and planned for percutaneous cryoablation of cancerous tissue in the kidney, lung and liver and palliative intervention for pain associated with metastases. After studies are complete, coverage decisions and unique reimbursement codes will be sought from Medicare and private payers. As of January 1, 2008, a clinical CPT Category I code has been established for percutaneous renal cryoablation.

Clearance to market a new device or technology by the FDA does not guarantee payment by Medicare or other payers. Future devices and technology that we develop would have to be approved for coverage by Medicare after we obtain FDA approval or clearance. The Medicare approval process is lengthy and there is no assurance that Medicare approval would be granted. Each private insurer makes its own determination whether to cover a device or procedure and sets its own reimbursement rate.

 

Backlog

 

As of December 31, 2008, we had no backlog for our products. Our policy is to carry enough inventory to be able to ship most orders within a few days of receipt of order. Historically, most of our orders have been for shipment within 30 days of the placement of the order. Therefore, we rely on orders placed during a given period for sales during that period.

 

Manufacturing

 

We manufacture our Cryocare Surgical System and related disposables at our facilities in Irvine, California. We have been issued a Device Manufacturing License by the California Department of Health Services. Our license is renewable in April 2009. Manufacturers of medical devices are required to manufacture devices in compliance with various federal, state and foreign requirements including compliance with FDA’s Quality System Regulation. Our manufacturing facility is subject to periodic inspections and/or audits by the State of California, FDA and other parties. Our facility has been inspected, most recently in 2008 by the California Department of Health Services. There are no outstanding non-conformities from the state’s inspection.

 

Our manufacturing facility has been subjected to Quality System Regulation compliance inspections by the FDA most recently in late January 2009. The inspection has been closed with the FDA. We are certified to ISO 13485:2003, CE Marking and Canadian CMDCAS certifications, indicating substantial compliance with European standards for a robust Quality Management System, quality assurance and manufacturing process control.

 

Government Regulation

 

Governmental regulation in the United States and other countries is a significant factor affecting the research and development, manufacture and marketing of medical devices, including our products. In the United States, the FDA has broad authority under the FD&C Act to regulate the development, distribution, manufacture, marketing and sale of medical devices. Foreign sales of medical devices are subject to foreign governmental regulation and restrictions that vary from country to country.

 

Medical devices intended for human use in the United States are classified into one of three categories, depending upon the degree of regulatory control to which they will be subject. Such devices are classified by regulation into either Class I (general controls), Class II (special controls) or Class III pre-market approval (PMA), depending upon the level of regulatory control required to provide reasonable assurance of the safety and effectiveness of the device.

 

Most Class I devices are exempt from pre-market notification (510(k)) or PMA. However Class I devices are subject to “general controls,” including compliance with FDA manufacturing requirements (Quality System Regulation (QSR), sometimes referred to as current good manufacturing practices or cGMPs), adverse event reporting, labeling and other requirements. Class II devices are subject to general controls, special standards and ordinarily to the pre-market notification requirements under Section 510(k) of the FD&C Act. For a 510(k) to be cleared by the FDA, the manufacturer must demonstrate to the FDA that a device is substantially equivalent to another legally marketed device that was either cleared through the 510(k) process or on the market prior to 1976. It generally takes four to twelve months from the date of submission to obtain 510(k) clearance although it may take longer. Class III is the most stringent regulatory category for devices. Class III devices are those for which insufficient information exists to assure safety and effectiveness solely through general or special controls. Class III devices are usually those that support or sustain human life, are of substantial importance in preventing impairment of human health, or which present a potential, unreasonable risk of illness or injury. Class III devices also include devices that are not substantially equivalent to other legally marketed devices. To obtain approval to market a

Class III device, a manufacturer must obtain FDA approval of a PMA application. The PMA process requires more data, specifically data from clinical studies testing the device in humans, takes longer and is typically a significantly more complex and expensive process than the 510(k) procedure. Clinical studies of devices in humans are also subject to regulation by the FDA. Testing must be conducted in compliance with the investigational device exemption (IDE) regulations.

 

Our Cryocare Surgical Systems have been cleared for marketing through the 510(k) process.

 

We can provide no assurance that we will be able to obtain or maintain clearances or approvals for clinical testing or for manufacturing and sales of our existing products for all applications in all targeted markets, or that we will be able to obtain or maintain clearances or approvals needed to introduce new products and technologies. After a device is placed on the market, numerous regulatory requirements apply. These include, but are not limited to:

 

 

Failure to comply with applicable regulatory requirements can result in enforcement action by the FDA, which may include, but is not limited to, any of the following sanctions:

 

 

Medical device laws are also in effect in many of the countries outside of the United States in which we do business. These laws range from comprehensive device approval and quality system requirements for some or all of our medical device products to simple requests for product data or certifications. The number and scope of these requirements are increasing. In June 1998, the European Union Medical Device Directive became effective, and all medical devices must meet the Medical Device Directive standards and receive CE mark certification. CE mark certification involves a comprehensive Quality System program, and submission of data on a product to the Notified Body in Europe.

 

We have obtained the CE mark certification for distribution of our Cryocare Surgical System in Europe and approval for distribution in Australia, Canada, New Zealand, China, Taiwan, Korea and Mexico.

 

Health Care Regulatory Issues

 

The health care industry is highly regulated and the regulatory environment in which we operate may change significantly in the future. In general, regulation of health care-related companies is increasing. Endocare anticipates that Congress and state legislatures will continue to review and assess alternative health care delivery and payment systems. We cannot predict what impact the adoption of any federal or state health care reform measures may have on our business.

 

We regularly monitor developments in statutes and regulations relating to our business. We may be required to modify our agreements, operations, marketing and expansion strategies from time to time in response to changes in the statutory and regulatory environment. We plan to structure all of our agreements, operations, marketing and

strategies in accordance with applicable law, although we can provide no assurance that our arrangements will not be challenged successfully or that required changes may not have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

We believe that the following discussion summarizes all of the material health care regulatory requirements to which we currently are subject. Complying with these regulatory requirements may involve expense to us, delay in our operations and/or restructuring of our business relationships. Violations could potentially result in the imposition of civil and/or criminal penalties.

 

Anti-Kickback Laws

 

The federal health care program “anti-kickback” law prohibits the knowing and willful offer, payment, solicitation or receipt of any form of remuneration in return for, or in order to induce, (i) the referral of a person for services, (ii) the furnishing or arranging for the furnishing of items or services, or (iii) the purchase, lease or order or arranging or recommending purchasing, leasing or ordering any item or service, in each case, reimbursable under any federal health care program. Because our products are reimbursable under Medicare, Medicaid and other federal health care programs, the anti-kickback law applies. Many states have similar anti-kickback or anti-referral laws, and in many cases these laws apply to all patients, not just federal health care program beneficiaries. Noncompliance with, or violation of, the federal anti-kickback law can result in exclusion from federal health care programs and civil and criminal penalties. Similar penalties are provided for violation of state anti-kickback laws. Several federal courts have held that the anti-kickback law is violated if just one purpose of payment is to induce the referral of patients. To the extent that we are deemed to be subject to these federal or similar state laws, we believe that our activities and contemplated activities comply in all material respects with such statutes and regulations.

 

Regulations to the federal anti-kickback law specify payment practices that will not be subject to prosecution under the anti-kickback law. These are known as the “safe-harbors.” Failure to comply fully within a safe-harbor does not mean the practice is per se illegal, and many common arrangements in the health care industry do not fit within a safe harbor, yet are not violations of the anti-kickback law. Rather, if a practice does not fit within a “safe harbor,” no guarantee can be given that the practice will be exempt from prosecution; it will be viewed under the totality of the facts and circumstances.

 

Many of our relationships with customers, such as volume and other discounts, fit within a safe harbor. However, our service agreements with physician-owned entities (which constitute less than twenty percent (20%) of our urology business) do not fit completely within a safe harbor. For example, the safe harbor for equipment leases and the safe harbor for personal services both require that the aggregate amount of the rental or service payment be fixed in advance for the term of the arrangement, which must be at least one year. However, where the need for medical procedures is not known in advance, it is sometimes more appropriate to arrange for payment on a per procedure (also known as “per-click”) basis, rather than determining a year’s total compensation in advance. For the reasons described below, certain of our arrangements with physician-owned entities currently provide for payment on a per procedure basis.

 

In the case of cryoablation, hospitals often do not want to invest in the required capital equipment. Rather, hospitals enter into arrangements with specialty mobile service providers or equipment manufacturers to obtain the use of the necessary equipment and disposable products (such as cryoprobes), as well as technical support services, where applicable, on a per procedure basis. In the case of cryoablation equipment and disposables, some physicians have formed or invested in mobile service providers that provide cryoablation equipment, disposables and services directly to hospitals. In such cases, our relationship to the physician-owned entities is only as a seller of our products, where discounts are provided in accordance with the discount safe harbor. However, in some cases, we contract directly with hospitals to provide the necessary equipment/disposables and technical support. These contracts generally provide for the hospital to pay for the equipment/disposables and support package on a per procedure basis. Since we are primarily in the business of selling our equipment and disposable products, not providing services, when we contract to provide equipment to hospitals we typically subcontract with a mobile service provider or other equipment owner to furnish the equipment as our subcontractor. A significant number of these businesses are owned entirely or in part by urologists who purchase the equipment in order to make cryoablation available in their communities. Since the hospitals pay us on a per procedure basis, we in turn pay our

subcontractors on a per procedure basis pursuant to service agreements. These service agreements do not meet a safe harbor since, as noted above, the safe harbors for equipment leases and service arrangements require that the aggregate payment for the term of the arrangement must be set in advance. Although the service agreements do not meet a safe harbor, our service agreements with physician-owned entities include a number of safeguards intended to address anti-kickback law concerns.

 

As noted in the section entitled “Risks Related to Endocare and the Combined Company and the Industry in Which They Will Operate” as well as in the following section, arrangements with physician-owned entities that involve “per-click” leases will have to be restructured by October 1, 2009. We are pursuing restructuring options and expect that the restructured arrangements will continue to comply in all material respects with the federal anti-kickback law and similar state laws.

 

Patient Referral Laws

 

The Stark Law prohibits a physician from referring a Medicare patient for “designated health services,” or DHS, to an entity with which the physician has a direct or indirect financial relationship, whether in the nature of an ownership interest or a compensation arrangement, subject only to limited exceptions. The Stark Law also prohibits the recipient of a prohibited referral from billing for the DHS provided pursuant thereto. DHS include inpatient and outpatient hospital services.

 

Physicians who have an ownership or compensation relationship with the entities (such as mobile vendors) that furnish our equipment to hospitals, and the hospitals that obtain equipment and services directly or indirectly from such entities, are considered to have an “indirect compensation arrangement,” and therefore that relationship must meet a Stark Law exception in order for the physicians to make DHS referrals to the hospital.

 

As noted in the section entitled “Risks Related to Endocare and the Combined Company and the Industry in Which They Will Operate,” CMS recently issued a final rule that includes amendments to the regulations that implement the Stark Law. Certain elements of the final rule that will be effective October 1, 2009 likely will require restructuring of our contracts with physician-owned entities that provide equipment and services in connection with our arrangements to furnish equipment, products and services to hospitals. The rule narrows the exception that, before October 1, 2009, was available for “per-click” lease arrangements in which a physician-owned entity is the lessor and receives a per-click payment, either directly or indirectly, from a DHS provider such as a hospital for space or equipment used by the hospital in the provision of services to patients, including patients who were referred by the lessor to the lessee. Such “per click” leases will no longer be eligible for a Stark Law exception. The arrangements where we hold the hospital contract and subcontract with a physician-owned entity constitute less than 20% of our urology business, and we are actively pursuing various restructuring options. At this time, we are unable to predict whether, and to what the extent, such restructuring will affect our business or future business arrangements, but there is no guarantee that it will not have an adverse effect on our business.

 

In addition, for the same reasons as noted above, by October 1, 2009, physician-owned entities that purchase our equipment and disposables and then furnish the equipment, disposables, and technical support services to hospitals on a “per click” basis will be required to restructure their “per click” contracts with the hospital or potentially divest the physician-owners. Although there is a reasonable position at this time that these entities can avoid divesture of their physician-owners, these entities will likely have to be restructured to address the Stark Law rule change effective October 1, 2009. A significant percentage of the urology cases using our equipment in hospitals involves the aforementioned “per-click” arrangement. We understand that these entities are also actively pursuing potential restructuring options. We expect that our arrangements and those of our customers involved in furnishing our products will be fully compliant with the new regulatory requirements before the October 1, 2009 deadline. Although too early to assess, it is possible that such restructuring will have an adverse effect on our business. Interventional radiology services outside of the urology business that involve use of our products generally do not involve physician-owned businesses, and therefore will not be affected by the new rule.

 

Many states also have patient referrals laws, some of which are more restrictive than the Stark Law and regulate referrals by all licensed healthcare practitioners for any health care services to an entity with which the licensee has a financial relationship unless an exception applies. Such laws in particular states may prohibit us from entering into relationships with physicians and physician-owned entities, which may limit business development.

HIPAA and Other Privacy Laws

 

As of April 14, 2003, the privacy regulations developed under the Health Insurance Portability and Accountability Act of 1996, referred to as “HIPAA,” took effect. The privacy regulations place limitations on a “covered entity’s” use and disclosure of identifiable patient information, including research data. While Endocare is not a “covered entity” under HIPAA, Endocare’s relationships with covered entities, such as hospitals and physicians, sometimes implicate HIPAA. Accordingly, Endocare has adopted policies and procedures regarding confidentiality and each employee who comes into contact with Protected Health Information (PHI or patient data) is trained in the proper handling of such information. Endocare has also established procedures to determine when Endocare is required to sign a “business associate agreement” with a covered entity in connection with receipt of PHI and when such measures are not required.

 

We believe that we have implemented appropriate measures to ensure that our relationships with covered entities are appropriate and consistent with HIPAA. However, there are many uncertainties remaining about how HIPAA applies to medical device companies, and no assurance can be given that HIPAA will not be interpreted in a manner that will hamper our ability to conduct medical research and receive medical information for other purposes as well.

 

Other United States Regulatory Requirements

 

In addition to the regulatory framework for product approvals, we are and may be subject to regulation under federal and state laws, including requirements regarding advertising and promotion, occupational health and safety, laboratory practices and the use, handling and disposing of toxic or hazardous substances. We may also be subject to other present and future local, state, federal and foreign regulations.

 

Seasonality

 

We believe that holidays, major medical conventions and vacations taken by physicians, patients and patient families may have a seasonal impact on our sales of cryoablation products because cryoablation procedures can be scheduled in advance. For example, for the past several years, we have noted that the three months ended September 30 each year result in revenues that are lower than during the three months ended June 30 each year.

 

Competition

 

The cryotherapy products manufactured and distributed by Endocare and Galil compete vigorously with other treatment modalities. Endocare and Galil believe that their primary competition consists of other, better-established modalities of treatment for prostate cancer, including surgery, which is considered the “gold standard,” and radiation therapies that presently dominate the market. Significant competitors in the area of prostate cancer and other tumor ablation (renal, liver, lung, palliative intervention, and, in the case of Galil, women’s health) include companies that offer one or more of the following products: surgical devices (such as robotic surgery equipment); intensity-modulated radiation therapy (IMRT), image-guided radiation therapy (IGRT), brachytherapy seeds and other forms of radiation therapy; and other ablation products such as microwave and radiofrequency ablation (RFA) products. Additional devices in development, such as high intensity focused ultrasound (HIFU), may be competitive devices in the future. Many of the existing and potential competitors of Endocare and Galil have significantly greater financial and human resources than they do.

 

Employees

 

As of December 31, 2008, we had a total of 120 employees. Of these employees, 8 are engaged directly in research and development activities, 7 in regulatory affairs/quality assurance, 28 in manufacturing, 52 in sales, marketing, clinical support and customer service and 25 in general and administrative positions. We have never experienced a work stoppage, none of our employees are represented by a labor organization, and we consider our employee relations to be good.

Available Information

 

Our website address is www.endocare.com. All filings we make with the SEC, including our annual report on Form 10-K, our quarterly reports on Form 10-Q, and our current reports on Form 8-K, and any amendments thereto, are available at no charge through links displayed on our website as soon as reasonably practicable after they are filed or furnished to the SEC. The reference to our website address does not constitute incorporation by reference of the information contained on the website, and the information contained on the website is not part of this document.

 

 

Risks Associated with Endocare’s Business

 

We have a limited operating history with significant losses and can give no assurances when or whether we will ever be profitable or have capital sufficient to sustain our operations.

 

We have yet to establish any history of profitable operations. We have incurred losses from operations of $8.6 million, $9.3 million, and $15.4 million, respectively, during the fiscal years ended December 31, 2008, 2007, and 2006. As a result, at December 31, 2008 and 2007 we had an accumulated deficit of $198.2 million and $189.8 million, respectively. We have incurred net losses from continuing operations of $8.4 million, $8.9 million, and $11.1 million respectively, during the fiscal years ended December 31, 2008, 2007 and 2006. We had an operating cash flow deficit of $8.1 million, $4.6 million, and $13.6 million for the years ended December 31, 2008, 2007, and 2006. As of December 31, 2008, we had cash and cash equivalents of $2.7 million.

 

To date, our revenues have not been sufficient to sustain our operations. We expect that our revenues as a standalone company will not be sufficient to sustain our operations for the foreseeable future. We can give no assurances when or whether we will ever be profitable.

 

As a result of our recurring losses from operations and limited capital resources, our independent registered public accounting firm’s report on our financial statements as of and for the fiscal year ended December 31, 2008 includes an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern.

 

We have historically financed our operations and growth through borrowings and equity financings. In the short term, we expect to use existing cash reserves and working capital through the sale of our products, and if the Merger and Financing are consummated, the proceeds of the Financing, to finance our projected operating and cash flow needs. However, our cash needs are not entirely predictable, and additional cash may be required, including from our bank credit facility. Furthermore, inclusion of a “going concern qualification” in the report of our independent registered public accountants may have a negative impact on our ability to raise additional capital and may adversely impact our stock price. The credit facility is currently scheduled to expire on May 27, 2009. Upon termination of the credit facility, we may not be able to renew our credit facility or replace the funds that are available under the credit facility.

 

Our credit facility contains a minimum tangible net worth covenant measured on a monthly basis. We were not in compliance with this covenant as of December 31, 2008 and January 31, 2009. In connection with the extension we executed on February 26, 2009, the bank granted us a waiver of the noncompliance, redefined the tangible net worth requirement and established a new lower tangible net worth covenant for the months from February through April 2009. We are in discussions with the lender to obtain more permanent long-term financing although such financing may not be available or available on terms acceptable to us.

 

We may not have sufficient capital to fund our ongoing operations. In addition, in the event that our available cash drops below $1.0 million for more than ten business days, Galil has the right to terminate the Merger Agreement.

 

Our business may be materially and adversely impacted by the loss of our largest customer or the reduction, delay or cancellation of orders from this customer; in addition, our business may be materially and adversely impacted if this customer delays payment or fails to pay for products.

 

For the fiscal year ended December 31, 2008, our largest customer accounted for 37% of our revenues, and as of December 31, 2008 this customer accounted for 40.4% of our accounts receivable. Our sales to this customer may

be materially and adversely impacted by various factors relating to this customer’s business, financial condition, results of operations and cash flows. Our business, financial condition, results of operations and cash flows may be materially and adversely impacted by the loss of this customer, or the reduction, delay or cancellation of orders by this customer. In addition, our business, financial condition, results of operations and cash flows may be materially and adversely impacted if this customer delays payment or fails to pay for products sold. This customer is not obligated to purchase a specific quantity of our products or provide binding forecasts of purchases for any period.

 

We may be required to make tax payments that exceed our settlement estimates, which may result in a material adverse effect on our financial condition, results of operations and cash flows.

 

As of December 31, 2006, 2007, and 2008 we estimated that we owed $2.8 million, $2.2 million, and $2.2 million, respectively, as of each balance sheet date in state and local taxes, primarily sales and use taxes, in various jurisdictions in the United States. We are in the process of negotiating resolutions of the past due tax obligations with the applicable tax authorities. While we hope that these obligations can be settled for less than the amounts accrued, we cannot predict whether we will obtain favorable settlement terms from the various tax authorities, or that after settling, we will satisfy the conditions necessary to avoid violating the settlements. Our failure to obtain favorable settlement terms or to satisfy the settlement conditions may result in a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our facilities and systems are vulnerable to natural disasters or other catastrophic events, which could interrupt our operations for an extended period of time, and could have a material adverse effect on our business.

 

Our headquarters, cryoablation products manufacturing facilities, research facilities and much of our infrastructure, including computer servers, are located in California, an area that is susceptible to earthquakes, fires and other natural disasters. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, terrorist attack or other comparable problems could cause interruptions or delays in our business and loss of data or render us unable to accept and fulfill customer orders in a timely manner, or at all. We have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for losses that may occur. In the event that an earthquake, or other natural disaster or other catastrophic event were to destroy any part of our facilities or interrupt our operations for any extended period of time, or if harsh weather conditions prevent us from delivering products in a timely manner, it could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Risks Associated with an Investment in Endocare’s Common Stock

 

The market price of our common stock is highly volatile.

 

The market price of our common stock has been and is expected to continue to be highly volatile in the future. This volatility is in response to a number of factors, including:

 

 

 

As a result of any of these factors the market price of our common stock may fall abruptly and significantly. Moreover, recently the stock market in general has experienced extreme price and volume fluctuations. This volatility has had a significant effect on the market price of securities issued by many companies for reasons often unrelated to their operating performance. These broad market fluctuations may adversely affect the market price of our common stock, regardless of our operating results. Any of these factors could have a material adverse effect on your investment in our common stock. As a result, you could lose some or all of your investment.

 

Historically our common stock has a low trading volume and any sale of a significant number of shares is likely to depress the trading price.

 

Our common stock is currently listed on the NASDAQ Capital Market. Traditionally, the trading volume of our common stock has fluctuated significantly. Because of this periodic and limited trading volume, our stockholders may not be able to sell quickly any significant number of shares of our common stock, and any attempted sale of a large number of our shares may have a material adverse impact on the price of our common stock. In addition, the price per share is subject to volatility and may continue to be subject to rapid and significant price swings in the future.

 

Future sales of shares of our common stock, or the perception of significant future sales, may negatively affect our stock price.

 

We had an aggregate of [ • ] shares of common stock outstanding as of [ • ], 2009. After the Merger and the Financing are consummated, we expect to have an aggregate of [ • ] shares of our common stock outstanding, including the Escrow Shares. The 16,250,000 shares of our common stock expected to be issued in the Financing will initially be subject to restrictions on transfer. Future sales of our common stock, including shares issued in the Financing, shares issues upon the exercise of outstanding options and warrants, sales of equity related securities, or hedging or other derivative transactions with respect to our common stock, could have a significant negative effect on the market price of our common stock. These sales, or anticipated sales, also might make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that we would deem appropriate or necessary.

 

Investors in our financing consummated in March 2005 received warrants to purchase an aggregate of 657,446 shares of our common stock at an exercise price of $10.50 per share and 657,446 shares of our common stock at an exercise price of $12.00 per share. These warrants have an anti-dilution clause that in certain circumstances reduces the effective exercise price of the warrants and proportionately increases the number of shares underlying the warrants. As a result of our issuance of shares of common stock in the Financing and prior issuances, the exercise price of the Series A Warrants will be decreased to $5.41 and provide holders the right to purchase an additional 618,130 shares and the exercise price of the Series B Warrants will be decreased to $6.07 and provide holders the right to purchase an additional 642,834 shares.

 

We entered into registration rights agreements in connection with other recent financings, and will enter into a registration rights agreement in connection with the Financing, in each case pursuant to which we agreed or will agree to register for resale by the investors the shares of common stock issued. The sale or anticipated sale of shares covered by these registration statements could have a material adverse effect on the market price of our shares.

 

If Endocare fails to meet all applicable continued listing requirements of the NASDAQ Capital Market and NASDAQ determines to delist Endocare’s common stock, the market liquidity and market price of Endocare’s common stock could decline.

 

Our common stock is currently listed on the NASDAQ Capital Market. In order to maintain that listing, Endocare must satisfy minimum financial and other listing requirements. In addition, the issuance of Endocare common stock in the Merger and the Financing may constitute a “change of control” for purposes of NASDAQ

Marketplace Rule 4340(a). Whether a “change of control” exists under NASDAQ Marketplace Rule 4340(a) is a facts and circumstances determination that is currently being undertaken by NASDAQ based on an evaluation of certain factors, such as changes in Endocare’s management, board of directors, voting power, ownership and financial structure as a result of the Merger and the Financing. If NASDAQ determines that the Merger and the Financing constitute a change of control of Endocare, Endocare will be required to submit a new original listing application with NASDAQ and comply with the NASDAQ Capital Market initial listing requirements, including a $4.00 minimum bid price, in order for Endocare’s common stock to continue to be listed on the NASDAQ Capital Market after consummation of the Merger and the Financing. In addition, NASDAQ Marketplace Rule 4310(c)(4) sets a minimum per share price of $1.00 for continued listing on the NASDAQ Capital Market. Endocare’s common stock has traded below $4.00 since July 21, 2008, and below $1.00 since November 29, 2008. The closing price of Endocare’s common stock as of [ • ], 2009 was $[ • ]. Accordingly, there can be no assurance that Endocare will be able to retain its listing on the NASDAQ Capital Market if NASDAQ determines that the Merger and the Financing constitute a “change of control” or determines to delist Endocare for failure to meet the $1.00 minimum bid price for continued listing.

 

If Endocare fails to meet all applicable listing requirements of the NASDAQ Capital Market at any time and NASDAQ determines to delist its common stock, an active trading market for Endocare’s common stock may not be sustained and the market price of Endocare’s common stock could decline. If an active trading market for Endocare’s common stock is not sustained, it will be difficult for Endocare’s stockholders to sell shares of Endocare’s common stock without further depressing the market price of such common stock, if at all. A delisting of Endocare’s common stock also could make it more difficult for Endocare to obtain financing for the continuation of operations and could result in the loss of confidence by investors, suppliers and employees.

 

The anti-takeover provisions in our charter, our stockholder rights plan and certain provisions of Delaware law could prevent a third party from acquiring us or limit the price that investors may be willing to pay for shares of our common stock.

 

Provisions of our Restated Certificate of Incorporation, as amended and our amended and restated bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of Endocare. Our Restated Certificate of Incorporation, as amended, authorizes our board of directors to issue preferred stock without stockholder approval. Depending on the rights and terms of any series of preferred stock created, and the reaction of the market to the series, the rights or the value of your Endocare common stock could be negatively affected. For example, subject to applicable law, the board of directors could create a series of preferred stock with preferential rights to dividends or assets upon liquidation, or with superior voting rights to the existing common stock. In addition, we have adopted a stockholder rights plan in which preferred stock purchase rights were distributed as a dividend. The stockholder rights plan is currently scheduled to terminate on April 15, 2009. These provisions may prevent or delay a third party from acquiring us, even if doing so would be beneficial to our stockholders.

 

We are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Subject to specified exceptions, this section provides that a corporation may not engage in any business combination with any interested stockholder during the three-year period following the time that such stockholder becomes an interested stockholder. This provision could have the effect of delaying or preventing a change of control of Endocare. The foregoing factors could reduce the price that investors or an acquirer might be willing to pay in the future for shares of our common stock. Our board of directors has taken all action necessary to exempt Galil’s shareholders and the purchasers in the Financing from the anti-takeover provisions of Section 203 of the Delaware General Corporation Law as it relates to shares of Endocare common stock acquired in the Merger and the Financing.

 

The issuance of common stock in the Merger and the Financing will trigger an ownership change that will negatively impact our ability to utilize net operating loss and capital loss deferred tax assets in the future.

 

As of December 31, 2008, we had a domestic federal net operating loss carryforward of approximately $131.1 million. Companies are subject to a change of ownership test under Section 382 of the Code that, if met, can

limit the annual utilization of the carryforward. We believe such test will be met as a result of the issuance of common stock in the Merger and Financing.

 

Generally, under that section, the yearly limitation on our ability to utilize such deductions will be equal to the product of the applicable long term tax exempt rate (presently 5.49 percent) and the value of our common stock immediately before the ownership change. Our ability to utilize depreciation deductions during the five-year period following the ownership change would also be limited under Section 382, together with NOLs, to the extent that such deductions reflect a net loss that was “built-in” to our assets immediately prior to the ownership change.

 

Similar rules under Section 383 of the Code will also limit our ability to utilize capital loss carryforwards. As of December 31, 2008, we had domestic federal capital loss carryforwards of approximately $39.6 million.

 

Because an ownership change will be triggered as a result of the issuance of common stock in the Merger and the Financing, our ability to use the net operating loss carryforward and capital loss carryforwards to offset future income will be substantially limited. Therefore, we may suffer higher-than-anticipated tax expense, and consequently lower net income, in those future years.

 

Risks Related to the Merger

 

If the proposed Merger with Galil is consummated, Endocare’s business could suffer materially and Endocare’s stock price could decline.

 

Subject to receipt of regulatory approvals, including the closing of the pending investigation by the FTC, and approvals by Endocare stockholders and Galil shareholders, Endocare is seeking to close the transactions in the second quarter of 2009. If the proposed Merger is consummated, Endocare may be subject to a number of material risks, and its business could be adversely affected, including the following:

 

 

We can give no assurance that we will be able to successfully complete and integrate the acquisition of Galil.

 

In addition, the market price of Endocare’s common stock after the Merger may decline for a number of other reasons, including if:

 

 

The Merger may be completed even though material adverse changes may result from the announcement of the Merger, industry-wide changes and other causes.

 

In general, either party can refuse to complete the Merger if there is a material adverse change affecting the other party between the date of the Merger Agreement and the closing. However, some types of changes do not

permit either party to refuse to complete the Merger, even if such changes would have a material adverse effect on Endocare or Galil, including the following:

 

 

If adverse changes occur but Endocare and Galil must still complete the Merger, the combined company’s operating results and financial condition may be materially and adversely impacted and Endocare’s stock price may suffer.

 

Ownership of Endocare’s common stock may be highly concentrated after consummation of the Merger and the Financing.

 

After consummation of the Merger and the Financing, certain stockholders will have beneficial ownership of significant blocks of Endocare’s outstanding common stock. Such stockholders, acting individually or as a group, will have substantial influence over the outcome of a corporate action of Endocare requiring stockholder approval, including the election of directors, any approval of a merger, consolidation or sale of all or substantially all of Endocare’s assets or any other significant corporate transaction, even if the outcome sought by such stockholders is not in the interest of Endocare’s other stockholders. These stockholders, acting as a group, may also delay or prevent a change in control of Endocare, even if such change in control would benefit the other stockholders of Endocare. In addition, pursuant to the Stock Purchase Agreement, if a purchaser defaults on its obligation to purchase shares in the Financing, the other parties to the Stock Purchase Agreement may acquire the defaulting party’s shares up to a maximum of 35% of the then outstanding shares of Endocare common stock after the Merger and the Financing. This could result in one or more stockholders owning more shares of Endocare’s outstanding common stock than currently expected. The significant concentration of stock ownership may adversely affect the value of Endocare’s common stock due to investors’ perception that conflicts of interest may exist or arise.

 

The required repayment of pre-merger bridge financing of Galil will decrease the funds available to Endocare after consummation of the Merger and the Financing.

 

Galil’s revenues have not been sufficient to sustain its operations, and Galil has secured additional required funds through bridge loans from certain current shareholders of Galil, which will be repaid out of the proceeds of the Financing. As of March 4, 2009, the amount of such bridge financing is $1.4 million. Galil may be required to seek additional external funding from such date until the closing of the Merger through one or more additional bridge loans. It is expected that such loans would also be repaid out of the proceeds of the Financing, which would reduce the amount of funds available to Endocare after consummation of the Merger and the Financing. The amounts to be repaid will include interest, which accrues at 18% per annum compounding monthly.

Antitrust authorities may attempt to delay or prevent consummation of the Merger.

 

Although Endocare is not required to make a pre-merger filing under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the “HSR Act”) with the FTC and Antitrust Division of the United States Department of Justice (the “DOJ”), the FTC has opened an investigation into whether the proposed Merger violates Section 7 of the Clayton Act, as amended, 15 U.S.C. §18, or Section 5 of the FTC Act, as amended, 15 U.S.C. §48. The parties are cooperating fully with the FTC’s investigation and are in the process of providing the FTC with information and materials. Endocare cannot provide any assurance that the FTC or DOJ will not place restrictions on the Merger or that there will not be any adverse consequences to the business of Endocare or Galil resulting from conditions that could be imposed in connection with any actions taken by the FTC or DOJ, including required licensing, divestitures or operating restrictions upon Endocare or the combined company. In addition, Endocare cannot provide any assurance that the FTC’s investigation will not delay or prevent consummation of the Merger. The Merger is conditioned upon (i) the lack of any governmental authority being in the process of investigating or conducting proceedings regarding the Merger, the Merger Agreement or transactions contemplated thereby that upon reasonable determination by Endocare or Galil would lead to the consummation of the Merger being enjoined and (ii) no court or other authority prohibiting the consummation of the Merger.

 

Endocare may assume significant tax liabilities of Galil with respect to which it may be dependent on third parties for indemnification or for which it may not be entitled to indemnification at all.

 

Endocare may assume significant potential tax liabilities of Galil in connection with the Merger, which, if adversely determined, could be substantial. While certain major shareholders of Galil have agreed to indemnify Endocare for any losses incurred by Endocare arising from certain specified tax liabilities assumed in the Merger in excess of $2 million, Endocare is not entitled to indemnification for the amount of any such tax liability incurred in an amount less than $2 million, except to the extent of the value of the Escrow Shares remaining in the indemnity escrow fund pursuant to the Merger Agreement, at the time a claim for indemnification is made. In addition, Endocare cannot be assured that the Galil shareholders that have agreed to indemnify Endocare for such tax liabilities will have the resources to pay it in such event, or that Endocare will be able to recover such amounts.

 

Endocare’s stockholders and Galil’s shareholders may not realize a benefit from the Merger commensurate with the ownership dilution they will experience in connection with the Merger and the Financing.

 

If the combined company is unable to realize the strategic and financial benefits currently anticipated from the Merger, Endocare’s stockholders and Galil’s shareholders will have experienced substantial dilution of their ownership interest in connection with the Merger and the Financing without receiving any commensurate benefit.

 

During the pendency of the Merger, Endocare may not be able to implement desirable business decisions or enter into a business combination with another party because of restrictions in the Merger Agreement.

 

Covenants in the Merger Agreement impede the ability of Endocare to take any actions that are not in the ordinary course of business pending completion of the Merger. As a result, whether or not the Merger is completed, Endocare may be at a disadvantage to its competitors. In addition, while the Merger Agreement is in effect, and subject to limited exceptions, Endocare is prohibited from soliciting, initiating, encouraging or taking actions designed to facilitate any inquiries or the making of any proposal or offer that could lead to entering into certain extraordinary transactions with any third party, such as a sale of assets, an acquisition of Endocare’s common stock, a tender offer for Endocare’s common stock, or a merger or other business combination outside the ordinary course of business, whether or not any such transactions are favorable to Endocare’s stockholders.

 

The lack of a public market for Galil’s shares makes it difficult to evaluate the fairness of the Merger consideration payable to the Galil shareholders, and the Galil shareholders may receive consideration in the Merger that is greater than the fair market value of Galil’s shares.

 

The outstanding capital stock of Galil is privately held and is not traded in any public market. The lack of a public market makes it extremely difficult to determine the fair market value of Galil. Since the percentage of

Endocare’s equity to be issued to Galil’s shareholders was determined based on negotiations between the parties, it is possible that the value of Endocare’s common stock to be issued in connection with the Merger will be greater than the fair market value of Galil.

 

If any of the events described in “Risks Associated with Endocare’s Business,” “Risks Related to Galil” or “Risks Related to Endocare and the Combined Company and the Industry in Which They Will Operate” occur, those events could cause the potential benefits of the Merger not to be realized.

 

Following the effective time of the Merger, the combined company will be susceptible to many of the risks described in the sections herein entitled “Risks Associated with Endocare’s Business,” “Risks Related to Galil” and “Risks Related to Endocare and the Combined Company and the Industry in Which They Will Operate.” To the extent any of the events in the risks described in those sections occur, those events could cause the potential benefits of the Merger not to be realized and the market price of the combined company’s common stock to decline.

 

If the proposed Merger with Galil is not consummated, Endocare’s business could suffer materially and Endocare’s stock price could decline.

 

The consummation of the proposed Merger with Galil is subject to a number of closing conditions. Subject to receipt of regulatory approvals, including the closing of the pending investigation by the FTC, and approvals by Endocare stockholders and Galil shareholders, Endocare is seeking to close the transaction in the second quarter of 2009. If the Merger is not consummated, Endocare may be subject to a number of material risks, and its business and stock price could be adversely affected, as follows:

 

 

Risks Related to Galil

 

Galil is incorporated under the laws of, and its principal offices are located in, the State of Israel and therefore its business operations may be harmed by adverse political, economic and military conditions affecting Israel.

 

Galil is incorporated under the laws of, and its principal executive offices and research and development facilities are located in, the State of Israel. In addition, some of its subcontractors are located in Israel. Accordingly, political, economic and military conditions in Israel may directly affect its business. The Israeli economy has

suffered in the past and may suffer in the future from instability, which may adversely affect Galil’s financial condition and results of operations.

 

Following the recession and the instability that characterized the Israeli economy during the years 2001 and 2003, the Israeli economy showed signs of improvement during 2004, 2005, 2006 and 2007. The Israeli economy has also been subject to significant changes, as a result of implementation of new economic policies and privatization. If the results of these changes are unsuccessful or the economic situation in Israel deteriorates, it may also adversely affect Galil’s financial conditions, its results of operations and its ability to obtain financing from Israeli banks.

 

In addition, since the establishment of the State of Israel in 1948, a number of armed conflicts have occurred between Israel and its Arab neighbors. Any hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could affect adversely Galil’s operations. Since October 2000, terrorist violence in Israel has increased significantly, primarily in the West Bank and Gaza Strip, and Israel has experienced terrorist incidents within its borders. Recently, there has been a further escalation in violence among Israel, Hamas, the Palestinian Authority and other groups. In addition, since July 2006, there have been extensive hostilities along Israel’s northern border with Lebanon and in the Gaza Strip. Since June 2007, the Hamas militant group has taken over the Gaza Strip from the Palestinian Authority, and the hostilities along Israel’s border with the Gaza Strip have increased. Beginning in late December of 2008, open hostilities between Israel and Hamas in the Gaza Strip have intensified significantly. Ongoing and increased hostilities or other Israeli political or economic factors could harm Galil’s operations and product development and cause its sales to decrease. Furthermore, several countries still restrict business with Israel and Israeli companies. These restrictive laws and policies may seriously limit Galil’s ability, and that of the combined company, to sell its products in these countries.

 

Galil has a limited operating history with significant losses.

 

Galil has yet to establish any history of profitable operations. Galil has incurred losses from operations of $30.1 million, $9.9 million, $1.9 million, respectively, during the fiscal years ended December 31, 2008, 2007 and 2006. The loss of $30.1 million for the year ended December 31, 2008 includes a one-time non-cash charge of $16.8 million relating to goodwill impairment. As a result, at December 31, 2008, Galil had an accumulated deficit of $76.2 million. Galil has incurred net losses of $30.4 million, $9.5 million and $13.0 million, respectively, during the fiscal years ended December 31, 2008, 2007, and 2006. Galil had an operating cash flow deficit of $11.3 million, $3.8 million and $0.6 million for the years ended December 31, 2008, 2007 and 2006. As of December 31, 2008, Galil had cash and cash equivalents of $2.5 million.

 

As a result of Galil’s recurring operating losses and negative cash flows from operating activities, among other matters, Galil’s independent registered public accounting firm’s report on its financial statements as of and for the fiscal year ended December 31, 2008 includes an explanatory paragraph expressing substantial doubt about Galil’s ability to continue as a going concern.

 

To date, Galil’s revenues have not been sufficient to sustain Galil’s operations. Galil expects that its revenues as a standalone company will not be sufficient to sustain its operations for the foreseeable future. There can be no assurances as to when or whether Galil will ever be profitable.

 

Tax benefits Galil receives through operating in Israel may be terminated or reduced in the future, which would increase Galil’s costs.

 

If Galil generates income, it may be able to take advantage of tax exemptions and reductions resulting from the “Approved Enterprise” and “Benefited Enterprise” status of Galil’s facilities in Israel. To remain eligible for these tax benefits, Galil must continue to meet certain conditions, including making specified investments in property and equipment. If Galil fails to meet these conditions in the future, the tax benefits would be canceled. In addition, these tax benefits may not be continued in the future at their current levels or at any level. The termination or reduction of these tax benefits may increase Galil’s expenses in the future, which would reduce its expected profits or increase its losses. Additionally, if Galil increases its activities outside of Israel, the increased activities generally will not be eligible for inclusion in Israeli tax benefit programs. Under the original approved plan, Galil enjoyed a tax holiday for the years 2001 through 2003. On January 1, 2004 the plan was cancelled. A base turnover was determined at

$2.5 million dollars. Galil received the Investment Center’s approval for its second plan and will be entitled to a tax holiday for 10 years commencing on the first year of taxable income (but not later than the year 2016).

 

On September 2007, Galil applied to the Israeli tax authority for approval of a new “Benefited Enterprise” status and requested the year 2007 to be the year of election. Galil expects to receive the taxation decision soon.

 

The Israeli government grants Galil has received for research and development expenditures restrict its ability to manufacture products and transfer technologies outside of Israel and require it to satisfy specified conditions.

 

Until 2003, Galil received grants totaling $2.3 million from the government of Israel through the Office of the Chief Scientist of the Israeli Ministry of Industry, Trade and Labor (“OCS”), including the Magnet Division, for the financing of a portion of its research and development expenditures for its cryoablation products. Under Israeli law, Galil is prohibited from manufacturing products incorporating know-how developed with grants from the OCS outside of Israel, unless prior approval of a governmental committee is obtained. Even if Galil receives approval to manufacture its products outside of Israel, it may be required to pay an increased total amount of royalties, which may be up to 300% of the aggregate grants amount plus interest (less royalties which have been paid to date), depending on the manufacturing volume that is performed outside of Israel. These restrictions may impair its ability to outsource manufacturing or engage in similar arrangements for those products or technologies. In addition, Galil is prohibited from transferring to third parties the technology developed with these grants without the prior approval of a governmental committee and, possibly, the payment of a fee.

 

Galil’s operations may be disrupted by the obligation of its personnel to perform military service.

 

Some of Galil’s officers and employees in Israel are obligated to perform annual military reserve duty in the Israeli Defense Forces and may be called to active duty under emergency circumstances at any time. If a military conflict or war arises, these individuals could be required to serve in the military for extended periods of time. Galil’s operations could be disrupted by the absence for a significant period of one or more of its officers or key employees or a significant number of its other employees due to reserve duty. Any such disruption in Galil’s operations may harm its business.

 

Galil is subject to risks arising from currency exchange rates, which could increase its costs and may have a negative effect on its results of operations.

 

A majority of Galil’s revenues and a substantial portion of its expenses are denominated in U.S. dollars. However, a small portion of its revenues and a portion of its costs, including manufacturing and research and development, are incurred in New Israeli Shekels and Euro. Inflation in Israel or Europe or a weakening of the U.S. dollar against other currencies may have the effect of increasing the U.S. dollar cost of Galil’s operations in that jurisdiction, which may have a material adverse impact on its results of operations. During 2007, the New Israeli Shekel appreciated against the U.S. dollar by approximately 9%, which contributed to a significant increase in the U.S. dollar cost of Galil’s operations in Israel. In addition, during 2007, the Euro appreciated against the U.S. dollar by approximately 11.7%, which contributed to a significant increase in the U.S. dollar cost of Galil’s operations in Europe. During 2008 the New Israeli Shekel appreciated against the U.S. dollar by approximately 2%, and the Euro depreciated against the U.S. dollar by approximately 5%. If the U.S. dollar continues to decline in value in relation to one or more of these currencies, it will become more expensive for Galil to fund its operations in the jurisdictions that use those other currencies.

 

Although Galil may use hedging techniques to reduce the risk associated with fluctuations in currency exchange rates, it may not be able to eliminate the effects of currency fluctuations. Thus, exchange rate fluctuations could have a material adverse impact on Galil’s results of operations.

Risks Related to Endocare and the Combined Company and the Industry in Which They Will Operate

 

We may require additional financing in the future to sustain our operations and without it we may not be able to continue operations.

 

Endocare and Galil have each historically incurred losses from operations and experienced negative cash flows. As of December 31, 2008, Endocare and Galil had combined cash and cash equivalents of $5.1 million. We currently anticipate that the cash proceeds from the Financing will provide the combined company sufficient cash to enable it to reach positive adjusted EBITDA. However, we can give no assurance that we will be able to successfully integrate the acquisition of Galil and achieve positive adjusted EBITDA, or that this will be done without the need for additional capital.

 

In addition, as a result of each of Endocare’s and Galil’s historical operating losses, among other matters, the reports of each company’s respective independent registered public accountant on the companies’ financial statements as of and for the fiscal year ended December 31, 2008 included an explanatory paragraph expressing substantial doubt about each company’s ability to continue as a going concern.

 

As a result, we may be required to seek additional capital, whether from sales of equity or by borrowing money, to fund our operations. The availability of additional capital, whether from private capital sources (including banks) or the public capital markets, fluctuates as market conditions change. There may be times when the private capital markets and the public debt or equity markets lack sufficient liquidity or when our securities cannot be sold at attractive prices, in which case we would not be able to access capital from these sources. In addition, a weakening of our financial condition or strength could adversely affect our ability to obtain necessary funds.

 

Even if available, additional financing could be costly or have adverse consequences. If additional funds are raised through the issuance of stock, dilution to stockholders will result. In addition, our Restated Certificate of Incorporation, as amended, also authorizes our board of directors to issue “blank check” preferred stock without stockholder approval. If any such series of preferred stock was created, depending on the rights and terms of any new series created, and the reaction of the market to the series, the rights or the value of our common stock could be negatively affected. If additional funds are raised through the incurrence of debt, we will incur increased debt servicing costs and may become subject to additional restrictive financial and other covenants. We can give no assurance as to the terms or availability of additional capital.

 

In addition, under our current credit agreement with Silicon Valley Bank, which expires on May 27, 2009, funds available for borrowing under this facility are based on eligible trade receivables and inventory as defined therein. The credit agreement contains a subjective acceleration clause and a requirement to maintain a lockbox with the lender to which all receivable collections are deposited. Under the subjective acceleration clause, the lender may accelerate repayment of amounts borrowed and/or cease making advances to us if it determines that a material adverse change has occurred in our business or our ability to meet our obligations under the credit agreement. In addition, the proceeds from the lockbox will be applied to reduce the outstanding borrowings upon an event of default (including the occurrence of a material adverse change) or if trigger events occur. Our ability to access funds under the credit agreement is subject to our ability to meet all restrictive covenants and comply with all representations and warranties.

 

Our success is reliant on the acceptance by doctors and patients of our cryoablation systems as a preferred treatment for tumor ablation.

 

Cryoablation has existed for many years, but has not been widely accepted primarily due to concerns regarding safety and efficacy and widespread use of alternative therapies. Because the technology previously lacked precise monitoring capabilities, prostate cryoablation procedures performed in the 1970’s resulted in high cancer recurrence and negative side effects, such as rectal fistulae and incontinence, and gave cryoablation treatment negative publicity. To overcome these negative side effects, we have developed ultrasound guidance and temperature sensing to enable more precise monitoring in our cryoablation systems. Nevertheless, we need to overcome the earlier negative publicity associated with cryoablation in order to obtain market acceptance for our products. In addition, use of our cryoablation systems requires significant physician education and training. As a result, we may have difficulty obtaining adoption of the technology and recommendations and endorsements of physicians and patients

for our cryoablation systems. We may also have difficulty raising the brand awareness necessary to generate interest in our cryoablation systems. Any adverse side effects, including impotence or incontinence, recurrence of cancer or future reported adverse events or other unfavorable publicity involving patient outcomes from the use of cryoablation, whether from our products or the products of our competitors, could adversely affect acceptance of cryoablation. In addition, emerging new technologies and procedures to treat prostate cancer may negatively affect the market acceptance of cryoablation. If our cryoablation systems do not achieve broad market acceptance, we will likely remain unprofitable.

 

If we are unable to continue to enhance our cryoablation systems, our business will suffer.

 

Our growth depends in part on continued ability to successfully develop, manufacture and commercialize enhancements to our cryoablation systems. We may experience difficulties that could delay or prevent the successful development, manufacturing and commercialization of these products. As a result of our financial condition, we have had to forgo making investments in research and development expenditures, and in some cases have had to eliminate projects and reduce spending. Our products in development may not prove safe and effective in clinical trials. Clinical trials may identify significant technical or other obstacles that must be overcome before obtaining necessary regulatory or reimbursement approvals. In addition, our competitors may succeed in developing commercially viable products or alternative technologies that render our products obsolete or less attractive. Failure to successfully develop, manufacture and commercialize new products and enhancements could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our intangible assets could become impaired.

 

Intangible assets acquired in a purchase, such as intellectual property or developed technology, are generally amortized over various periods depending on their anticipated economic benefits or useful lives. Long-lived assets, including amortizable intangibles, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the asset. Following a review, if such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying value of the assets exceeds the fair value of the assets. Any impairment could have a material adverse effect on our financial conditions and results of operations.

 

Significant estimates, including assumptions regarding future events and circumstances that cannot be easily predicted, are required to perform an analysis of the value of intangible assets. These estimates and assumptions may differ materially from actual outcomes and occurrences.

 

We are faced with intense competition and rapid technological and industry change, which may make it more difficult for us to achieve significant market penetration.

 

The medical device industry generally, and the cancer treatment market in particular, are characterized by rapid technological change, changing customer needs and frequent new product introductions. If our competitors’ existing products or new products are more effective than or considered superior to our products, the commercial opportunity for our products will be reduced or eliminated. We face intense competition from companies offering other treatment options, including radical prostatectomy, radiation therapy and hormone therapy. If we are successful in penetrating the market for treatment of prostate cancer with our cryoablation treatment, other medical device companies may be attracted to the marketplace. Many of our competitors and potential competitors are significantly larger than we are and have greater financial, technical, research, marketing, sales, distribution and other resources than we do. We believe there will be intense price competition for products developed to treat cancer. Our competitors may develop or market technologies and products that are more effective or commercially attractive than any that we are developing or marketing. Our competitors may obtain regulatory approval and introduce and commercialize products before we do. These developments could have a material adverse effect on our business, financial condition, results of operations and cash flows. Even if we are able to compete successfully, we may not be able to do so in a profitable manner.

There is uncertainty relating to third-party reimbursement, which is critical to market acceptance of our products.

 

Hospitals and other health care providers in the United States generally rely on third-party payers, principally federal Medicare, state Medicaid and private health insurance plans, to reimburse all or part of the cost of medical procedures involving our products. While private health insurers in some areas of the United States provide reimbursement for procedures in which our products are used, we can provide no assurance that private insurance reimbursement will be adopted nationally or by additional insurers. Furthermore, those private insurance companies currently paying for procedures in which our products are used may terminate such coverage. If reimbursement levels from Medicare, Medicaid, other governmental health care programs or private insurers are not sufficient, physicians may choose not to recommend, and patients may not choose, procedures using our products.

 

International market acceptance of our products may depend, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country, and include both government sponsored health care and private insurance. We may not obtain international reimbursement approvals in a timely manner, if at all, and international reimbursement approvals, once obtained, may be subsequently withdrawn or reduced. Our failure to receive and maintain international reimbursement approvals may negatively impact market acceptance of our products in the international markets in which those approvals are sought.

 

From time to time significant attention has been focused on reforming the health care system in the United States and other countries. Any changes in Medicare, Medicaid or third-party medical expense reimbursement, which may arise from health care reform, may have a material adverse effect on reimbursement for our products or procedures in which our products are used and may reduce the price we are able to charge for our products. In addition, changes to the health care system may also affect the commercial acceptance of products we are currently developing and products we may develop in the future. Potential changes that have been considered include controls on health care spending and price controls. Several proposals have been made in the United States Congress and various state legislatures recently that, if adopted, would potentially reduce health care spending, which may result in a material adverse effect on our business, financial condition, results of operations and cash flows.

 

If we fail to protect our intellectual property rights, our competitors may take advantage of our ideas and compete directly against us.

 

Our success will depend to a significant degree on our ability to secure and protect intellectual property rights and to enforce patent and trademark protections relating to our technology. From time to time, litigation may be advisable to protect our intellectual property position. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. Any litigation in this regard could be costly, and it is possible that we will not have sufficient resources to fully pursue litigation or to protect our other intellectual property rights. Litigation could result in the rejection or invalidation of our existing and future patents. Any adverse outcome in litigation relating to the validity of our patents, or any failure to pursue litigation or otherwise to protect our patent position, could have a material adverse effect on our business, financial condition, results of operations and cash flows. Also, even if we prevail in litigation, the litigation would be costly in terms of management distraction as well as in terms of cash resources. In addition, confidentiality agreements with our employees, consultants, customers, and key vendors may not prevent the unauthorized disclosure or use of our technology. It is possible that these agreements could be breached or that they might not be enforceable in every instance, and that we might not have adequate remedies for any such breach. Enforcement of these agreements may be costly and time consuming. Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States.

 

Because the medical device industry is litigious, we may be sued for allegedly violating the intellectual property rights of others.

 

The medical technology industry has in the past been characterized by a substantial amount of litigation and related administrative proceedings regarding patents and intellectual property rights. In addition, major medical

device companies have used litigation against emerging growth companies as a means of gaining or preserving a competitive advantage.

 

Should third parties file patent applications or be issued patents claiming technology also claimed by us in pending applications, we may be required to participate in interference proceedings in the United States Patent and Trademark Office to determine the relative priorities of our inventions and the third parties’ inventions. We could also be required to participate in interference proceedings involving our issued patents and pending applications of another entity. An adverse outcome in an interference proceeding could require us to cease using the technology or to license rights from prevailing third parties. If we are required to license rights from a third party, such license may be expensive and on terms that are unacceptable to us.

 

Third parties may claim we are using their patented inventions and may go to court to stop us from engaging in our normal operations and activities. These lawsuits are expensive to defend and conduct and would also consume and divert the time and attention of our management. A court may decide that we are infringing a third party’s patents and may order us to cease the infringing activity. A court could also order us to pay damages for the infringement. These damages could be substantial and could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

If we are unable to obtain any necessary license following an adverse determination in litigation or in interference or other administrative proceedings, we would have to redesign our products to avoid infringing a third party’s patent and could temporarily or permanently have to discontinue manufacturing and selling some or all of our products. If this were to occur, it would negatively impact future sales and, in turn, our business, financial condition, results of operations and cash flows.

 

Our ability to conduct medical research and receive medical information may be hampered by the privacy regulations developed under the Health Insurance Portability and Accountability Act of 1996, referred to as “HIPAA.”

 

The privacy regulations of HIPAA place limitations on a “covered entity’s” use and disclosure of identifiable patient information, including research data. While Endocare is not a “covered entity” under HIPAA, Endocare’s relationships with covered entities, such as hospitals and physicians, sometimes implicate HIPAA. We believe that we have implemented appropriate measures to ensure that our relationships with covered entities are appropriate and consistent with HIPAA. However, there are many uncertainties remaining about how HIPAA applies to medical device companies, and no assurance can be given that HIPAA will not be interpreted in a manner that will hamper our ability to conduct medical research and receive medical information for other purposes as well.

 

If we fail to obtain or maintain necessary regulatory clearances or approvals for products, or if approvals are delayed or withdrawn, we will be unable to commercially distribute and market our products or any product modifications.

 

Government regulation has a significant impact on our business. Government regulation in the United States and other countries is a significant factor affecting the research and development, manufacture and marketing of our products. In the United States, the Food and Drug Administration (the “FDA”) has broad authority under the Federal Food, Drug and Cosmetic Act (the “FD&C Act”) to regulate the development, distribution, manufacture and sale of medical devices. Foreign sales of drugs and medical devices are subject to foreign governmental regulation and restrictions, which vary from country to country. The process of obtaining FDA and other required regulatory clearances and approvals (collectively, “regulatory approvals”) is lengthy and expensive. We may not be able to obtain or maintain necessary regulatory approvals for clinical testing or for the manufacturing or marketing of our products. Failure to comply with applicable regulatory approvals can, among other things, result in fines, suspension or withdrawal of regulatory approvals, product recalls, operating restrictions and criminal prosecution. In addition, new or additional governmental regulations may be established which could prevent, delay, modify or rescind regulatory approval of our products. Any of these actions by the FDA or foreign regulatory authority, or change in FDA regulations or those of a foreign regulatory authority, could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Regulatory approvals, if granted, may include significant limitations on the indicated uses for which our products may be marketed. In addition, to obtain such regulatory approvals, the FDA and foreign regulatory authorities may impose numerous other requirements on us. FDA enforcement policy prohibits the marketing of approved medical devices for unapproved uses. In addition, regulatory approvals can be withdrawn for failure to comply with regulatory standards or as a result of unforeseen problems following initial marketing. We may not be able to obtain or maintain regulatory approvals for our products on a timely basis, or at all, and delays in receipt of or failure to receive such regulatory approvals, the loss of previously obtained regulatory approvals or failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

We may be required to modify our agreements, operations, marketing and expansion strategies in response to changes in the statutory and regulatory environment.

 

We regularly monitor developments in statutes and regulations relating to our business. However, we may be required to modify our agreements, operations, marketing and expansion strategies from time to time in response to changes in the statutory and regulatory environment. We plan to structure all of our agreements, operations, marketing and strategies in accordance with applicable law, although we can provide no assurance that our arrangements will not be challenged successfully or that required changes may not have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our products may be subject to product recalls even after receiving FDA clearance or approval, which would harm our reputation and our business.

 

The FDA and similar governmental authorities in other countries have the authority to request and, in some cases, require the recall or similar actions for our products in the event of material deficiencies or defects in design, manufacture or labeling or in the event of patient injury. A governmental mandated or voluntary recall by us could occur as a result of component failures, manufacturing errors or design defects. Any recall of product would divert managerial and financial resources and harm our reputation with customers and our business, impact our ability to distribute the recalled product in the future, require costly redesign or manufacturing changes and leave Endocare vulnerable to additional regulatory sanctions and product liability litigation.

 

We are subject to risks associated with doing business internationally.

 

The conduct of our business internationally is subject to certain risks inherent in international business, many of which are beyond our control. These risks include, among other things:

 

 

In addition, foreign sales subject us to numerous stringent United States and foreign laws, including the Foreign Corrupt Practices Act (“FCPA”), and comparable foreign laws and regulations which prohibit improper payments or offers of payments to foreign governments and their officials and political parties by United States and other business entities for the purpose of obtaining or retaining business. As we expand our international operations, there is some risk of unauthorized payments or offers of payments by one of our employees, consultants, sales agents or distributors, which could constitute a violation by us of various laws including the FCPA, even though such parties are not always subject to our control. Safeguards that we implement to discourage these practices may prove to be less than effective and violations of the FCPA and other laws may result in severe criminal or civil sanctions, or other liabilities or proceedings against us, including class action lawsuits and enforcement actions from the SEC, Department of Justice and overseas regulators, which could adversely affect our reputation, business, financial condition and results of operations.

 

Any of these factors, or any other international factors, could have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that we can successfully manage these risks or avoid their effects.

 

We could be negatively impacted by future interpretation or implementation of the federal anti-kickback and Stark Laws and other federal and state anti-self-referral and anti-kickback laws.

 

The Centers for Medicare & Medicaid Services (“CMS”) recently issued a final rule which includes amendments to the regulations that implement the physician self-referral law (Section 1877 of the Social Security Act), popularly known as the “Stark Law.” Certain elements of the final rule that will be effective October 1, 2009 likely will require restructuring of our contracts with physician-owned entities that provide equipment and services in connection with our arrangements to furnish equipment, products and services to hospitals. CMS is prohibiting “per-click” lease arrangements in which a physician-owned entity is the lessor and receives a “per-click” payment, either directly or indirectly, from a provider of “designated health services” (“DHS”) such as a hospital for space or equipment used by the hospital in the provision of services to patients who were referred by the lessor to the lessee. These arrangements where we hold the hospital contract and subcontract with a physician-owned entity constitute less than 20% of our urology business, and we are actively pursuing various restructuring options. At this time, we are unable to predict whether, and to what the extent, such restructuring will affect our business or future business arrangements, but there is no guarantee that it will not have an adverse effect on our business.

 

In addition, for the same reasons as noted above, by October 1, 2009, physician-owned entities that purchase our equipment and disposables and then furnish the equipment, disposables, and technical support services to hospitals on a “per click” basis will be required to restructure their “per click” contracts with the hospital or potentially divest the physician-owners. Although there is a reasonable position at this time that these entities can avoid divesture of their physician-owners, these entities will likely have to be restructured to address the Stark Law rule change effective October 1, 2009. A significant percentage of the urology cases using our equipment in hospitals involves the aforementioned “per-click” arrangement. We understand that these entities are also actively pursuing potential restructuring options. We expect that our arrangements and those of our customers involved in furnishing our products will be fully compliant with the new regulatory requirements before the October 1, 2009 deadline. Although too early to assess, it is possible that such restructuring will have an adverse effect on our business. Interventional radiology services outside of the urology business that involve use of our products generally do not involve physician-owned businesses, and therefore will not be affected by the new rule.

 

The new rules also may make physician investment in mobile service providers and other ventures that purchase our equipment and products and furnish them to hospitals potentially less attractive. At this time, we are unable to predict whether, and to what extent, implementation of the changes made necessary by the new rules will affect our business or future business arrangements.

 

If we become subject to product liability claims, we may be required to pay damages that exceed our insurance coverage.

 

Our business exposes us to potential product liability claims that are inherent in the testing, production, marketing and sale of medical devices. While we believe that we are reasonably insured against these risks, we may

not maintain insurance in amounts or scope sufficient to provide us with adequate coverage. A claim in excess of our insurance coverage or not covered by our insurance carriers would have to be paid out of our cash reserves, which could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, any product liability claim could harm our reputation in the industry and our business.

 

If our products are not accepted by the medical community, or if our products are replaced by new technologies, our business may suffer.

 

The success of our existing products depends on acceptance of these products by the medical community, which acceptance levels we cannot predict. The success of any products we develop in the future will depend on their adoption by our targeted markets. We cannot predict how quickly, if at all, the medical community will accept our future products, or the extent to which those products will be used. If we encounter difficulties introducing future products into our targeted markets, our operating results and business may be substantially impaired. In addition, new technologies and techniques or improvements on such technologies or techniques may be developed which may render obsolete our current products, along with those under development.

 

Our future growth is dependent upon the development of new products, which requires significant investment in research and development and clinical trials, and may not result in commercially viable products.

 

Our future growth is dependent upon the development of new products, which requires that significant resources be devoted to research and development activities and clinical trials. In order to develop new products and improve current product offerings, we focus our research and development programs largely on the development of next-generation and new technology offerings. If we are unable to develop and launch new products as anticipated or if our R&D efforts do not achieve products with technical feasibility, or take longer than anticipated, our ability to maintain or expand our market position may be adversely impacted. As a result of our financial condition, we have had to forgo making investments in research and development expenditures, and in some cases, have had to eliminate projects and reduce spending.

 

Our success will depend on our ability to attract and retain key skilled personnel and if we are not successful, our business will be adversely affected.

 

In order to execute our business plan, we need to attract, retain and motivate a significant number of highly qualified managerial, technical, financial and sales personnel. If we fail to attract and retain skilled scientific and sales personnel, our research and development and sales and marketing efforts will be hindered. Our future success depends to a significant degree upon the continued services of key management personnel. None of our key management personnel is covered by an insurance policy of which we are the beneficiary.

 

Endocare and the combined company will be subject to each of the risks described in the sections above entitled “Risks Associated with Endocare’s Business” and “Risks Related to Galil.” If any of those risks occur, it may have a negative effect on our results of operations and our stock price could decline.

 

Following the effective time of the Merger, Endocare and the combined company will be subject to each of the risks described in the sections above entitled “Risks Associated with Endocare’s Business” and “Risks Related to Galil.” If any of those risks occur, it may have a negative effect on our results of operations and our stock price could decline.

 

 

Not Applicable

 

 

Our executive offices, as well as our principal manufacturing and research facilities, are located in a 28,000 square foot facility in Irvine, California. The lease for this facility expires in 2010, with an option to

extend the lease for an additional five years. We believe that our property and equipment are generally well maintained, in good operating condition and are sufficient to meet our current needs.

 

 

Endocare is a party to lawsuits in the normal course of its business. Litigation and governmental investigation can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. Significant judgments or settlements in connection with legal proceedings may have a material adverse effect on our business, financial condition, results of operations and cash flows. Other than as described below, we are not a party to any legal proceedings that we believe to be material.

 

Governmental Legal Proceedings

 

The FTC has opened a preliminary investigation into whether the proposed Merger with Galil violates Section 7 of the Clayton Act, as amended, 15 U.S.C. § 18, or Section 5 of the FTC Act, as amended, 15 U.S.C. § 48. The parties are cooperating fully with the FTC’s investigation and are in the process of providing the FTC with information and materials. Endocare cannot provide any assurance that the FTC’s investigation will not delay or prevent consummation of the Merger.

 

 

Not applicable.

 

 

Market Information

 

Endocare’s common stock is listed on the NASDAQ Capital Market under the symbol “ENDO.” On October 21, 2005, Endocare’s stock began to be quoted on the OTC Bulletin Board or “OTCBB.” On October 10, 2007, Endocare’s stock became listed on the NASDAQ Capital Market. The following table sets forth, for the periods indicated, the intraday high and low per share sales prices for Endocare’s common stock as reported on the OTCBB or the NASDAQ Capital Market, as applicable. All prices have been adjusted to reflect the one-for-three reverse stock split that occurred on August 20, 2007.

 

 

Holders

 

As of February 28, 2009, there were 213 holders of record of our common stock. This number was derived from our stockholder records and does not include beneficial owners of our common stock whose shares are held in the names of various dealers, clearing agencies, banks, brokers, and other fiduciaries.

 

Dividends

 

Endocare has never declared or paid cash dividends on its capital stock. Endocare currently intends to retain earnings, if any, to finance the growth and development of its business, and does not expect to pay any cash dividends to its stockholders in the foreseeable future. Payment of future dividends, if any, will be at the discretion of Endocare’s board of directors.

 

Recent Sales of Unregistered Securities

 

None, except as previously reported in a Quarterly Report on Form 10-Q or Current Report on Form 8-K.

 

Issuer Purchases of Equity Securities

 

Not applicable.

 

 

Not applicable.

 

 

The following discussion should be read in conjunction with “Item 1 — Business,” “Item 1A — Risk Factors,” and “Item 8 — Financial Statements and Supplementary Data,” as well as our consolidated financial statements and related notes contained elsewhere in this Annual Report on Form 10-K. This discussion contains forward-

looking statements based on our current expectations. There are various factors — many beyond our control — that could cause our actual results or the occurrence or timing of expected events to differ materially from those anticipated in these forward-looking statements. Some of these factors are described below and other factors are described elsewhere in this Annual Report on Form 10-K, including above under “Risks Factors” in Item 1A of this Annual Report on Form 10-K. In addition, there are factors not described in this Annual Report on Form 10-K that could cause our actual results or the occurrence or timing of expected events to differ materially from those anticipated in these forward-looking statements. All forward-looking statements included in this Annual Report on Form 10-K are based on information available to us as of the date hereof, and, except as required by law, we assume no obligation to update any such forward-looking statements.

 

Overview

 

We are an innovative medical device company focused on the development of minimally invasive technologies for tissue and tumor ablation through cryoablation, which is the use of lethal ice to destroy tissue, such as tumors, for therapeutic purposes. We develop and manufacture devices for the treatment of prostate and renal cancers and we believe that our proprietary technologies have broad applications across a number of markets, including the ablation of tumors in the lung and liver and palliative intervention (treatment of pain associated with metastases).

 

Today, our FDA-cleared Cryocare Surgical System is used in the treatment of prostate and renal cancers. Because of our initial concentration on prostate and renal cancers, the majority of our sales and marketing resources are directed toward the promotion of our technology to urologists. We also employ a dedicated sales team focused on the interventional radiology market in which our products are used to treat renal, liver and lung cancer and for palliative intervention. In addition to selling our cryoablation disposable products to hospitals and mobile service companies, we contract directly with hospitals for the use of our Cryocare Surgical System and disposable products on a fee-for-service basis. We intend to continue to identify and develop new markets for our cryoablation products and technologies, particularly in the area of tumor ablation.

 

Recent Events

 

On November 10, 2008, Endocare and Galil entered into the Merger Agreement, pursuant to which Orange Acquisition Ltd, (a newly-formed wholly owned subsidiary of Endocare) will merge with and into Galil, with Galil continuing after the Merger as the surviving company and a wholly owned subsidiary of Endocare. The Merger will be effected via the exchange of Endocare common stock and stock options for Galil’s outstanding ordinary shares and options.

 

At the effective time of the Merger, it is expected that 11,092,330 shares of Endocare common stock will be issued in the Merger. The exact conversion ratio cannot be calculated until immediately prior to the effective time of the Merger, but it is expected that approximately 33.0 ordinary shares of Galil will be converted into one share of Endocare common stock. Immediately following the effective time of the Merger and attributing ownership to Galil’s shareholders of the Endocare common stock to be deposited into the escrow (the Escrow Shares), Galil’s shareholders will own approximately 48.0%, and Endocare’s stockholders will own approximately 52.0%, of Endocare’s common stock, without giving effect to the shares issuable pursuant to the concurrent Financing described below. The Merger will have no effect on the number of shares of common stock of Endocare owned by existing Endocare stockholders. Subject to receipt of regulatory approvals, including the closing of the pending investigation by the FTC, and approvals by Endocare stockholders and Galil shareholders, we are seeking to close the Merger in the second quarter of 2009.

 

Concurrent with the execution of the Merger Agreement, Endocare and certain existing institutional accredited stockholders of Endocare and Galil entered into the Stock Purchase Agreement, relating to the private placement by Endocare of 16,250,000 shares of Endocare common stock at a purchase price of $1.00 per share. The offering gross proceeds to Endocare from the Financing are expected to be $16,250,000. The closing of the Financing is subject to the concurrent closing of the Merger and certain other conditions, including the sale of shares with a minimum aggregate purchase price of $12,000,000 and that Endocare’s common stock remains listed on the NASDAQ Capital Market or the Over-The-Counter Bulletin Board. Upon consummation of the Merger and the Financing, and attributing ownership to Galil’s shareholders of the Escrow Shares, Endocare stockholders will own approximately 38.5% of

Endocare’s outstanding common stock and the former shareholders of Galil will own approximately 61.5% of Endocare’s outstanding common stock. Primarily as a result of this factor, the Merger will be accounted for as a reverse acquisition and equity recapitalization in accordance with U.S. generally accepted accounting principles. Under this method of accounting, after completion of the Merger and the Financing, Endocare will be treated as the “acquired” company for financial accounting and reporting purposes, and the combined entity’s results of operations prior to completion of the Merger will be those of Galil. We are obligated to pay a transaction fee of $800,000 and a percentage of the Financing proceeds (estimated to be approximately $265,000) to our financial advisor and placement agent upon the closing of the Merger and Financing.

 

Consummation of the Merger is subject to certain closing conditions, including, among other things, approval by Endocare stockholders and those of Galil. As a condition to the parties entering into the Merger Agreement, certain of Galil stockholders who in the aggregate own approximately 97.5% of Galil stock on an as if converted to common stock basis, have entered into voting agreements whereby they have agreed to vote in favor of the transactions contemplated by the Merger Agreement subject to the terms of the voting agreements.

 

The Merger Agreement terminates pursuant to its terms if the Merger has not occurred on or prior to June 30, 2009, unless the parties agree otherwise. The Merger Agreement contains certain other termination rights for both Endocare and Galil, including each party’s right to terminate the Merger Agreement in the event the other party’s available cash drops below $1.0 million for more than ten business days. Upon termination of the Merger Agreement for specified breaches and certain similar circumstances, either party may be required to pay the other party a termination fee of $900,000 and, in some circumstances, reimburse the other party for expenses incurred in connection with the Merger, up to a maximum of $850,000.

 

The Merger Agreement and Stock Purchase Agreement, which have been filed as exhibits to this Annual Report on Form 10-K, have been included as exhibits to provide you with information regarding the terms of the transactions described therein and are not intended to provide any other factual information or disclosure about Endocare, Galil or the investors in the Financing. The representations, warranties and covenants contained in the Merger Agreement and Stock Purchase Agreement were made only for purposes of such agreements and as of a specific date, were solely for the benefit of the parties to such agreements, may be subject to limitations agreed upon by the contracting parties, including being qualified by disclosure schedules made for the purposes of allocating contractual risk between the parties thereto instead of establishing these matters as facts, and may be subject to standards of materiality applicable to the contracting parties that differ from those applicable to investors. Moreover, information concerning the subject matter of the representations and warranties may change after the dates of the Merger Agreement and the Stock Purchase Agreement, which subsequent information may or may not be fully reflected in Endocare’s public disclosures. Investors are not third-party beneficiaries under the Merger Agreement or the Stock Purchase Agreement and, in light of the foregoing reasons, should not rely on the representations, warranties and covenants or any descriptions thereof as characterizations of the actual state of facts or condition of Endocare, Galil, Orange Acquisitions, Ltd., the investors in the Financing or any of their respective subsidiaries or affiliates. Information regarding Endocare is provided elsewhere in this Annual Report on Form 10-K and Endocare’s other SEC filings, which are available at www.endocare.com and on the SEC’s website at www.sec.gov.

 

Strategy and Key Metrics

 

Our strategy is to strengthen cryoablation’s position in the prostate and renal cancer markets, and further develop and increase the acceptance of our technology in the interventional radiology and oncology markets for treatment of liver and lung cancers and palliative intervention (treatment of pain associated with metastases). At the same time, we seek to achieve penetration across additional markets with our proprietary cryoablation technology.

 

The factors driving interest in and utilization of cryoablation include increased awareness and acceptance of cryoablation by industry thought leaders, continued publication of clinical data on the effectiveness of cryoablation, increased awareness among patients of cryoablation and its preferred outcomes as compared to other modalities, the efforts of our sales force and our continued expenditure of funds on patient education and advocacy.

 

Our primary objective is to improve the penetration of cryoablation, which we have historically measured in terms of the estimated number of domestic cryoablation procedures performed with our Cryocare Surgical System,

which we calculate using two primary components. The first component is the actual number of cryoablation cases for which we perform the service element on behalf of the healthcare facility and provide the required disposable products. In the second, we compute a procedure case equivalent based on direct sales of our cryoablation disposable products (without the service element) by using the expected disposable product usage for each procedure for those sales. In 2005, we began gradually shifting our revenue model from providing the service component of our cryoablation procedure (revenues from cryoablation procedure fees) to focusing on selling our cryoablation disposable products without responsibility for the service element of the procedure (revenues from sales of cryoablation disposable products), thereby reducing the incremental revenues associated with our business in favor of a more straightforward disposable sales model. We did so recognizing that this strategic business model change would result in a flattened revenue curve until the change was complete since the average revenue per case where we only sell the disposables is less than that for a case where we also provide the service component. Because of that, we continued to communicate the estimated number of procedures performed each quarter so that the users of our financial information could monitor market adoption and progress within our markets.

 

Today, the transition is largely complete and the remaining transition should be relatively small in future periods. Therefore, we believe that revenue growth will once again become one of our most important business metrics going forward. Because our customers are now directly purchasing and carrying inventories of our disposables and because of the resulting variability of probe use across patients and applications, making precise determinations about how many procedures are performed is increasingly difficult. As a consequence, we decided that, beginning with our operating results for the three months ended December 31, 2007, we will report the number of cryoprobes sold during the period.

 

The following tables summarize for the periods presented the total estimated domestic cryoablation procedures our customers performed or which are represented by the procedure case equivalent we computed from sales of our cryoablation disposable products. We also summarize the number of probes sold for each period. We are providing this summary to allow users of the financial information greater clarity regarding the transition from the former metric (procedure growth) we reported to the new metric (revenue growth measured by the number of probes sold) we will report going forward.

 

 

The number of cryoprobes sold represents the domestic sales of cryoprobes during the periods presented. Straight probes are typically, although not always, used in prostate procedures and right-angle probes are typically used in procedures other than prostate procedures.

 

We recently conducted a thorough review of our 2008 performance, including the number and types of cases performed by each of our physician customers. This review suggested that urology prostate cancer cases were impacted primarily by the emergence of robotic prostatectomy and intensity-modulated radiation therapy (IMRT). In the financial results press release that we issued on August 6, 2008, we announced a number of initiatives to help us regain the growth that we have demonstrated in the past. The initiatives include programs intended to impact the number of new physicians trained, increase revenues from our existing customers and communicate directly and more broadly with patients to educate them about the significant benefits of cryoablation. The programs include additional new urology sales personnel, significantly enhanced patient outreach and advertising and programs that assist our existing physician customers in reaching more patients through community-based marketing. An important element of these programs is an increased emphasis on focal cryoablation, since we believe that this is an area where we have a potentially substantial competitive advantage.

Results of Operations

 

Revenues and cost of revenues from continuing operations related to the following products and services for the three-year period ended December 31, 2008 are as follows:

 

 

We recognize revenues from sales of Cryocare Surgical Systems and disposable cryoprobes when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable, and collectibility is reasonably assured. Per-procedure fees are recorded when the service has been rendered.

 

Costs of revenues for cryoablation disposable products and procedure fees are combined for reporting purposes. Sales of cryoablation disposable products and procedure fees incorporate similar inventory when sold and we do not separately track the cost of disposable products sold directly to customers and those consumed in cryoablation procedures.

 

Costs of revenues consist of fixed and variable costs incurred in the manufacture of our products in addition to depreciation of Cryocare Surgical Systems placed in the field with customers under our placement program or with our sales and service personnel. We incur an additional cost of revenues in the form of a fee for equipment usage and other services when a procedure is performed on a system owned by an unrelated third-party service provider. The fee paid to the third-party service provider is charged to costs of revenues when the procedure is performed and billed.

 

Research and development expenses include expenses associated with the design and development of new products as well as enhancements to existing products. We expense research and development costs when incurred. Our research and development efforts are occasionally subject to significant non-recurring expenses and fees that can cause some variability in our quarterly research and development expenses.

 

Selling and marketing expenses primarily consist of salaries, commissions and related benefits and overhead costs for employees and activities in the areas of selling, marketing and customer service. Expenses associated with advertising, trade shows, promotional and physician training costs related to marketing our products are also classified as selling and marketing expenses.

 

General and administrative expenses primarily consist of salaries and related benefits and overhead costs for employees and activities in the areas of legal affairs, finance, information technology, human resources and administration. Fees for attorneys, independent auditors and certain other outside consultants are also included where their services are related to general and administrative activities. This category also includes reserves for bad debt, and litigation losses less amounts recoverable under our insurance policies. Litigation reserves and insurance

recoveries are recorded when such amounts are probable and can be reasonably estimated. In the 2008 period, general and administrative expenses also included certain costs related to our pending merger with Galil.

 

We account for equity awards to employees and non-employee directors under Statement of Financial Accounting Standards No. 123 (revised 2004), Share Based Payment (SFAS No. 123R). As of December 31, 2008, there was $0.9 million of total unrecognized compensation costs related to unvested stock options. That cost is expected to be amortized on a straight-line basis over a weighted average service period of 0.7 years less any stock options forfeited prior to vesting. Unrecognized compensation for restricted stock units was $1.7 million as of December 31, 2008 (assuming that all service and performance conditions will be met) and will be recognized over a weighted average period of 0.9 years. Compensation costs related to restricted stock units is recorded over the service period (2007 through 2009) if it is probable the performance conditions (profitability and sales goals) will be satisfied. Stock-based compensation expense recorded in the years ended December 31, 2008, 2007 and 2006 was $1.2 million, $3.9 million, and $2.8 million respectively. The expense for 2008 is net of a cumulative adjustment to reverse $1.3 million in previously recorded expense due to a change in vesting probability and forfeitures from terminations.

 

Costs, expenses, gains and losses from continuing operations for the three-year period ended December 31, 2008 are as follows:

 

 

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

 

Revenues

 

 

The number of cryoprobes sold during the year ended December 31, 2008 decreased by approximately 0.2 percent to 45,142 compared to 45,217 probes sold during this same period in 2007. The reduction in revenue was offset by higher average sales prices of probes sold and used in procedures, which increased 7.2 percent during the year ended December 31, 2008 compared to this same period in 2007. This is primarily the result of migration of

sales to higher priced probes and secondarily to certain increases implemented in the second quarter. Sales of straight probes, which are typically, although not always, used in prostate cancer procedures decreased 4.8 percent and right-angle probes, which are typically used in procedures other than prostate cancer procedures, increased 28.6 percent.

 

Revenues from sales of Cryocare Surgical Systems decreased as a result of fewer sales of such systems primarily in domestic markets. Cardiac royalty revenues increased for the year ended December 31, 2008 over the same period in 2007 due to increased sales by the licensee. Other revenues decreased due to a one-time non-refundable payment received under a term sheet with a potential collaboration partner in 2007. The term sheet was subsequently terminated without the parties reaching a definitive agreement.

 

Cost of Revenues

 

 

Costs of revenues increased as a result of an increase in the provision for excess and obsolete inventory of $0.3 million offset by a decrease in salary and stock compensation expense of $0.1 million.

 

Gross Profit and Gross Margin

 

 

 

We have continued to reduce manufacturing costs for our cryoablation disposable products and surgical systems, while increasing efficiencies in production. In addition, gross margins were negatively affected during the year ended December 31, 2007 by transactions where we allowed certain customers to upgrade to our Cryocare CS System from a previous generation of our Cryocare Surgical System with nominal additional payment.

 

Research and Development Expenses

 

The decrease was primarily attributable to a reduction in the bonus expense of $0.1 million and stock-based compensation expense of $0.1 million. Expenses related to clinical studies for the year ended December 31, 2008 have remained consistent with the same period of last year. In both 2008 and 2007, we have focused a significant portion of our research dollars on those areas in which cryoablation research is required to substantiate reimbursement codes and coverage.

 

Selling and Marketing Expenses

 

 

The decrease in selling and marketing expenses primarily related to reductions in incentive compensation of $0.4 million, reductions in the training expenses for new physicians of $0.2 million and a reduction in stock-based compensation expense of $0.1 million. The total decrease of $0.7 million was offset by a $0.4 million increase in consulting expenses related to further development and enhancement of a database of cryoablation patients and treatment outcomes which we support and maintain as well as a $0.1 million increase in fees for trade shows. Included in selling and marketing expenses for the years ended December 31, 2008 and 2007 were $0.5 million and $0.7 million, respectively, in non-cash stock-based compensation expenses related to stock options, deferred stock units and restricted stock units.

 

General and Administrative Expenses

 

 

The change in 2008 is primarily due to reductions in stock-based compensation of $2.1 million, incentive compensation of $1.0 million and board of directors fees of $0.3 million. Offsetting the total decrease of $3.4 million was an increase in legal expenses of $0.8 million as a result of us having exhausted all remaining insurance coverage for indemnification matters relating to our former executives, legal and financial advisory expense related to the pending merger with Galil of $2.4 million and an increase in sales and use tax expenses of $0.3 million as a result of the settlement of liabilities related to previous years that did not recur in the 2008 period. The provision for bad debts in 2008 was also higher by $0.4 million due to a favorable change in estimate during 2007 regarding the expected collections of a note receivable we received in connection with our 2006 sale of Timm Medical.

 

Of the $4.0 million in legal expenses in 2008 (net of insurance recoveries), $1.8 million related to the legal proceedings of our former CEO and former CFO and $1.7 million related to legal expenses incurred from evaluating potential strategic opportunities, including the merger with Galil. These expenditures were recorded as general and administrative expenses as incurred since the transaction is not expected to occur until the second quarter of 2009, and these costs will be required to be expensed under Statement of Financial Accounting Standards (SFAS) No. 141(R), Business Combinations. As of March 31, 2008, we exhausted all remaining insurance coverage for indemnification matters relating to our former executives. In August and October 2008, our indemnification agreements with our former CFO and former CEO respectively, were terminated. As a result of the termination agreements, we are no longer obligated to pay any future legal expenses.

 

Total stock-based compensation expense included in general and administrative expenses related to stock options, deferred stock units and restricted stock units for the years ended December 31, 2008 and 2007 was $0.6 million and $3.0 million, respectively. The reduction in stock-based compensation was due to a cumulative adjustment to reverse $1.3 million in expenses related to equity awards that are no longer expected to vest,

$0.8 million of stock based compensation that became fully vested during 2007 and therefore did not recur in 2008 and $0.3 million reduction in employee deferred stock units issued for compensation.

 

Gain on Recovery of Note Receivable

 

 

In the third quarter of 2008 we received $0.8 million for the receipt of a payment in full satisfaction of a note receivable from SRS Medical related to the sale of a product line in October 2003. Due to uncertainty of collection, the note was fully reserved at the time of sale in 2003 and the payment was recorded as a gain on recovery when received.

 

Investment impairment

 

 

In the fourth quarter of 2008 we recorded an impairment charge of $0.9 million, which was equivalent to the carrying value of our investment in a privately held medical device company. The impairment charge was recorded upon us determining that the fair value of our investment had declined below our carrying value and our belief that the impairment was other-than-temporary. See Note 11 — “Collaborative and Other Agreements” in the notes to our consolidated financial statements for further discussion.

 

Litigation Settlement, Net of Related Legal Expenses

 

 

In the third quarter of 2007, we recorded a gain of $0.7 million for litigation settlement, net of related legal expenses. This amount relates to the settlement with KPMG LLP, our former independent auditor, for claims of professional negligence and breach of contract in the amount of $1.0 million for damages and $0.2 million for recovery of audit fees paid. We were required to pay one-third of the settlement amount and one-third of the returned fees to our outside litigation counsel.

 

Interest Income (Expense), Net

 

 

Interest income, net in the 2008 and 2007 periods included interest income earned from the investment of our cash balances, as well as interest expense related to our line of credit. Interest expense paid on our line of credit decreased due to a lower average balance on the line of credit and lower interest rate for the year ended

December 31, 2008 compared to the same period in 2007. Interest income also decreased due to lower cash balances in 2008 resulting from cash used to fund operations.

 

Net Loss

 

 

Net loss for the year ended December 31, 2008 was $0.71 per basic and diluted share on 11.9 million weighted average shares outstanding, compared to a net loss of $0.80 per basic and diluted share on 11.1 million weighted average shares outstanding during the same period in 2007.

 

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

 

Revenues

 

 

Although our total number of estimated domestic procedures increased approximately 20 percent to 9,373 for the year ended December 31, 2007 from 7,802 for the year ended December 31, 2006, the growth in revenues is not reflective of this increase because of the change in revenue mix from procedure fees to direct sale of disposable products without the service component. Generally, we earn less revenue per case for sales of cryoablation disposable products than for procedure fees; however the related gross margin as a percent of revenues for sales of cryoablation disposable products is greater. Of the total estimated procedures performed during the year ended December 31, 2007, 14 percent were those for which we provided cryoablation services and 86 percent were from the sale of cryoablation disposable products. This compares to 32 percent for cryoablation services and 68 percent for sales of cryoablation disposable products during the year ended December 31, 2006.

 

Also contributing to growth in sales of cryoablation products was an increase in sales to a market served by interventional radiologists, who are physicians who treat tumors in the kidney, lung and liver and perform palliative intervention. Direct sales of disposable products and interventional radiology procedures generally have a lower average selling price than procedures performed by urologists on prostate and renal treatments although costs of revenues are also lower.

 

The decrease in royalty revenues for the year ended December 31, 2007 is related to a decrease in the contractual rate of royalties that we are paid from 5.0 percent in 2006 to 3.0 percent in 2007.

 

Revenues from sales of Cryocare Surgical Systems increased as a result of a greater number of systems sold.

Cost of Revenues

 

 

The decrease in cost of revenues resulted primarily from the change in the mix of our revenues from those where we are responsible for providing cryoablation procedure services to solely selling cryoablation disposable products. This mix shift led to a decrease in the number of cases for which we paid fees to third party service providers. Fees to service providers were $2.5 million in 2007 and $4.7 million in 2006. In addition, costs of revenues declined due to decreases in materials, labor and overhead costs. During the years ended December 31, 2007 and 2006, substantially all of our cryoablation procedures for which we were responsible for the service element were performed by third party service providers at an additional cost to us.

 

Gross Profit and Gross Margin

 

 

 

The positive trend in gross margins (gross profit as a percentage of revenues) was primarily related to our shift from procedures where we bear responsibility for the service element of the procedure to those where we solely sell our cryoablation disposable products. Sales of cryoablation disposable products yield a higher gross margin than procedures performed by third party subcontractors. We also have continued to reduce manufacturing costs for our cryoablation disposable products, while increasing efficiencies in production.

 

Research and Development Expenses

 

 

This decrease in research and development expenses is primarily attributable to a $0.2 million reduction in educational grants and clinical studies expenses. In 2007, we focused our research dollars on those areas in which cryoablation research is required to substantiate reimbursement codes and coverage. In addition, these expenses are

generally recognized in conjunction with milestones inherent in the studies and are not always predictable in amount and timing.

 

Selling and Marketing Expenses

 

 

The decrease in selling and marketing expenses is due mainly to reductions in travel and entertainment costs, consulting costs, depreciation and amortization, and advertising, trade shows and related expenses totaling $1.4 million for the year ended December 31, 2007. These reductions were offset by increases in compensation and related costs in the amount of $1.1 million. Included in selling and marketing expenses for the years ended December 31, 2007 and 2006 were $0.7 million and $0.6 million, respectively, in non-cash stock-based compensation expense related to stock options, deferred stock units and restricted stock units.

 

General and Administrative Expenses

 

 

As a result of our concerted effort to reduce costs, our audit, accounting, insurance, professional and consulting fees decreased by over $1.3 million for the year ended December 31, 2007 as compared to the same period in 2006. In 2006, we wrote off a $0.3 million note receivable from a related party that was deemed uncollectible, which was a one time event. In addition, we reduced the carrying value of the $1.4 million note receivable from Plethora relating to the sale of Timm Medical to $1.1 million in the fourth quarter of 2006 in anticipation of the acceptance of a discount in exchange for early repayment. No agreement was ultimately reached and we reinstated the note receivable to its face value in the third quarter of 2007. The note was collected in February 2008 upon scheduled maturity.

 

These decreases were partially offset by increased legal fees of $0.2 million generated by law firms representing the former officers and former directors in connection with ongoing SEC and DOJ investigations and legal proceedings. Also, in 2007, we recorded a $0.1 million benefit for payroll tax liabilities that were no longer statutorily due, compared to a similar benefit in the amount of $0.9 million in 2006. Included in general and administrative expenses for the year ended December 31, 2007 and December 31, 2006 were $3.0 million and $2.0 million, respectively, of non-cash stock-based compensation expense related to stock options, deferred stock units and restricted stock units.

 

Litigation Settlement, Net of Related Legal Expenses

 

 

In the third quarter of 2007, we recorded a gain of $0.7 million for litigation settlement, net of related legal expenses. This amount relates to the settlement with KPMG LLP, our former independent auditor, for claims of professional negligence and breach of contract in the amount of $1.0 million for damages and $0.2 million for

recovery of audit fees paid. We were required to pay one-third of the settlement amount and one-third of the returned fees to our outside litigation counsel.

 

Interest Income, Net

 

 

Interest income (expense), net in the 2007 and 2006 periods includes interest income on a note receivable from the 2003 sale of our urinary incontinence product line and income earned on the investment of our cash balances. The 2007 amount also includes $0.1 million in interest income on the note receivable from Plethora related to the 2006 sale of Timm Medical. We suspended interest accrual on the note in 2006 and resumed accrual in 2007. The note and related interest receivable was collected in February 2008. The increase in interest income in 2007 was offset by $0.1 million of interest expense on the credit line.

 

Interest Expense Related to Common Stock Warrants

 

 

For the year ended December 31, 2006, the negative interest expense on common stock warrants resulted from a decrease in the fair value of common stock warrants related to our March 2005 private placement. As a result of a provision for liquidated damages under a related registration rights agreement, these warrants were accounted for as derivatives through December 31, 2006 and were carried at fair value with changes in fair value recorded through interest expense. Effective January 1, 2007, we adopted FASB Staff Position (FSP) EITF No. 00-19-02, Accounting for Registration Payment Arrangements, which no longer requires the warrants to be recorded as a liability and no interest expense was recorded for these warrants during the year ended December 31, 2007. See Note 6 — “Private Placement of Common Stock and Warrants” in the notes to our consolidated financial statements for further discussion.

 

Loss from Continuing Operations

 

 

Loss from continuing operations for the year ended December 31, 2007 was $0.80 per basic and diluted share on 11.1 million weighted average shares outstanding compared to a loss from continuing operations of $1.10 per basic and diluted share on 10.1 million weighted average shares outstanding for 2006. Losses decreased in 2007 due to a $4.3 million increase in gross profit over 2006, lower spending across all major expense categories and a $0.7 million gain on a litigation settlement. This was partially offset by non-cash expenses including $3.9 million of stock-based compensation expense in 2007, compared to $2.8 million in 2006, and a negative interest expense of $3.7 million in 2006 from the change in the fair value of common stock warrants which did not occur in 2007.

Income from Discontinued Operations

 

 

Income from discontinued operations for the year ended December 31, 2006 represents the operating results of Timm Medical through the date of sale on February 10, 2006. Income for the 2006 period was $0.03 per basic and diluted share on 10.1 million weighted average shares outstanding. The 2006 income included a $0.5 million gain on the sale of Timm Medical and a tax provision of $0.2 million.

 

Net Loss

 

 

Net loss for the year ended December 31, 2007 was $0.80 per basic and diluted share on 11.1 million weighted average shares outstanding, compared to a net loss of $1.07 per basic and diluted share on 10.1 million weighted average shares outstanding during the same period in 2006.

 

Off Balance Sheet Financing

 

Other than lease commitments, legal contingencies incurred in the normal course of business, obligations under royalty and joint technology development arrangements and employment contracts, we do not have any off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K. In addition, our policy is not to enter into derivative instruments, futures or forward contracts. Our business is transacted solely in U.S. dollars and, while future fluctuations of the U.S. dollar may affect the price competitiveness of our products, there is no known significant direct foreign currency exchange rate risk. Finally, we do not have any majority-owned subsidiaries or any interests in, or relationships with, any material special-purpose entities that are not included in the consolidated financial statements.

 

Liquidity and Capital Resources

 

Since inception, we have incurred losses from operations and have reported negative cash flows. As of December 31, 2008, we had cash and cash equivalents of $2.7 million. We do not expect to reach positive adjusted Earnings Before Income Tax, Depreciation and Amortization (“EBITDA”) on an annual basis in 2009, and, both as a standalone company and as a combined company after the Merger, we expect to continue to generate losses from operations for the foreseeable future.

 

We face large cash expenditures in the future related to past due state and local taxes, primarily sales and use tax obligations, which we estimate to be approximately $2.2 million. The amount was fully accrued as of December 31, 2008. We are in the process of negotiating resolutions of the past due state and local tax obligations with the applicable tax authorities. However, there is no assurance that these obligations will be reduced as a result of the negotiations or that we will be allowed to pay the amounts due over an extended period of time.

 

During the year ended December 31, 2008, we incurred $2.4 million of expenses in relation to potential strategic transactions, including the Merger. We will incur an estimated $1.1 million in additional transaction related expenses in 2009 to complete the Merger and Financing. At closing, we will pay total transaction fees of approximately $1 million from the Financing proceeds to our investment banker. Merger related expenditures are recorded as general and administrative expenses as incurred since the Merger will be completed in 2009 and these costs are required to be expensed under Statement of Financial Accounting Standards (SFAS) No. 141(R), Business Combinations. In addition, we anticipate significant cash expenditures in connection with post-closing integration

activities. Consummation of the Merger, including post-closing integration costs, or, if the Merger is not consummated, any continued exploration of other strategic alternatives, is expected to continue to require a significant use of cash.

 

We have historically financed our operations and growth through borrowings and equity financings. In the short term, we expect to use existing cash reserves, working capital through the sale of our products and our credit facility to fund operations until we complete the Merger. If the Merger and Financing are consummated, the proceeds of the Financing will be used to finance the operations, integration costs and other cash flow needs of the combined company. The gross proceeds to Endocare of the Financing are expected to be approximately $16.25 million. We believe that the proceeds from the Financing along with expected expense reductions from eliminating duplicate or redundant facilities, infrastructure and functions will be adequate to enable the post-merger combined company to ultimately reach positive adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). The closing of the Financing is subject to the concurrent closing of the Merger and certain other conditions including the sale of shares in the Financing with a minimum aggregate purchase price of $12,000,000.

 

Our cash needs are not entirely predictable. The future availability of funds from our bank credit facility is subject to many conditions, including the subjective acceleration clause and other provisions that are predicated on events not within our control. The funds we can borrow are based on eligible trade receivables and inventory as defined. The credit facility includes a subjective acceleration clause and a requirement to maintain a lock box with the lender, the proceeds from which will be applied to reduce the outstanding borrowings upon our default or if other borrowing conditions are met.

 

In 2008, we borrowed an additional $1.0 million under our credit facility, bringing the total amount currently outstanding under the credit facility to $1.9 million. As of December 31, 2008, there was $2.1 million available for additional borrowing under the credit facility. On February 26, 2009 the credit facility was extended to expire on May 27, 2009.

 

Our credit facility contains a minimum tangible net worth covenant measured on a monthly basis. We were not in compliance with this covenant as of December 31, 2008 and January 31, 2009. In connection with the extension we executed on February 26, 2009, the lender granted us a waiver of the noncompliance, redefined the tangible net worth requirement and established a new lower tangible net worth covenant for the months from February through April 2009. We are in discussions with the lender to obtain more permanent long-term financing although such financing may not be available or available on terms acceptable to us.

 

There is no assurance that the Merger and Financing will occur and we cannot guarantee that we will be able to obtain permanent long-term financing or the availability of these capital resources or that they will be sufficient to fund our ongoing operations to the point where we can generate positive cash flows on a consistent basis. In light of the investments required to fund our operations and growth initiatives, we will continue to assess the adequacy of our capital resources and may need to use existing and new sources of capital to finance the growth of the business. If the Merger and Financing are not consummated, Endocare, as a standalone company, expects that it will need to raise additional capital during 2009 to fund its ongoing operations. Should such financing be unavailable or prohibitively expensive when we require it, the consequences would have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our continuing losses, cashflow deficits and obligations along with the contingencies in our funding sources, together raise substantial doubt about our ability to continue as a going concern. As a result, our independent registered public accounting firm’s report on our financial statements as of and for the fiscal year ended December 31, 2008 includes an explanatory statement expressing substantial doubt about our ability to continue as a going concern. The 2008 consolidated financial statements included in this Form S-4 have been prepared assuming that we will continue as a going concern and do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or amounts and classification of liabilities that may result from the outcome of this uncertainty.

Critical Accounting Policies

 

The foregoing discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of the financial statements requires management to make estimates and assumptions in applying certain critical accounting policies. Certain accounting estimates are particularly sensitive because of their significance to our consolidated financial statements and because of the possibility that future events affecting the estimates could differ significantly from current expectations. Factors that could possibly cause actual amounts to differ from current estimates relate to various risks and uncertainties inherent in our business, including those set forth under “Risk Factors” in this Form S-4. Management believes that the following are some of the more critical judgment areas in the application of accounting policies that affect our financial statements.

 

Revenue Recognition.  We follow the provisions of Staff Accounting Bulletin 104, “Revenue Recognition in Financial Statements” (SAB 104) and Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” for revenue recognition. Under SAB 104, four conditions must be met before revenue can be recognized: (i) there is persuasive evidence that an arrangement exists, (ii) delivery has occurred or service has been rendered, (iii) the price is fixed or determinable and (iv) collection is reasonably assured.

 

We reduce our revenues for customer concessions, and defer revenue recognition for minimum procedure guarantees, contingent payment arrangements and when we have continuing performance obligations until a future date when the contingencies are resolved and obligations met.

 

Where we own the equipment used in the procedure, we bill the medical facility and retain the entire procedure fee. In many instances, however, the equipment is owned by a third-party who contracts with us to perform the service component of the procedure. Third-party service providers are at times entities owned or controlled by urologists who perform cryoablation procedures. In the latter case, we still invoice the medical facility but we pay a fee to the third-party service provider. The procedure fee is recorded as revenue in the period when the procedure is performed and, where applicable, the fee paid to a third-party service provider is included in cost of revenues for the same period.

 

From time to time we provide loaner equipment to customers as part of a strategy aimed at promoting broader acceptance of our technology and driving sales of disposable products faster than would be possible if we restricted use of the device only to customers willing to make a significant capital investment to purchase a Cryocare Surgical System. In these situations, we either loan a mobile Cryocare Surgical System to a hospital or consign a stationary Cryocare Surgical System with the hospital under our placement program and charge a fee for each procedure in which the equipment is used. Cost of revenues includes depreciation on the Cryocare Surgical Systems we own over an estimated useful life of three years. We have also reduced the selling price of our Cryocare Surgical System to at or near cost to promote sales of our cryoablation disposable products.

 

Under certain circumstances, we will upgrade our older model Cryocare Surgical Systems for our new model with select customers. The terms of the upgrade can include the trade-in of an older system for a refurbished system at no additional cost to the customer, or a trade-in of an older system plus cash for a refurbished or new Cryocare Surgical System. These upgrades are not part of a bundled arrangement conditioned upon past or future purchases of our products. They are offered at our election as a means to introduce our latest technology to the market place. The older systems received in the trade are then redeployed for interventional radiology procedures or sold in secondary markets. When these upgrades take place, we invoice the customer for the upgraded Cryocare Surgical System and expense the cost of the system upon shipment. If we determine that there will be a loss on the trade, we may record the loss at the time the commitment is made. We recognize revenue to the extent of the cash consideration upon shipment. We do not assign a value to the older trade-in system since they generally have exceeded our estimated useful life of three years

 

We routinely assess the financial strength of our customers and, as a consequence, believe that our accounts receivable credit risk exposure is limited. Accounts receivable are carried at original invoice amount less all discounts and allowances, and less an estimate for doubtful accounts and sales returns based on a periodic review of outstanding receivables. Allowances are provided for known and anticipated credit losses as determined by management in the course of regularly evaluating individual customer receivables. This evaluation takes into

consideration a customer’s financial condition and credit history as well as current economic conditions. Accounts receivable are written off when deemed uncollectible. Recoveries of accounts receivable previously written off are recorded when received.

 

Impairment of Long-Lived Assets.  We have a significant amount of property, equipment and amortizable intangible assets primarily consisting of purchased patents and acquired technology. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, we review our long-lived assets and identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Recoverability of long-lived and amortizable intangible assets to be held and used is measured by a comparison of the carrying amount of an asset to the undiscounted future net operating cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying value of the assets exceeds their fair value.

 

Legal and Other Loss Contingencies.  In the normal course of business, we are subject to contingencies, such as legal proceedings and claims arising out of our business that cover a wide range of matters, including tax matters, product liability and workers’ compensation. In accordance with SFAS No. 5, Accounting for Contingencies, we record accruals for such contingencies when it is probable that a liability will be incurred and the amount of loss can be reasonably estimated. A significant amount of management estimation is required in determining when, or if, an accrual should be recorded for a contingent matter and the amount of such accrual, if any. Due to the uncertainty of determining the likelihood of a future event occurring and the potential financial statement impact of such an event, it is possible that upon further development or resolution of a contingent matter, a charge could be recorded in a future period that would be material to our consolidated results of operations, financial position or cash flows.

 

Other Investments.  We review our equity investments for impairment based on our determination of whether a decline in the market value of the investment below our carrying value is other than temporary. In making this determination, we consider SFAS No. 157, Fair Value Measurements, and FASB Staff Accounting Position (FSP) FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which set forth factors to be evaluated in determining whether a loss in value should be recognized. Factors include the investee’s operational performance, indicators of continued viability, financing status, liquidity prospects and cash flow forecasts. We also consider our ability to hold the investment until we recover our cost, the market price and market price fluctuations of the investee’s shares if they are publicly traded and the ability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. In addition, we assess if these equity investees constitute variable interest entities and are required to be consolidated under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.

 

Income Taxes.  In the preparation of our consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate, including estimating both actual current tax exposure and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. Assessment of actual current tax exposure includes assessing tax strategies, the status of tax audits and open audit periods with the taxing authorities. To the extent that we have deferred tax assets, we must assess the likelihood that our deferred tax assets will be recovered from taxable temporary differences, tax strategies or future taxable income and to the extent that we believe that recovery is not likely, we must establish a valuation allowance. As of December 31, 2008 we have established a full valuation allowance of $4.7 million against our deferred tax assets due to our history of operating losses. In the future, we may adjust our estimates of the amount of valuation allowance needed and such adjustment would impact our provision for income taxes in the period of such change. Effective January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109 (FIN 48). FIN 48 prescribes a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements.

 

Stock based Compensation.  As a normal practice, we compensate employees and non-employee directors through stock-based compensation. We account for our stock-based compensation under the provisions of SFAS No. 123R, Share-Based Payments. SFAS No. 123R requires companies to recognize in the financial statements the cost of employee services received in exchange for awards of equity instruments based on the

grant date fair value of those awards that are expected to vest. The estimation of stock-based compensation requires the use of complex option pricing models and application of judgment in selecting the appropriate valuation assumptions, as such volatility, forfeiture rates and expected term. We value our stock-based compensation using the Black-Scholes option pricing model and the single option award approach, in accordance with the requirements of SFAS No. 123R and Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment. We reduce our compensation expense for estimated forfeitures based on historical forfeiture behavior, excluding unusual events or behavior that is not indicative of future expectations. In addition, certain equity awards vest based on performance conditions, such as sales and profitability goals. Compensation expense is recorded only if it is probable that the award will vest. Assessing whether the milestones will be met and the implicit service period requires significant judgment. We re-assess the appropriateness of the milestone and valuation assumptions, including our calculated forfeiture rate, on a quarterly basis or when events or changes in circumstances warrant a re-evaluation. In addition, we monitor equity instruments with non-standard provisions, such as performance-based vesting conditions, accelerated vesting based on achievement of performance milestones and features that require the instruments to be accounted for as liabilities.

 

Inflation

 

The impact of inflation on our business has not been significant to date.

 

 

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our invested cash without significantly increasing the risk of loss. Our financial instruments include cash, cash equivalents, accounts and notes receivable, minority investments, accounts payable, accrued liabilities, and a line of credit. Our policy is not to enter into derivative financial instruments. In addition, we do not enter into any futures or forward contracts and therefore, we do not have significant market risk exposure with respect to commodity prices.

 

As of December 31, 2008, $2.0 million of our cash is invested in a money market mutual fund (the Citi Institutional Liquid Reserves) that includes in its investment portfolio commercial paper, time deposits, certificates of deposits, bank notes, corporate bonds and notes and U.S. government agency securities. Although the fund seeks to preserve the value of the investment at $1.00 per share, it is possible to lose our principal if the underlying securities suffer losses. As of January 31, 2009, the fund reported that certain securities within the portfolio are illiquid, in default, under restructuring or have been subject to a ratings downgrade. However, the fund continues to report a per share net asset value (NAV) of $1.00, representing the price at which investors buy (“bid price”) and sell (“redemption price”) fund shares from and to the fund company. The NAV is computed once at the end of each trading day based on the closing market prices of the portfolio’s securities. We believe that our investment has not been impaired and that we can withdraw our funds at any time without restriction. Effective September 2008, the federal government provided a temporary guarantee through April 30, 2009 on all publicly traded or regulated money market mutual funds that elect to participate in the program. The guarantee may be extended through September 18, 2009 at the discretion of the U.S. Treasury Department. We will continue to monitor the value of the fund periodically for potential indicators of impairment.

 

Although we transact our business in U.S. dollars, future fluctuations in the value of the U.S. dollar may affect the price competitiveness of our products. However, we do not believe that we currently have any significant direct foreign currency exchange rate risk and have not hedged exposures denominated in foreign currencies or any other derivative financial instruments.

 

 

Our financial statements and schedule, as listed under Item 15, appear in a separate section of this Annual Report on Form 10-K beginning on page F-1.

 

 

Not applicable.

 

(a) Evaluation of Disclosure Controls and Procedures.  We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports pursuant to the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level.

 

(b) Management’s Annual Report on Internal Control Over Financial Reporting.  Management of the company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that:

 

(i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;

 

(ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

 

(iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework.

 

Based on our assessment and those criteria, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2008.

 

The Company’s independent registered public accounting firm has issued an attestation report on the Company’s internal control over financial reporting. That report appears below in this Item 9A.

 

(c) Changes in Internal Controls.  There was no change in our internal control over financial reporting during our fourth fiscal quarter for 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders of

Endocare, Inc.

 

We have audited Endocare Inc.’s (the Company’s) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Endocare, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Endocare, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Endocare, Inc. as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008 and our report dated March 6, 2009 expressed an unqualified opinion thereon that included an explanatory paragraph regarding Endocare’s ability to continue as a going concern.

 

 

Los Angeles, California

March 6, 2009

 

Not applicable.

 

 

Directors

 

Information is set forth below concerning the current members of Endocare’s board of directors.

 

 

 

 

John R. Daniels, M.D. has served as a director since January 2004. Dr. Daniels is former chief executive officer and chairman at a number of medical technology companies, as well as an accomplished clinician and past faculty member of the Stanford University School of Medicine. From 1990 to the present, Dr. Daniels has served as an associate professor of medicine in the Division of Oncology at the University of Southern California School of Medicine. Dr. Daniels is the founder or co-founder of five start-up companies, including: Collagen Corporation, which was acquired by Inamed, a publicly-traded healthcare company; Target Therapeutics, today a division of Boston Scientific Corporation, a publicly-traded medical device company; and Balance Pharmaceuticals, a company founded in 1992 to develop and market a drug to moderate hormone levels in pre-menopausal women. Dr. Daniels is currently a director and Chairman of Balance Pharmaceuticals. From 1997 until 2002, Dr. Daniels was Chairman of Cohesion Technologies, a publicly-traded spin-off from Collagen Corporation, which developed sealing technologies for surgery. In 2003 Cohesion Technologies was acquired by Angiotech Pharmaceuticals, a publicly-traded company that develops drug-coated medical devices and drug-loaded surgical implants. Dr. Daniels holds a B.A. from Stanford University and an M.D. from the Stanford University School of Medicine.

 

David L. Goldsmith has served as a director since June 2005 and was named Interim Chairman of the Board in March 2009. A private investor and business consultant since 2004, Mr. Goldsmith previously served as Managing Director of RS Investment Management, an investment management firm, from 1999 to 2003. From 1981 to 1999, Mr. Goldsmith held a variety of investment management and research positions at Robertson Stephens and Company. From 1978 to 1981, Mr. Goldsmith worked with BA Investment Management, eventually becoming Associate Director of Research. Mr. Goldsmith currently serves as Chairman of the Board of Directors of Apria Healthcare Group, Inc. He is also on the board of directors of a number of privately-held companies. Mr. Goldsmith is a chartered financial analyst, and holds a B.A. from Occidental College and an M.B.A. from Columbia University Graduate School of Business.

 

Eric S. Kentor has served as a director since February 2005 and currently serves as Chairman of the Compensation Committee. From 2002 to the present, he has been an independent business consultant, primarily to health care technology companies. From 1995 to 2001, he was Senior Vice President, General Counsel and Corporate Secretary of MiniMed, Inc., a company engaged in the design, development, manufacture and marketing of advanced systems for the treatment of diabetes. Mr. Kentor also served as an original and permanent member of MiniMed’s Executive Management Committee. From 1994 to 1995, Mr. Kentor served as Vice President and

Executive Counsel of Health Net Health Plans. From 1987 to 1994, Mr. Kentor practiced with the law firm McDermott, Will & Emery, where he was elected partner. Mr. Kentor holds a B.A. from the University of California, Los Angeles and a J.D. from UCLA School of Law.

 

Terrence A. Noonan has served as a director of Endocare since September 2003. From October 2008 to March 2009 Mr. Noonan served as our Interim Chief Executive Officer, President and Chairman. From 1991 to 1999, Mr. Noonan was President and Chief Operating Officer of Furon Company, a New York Stock Exchange-listed manufacturer of industrial and medical polymer components. Mr. Noonan served as an Executive Vice President of Furon from 1989 to 1991 and as a Vice President of Furon from 1987 to 1989. Prior to joining Furon in 1987, Mr. Noonan served as a Group Vice President of Eaton Corporation, a diversified global manufacturer of transportation and electrical products. From 1999 to the present, Mr. Noonan has been serving as a board member to several companies. Mr. Noonan received a B.S. from Miami University and an E.M.B.A. from Case Western Reserve University.

 

Thomas R. Testman has served as a director since April 2003 and currently serves as Chairman of the Audit Committee. Mr. Testman is a former Managing Partner of Ernst & Young LLP where, during his tenure from 1962 to 1992, he served as Managing Partner of both Health Care Services and Management Consulting Services for the West Coast and National Practices. He also served as an area Managing Partner for the audit and tax practices. From 1993 to the present, Mr. Testman has been serving as a board member to both public and private companies. Mr. Testman recently served as a director and member of the Audit Committee of Amylin Pharmaceuticals, Inc. From 1996 to 2004, Mr. Testman served as a director of Specialty Laboratories, Inc., including serving as Chairman and as a member of the Audit Committee. He also serves or has served on the board of several privately-held companies, including serving as Chairman of Covenant Care, Inc. and Pacific Health Corporation. Mr. Testman previously was a director and Chairman of the Audit Committee of MiniMed Inc. Mr. Testman has also served on numerous professional, civic and charitable organization boards, including the Finance Council of the American Hospital Association and the Advisory Council of the California Hospital Commission. He has an M.B.A. from Trinity University and is a certified public accountant (retired).

 

Executive Officers

 

Endocare’s executive officers are as follows:

 

 

 

 

Michael R. Rodriguez has served as our Senior Vice President, Finance and Chief Financial Officer since August 2004. From January 2004 until August 2004, Mr. Rodriguez served as a consultant to Endocare, providing assistance on a variety of financial and operational projects and compliance with Section 404 of the Sarbanes-Oxley Act. Prior to joining us as a consultant, Mr. Rodriguez served as Executive Vice President and Chief Financial Officer of Directfit, Inc., a provider of information technology staffing services, from June 2000 to November 2003. From September 1997 to June 2000, Mr. Rodriguez held a variety of positions, including Senior Vice President and Chief Financial Officer, with Tickets.com, Inc., a publicly-traded Internet-based provider of entertainment ticketing services and software. From June 1995 to September 1997, Mr. Rodriguez was Corporate Controller and Director of Finance at EDiX Corporation, a medical informatics company. Mr. Rodriguez began his career at Arthur Andersen LLP and was with that firm from 1989 to 1993. Mr. Rodriguez holds a B.S. in accounting from the University of Southern California and an M.B.A. from Stanford University. Mr. Rodriguez is a certified public accountant.

Clint B. Davis joined us in January 2006 as Senior Vice President, Legal Affairs, General Counsel and Secretary. From August 2000 to January 2006, Mr. Davis was a corporate attorney with the San Diego office of Morrison & Foerster LLP. While at Morrison & Foerster, Mr. Davis served as outside counsel to Endocare since January 2003 and represented a number of other life sciences and technology companies in a wide variety of business transactions, contractual arrangements and corporate governance matters. Prior to his employment with Morrison & Foerster, Mr. Davis was a corporate attorney with law firms in Boston and Los Angeles. Mr. Davis holds a B.A. from Rice University and a J.D. from Harvard Law School.

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Securities Exchange Act of 1934 requires our executive officers and directors, and generally persons who own more than 10% of a registered class of our equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission, or SEC. Officers, directors and greater than 10% stockholders are required by SEC regulation to furnish us with copies of all Section 16(a) reports they file. Based solely upon the copies of Section 16(a) reports which we received from such persons or written representations from them regarding their transactions in our common stock, we believe that, during the period from January 1, 2008 through December 31, 2008, all Section 16(a) filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were met in a timely manner.

 

Financial Code of Ethics

 

We have adopted a financial code of ethics that applies to all of our employees. This financial code of ethics constitutes a “code of ethics,” as defined in SEC Regulation S-K Item 406(b). A copy of our current financial code of ethics is available on our website www.endocare.com under the menu item entitled “On Endocare — Corporate Governance Documents.” If we make any amendments to our financial code of ethics, other than technical, administrative or other non-substantive amendments, or grant any waivers, including implicit waivers, from a provision of our financial code of ethics to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, then we will disclose the nature of the amendment or waiver, its effective date and to whom it applies on our website www.endocare.com under the menu item entitled “On Endocare — Corporate Governance Documents” or in a report on Form 8-K filed with the SEC.

 

Audit Committee

 

Our board of directors has established a standing Audit Committee to assist the Board in overseeing the integrity of our financial statements, our compliance with legal and regulatory requirements, the independent auditors’ qualifications and independence and the performance of our internal and independent auditors. The current Chairman of the Audit Committee is Mr. Testman and the other current members of the Audit Committee are Messrs. Goldsmith and Kentor. Our board of directors has determined that Mr. Testman is an “audit committee financial expert,” as defined in SEC Regulation S-K Item 407.

 

2008 SUMMARY COMPENSATION TABLE