S-1/A 1 d415166ds1a.htm AMENDMENT NO. 4 TO FORM S-1 Amendment No. 4 to Form S-1
Table of Contents

As filed with the Securities and Exchange Commission on October 16, 2012

Registration Number 333-177972

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

Amendment No. 4

to

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

APPLIED MEDICAL CORPORATION

(Exact name of Registrant as specified in its charter)

 

Delaware   3841   27-2245891

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

22872 Avenida Empresa

Rancho Santa Margarita, California 92688

(949) 713-8000

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

Said S. Hilal

President and Chief Executive Officer

Applied Medical Corporation

22872 Avenida Empresa

Rancho Santa Margarita, California 92688

(949) 713-8000

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

Copies to:

 

Gregg A. Noel

Brian J. McCarthy

Skadden, Arps, Slate, Meagher & Flom LLP

300 South Grand Avenue

Los Angeles, CA 90071

(213) 687-5000

 

Bruce A. Mann

Andrew D. Thorpe

Morrison & Foerster LLP

425 Market Street

San Francisco, CA 94105-2482

(415) 268-7000

 

 

As soon as practicable after the effective date of this Registration Statement.

(Approximate date of commencement of proposed sale to the public)

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

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

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

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

Indicate by check mark whether there 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):

Large accelerated filer  ¨            Accelerated filer  ¨                   Non-accelerated filer  x             Smaller reporting company  ¨

(Do not check if a smaller reporting company)

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of Each Class of Securities to be Registered   Proposed Maximum
Aggregate Offering Price(1)
 

Amount of

Registration Fee

Class B Common Stock, $0.001 par value per share

  $24,813,132.00   $2,843.58(2)

 

 

(1) Estimated solely for the purpose of computing the amount of the registration fee in accordance with Rule 457(o) promulgated under the Securities Act of 1933.
(2) Previously paid.

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933, OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE.

 

 

 


Table of Contents

The information in this prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

PROSPECTUS (Subject to Completion) Dated October 16, 2012.

 

 

 

LOGO

 

 

729,798 Shares

CLASS B COMMON STOCK

 

This is the initial public offering of Class B common stock of Applied Medical Corporation. No public market currently exists for our shares. The selling stockholders are offering 729,798 shares of our Class B common stock. We will not receive any of the proceeds from the sale of shares by the selling stockholders.

We have been informed by the underwriter that its bona fide estimate of the range of the maximum offering price is between $30.00 and $34.00 per share. We do not intend to apply to list our Class B common stock on any national securities exchange.

 

THE OFFERING    PER SHARE    TOTAL

Public Offering Price

   $                $                    

Placement Agency Fee (1)

   $                $                    

Proceeds to Selling Stockholders

   $                $                    

 

(1) Additional items of underwriting compensation are described in the “Plan of Distribution” section of this prospectus beginning on page 137.

 


OpenIPO® and Best Efforts Offering: The method of distribution being used by the underwriter in this offering differs somewhat from that traditionally employed in firm commitment underwritten public offerings. In particular, the public offering price and allocation of shares will be determined primarily by an auction process conducted by the underwriter participating in this offering. In addition, the selling stockholders are not required to sell any specific number or dollar amount of shares of Class B common stock but the underwriter has agreed to use its best efforts to procure potential purchasers for the shares of Class B common stock offered pursuant to this prospectus. The auction will close and a public offering price will be determined after the registration statement becomes effective. The minimum size of any bid is 100 shares. A more detailed description of the OpenIPO process and the best efforts offering is included in the “Plan of Distribution” section of this prospectus beginning on page 137.

 

 


The underwriter expects to deliver the shares of Class B common stock to purchasers on                    .

This offering involves substantial risk. You should purchase

shares only if you can afford a complete loss of your investment.

See “Risk Factors” beginning on page 9.

 

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

Applied Medical Corporation is an emerging growth company, as defined in Section 2(a) of the Securities Act of 1933.

 

LOGO

The date of this prospectus is      2012.

 


Table of Contents

TABLE OF CONTENTS

 

     Page  

Prospectus Summary

     1   

The Offering

     5   

Summary Consolidated Financial Data

     7   

Risk Factors

     9   

Special Note Regarding Forward-Looking Statements

     42   

Use of Proceeds

     44   

Dividend Policy

     44   

Capitalization

     45   

Dilution

     46   

Selected Consolidated Financial Data

     47   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     49   

Description of Certain Indebtedness

     74   

Business

     76   

Management

     90   

Executive Compensation

     96   

Certain Relationships and Related Party Transactions

     112   

Principal and Selling Stockholders

     118   

Description of Capital Stock

     123   

Shares Eligible for Future Sale

     133   

Material United States Federal Income Tax Consequences to
Non-U.S. Holders

     135   

Plan of Distribution

     139   

Legal Matters

     150   

Experts

     150   

Where You Can Find More Information

     150   

Index to Consolidated Financial Statements

     F-1   

 

 

You should rely only on the information contained in this prospectus and any free-writing prospectus that we authorize to be distributed to you. We have not authorized anyone to provide you with information different from or in addition to that contained in this prospectus or any related free-writing prospectus. If anyone, including the underwriter, provides you with different or inconsistent information, you should not rely on it. In particular, you should not rely on any research reports provided by the underwriter, either through its website or by other means. We specifically disavow any such research reports. We believe that one such research report posted on, and subsequently removed from, the underwriter’s website contained untrue statements of material fact about our business and prospects. The selling stockholders are offering to sell and are seeking offers to buy shares of our Class B common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus and any free-writing prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or any free-writing prospectus or of any sale of the Class B common stock. Our business, financial condition, results of operations and prospects may have changed since that date.


Table of Contents

 

 

 

PROSPECTUS SUMMARY

The following summary highlights information contained elsewhere in this prospectus. It is not complete and does not contain all of the information that you should consider before investing in our Class B common stock. You should read the entire prospectus carefully, especially the risks of investing in our Class B common stock discussed under “Risk Factors” and our consolidated financial statements and accompanying notes. In this prospectus, unless the context otherwise requires, “Applied Medical,” “Applied,” “we,” “us” or “our” refer to Applied Medical Corporation and its subsidiaries.

Applied Medical Corporation

We develop, manufacture and market medical devices for general, colorectal, bariatric, vascular, gynecological, urological and pediatric surgical procedures. We generate revenue by delivering surgical devices that reduce the invasiveness of open procedures and minimize the likelihood of trauma and wound-site infections during these procedures.

Our Mission

Our mission is to improve clinical outcomes and enhance the choices available to end users while increasing the availability and affordability of healthcare in general. We offer our customers the following key benefits:

 

   

Innovation. We have a long history of investing significant portions of our revenues in research and development. As of September 30, 2012, we have compiled a portfolio of 389 issued and 274 pending patents in the U.S., Europe, Japan, Australia and Canada. We respect other parties’ intellectual property and resolutely defend ours from infringers.

 

   

Lower Cost. We strive to reduce the cost of surgical procedures and related supplies. We spend approximately half of our research and development budget on developing reliable processes and automation for manufacturing our products.

 

   

Choices. We are reluctant to eliminate a product choice or an option for the hospital or surgeon. Although we discontinue some older products from time to time, our process for phasing out products is elaborate and takes into consideration our customers’ needs.

 

   

Exceptional Service. We have dedicated considerable time, capital and resources to serve our customers, from training to servicing clinical teams. We have also foregone opportunities for faster growth in order to dedicate time and effort towards updating our customers on the latest innovations and improvements.

 

   

Commitment to Science. We conduct basic scientific research in order to foster our product development. For example, our scientists have enhanced processes for incorporating titanium, gel and other materials into our products.

 

   

Commitment to Independent and Credible Research. We encourage independent clinical research by providing our products and sharing our knowledge regarding treatment protocols with researchers in order to foster better science, research design and implementation, as well as credible and accurate conclusions.

 

   

Commitment to Quality and Regulatory Compliance. We continue to strive towards unequivocal compliance with regulatory requirements, including quality system regulations and related policies and procedures.

While many of our competitors aspire to provide one or more of these benefits, we are committed to delivering all of them. This means that we strive to offer an improved product or outcome at a lower

 

 

 

 

 

1


Table of Contents

 

 

 

cost. We tend to price and sell our products at levels significantly below the prevailing average selling price, or ASP, in the marketplace. Although this approach may not be new in many markets, we believe it differentiates us in the medical device arena. We have remained committed to this approach throughout our 24 years. Our approach has tended to reduce ASPs and, to a great extent, meaningfully shrink the size, based on revenue, of our target markets. We believe that this approach is an efficient way of breaking into some highly contested and often foreclosed market segments.

Our Products

We provide medical devices for surgical procedures in the U.S. and select international markets. Our customers consist of hospitals and out-patient surgical centers. We sell our products to these customers either directly, through distribution agreements with third parties or under arrangements with Group Purchasing Organizations, or GPOs. We have developed direct distribution channels in the U.S., select European countries and Australia. In other countries, we rely on independent distributors who understand our mission and the promise of our brand. Our products are employed by surgeons in a wide variety of general, colorectal, bariatric, vascular, gynecological, urological and pediatric surgical procedures.

We have two principal product lines, which consist of surgical access devices and surgical instruments. Our surgical access products include trocars used in laparoscopic procedures, our GelPort and GelPOINT products used in hand assisted laparoscopic and single-incision procedures, respectively, and our Alexis wound protectors/retractors for open surgical procedures. A trocar is an access port introduced into the patient’s abdomen in laparoscopic surgery, also known as “keyhole surgery,” which is a minimally invasive surgical technique performed in the abdomen through small incisions less than two centimeters, as opposed to open surgery using much larger incisions. Our surgical instrument products include laparoscopic clip appliers, scissors, graspers, dissectors, retrieval systems and a variety of atraumatic clips and clamps used in vascular procedures.

Reasons for this Offering

We are conducting this offering because Institutional Venture Partners IV, L.P., or IVP, and the selling stockholders are compelling us to register the shares of Class B common stock offered hereby by exercising demand registration rights. We and our board of directors believe doing so, under the timing and in the manner demanded by IVP, is not in the best interests of Applied, and that we will derive little benefit from the registration of our Class B common stock, as we do not currently propose or intend to use our common stock to raise capital in the public markets or as acquisition consideration. We have had no discussions with the selling stockholders regarding alternative liquidity events with respect to their demand registration.

Corporate Information

Applied Medical Corporation was incorporated in Delaware in February 2010 to become the holding company for Applied Medical Resources Corporation, which was founded in California in 1987. Our principal executive offices are located at 22872 Avenida Empresa, Rancho Santa Margarita, California 92688, and our telephone number is (949) 713-8000. Our corporate website is www.appliedmedical.com. Information contained on our website is not a part of this prospectus and the inclusion of our website address in this prospectus is an inactive textual reference only.

Trademarks and Logos

Applied Medical, Separator® access system, Universal® seal, GelPort, GelPOINT, Alexis, Fios, Kii, Epix, Inzii, Stealth and the Applied Medical logo are registered trademarks of Applied. This prospectus also includes the registered and unregistered trademarks of other persons.

 

 

 

 

 

2


Table of Contents

 

 

 

Emerging Growth Company Status

We are an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, or the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. As such, we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, reduced disclosure obligations regarding executive compensation, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. We intend to take advantage of any or all of these exemptions, but do not know if some investors will find our Class B common stock less attractive as a result. The result may be a less active trading market for our Class B common stock and our stock price may be more volatile.

In addition, Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with accounting standards newly issued or revised after April 5, 2012. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We intend to take advantage of the benefits of this extended transition period.

We could remain an “emerging growth company” for up to five years, or until the earliest of (a) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (b) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Securities Exchange Act of 1934, or Exchange Act, which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, (c) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three-year period, or (d) the last day of the fiscal year following the fifth anniversary of our initial public offering of common equity securities.

Summary Risk Factors

This offering and our business are subject to numerous risks described in the section entitled “Risk Factors” and elsewhere in this prospectus. You should carefully consider these risks before making an investment. Some of these risks include:

 

   

this offering is made at the demand of the selling stockholders and IVP, and our board of directors and executive officers believe this offering is not in the best interests of Applied;

 

   

the underwriter’s estimate of the range of initial public offering prices was established without consultation with us;

 

   

our stock price could decline significantly and rapidly following this offering;

 

   

liquidity and trading volume of our Class B common stock may be limited as a result of the unique circumstances of this offering;

 

   

our business is highly competitive, and competition presents an ongoing threat to the success of our business;

 

   

we may not be able to sustain our position in the trocar market;

 

   

our reliance on research and development efforts, innovation and long-term investments in capital expenditures may not allow us to remain competitive;

 

 

 

 

 

3


Table of Contents

 

 

 

 

   

this offering and operating as a public company may negatively impact the creativity, initiative and teamwork fostered by our unique culture;

 

   

our business is subject to complex and evolving U.S. and foreign laws and regulations regarding manufacturing and distribution of medical devices;

 

   

three of our executive officers have control over key decision making as a result of a voting agreement among holders of over a majority of our voting stock;

 

   

the loss of Said Hilal, Nabil Hilal, Ted Stanley, Gary Johnson or Samir Tall or other key team members could harm our business;

 

   

there are risks associated with the auction process for this offering;

 

   

the market price of our Class B common stock may be volatile or may decline, and you may not be able to resell your shares at or above the initial public offering price; and

 

   

our Class B common stock could be less attractive to investors if we take advantage of certain exemptions from reporting requirements available to emerging growth companies.

 

 

 

 

 

4


Table of Contents

 

 

 

THE OFFERING

 

Class B common stock offered by the selling stockholders

729,798 shares

 

Class B common stock to be outstanding after this offering

13,040,623 shares

 

Class A common stock to be outstanding after this offering

153,739 shares

 

Preferred stock to be outstanding after this offering

6,266,171 shares

 

Total Class A and Class B common stock and preferred stock to be outstanding after this offering

19,460,533 shares

 

Voting, conversion and other rights

The rights of holders of Class A common stock and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one vote. Each share of Class B common stock is entitled to ten votes and is convertible at any time into one share of Class A common stock.

 

  Each share of preferred stock at the option of the holder thereof is convertible at any time into one share of Class B common stock, subject to adjustment in certain circumstances. Each share of preferred stock is subject to automatic conversion into shares of Class B common stock upon the occurrence of certain events, including a public offering of our common stock in a firm-commitment underwriting. See “Description of Capital Stock—Preferred Stock” for a summary of the additional rights, privileges and preferences to which the preferred stock is entitled.

 

Use of proceeds

We will not receive any proceeds from this offering.

Except as otherwise indicated, all share information in this prospectus is based on 153,739 shares of Class A common stock, 12,310,825 shares of Class B common stock and 6,995,969 shares of preferred stock outstanding as of June 30, 2012 and:

 

   

assumes the conversion of 729,798 outstanding shares of our preferred stock into 729,798 shares of Class B common stock;

 

   

excludes 37,950 shares of Class B common stock that we have repurchased from Mr. T. Peter Thomas, a former member of our board of directors, pending Mr. Thomas’ compliance with the repurchase provisions of the applicable stock option agreements;

 

 

 

 

 

5


Table of Contents

 

 

 

 

   

excludes 6,313 shares and 36,640 shares of Class A and Class B common stock, respectively, which were held in treasury;

 

   

includes 45,531 shares and 1,066,856 shares of Class A and Class B common stock, respectively, which were obtained with nonrecourse notes receivable or pursuant to an early exercise feature, which shares are not presented as outstanding in the accompanying consolidated financial statements;

 

   

excludes 43,600 shares of Class A common stock and 2,968,694 shares of Class B common stock issuable upon exercise of outstanding stock options that have been granted under our stock incentive plans; and

 

   

excludes 2,535,871 shares of Class A common stock and Class B common stock available for future grant or issuance under our Third Amended and Restated 2008 Stock Incentive Plan.

 

 

 

 

 

6


Table of Contents

 

 

 

SUMMARY CONSOLIDATED FINANCIAL DATA

The following table presents summary consolidated historical financial data. We derived the summary income statement data for the years ended December 31, 2010 and 2011 and the summary balance sheet data as of December 31, 2010 and 2011 from our audited consolidated financial statements and notes thereto included in this prospectus. We derived the summary income statement data for the six months ended June 30, 2011 and 2012 and the summary balance sheet data as of June 30, 2012 from our unaudited consolidated financial statements and notes thereto included in this prospectus. We have prepared this unaudited information on the same basis as the audited financial statements and have included all adjustments, consisting of normal recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results for such periods. Our historical results are not necessarily indicative of the results that may be expected in the future. You should read this data together with our consolidated financial statements and the notes thereto, “Selected Consolidated Financial Data,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this prospectus.

 

     Year Ended December 31,     Six Months Ended June 30,  
           2010                  2011           2011
(unaudited)
     2012
(unaudited)
 
     (in thousands, except per share information)  

Consolidated Income Statement Data:

          

Revenues:

          

Product revenue

   $ 271,810       $ 338,453      $ 159,991       $ 178,975   

Royalties and licensing revenue

     10,365         11,631        6,859         3,029   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total revenues

     282,175         350,084        166,850         182,004   

Cost of revenues

     55,041         69,634        32,139         36,959   
  

 

 

    

 

 

   

 

 

    

 

 

 

Gross profit

     227,134         280,450        134,711         145,045   
  

 

 

    

 

 

   

 

 

    

 

 

 

Operating expenses:

          

Selling, general and administrative

     156,781         169,803        76,044         90,438   

Research and development

     38,308         48,340        21,975         29,782   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total operating expenses

     195,089         218,143        98,019         120,220   
  

 

 

    

 

 

   

 

 

    

 

 

 

Operating income

     32,045         62,307        36,692         24,825   
  

 

 

    

 

 

   

 

 

    

 

 

 

Other income (expense):

          

Interest and other income

     1,007         1,299        617         904   

Interest expense

     (2,358      (2,069     (1,109      (2,038
  

 

 

    

 

 

   

 

 

    

 

 

 

Other expense, net

     (1,351      (770     (492      (1,134
  

 

 

    

 

 

   

 

 

    

 

 

 

Income before provision for income taxes

     30,694         61,537        36,200         23,691   

Provision for income taxes

     9,809         17,162        10,279         8,559   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net income

     20,885         44,375        25,921         15,132   
  

 

 

    

 

 

   

 

 

    

 

 

 

Other comprehensive income (loss)

          

Foreign currency translation adjustments

     680         (1,425     3,742         (1,842

Unrealized gain on long-term investments, net
of tax

     —           —          —           479   
  

 

 

    

 

 

   

 

 

    

 

 

 

Other comprehensive income (loss)

     680         (1,425     3,742         (1,363
  

 

 

    

 

 

   

 

 

    

 

 

 

Comprehensive income

   $ 21,565       $ 42,950      $ 29,663       $ 13,769   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net income attributable to common stockholders

   $ 11,667       $ 27,097      $ 15,853       $ 9,283   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net income per share:

          

Basic

   $ 1.19       $ 2.30      $ 1.37       $ 0.75   
  

 

 

    

 

 

   

 

 

    

 

 

 

Diluted

   $ 1.18       $ 2.20      $ 1.32       $ 0.74   
  

 

 

    

 

 

   

 

 

    

 

 

 

Weighted-average number of common shares:

          

Basic

     9,785         11,793        11,611         12,370   
  

 

 

    

 

 

   

 

 

    

 

 

 

Diluted

     9,901         12,305        12,021         12,596   
  

 

 

    

 

 

   

 

 

    

 

 

 

 

 

 

 

 

7


Table of Contents

 

 

 

 

     As of December 31,      As of June 30,  
Consolidated Balance Sheet Data:    2010      2011      2012  
                   (unaudited)  
     (in thousands)  

Cash and cash equivalents

   $ 52,789       $ 59,870       $ 63,934   

Property, plant and equipment

     122,583         163,940         206,299   

Total assets

     235,652         315,098         377,767   

Total long-term liabilities

     61,910         75,006         92,848   

Redeemable convertible preferred stock

     14,118         14,106         14,106   

Total stockholders’ equity

     114,203         162,125         180,641   

 

 

 

 

 

8


Table of Contents

RISK FACTORS

You should carefully consider the risks described below before making a decision to buy our Class B common stock. If any of the following risks actually occur, our business, financial condition and results of operations could be harmed. In that case, the trading price of our Class B common stock could decline and you might lose all or part of your investment. You should also refer to the other information set forth in this prospectus, including our consolidated financial statements and related notes.

Special Risks Related to this Offering

Institutional Venture Partners IV, L.P. is compelling us to register the shares of Class B common stock offered hereby by exercising demand registration rights and selecting an underwriter of its own choosing. While we intend to comply with our obligations under the Master Rights Agreement, our board of directors and executive officers believe that filing the registration statement of which this prospectus is a part and effecting an initial public offering of our Class B common stock are not in the best interests of Applied.

Institutional Venture Partners IV, L.P., or IVP, is compelling us to register shares of its Class B common stock for sale by means of an initial public offering. Applied and its board of directors believe doing so, under the timing and in the manner demanded by IVP, is not in the best interests of Applied.

We and certain of our stockholders are parties to an Amended and Restated Master Rights Agreement, dated as of November 8, 1991, or the Master Rights Agreement. Under the demand registration rights provisions of the Master Rights Agreement, holders of at least 50% of the shares having registration rights may request that we file a registration statement for the resale of their shares under the Securities Act. Our registration obligations are subject to the terms and conditions of the Master Rights Agreement, including our right to defer our registration obligations for up to 90 days under certain conditions. On August 25, 2011, IVP notified us of its original request for registration of our Class A common stock. IVP’s initial request for registration called for the registration of 4,417,456 shares of Class A common stock for sale by IVP and its affiliated partners. Beginning on February 24, 2012, we received multiple correspondence from Morrison & Foerster LLP (counsel to WR Hambrecht + Co) and certain of our stockholders, including IVP, requesting significant changes to a number of key aspects of the structure of the original request for registration by IVP, including the class of our securities to be registered and the number of shares to be sold. We have concluded that such correspondence constitutes an election to initiate a new demand registration under the Master Rights Agreement with respect to our Class B common stock. Bank of America Ventures, Pantheon International Participations PLC, Landmark Equity Partners, other stockholders affiliated with IVP and the other selling stockholders identified herein have elected to participate in this restructured offering pursuant to the registration rights provisions of the Master Rights Agreement. IVP has determined not to offer any shares or convert any of its preferred stock into common stock. IVP and the participating selling stockholders have informed us that they would not approve certain amendments to our certificate of incorporation which were expected to be made on the basis of IVP’s initial request for registration of shares of Class A common stock.

WR Hambrecht + Co was selected as the underwriter for this offering by IVP, not by us. WR Hambrecht + Co has not communicated or cooperated with us to the extent that we would have expected from an underwriter in an initial public offering. In addition, we believe that WR Hambrecht + Co may be taking actions that are not in the best interests of us, our stockholders and potential investors. For example, WR Hambrecht + Co posted on its “OpenIPO” website a research report about Applied prepared by DBK Consulting under a consulting arrangement with WR Hambrecht + Co. We believe several statements in this research report, as posted, were directly contradictory to information included in this prospectus, and other statements in this research report reflected opinions about our

 

9


Table of Contents

industry that are contrary to our management’s view. We believe WR Hambrecht + Co made this research report available without determining that the content of the report contains no untrue statements of material fact or is otherwise not false or misleading. We informed WR Hambrecht + Co of certain statements in the DBK Consulting report which are false or misleading, in response to which WR Hambrecht + Co removed the report from its website pending its review of the contents of the report. We have demanded that WR Hambrecht + Co inform potential investors that they should not rely on any such report. We specifically disavow the content of the DBK Consulting research report. You should not take any such report into account at all when making a decision whether or not to buy our Class B common stock.

As a result of the registration of shares of our Class B common stock for sale under the Securities Act, we will be required to incur the time and costs associated with the preparation of filings with the U.S. Securities Exchange Commission, or the SEC, including reports required by the Exchange Act. As a consequence of making these filings with the SEC, detailed information regarding Applied and our stockholders will be fully available for review by any member of the public. In addition, the costs associated with these reports and other filing obligations will constitute significant additional overhead expense. These costs include professional fees for our independent registered public accounting firm and corporate/securities counsel, printing and mailing costs and internal compliance costs. Because we will be a public company, we may be required to publicly disclose information that we consider sensitive, including product development activities, margin and significant customer and project information, which information will be available to our competitors. We will also incur substantial costs as a result of, among other things, management’s time expended in preparing and reviewing such filings.

At the same time, our board of directors believes that we will derive little benefit from the registration of our Class B common stock, as we do not currently propose or intend to use our common stock to raise capital in the public markets or as acquisition consideration. As a result, our board of directors believes that we will derive little benefit from being a public company and that the public disclosure of sensitive financial and other information to our competitors may competitively disadvantage us. If our concerns about becoming a public company are realized, we may in the future take steps to cease our status as a public company.

Our stock price could decline significantly and rapidly following this offering.

The initial public offering price for the shares of Class B common stock to be offered and sold by the selling stockholders will be determined by an auction process conducted by the underwriter. The underwriter has informed us that it expects the initial public offering price to be between $30.00 and $34.00 per share. Unlike a typical underwritten public offering, the underwriter did not consult with our management team or board of directors prior to estimating the initial public offering price range. Accordingly, the underwriter’s estimate of the initial public offering price range may not have taken into account the risks and challenges that we expect to affect our business or the risks associated with this offering and the auction process described in this section of the prospectus. For example, we believe the estimated price range was primarily influenced by historical operating results and was determined without regard to our ability to sustain the same levels of revenue growth, operating margins, operating income, net income and net income per share in future periods. We believe we are more likely than not to be unable to sustain profitability levels experienced in 2011 or prior periods. For example, our operating income, net income and net income per share (basic) for the six months ended June 30, 2012 declined 32.3%, 41.6% and 45.3%, respectively, as compared to the six months ended June 30, 2011. While the underwriter expects the auction process to provide information about market demand for our Class B common stock at the time of this initial public offering, this information will be based upon an offering of a number of shares representing only 3.8% of our outstanding shares. We also believe the underwriter’s estimate of the initial offering price range does not take into account the likelihood that the offering price may not reflect the possibility of inadequate demand for the shares in the trading market. The underwriter

 

10


Table of Contents

has informed us that it expects the bidding process to reveal a clearing price for shares of our Class B common stock offered in the auction. However, this clearing price may not bear any relation to future prices for our shares following completion of this offering. Unlike a typical initial public offering, where holders of substantial numbers of outstanding shares are subject to “lock-up” agreements or “market stand-off” provisions, a significant number of shares of our Class B common stock held by the selling stockholders and other stockholders will be eligible for sale immediately following completion of this offering. As discussed below under “Substantial future sales of our Class B common stock in the public market could cause our stock price to fall,” holders of approximately 10,224,804 shares of our Class B common stock (including shares issuable upon conversion of preferred stock and all of the shares of Class B common stock sold in this offering) will not be subject to any agreement to refrain from trading for any period of time (contrary to the case in most typical initial public offerings), and those shares will be immediately eligible for sale following the completion of this offering. Because only a very small number of our outstanding shares will be sold in this offering and approximately fourteen times that number will be immediately eligible for sale following the completion of this offering, we believe it is likely that the initial public offering price will have only a limited relationship to the market demand for the total number of shares of our Class B common stock that will be eligible for sale by the selling stockholders and other stockholders once trading begins. If there is little or no demand for our shares of Class B common stock at or above the initial public offering price following the completion of this offering, or if the number of shares that become available for trading subsequent to the completion of this offering exceeds the demand for our shares, the price of our shares will decline. Any significant decline in our stock price following the completion of this offering could lead to securities class-action litigation that would be expensive, time-consuming and distracting to our management team. If your objective is to make a short-term profit by selling the shares you purchase in the offering shortly after trading begins, you should not submit a bid in the auction.

As a result of the unique circumstances surrounding this offering, we expect that the liquidity of our Class B common stock may be limited.

A number of factors particular to this offering may significantly limit the liquidity and trading volume of our Class B common stock. Our Class B common stock will not be listed on a national securities exchange in connection with this offering. After the consummation of this offering, our Class B common stock may be traded in the over-the-counter market and may be quoted on the OTC Bulletin Board quotation system, or the OTCBB, which is a FINRA-sponsored and operated inter-dealer automated quotation system for equity securities. We do not intend to seek to have our Class B common stock quoted on the OTCBB; however, the underwriter intends to arrange for our Class B common stock to be quoted on the OTCBB. Quotation of our Class B common stock on the OTCBB may limit the liquidity, trading volume and price of our Class B common stock more than if our Class B common stock were quoted or listed on the Nasdaq or another national securities exchange. Additionally, over-the-counter bulletin board stocks may not be purchased on margin and may not be used as collateral for margin loans under the rules of the Federal Reserve Board. Investors’ inability to acquire the Class B common stock on margin or use their shares of Class B common stock as collateral for margin loans may further limit the trading volume of our shares. We expect that our Class B common stock will remain eligible for quotation on the OTCBB only until December 31, 2012, unless at the end of 2012 our Class B common stock is held by more than 300 holders of record or we are otherwise contractually required to register our Class B common stock under the Exchange Act. If our Class B common stock becomes ineligible for quotation on the OTCBB, we expect the liquidity, trading volume and price of our Class B common stock may be further impaired.

We currently have no intention of registering our Class B common stock under the Exchange Act, unless at the end of 2012 our Class B common stock is held by more than 300 holders of record or we are otherwise contractually required to register our Class B common stock under the Exchange Act. While we will file periodic reports as required by the Exchange Act, if we do not have a class of securities registered

 

11


Table of Contents

under the Exchange Act, we will not be required to file, and have no current intention of voluntarily filing, proxy statements and certain other disclosures required by the Exchange Act. If we do not file proxy statements and such other disclosures because we are not required to do so, we expect the liquidity, trading volume and price of our Class B common stock to be further impaired.

In addition, we currently have no intention to raise capital in the future by selling shares of our Class B common stock in the public markets. As a result, the public trading volume of our Class B common stock will be largely limited to the shares being offered by this prospectus. Furthermore, we may in the future repurchase shares of our Class B common stock in the public markets, which would further reduce the trading volume of our Class B common stock. Also, our management does not intend to hold quarterly earnings calls or otherwise engage in conversations with stock market analysts. Any limitation on the amount of information available to analysts or other investors about Applied is likely to limit the interest of public investors in owning or trading Applied’s securities. Lack of liquidity in our Class B common stock may limit the price at which you may be able to sell our securities.

T. Peter Thomas, an affiliate of IVP and one of our former directors, has questioned our determination of the fair market value of our Class B common stock in connection with our repurchase of certain of his shares of Class B common stock. Resolving this potential claim may require costly and time-consuming litigation, which could have a material adverse impact on our financial condition and results of operations.

T. Peter Thomas, an affiliate of IVP and a member of our compensation committee from January 1989 until February 2011, was removed from our board of directors by action of our stockholders in January 2012. Following his removal from the board of directors, Mr. Thomas exercised vested stock options to purchase 37,950 shares of our Class B common stock and paid the aggregate exercise price of $277,650 for such shares. On February 16, 2012, we exercised our right to repurchase all of such shares pursuant to the applicable stock option agreements between Applied and Mr. Thomas. In connection with the repurchase of these shares, we provided Mr. Thomas with a check in the amount of $495,247.50, which reflects a repurchase price of $13.05 per share. The repurchase price reflects our compensation committee’s good faith determination of the fair market value of our Class B common stock most recently preceding the date of Mr. Thomas’ removal as a director. The determination of fair market value was made in accordance with our long-standing equity valuation process for equity transactions under our stock incentive plans, which also considers stock valuations received from a qualified and independent third party. In December 2011, we granted stock options and awarded restricted shares for an aggregate of 25,000 shares of Class B common stock and 10,000 shares of Class A common stock on the basis of the same determination of fair market value. Mr. Thomas has asserted, with the support of IVP, that the fair market value determination used in connection with the repurchase of his shares was not made in good faith, thereby challenging the process we use for establishing stock option values used in our financial statements. Mr. Thomas claims to have received a third-party offer to purchase his shares of Class B common stock at a price of $25.00 per share. In addition, Mr. Thomas has informed us that IVP values its Applied shares at $32.66 per share for purposes of preparing IVP’s own audited financial statements, based on a valuation conducted by a valuation firm engaged by IVP. Until September 10, 2012, Mr. Thomas rejected our compensation committee’s determination of fair market value, requested additional cash consideration from us for the repurchase of his shares and refused to transfer the Class B common stock that he had received upon exercise of his options to us. On August 31, 2012, we initiated litigation against Mr. Thomas and IVP, asserting claims for breach of contract, breach of the implied covenant of good faith and fair dealing, conversion and declaratory relief against Mr. Thomas and claims for conversion and aiding and abetting conversion against IVP. On September 11, 2012, Mr. Thomas delivered to us a stock transfer instrument to complete the transfer of the 37,950 shares of Class B common stock, but reserved the right to continue to challenge our compensation committee’s determination of fair market value and to request additional cash consideration from us for the

 

12


Table of Contents

repurchase of his shares. We continue to disagree with Mr. Thomas’ assertions regarding the fair market value of our common stock.

We have reviewed the valuations commissioned by IVP, and notwithstanding the valuation set forth in IVP’s reports, we and our board of directors continue to believe the valuation process used by our board of directors is appropriate. In contrast to the valuation assertions made by Mr. Thomas and IVP, our compensation committee has determined that the fair market value of our Class B common stock was $8.36 per share as of March 14, 2012 and $9.83 per share as of June 15, 2012. Resolving Mr. Thomas’ refusal to perform under certain stock agreements and his assertions regarding the process we use for establishing stock option values to our satisfaction is distracting our senior management from operating our business. Even though Mr. Thomas has satisfied his obligation under the applicable stock option agreements to deliver the necessary stock transfer instruments, we continue to seek damages against Mr. Thomas and IVP as a result of their actions. Litigation to resolve these matters could be costly and time-consuming. See “Business – Legal Proceedings.” Mr. Thomas’ assertions may have additional adverse effects that we are unable to predict or quantify in advance. The consequences of Mr. Thomas’ assertions may have a material adverse impact on our financial condition and results of operations.

Our outstanding shares of preferred stock have rights, preferences and privileges senior to our common stock, and more than a majority of the outstanding shares of preferred stock will remain held by IVP, which may restrict our ability to engage in various transactions.

As of June 30, 2012, we had 6,995,969 shares of redeemable convertible preferred stock issued and outstanding in six different series. The selling stockholders will convert 729,798 shares of preferred stock into 729,798 shares of Class B common stock in connection with this offering, after which 6,266,171 shares of preferred stock will remain issued and outstanding. Our preferred stock has rights, preferences and privileges senior to our common stock, including rights to receive, prior and in preference to the holders of common stock, cash dividends and the proceeds from any liquidation, dissolution or winding up of us, either voluntary or involuntary. The holders of our preferred stock have voting rights and, as of June 30, 2012, accounted for 36% of the total voting power of our capital stock. In addition, the holders of our preferred stock are entitled to certain special voting rights that may prevent us from taking an action or consummating a transaction that our board of directors may determine is in our best interest and the best interests of the holders of our common stock, as long as more than 300,000 shares of preferred stock remain outstanding. IVP, stockholders affiliated with IVP and other selling stockholders will continue holding 5,964,794 shares of preferred stock, of which 3,580,204 shares of preferred stock will be held by IVP. As long as IVP holds more than a majority of the outstanding shares of our preferred stock, IVP will control the vote of all matters requiring the approval of the holders of preferred stock. There can be no assurance that IVP will approve any such matters that our board of directors may consider beneficial to us and our stockholders. Additionally, our certificate of incorporation has authorized 25 million shares of Class A common stock and 25 million shares of Class B common stock. The holders of at least a majority of the outstanding shares of preferred stock must approve any amendment to our certificate of incorporation to increase the authorized number of shares of Class A and Class B common stock. There can be no assurance that IVP would approve any such amendment. As a result, in the future we may not have enough authorized shares to enable us to issue additional shares for acquisitions, financings, incentive compensation or other corporate purposes. All shares of preferred stock will automatically convert into shares of Class B common stock, and therefore the holders of preferred stock would no longer be able to block the type of transactions described above, if we effect a firm commitment registered public offering with an offering price of at least $9.00 per share and at least $10 million in the aggregate; however, there can be no assurance that we may undertake such an offering in the future. For a more detailed discussion of the rights, preferences and privileges of each series of our preferred stock, see “Description of Capital Stock — Preferred Stock.”

 

13


Table of Contents

If you are not an institutional investor, you may purchase our Class B common stock in this offering only if you reside within certain states in which we will apply to have the shares registered.

At the request of the underwriter, we will apply to register, or will rely on an exemption from registration for, the offer and sale of our Class B common stock to retail customers only in California, Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Louisiana, Maine, Maryland, Massachusetts, Minnesota, Mississippi, Missouri, Montana, Nevada, New Hampshire, New York, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Texas, Utah, Virginia, Washington, Wisconsin, and Wyoming. The selling stockholders and the underwriter will not offer or sell the shares to retail customers in any state unless and until registration in the state is effective or we have made any filings in the state necessary to claim an exemption from registration. If you are not an “institutional investor,” you must be a resident of one of these jurisdictions, and this offering must be registered or exempt from registration in such jurisdiction, to purchase our Class B common stock in this offering. The selling stockholders may offer and sell the shares to institutional investors in this offering pursuant to an exemption provided for sales to these investors under the Blue Sky laws of the various states. The definition of an “institutional investor” varies from state to state but generally includes financial institutions, broker-dealers, banks, insurance companies and other qualified entities. Under the National Securities Markets Improvement Act of 1996, states are pre-empted from regulating the registration of transactions in certain categories of securities that are designated as “covered securities.” We will initially be required to file reports under the Exchange Act and our securities will be considered covered securities as long as we continue to file such reports. Therefore, your resale of the Class B common stock will be exempt from state registration requirements until such time that we cease to file reports under the Exchange Act. As described elsewhere in this prospectus, we have no intention of registering our Class B common stock under the Exchange Act, unless at the end of 2012 our Class B common stock is held by more than 300 holders of record or we are otherwise contractually required to register our Class B common stock under the Exchange Act. Once we cease to file reports under the Exchange Act, holders of Class B common stock that are not institutional investors will need to comply with the registration requirements in the jurisdiction in which they reside in order to resell shares of our Class B common stock, which compliance may be onerous and expensive and may negatively impact your ability to sell your shares of Class B common stock at the time and for the price you desire. For a discussion of the Blue Sky state securities laws and registrations affecting this offering, please see the section entitled “Plan of Distribution — State Blue Sky Information” below.

Risks Related to Our Business

The markets in which we operate are highly competitive, and we may not be able to effectively compete against other providers of medical devices, particularly those with greater resources.

In the medical devices market, we face intense competition from companies with dominant market positions such as Ethicon Endo-Surgery, a division of Johnson & Johnson, and Covidien, among others. These competitors have significantly greater financial, technical, marketing and other resources than we have and may be better able to:

 

   

respond to new technologies or technical standards;

 

   

react to changing customer requirements and expectations;

 

   

acquire other companies to gain new technologies or products that may displace our product lines;

 

   

manufacture, market and sell products;

 

   

devote resources to the development, production, promotion, support and sale of products; and

 

   

deliver a broad range of competitive products at lower prices.

 

14


Table of Contents

Hospitals, Group Purchasing Organizations, or GPOs, Integrated Healthcare Networks, or IHNs, and Integrated Delivery Networks, or IDNs, make contracting and purchasing decisions based on their desire to secure a broad array of surgical supplies, many of which are unique to our principal competitors. Our principal competitors are able to leverage their broader product portfolios and dominant market positions in some segments by, for example, bundling their products into specially priced packages that create strong financial incentives for their customers to purchase their products. These practices may negate savings customers would gain from buying select products from Applied and may deter such customers from buying Applied’s products.

We expect competition in the markets in which we participate to continue to increase as existing competitors improve or expand their product offerings. As a result of all these factors, our customers could decide to purchase products from our competitors or reduce their purchases from us. Increased product competition may result in reduced market share and declining profitability.

We may not be able to sustain our position in the trocar market.

A substantial portion of our revenues are derived from the sales of trocars and other products, primarily surgical instruments, often used with trocars. We believe a significant contributor to the growth in our market share of trocars and these other products has been the positive effects of implementation of a “carve-out” in contracts between Ethicon Endo-Surgery, a division of Johnson & Johnson, on the one hand, and GPOs, IHNs and hospitals, on the other hand. The carve-out involved an agreement by Ethicon Endo-Surgery, Inc. and Ethicon, Inc. not to count purchases by their customers from non-full line medical device suppliers such as Applied to adversely impact the purchaser’s discounts on its purchases of Ethicon Endo-Surgery and/or Ethicon products. The carve-out benefits us by allowing our customers to purchase trocars and other products, primarily instruments, from Applied without triggering price increases on their purchases of Ethicon Endo-Surgery and/or Ethicon products. We believe the carve-out has significantly contributed to the growth in our market share of trocars and surgical instruments because our product revenue, the majority of which has been derived from the sales of trocars and surgical instruments, grew significantly from $46.9 million in 2003, when the carve-out was first implemented, to $338.5 million in 2011. We are unable to quantify the impact that the expiration of the carve-out may have on our sales of trocars and surgical instruments because the carve-out is only one factor that contributed to the growth in our market share of trocars and surgical instruments. We believe the growth in our sales of trocars and surgical instruments can also be attributed to a number of other factors, including our product innovations, the efforts of our sales team, the economic environment and our competitive pricing policies, the availability of clinical studies supporting the efficacy of our products, and the expansion of our global distribution capabilities.

The carve-out resulted, in part, from action taken by Applied in 2003, including participation in congressional hearings and the filing of an antitrust lawsuit against Johnson & Johnson, Johnson & Johnson Health Care Systems, Inc., Ethicon, Inc., Ethicon Endo-Surgery, Inc. and Novation LLC. In 2009, the U.S. District Court for the Central District of California approved a class action settlement agreement incorporating the carve-out. We believe the carve-out requirement of the class action settlement agreement will expire in October 2015.

We believe that Covidien voluntarily agreed to carve-outs in some additional circumstances for purchases from non-full line medical device suppliers by its customers and that Covidien no longer allows for these carve-outs. We are not aware of any contractual restriction that would prevent Covidien from instituting pricing practices targeted against non-full line medical device suppliers like Applied. If our principal competitors are able to assert their market power, then our sales of trocars and surgical instruments may be negatively impacted.

 

15


Table of Contents

If we do not continue to innovate, or if we reduce our research and development spending, we may not remain competitive and our operating results will suffer.

We rely on innovation through research and development activities, devoting a substantial portion of our revenues to research and development expenditures. Although markets for many of our products were — and to a certain extent remain — foreclosed by our competitors, innovation has been our most effective way to overcome the barriers to entry into these markets. Our success depends on providing improved clinical outcomes and value, both of which require heavy investments in research and development at a time when our competitors are also increasing their commitment to research and development. Adverse competitive and economic conditions may negatively impact our ability to continue the necessary level of commitment to our research and development activities.

From 2007 to 2011, we reduced the percentage of our revenues allocated to research and development, and to enhancing our products, processes, and automation, from 19% to 14%. This reduced spending may put us at a disadvantage with respect to the development of new technologies. Our operating results will also suffer if our innovations are not responsive to the needs of our customers or to changes in prevalent surgical techniques, or are not effectively brought to market. If we are unable to predict future customer preferences or modify our products or develop new ones to remain competitive, clinicians or hospitals may reduce their purchases of our products. As relevant technologies continue to develop, our competitors may be able to offer research results that are better than those generated by our research and development efforts.

Because we do not charge a premium for our products, despite our belief that our products provide enhanced clinical performance, our research and development efforts are also critical to reducing our manufacturing costs. Therefore, our recent reductions in research and development expenditures may negatively impact every facet of our business model. If we fail to maintain our ability to innovate, our cost structure may be negatively impacted, and we may be unable to continue to offer value or deliver on the premise of the Applied brand.

Our future performance will depend largely on the success of products we have not developed yet.

Technology is an important component of our business and growth strategy, and our success depends to a significant extent on the development, implementation and acceptance of new product designs. Commitments to develop new products must be made well in advance of any resulting sales, and technologies and standards may change during development, potentially rendering our products outdated or uncompetitive before their introduction. Our ability to develop products to meet evolving industry requirements and at prices acceptable to our customers will be significant factors in determining our competitiveness.

In addition, we will need to develop new products and technologies to replace declining revenues from existing product lines. For example, trocars and surgical instruments are responsible for a significant portion of our revenues, and the trocar market may decline on both a revenue-basis and a unit volume-basis over the near to intermediate-term future. As a result, we will need to develop and market additional products to compensate for the possible decline in trocar revenue, including products in new or adjacent product markets. We may expend considerable funds and other resources on the development of next-generation products without any guarantee that these products will be successful.

If we are not successful in bringing one or more of these potential products to market, whether because we fail to address marketplace demand, fail to develop viable technologies or otherwise, our revenues may decline and our results of operations could be seriously harmed.

 

16


Table of Contents

If we fail to maintain relationships with GPOs, sales of our products would decline.

Our ability to sell our products to U.S. hospitals depends in part on our relationships with GPOs. Many of our existing and potential customers become members of GPOs. GPOs negotiate pricing arrangements and contracts, sometimes exclusive, with medical supply manufacturers and distributors, and these negotiated prices are made available to a GPO’s affiliated hospitals and other members. If we are not one of the providers selected by a GPO, affiliated hospitals and other members may be less likely to purchase our products. If a GPO has negotiated a sole sourcing contract or a contract requiring that the GPO satisfy a minimum percentage of its requirements with another manufacturer’s products, we may be precluded from making sales to members of the GPO for the duration of the contractual arrangement. Our failure to renew contracts with GPOs may cause us to lose market share and could have a material adverse effect on our sales, financial condition and results of operations. In 2011 and during the six months ended June 30, 2012, revenue from the sale of our products to GPO members amounted to approximately $144 million and $73 million, respectively, representing approximately 66% and 65%, respectively, of our total revenue from sales to U.S. hospitals. In the future, if we are unable to maintain existing and develop new relationships with GPOs, our competitive position would likely suffer and our business would be harmed.

If we fail to effectively predict, sustain or manage our growth, our business and operating results could be harmed.

If we do not effectively manage our growth, the quality of our products, effectiveness of our regulatory compliance, responsiveness to our customers, reputation of our brand, and our financial and operational results will be negatively affected. To effectively manage our growth, we will need to continue to improve our operational and managerial skills and our reporting systems and procedures.

Applied’s high degree of vertical integration requires that growth trends be identified, quantified and addressed approximately two to three years in advance. Many of the manufacturing processes we employ are unique, or partially unique, to Applied, which creates obstacles for our supply chain unless we are prepared far in advance. Projected increases in production volume cannot be addressed by sending production to outside vendors. Increasing our production requires considerable capital investments in specialized facilities, power, advanced equipment, specialized tooling and, in certain situations, proprietary and unique materials and raw supplies. By contrast, if we overestimate growth and over-build, our fixed overhead will climb faster than revenues and adversely impact our margins.

Our rate of revenue growth decreased from approximately 32% annually in 2007 to approximately 24% annually in 2011. As a result of the economic recession and market conditions, we lowered our rate of investment in 2009 and 2010. If our rate of growth accelerates in the future, we may have difficulty increasing production to take advantage of the opportunities presented by such growth and our operating results could be harmed.

Our business model demands long-term investments in capital and operating expenses that are likely to cause significant fluctuation in our quarterly results.

To compete effectively, we have to be disproportionately agile, innovative, and strategic, with a willingness to sacrifice short-term results for long-term objectives and strategies. We expect that our quarterly results will continue to lack uniformity, either due to competitive pressures or because of our desire to prioritize the long-term health of our business over our immediate results. In particular, we may make significant expenditures in research and development and manufacturing processes that will not result in material improvements to our results of operations for the foreseeable future. We have no intention to vary our research and development and capital expenditures in response to quarter-to-quarter variations in our results of operations.

 

17


Table of Contents

The Applied culture is an integral part of our success. If we cannot maintain our culture at the management level as we grow, the innovation, creativity, initiative and teamwork fostered by our culture will be impaired, and our business may be harmed.

We believe that our success has its foundation in our culture and business model, which we believe fosters the development of our team members and drives our innovation, creativity, initiative and teamwork. One of the key unanswered and important questions about Applied’s future is the scalability of its culture at the management level. As our organization grows, and we are required to implement more stratified and complex management structures, including those necessary to comply with public disclosure and reporting obligations associated with becoming a public company, we may find it increasingly difficult to maintain the positive and beneficial aspects of our organizational culture. For example, the key members of our senior management team, consisting of Said Hilal, our President and Chief Executive Officer, Nabil Hilal, our Group President, Technology, Stephen E. Stanley, our Group President, Distribution, Gary Johnson, our Group President, Surgical, and Samir Tall, our Chief Financial Officer, have over 100 years of combined experience with Applied. Expanding our senior management team by adding individuals from different backgrounds will likely dilute the culture that has made Applied successful. This could negatively impact our business model, ability to implement our business strategies and our future success. This offering may create changes that could alter the Applied culture and its built-in advantages.

Our culture has specific and extensive requirements for staffing, which may hinder our ability to retain or hire qualified personnel needed to grow effectively.

Our performance is largely dependent on the talents and efforts of our highly skilled and exceptional team members. We have maintained a rigorous, highly selective and time-consuming hiring process and have made considerable investments in the training and development of our team members. We believe that our approach to hiring and training has significantly contributed to our culture and success to date. As we continue to grow, our hiring process may prevent us from hiring the personnel we need in a timely manner. If we fail to properly anticipate, prepare or develop candidates for future needs, we may adversely impact our staffing ability, growth, responsiveness, innovation or services.

Personnel retention is important to us because a considerable percentage of our management-level team members have been cultivated internally over a number of years through considerable training, rotation programs, mentoring and development. In many instances, and for a sizeable percentage of our operations, our only source of qualified team members is our internal training program. Failure to identify any external sources of qualified personnel may hinder our future growth.

In addition, our ongoing and future success depends in a large part upon the continued services of key members of our senior management team. Our senior management team has operated cohesively and cooperatively for many years while developing our next layer of leaders and managers. Our culture, strategies, competitive advantages and cultivating, mentoring style of management relies on the presence and cooperation of this senior management team and the teams reporting to every member of senior management.

Should we experience high turnover, our business may be damaged and our operating results may suffer. If we fail to design and maintain appropriate compensation programs, our ability to retain specially trained team members may suffer, which in turn will impair our ability to expand, retain business and deliver operating results in line with our projections.

Our senior management team has run Applied using a collective, consultative style. This approach may not be suitable for a public company, and may end up limiting our ability to manage our business effectively.

The Applied approach to decision-making is neither committee-based, nor individual-based. Rather, it relies on the collective intelligence of those who are well-informed and versed in our industry and

 

18


Table of Contents

the particulars of our business model. This process tends to be more deliberative and, therefore, slower than individual-based decision making. Disagreement among key individuals contributing to the collective intelligence could prevent key strategic decisions from being made in a timely manner. To date, this process has resulted in, and capitalized on, cohesiveness that is strongly evident within our organization. This managerial cohesiveness is derived largely from the strong relationships among our senior management team. Our collaborative approach may not be scalable, durable or appropriate once Applied grows beyond a certain size or expands our senior management team. If we fail to adapt in a timely manner to pressures on our decision making style, our growth, success, culture and profitability may all suffer.

We may acquire other companies or technologies, which could divert our management’s attention, result in additional dilution to our stockholders and otherwise disrupt our operations and harm our operating results.

Our success will depend, in part, on our ability to expand our product offerings and grow our business in response to changing technologies, end user demands and competitive pressures. In some circumstances, we may determine to do so through the acquisition of businesses or technologies rather than through internal development. We do not have experience acquiring other businesses and technologies. The pursuit of potential acquisitions may divert the attention of management and cause us to incur expenses in identifying, investigating and pursuing suitable acquisitions, whether or not they are consummated. Furthermore, even if we successfully acquire additional businesses or technologies, we may not be able to integrate the acquired personnel, operations and technologies successfully or effectively manage the combined business following the acquisition. We also may not achieve the anticipated benefits from the acquired business or technology. In addition, we may unknowingly inherit liabilities from future acquisitions that arise after the acquisition and are not adequately covered by indemnities. Acquisitions could also result in dilutive issuances of equity securities or the incurrence of debt, which could adversely affect our results of operations. If an acquired business or technology fails to meet our expectations, our business, results of operations and financial condition may suffer.

In response to increased prices and fees charged by certain of our third-party distributors, we are taking steps to improve our own direct distribution capabilities, and such efforts may not provide us with the anticipated benefits.

Certain of our third-party distributors have recently sought to increase the prices and related fees that they charge us to distribute our products to our customers. One key distributor, Owens & Minor, terminated a distribution agreement with us, effective June 30, 2012, after we refused the distributor’s attempt to unilaterally increase service fees. Sales through this distributor accounted for approximately 13% of our total revenues in 2011 and 9.5% during the six months ended June 30, 2012. Our operating results will be negatively impacted if our customers must arrange alternative distribution arrangements for our products. We are taking steps to enhance our own direct distribution capabilities to deliver our products, including the construction or acquisition of warehouse and distribution facilities in geographic areas outside of Southern California. In April 2012, we entered into a lease for a warehouse and distribution facility in New York and began shipping product from this facility in June 2012. We do not have experience in logistics or distribution and the pursuit of improving our own direct distribution channels may divert the attention of management and cause us to incur more expenses than relying on third-party distributors, even after accounting for such increases in prices and related fees, especially at first when we will not enjoy any economies of scale in our direct distribution activities. If we become reliant on our own distribution channels and such distribution channels fail to meet our expectations, our business, results of operations and financial condition may suffer.

We may seek to gain access to new technologies and markets by developing strategic partnerships with, or making investments in, other medical device manufacturers and these strategic partnerships and investments may not provide us with the anticipated benefits.

Instead of developing new technologies entirely with our own internal resources, we may seek to enter into strategic partnerships with other medical device manufacturers in order to gain access to

 

19


Table of Contents

new technologies and markets. These partnerships may take a number of forms, including joint development or licensing arrangements. We may not be able to enter into these relationships at all, our strategic partners may not devote sufficient resources to developing and implementing the technologies that we seek, and these relationships may not provide us access to commercially viable technology. In addition, these relationships may not be successful in generating additional revenue for us. Any reliance on strategic partnerships for the development of new technology may also slow down our internal research and development efforts, which will put us at a competitive disadvantage if we eventually decided to terminate future strategic relationships.

We have made and may continue to make investments in other companies that we believe provide strategic opportunities for us. In February 2012, we acquired 9% of the outstanding shares of Cardica, Inc., a designer and manufacturer of proprietary stapling and other surgical connection devices for cardiac and laparoscopic surgical procedures, for $5.4 million. We intend that these investments will complement our research and development and/or sales and distribution efforts, potentially provide access to new technologies and markets, and create opportunities for additional sales of our products and services. However, these investments may not have the desired results, and we may lose all or a large portion of these investments. We also may need to make further investments to support the activities of these other companies. These investments, potential impairment charges or additional costs could negatively affect our results of operations for a given period, cause variability of our operating results or negatively impact our operating results for several future periods.

Our business, financial condition and results of operations could be adversely affected by the political and economic conditions of the countries in which we conduct business and other risks related to our international operations.

In 2011 and during the six months ended June 30, 2012, approximately 38% and 39%, respectively, of our total revenue was generated from sales of products in countries other than the U.S. Our international distribution system consists of direct sales offices in Amersfoort, Netherlands, and Brisbane, Australia and approximately 70 distributors who sell in approximately 65 countries. Many of these countries are subject to varying degrees of political, economic and social instability. In particular, the ongoing financial uncertainty in Europe (including concerns that certain European countries may default in payments due on their national debt), the resulting economic uncertainty and the fluctuations in the values of the Euro and British pound compared to the U.S. dollar have, from time to time, adversely affected our sales in Europe. Multiple factors relating to our international operations could have a material adverse effect on our business, financial condition and results of operations. These factors include:

 

   

challenges associated with cultural differences, languages and distance;

 

   

differences in clinical practices, needs, products, modalities and preferences;

 

   

longer payment cycles in some countries;

 

   

credit risks of many kinds;

 

   

legal and regulatory differences and restrictions;

 

   

currency exchange fluctuations;

 

   

foreign exchange controls that might prevent us from repatriating cash earned in certain countries;

 

   

political and economic instability and export restrictions;

 

   

variability in sterilization requirements for multi-usage surgical devices;

 

   

potential adverse tax consequences;

 

   

higher cost associated with doing business internationally;

 

20


Table of Contents
   

challenges in implementing educational programs required by Applied’s approach to doing business;

 

   

negative economic developments in economies around the world and the instability of governments, including the threat of war, terrorist attacks, epidemic or civil unrest;

 

   

adverse changes in laws and governmental policies, especially those affecting trade and investment;

 

   

pandemics, such as the avian flu, which may adversely affect our workforce as well as our local suppliers and customers;

 

   

import or export licensing requirements imposed by governments;

 

   

differing labor standards;

 

   

differing levels of protection of intellectual property;

 

   

the threat that our operations or property could be subject to nationalization and expropriation;

 

   

varying practices of the regulatory, tax, judicial and administrative bodies in the jurisdictions where we operate; and

 

   

potentially burdensome taxation and changes in foreign tax laws.

A portion of our international sales are made through distributors. As a result, we are dependent upon the financial health of our distributors. If a distributor were to go out of business, it would take substantial time, cost and resources to find a suitable replacement and the products held by such distributor may not be returned to us or to a subsequent distributor in a timely manner or at all.

Any material decrease in our foreign sales may negatively affect our profitability. We generate our international sales primarily in Europe, where healthcare regulation and reimbursement for medical devices vary significantly from country to country. This changing environment could adversely affect our ability to sell our products in some European countries.

We compete internationally with the same competitors as in the U.S., and also with a number of international competitors. If we fail to deal with the differences between U.S. and international markets, or fail to compete effectively in the international markets, our business will be harmed.

We face different market characteristics and additional competitors outside the U.S. In certain markets, other companies have greater brand recognition, a more established image, or stronger connections and familiarity with the clinical community, hospital procurement practices, and local bidding processes. In some countries, bids are based on current usage and current products which, by nature, favor pre-existing suppliers. In many markets, we need to have an established presence in the market in order to be included in the bidding process. If we fail to understand international users and their requirements and preferences, we will fail to penetrate those markets.

We have no current plans to expand into emerging markets, which will limit our global reach, global potential and the size of many of our opportunities.

Many companies that compete with us target emerging markets, including China and India, giving these opportunities heavy emphasis and sizeable investments. Should their efforts succeed, our competitors might gain many advantages over us, including higher worldwide unit volumes. We do not invest in these emerging markets, and we currently have no plans to do so. If we fail to target emerging markets, we may end up conceding some significant competitive advantages to competitors who effectively address such opportunities. This in turn may impact our cost structure, margins and operating results and profitability.

 

21


Table of Contents

We occasionally become subject to commercial disputes that could harm our business by distracting our management from the operation of our business, by increasing our expenses and, if we do not prevail, by subjecting us to potential monetary damages and other remedies.

From time to time, we are engaged in disputes regarding our commercial transactions. These disputes could result in considerable legal expenses and litigation requirements that require monies, managerial time and attention. As a general approach, we are not inclined to settle those claims we feel are unfair or unwarranted, despite the possibility that such a settlement may be less expensive than pursuing a fair and just outcome. These disputes can, therefore, result in monetary damages or other remedies that could adversely impact our financial position or operations. Even if we prevail in these disputes, they may distract our management from operating our businesses and the cost of defending these disputes would reduce our operating results.

Our business is vulnerable to the availability of raw materials, our ability to forecast customer demand and our ability to manage production capacity.

Our ability to meet customer demand depends, in part, on our production capacity and on obtaining supplies, a number of which may be obtained only from a single supplier or a limited number of suppliers. A reduction or disruption in our production capacity or our supplies could negatively impact our business.

We must accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials. If we overestimate demand, we may experience underutilized capacity and excess inventory levels. If we underestimate demand, we may miss sales opportunities and incur additional costs for labor overtime, equipment overuse and logistical complexities. Additionally, our production capacity could be affected by manufacturing problems. Difficulties in the production process could reduce yields or interrupt production, and, as a result, we may not be able to deliver products on time or in a cost-effective, competitive manner. Our failure to adequately manage our capacity could have a material adverse effect on our business, financial condition and results of operations.

Our ability to meet customer demand also depends on our ability to obtain timely and adequate delivery of materials, parts and components from our suppliers. We generally do not maintain contracts with any of our key suppliers. From time to time, suppliers may extend lead times, limit the amounts supplied to us or increase prices due to capacity constraints or other factors. Supply disruptions may also occur due to shortages in critical materials. In addition, a number of our raw materials are obtained from a single supplier. Many of our suppliers must undertake a time-consuming qualification process before we can incorporate their raw materials into our production process. If we are unable to obtain materials from a qualified supplier, it can take up to a year to qualify a new supplier, assuming an alternative source of supply is available. A reduction or interruption in supplies or a significant increase in the price of one or more supplies could have a material adverse effect on our business, financial condition and results of operations.

Our business is vulnerable to inflation.

We are limited in our ability to raise prices as a result of our long-term GPO contracts, and because of our desire to maintain lower ASPs. As a result, increases in our raw materials, production and transportation costs may have a material adverse impact on our results of operations.

We may not be able to protect or enforce our intellectual property rights, which could impair our competitive position.

Our success depends significantly on our ability to protect our rights to the patents, trademarks, trade secrets, copyrights and all the other intellectual property rights used in our products. Protecting our intellectual property rights is costly and time consuming. We rely primarily on patent

 

22


Table of Contents

protection and trade secrets, as well as a combination of copyright and trademark laws and nondisclosure and confidentiality agreements to protect our technology and intellectual property rights. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or maintain any competitive advantage. Despite our intellectual property rights practices, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization, develop similar technology independently or design around our patents.

We cannot be assured that any of our pending patent applications will result in the issuance of a patent to us. The U.S. Patent and Trademark Office, or PTO, may deny or require significant narrowing of claims in our pending patent applications, and patents issued as a result of the pending patent applications, if any, may not provide us with significant commercial protection or be issued in a form that is advantageous to us. We could also incur substantial costs in proceedings before the PTO. Our issued and licensed patents and those that may be issued or licensed in the future may expire or may be challenged, invalidated or circumvented, which could limit our ability to stop competitors from marketing related technologies. Upon expiration of our issued or licensed patents, we may lose some of our rights to exclude others from making, using, selling or importing products using the technology based on the expired patents. There is no assurance that competitors will not be able to design around our patents. We also rely on unpatented proprietary technology. We cannot assure you that we can meaningfully protect all our rights in our unpatented proprietary technology or that others will not independently develop substantially equivalent proprietary products or processes or otherwise gain access to our unpatented proprietary technology.

Further, we may not be able to obtain patent protection or secure other intellectual property rights in all the countries in which we operate, and under the laws of such countries, patents and other intellectual property rights may be unavailable or limited in scope. If any of our patents fail to protect our technology, it would make it easier for our competitors to offer similar products. Our trade secrets may be vulnerable to disclosure or misappropriation by employees, contractors and other persons. Any inability on our part to adequately protect our intellectual property may have a material adverse effect on our business, financial condition and results of operations.

We seek to protect our know-how and other unpatented proprietary technology with confidentiality agreements and intellectual property assignment agreements with our team members, independent distributors and consultants. However, such agreements may not be enforceable or may not provide meaningful protection for our proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements or in the event that our competitors discover or independently develop similar or identical designs or other proprietary information. In addition, we rely on the use of registered and common law trademarks with respect to the brand names of some of our products. Common law trademarks provide less protection than registered trademarks. Loss of rights in our trademarks could adversely affect our business, financial condition and results of operations.

We may be subject to intellectual property infringement claims by third parties which could be costly to defend, divert management’s attention and resources, and may result in liability.

The medical devices field is characterized by vigorous protection and pursuit of intellectual property rights. Companies in the medical device industry have used intellectual property litigation to gain a competitive advantage in the marketplace. From time to time, third parties may and do assert against us their patent, copyright, trademark and other intellectual property rights relating to technologies that are important to our business. Searching for existing intellectual property rights may not reveal important intellectual property and our competitors may also have filed for patent protection, which is not publicly-available information, or claimed trademark rights that have not been revealed through our availability searches. We may be subject to claims that our team members have disclosed, or that we have used, trade secrets or other proprietary information of our team members’ former employers. Our efforts to identify and avoid infringing on third parties’ intellectual property rights may

 

23


Table of Contents

not always be successful. Any claims that our products or processes infringe these rights, regardless of their merit or resolution, could be costly, time consuming and may divert the efforts and attention of our management and technical personnel. In addition, we may not prevail in such proceedings given the complex technical issues and inherent uncertainties in intellectual property litigation.

Any claims of patent or other intellectual property infringement against us, even those without merit, could:

 

   

increase the cost of our products;

 

   

be expensive and time consuming to defend;

 

   

result in our being required to pay significant damages to third parties;

 

   

force us to cease making or selling products that incorporate the challenged intellectual property;

 

   

require us to redesign, reengineer or rebrand our products, product candidates and technologies;

 

   

require us to enter into royalty or licensing agreements in order to obtain the right to use a third party’s intellectual property on terms that may not be favorable or acceptable to us;

 

   

require us to develop alternative non-infringing technology, which would require significant effort and expense;

 

   

require us to indemnify third parties pursuant to contracts in which we have agreed to provide indemnification for intellectual property infringement claims;

 

   

divert the attention of our management and other key team members;

 

   

result in our customers or potential customers deferring or limiting their purchase or use of the affected products impacted by the claims until the claims are resolved; and

 

   

otherwise have a material adverse effect on our business, financial condition and results of operations.

Any of the foregoing could affect our ability to compete or have a material adverse effect on our business, financial condition and results of operations.

Certain competitors have shown a strong inclination to litigate against us. For years, we avoided settling cases where we believe the claim is unfounded, unfair or extortive in nature. This has proven to be very expensive and demanding. We are highly unlikely to change this disciplined approach, despite its costs.

Competitors may violate our intellectual property rights, and we may bring litigation to protect and enforce our intellectual property rights, which may result in substantial expense and may divert our attention from implementing our business strategy.

We believe that the success of our business depends, in significant part, on obtaining patent protection for our products and technologies, defending our patents and preserving our trade secrets. We continue to be involved in significant litigation to protect our patent position and may be required to engage in further litigation. From 1996 through 2009, we engaged in a series of litigation proceedings against U.S. Surgical Corporation, part of Tyco Healthcare (currently Covidien), in which we claimed that Covidien was infringing certain of our trocar patents. Through these proceedings, Applied obtained two judgments that Covidien’s predecessors, Tyco Healthcare and U.S. Surgical, willfully infringed Applied patents on the Universal® seal technology.

 

24


Table of Contents

In May 2011 and September 2011, we filed additional patent infringement lawsuits against Covidien. We may not prevail in these suits or receive any damages or other relief if we do prevail. See “Business — Legal Proceedings.”

Our failure to pursue any potential claim could result in the loss of our proprietary rights and harm our position in the marketplace. Therefore, we may be forced to pursue litigation to enforce our rights. Our ongoing and future litigation could result in significant additional costs and further divert the attention of our management and key personnel from our business operations and the implementation of our business strategy.

Our facilities are vulnerable to natural disasters and other unexpected losses, and we may not have adequate insurance to cover such losses.

We rely on our manufacturing facilities in Orange County, California. Our facilities are susceptible to damage from earthquakes as well as from fire, floods, loss of power or water supply, telecommunications failures and similar events. In particular, our headquarters and manufacturing facilities are located in a known earthquake fault zone near areas that have been affected by wild brush fires. A natural disaster could significantly disrupt our operations.

In the event that one of our facilities was affected by a natural or man-made disaster, we would be forced to rely on third-party manufacturers if we could not shift production to our other manufacturing facility. Our insurance for damage to our property and the disruption of our business from casualties may not be sufficient to cover all of our potential losses and may not continue to be available to us on acceptable terms, or at all. If we are forced to seek alternative facilities, or if we voluntarily expand one or more of our manufacturing operations to new locations, we may incur additional transition costs and we may experience a disruption in the supply of our products until the new facilities are available and operating. In addition, much of the machinery we use in our production process is custom-made. If such machinery is damaged, we may experience a long lead-time before this unique machinery is replaced or rebuilt and we are able to resume production.

Our manufacturing and distribution operations are highly dependant on our information technology systems and we do not currently have a redundant data center. In the event of a failure of our primary data center, our manufacturing and distribution operations will be disrupted which will adversely affect our business.

In addition, any disruption, delay, transition or expansion of our manufacturing operations could impair our ability to meet the demand of our customers and our customers may cancel orders or purchase products from our competitors, which could adversely affect our business, financial condition and results of operations.

We are subject to environmental, health and safety laws, which could increase our costs and restrict our operations in the future.

Our operations are subject to a variety of environmental, health and safety laws and regulations in each of the jurisdictions in which we operate. These laws and regulations concern, among other things, the generation, handling, transportation and disposal of hazardous substances or wastes, the clean up of hazardous substance releases, and the emission or discharge of materials into the air or water. We have incurred, and may in the future continue to incur, expenditures in connection with environmental health and safety laws and regulations. Any failure by us to comply with the requirements of such laws and regulations could result in the limitation or suspension of production or subject us to monetary fines or civil or criminal sanctions, or other future liabilities.

In addition, if there is any change in environmental, health or safety laws, we could incur substantial additional costs to alter our manufacturing processes and adjust our supply chain

 

25


Table of Contents

management. Such changes could also result in significant inventory obsolescence. Compliance with environmental, health and safety requirements could also restrict our ability to expand our facilities in the future.

We may need substantial additional funding and may be unable to raise capital when needed, which would force us to delay, reduce, eliminate or abandon growth initiatives or product development programs.

Our cash flow from operations may not be sufficient to meet all of our cash requirements. We intend to continue to make investments to support our business growth and may require additional funds to:

 

   

expand the distribution of our products;

 

   

acquire additional facilities for manufacturing, distribution and office uses and construct improvements in all facilities;

 

   

fund our operations;

 

   

continue our research and development;

 

   

protect our intellectual property rights or defend, in litigation or otherwise, any claims that we infringe third-party patents or other intellectual property rights; and

 

   

deliver our new products, if any such products receive regulatory clearance or approval for commercial sale.

Our funding requirements will depend on many factors, including:

 

   

market acceptance of our products;

 

   

the cost of our research and development activities;

 

   

the cost of filing and prosecuting patent applications and defending and enforcing our patent and other intellectual property rights;

 

   

the cost of defending, in litigation or otherwise, any claims that we infringe third-party patent or other intellectual property rights;

 

   

the cost and timing of additional regulatory clearances or approvals;

 

   

the cost and timing of expanding our sales, marketing and distribution capabilities;

 

   

the effect of competing technological and market developments; and

 

   

the extent to which we acquire or invest in businesses, products and technologies, although we currently have no commitments or agreements relating to any of these types of transactions.

Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. Any debt financing that we raise may contain terms that are not favorable to us or our stockholders. If we do not have, or are not able to obtain, sufficient funds, we may have to delay product development initiatives or license to third parties the rights to commercialize products or technologies that we would otherwise seek to market. We also may have to reduce marketing, customer support or other resources devoted to our products.

Continuing weakness in the global economy and turmoil in the credit markets may adversely affect our business until an economic recovery is underway.

If current economic conditions and turmoil in the credit markets continues or worsens, we could experience a material adverse effect on our sales and results of operations. Increasing levels of

 

26


Table of Contents

unemployment and pressures to contain healthcare costs could adversely affect the global growth rate of procedure volume, which could negatively affect our results. In addition, current economic conditions may have an adverse effect on our customers’ ability to borrow money from their existing lenders or to obtain credit from other sources to purchase our products. The recent economic crisis could also adversely affect our suppliers’ ability to provide us with materials and components, either of which may negatively impact our business.

Our operations may be adversely impacted by our exposure to risks related to foreign currency exchange rates.

We market our products in certain foreign markets through our subsidiaries and other international distributors. The related sales agreements may provide for payments in a foreign currency. A majority of our sales and expenditures are transacted in U.S. dollars, although we transact with foreign customers in currencies other than the U.S. dollar. These foreign currency revenues, when converted into U.S. dollars, can vary depending on average exchange rates during a particular period. In addition, we are exposed to foreign currency gains or losses on outstanding foreign currency denominated receivables. When converted to U.S. dollars, these receivables can vary depending on the monthly exchange rates at the end of the period. Certain of our foreign sales support subsidiaries transact in their respective country’s local currency, which is also their functional currency. As a result, expenses of these foreign subsidiaries when converted into U.S. dollars can vary depending on average monthly exchange rates during a particular period. Certain intercompany transactions may give rise to realized and unrealized foreign currency gains or losses. Accordingly, our operating results are subject to fluctuations in foreign currency exchange rates.

In addition, we hold a large proportion of our cash and cash equivalents in Euros and Australian dollars because of planned future investments in Europe and Australia. As of June 30, 2012, we held approximately 79% of our cash and cash equivalents in Euros and Australian dollars. The balance sheets of our foreign subsidiaries whose functional currency is not the U.S. dollar are translated into U.S. dollars at the rate of exchange at the balance sheet date and the statements of income and cash flows are translated into U.S. dollars using the average monthly exchange rate during the period. Any foreign exchange gain or loss as a result of translating the balance sheets of our foreign subsidiaries whose functional currency is not the U.S. dollar is included in equity as a component of accumulated other comprehensive income.

We currently do not hedge against our foreign currency exchange rate risks and therefore believe our exposure to these risks may be higher than if we entered into hedging transactions, including forward exchange contracts or similar instruments. If we decide in the future to enter into forward foreign exchange contracts to attempt to reduce the risk related to foreign currency exchange rates, these contracts may not mitigate the potential adverse impact on our financial results due to the variability of timing and amount of payments under these contracts. In addition, these types of contracts may themselves cause financial harm to us and have inherent levels of counterparty risk over which we would have no control.

Our operating results could be negatively impacted by future changes in the allocation of income to each of the entities through which we operate and to each of the income tax jurisdictions in which we operate.

We operate through multiple entities and in multiple income tax jurisdictions with different income tax rates both inside and outside the U.S. Accordingly, our management must determine the appropriate allocation of income to each such entity and each of these jurisdictions. Income tax audits associated with the allocation of this income and other complex issues, including inventory transfer pricing and cost sharing and product royalty arrangements, may require an extended period of time to resolve and may result in income tax adjustments if changes to the income allocation are required.

 

27


Table of Contents

Since income tax adjustments in certain jurisdictions can be significant, our future operating results could be negatively impacted by settlement of these matters.

Our outstanding debt agreements contain restrictive covenants that may limit our operating flexibility.

The agreements relating to our outstanding debt contain some financial covenants limiting our ability to transfer or dispose of assets, incur capital expenditures, merge with or acquire other companies, make investments, pay dividends, repurchase shares of capital stock, incur additional indebtedness and liens and conduct transactions with affiliates. We therefore may not be able to engage in any of the foregoing transactions until our current debt obligations are paid in full or we obtain the consent of the lenders. We may be unable to generate sufficient cash flow or revenue to meet the financial covenants or pay the principal and interest on our debt. Furthermore, future working capital, borrowings or equity financing may not be available to repay or refinance any such debt. See “Description of Certain Indebtedness — Covenants and Other.”

Our significant indebtedness could adversely affect our operations, including our ability to perform our obligations, and reduce our cash available for other purposes.

As of June 30, 2012, we had approximately $92.8 million of total outstanding indebtedness and $75.0 million of borrowing availability under the $150.0 million senior secured credit facility, or the senior secured credit facility, we entered into with Applied Medical Resources Corporation and Applied Medical Distribution Corporation, two of our wholly-owned subsidiaries, as co-borrowers. We may also be able to incur substantial indebtedness in the future, including additional senior indebtedness, which may or may not be secured. For a description of the senior secured credit facility, see “Description of Certain Indebtedness.”

Our significant indebtedness poses risks to our business, including the risks that:

 

   

we could have difficulty satisfying our debt obligations, and if we fail to comply with such obligations, an event of default could result;

 

   

we may be required to dedicate a substantial portion of our cash flow from operations to required payments on indebtedness, thereby reducing the cash flow available to fund working capital, capital expenditures and other general corporate activities or to pay dividends to or repurchase shares from stockholders;

 

   

covenants relating to our indebtedness may restrict our ability to pay dividends to or repurchase shares from our stockholders;

 

   

covenants relating to our indebtedness may limit our ability to obtain additional financing for working capital, capital expenditures and other general corporate activities, which may limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

 

   

as our operations evolve and our needs change, we may need to request amendments to the covenants in our senior secured credit facility; if we cannot obtain such required approvals, the limitations in our senior secured credit facility may have a negative impact on our operations;

 

   

covenants relating to our indebtedness may restrict us from making strategic acquisitions and exploiting business opportunities or cause us to make non-strategic divestitures;

 

   

we may be more vulnerable to general adverse economic and industry conditions;

 

   

our debt may negatively impact the terms on which customers or suppliers do business with us or alternatively require us to provide such customers or suppliers with credit support;

 

28


Table of Contents
   

our debt could limit our flexibility in planning for, or reacting to, changes in our business or the industry in which we operate, placing us at a competitive disadvantage compared to our competitors with less debt; and

 

   

we may have difficulty repaying or refinancing our obligations under the senior secured credit facility as interest or principal payments are due or on the maturity date.

If any of these risks occur, our financial condition, results of operations and ability to pay dividends could be adversely affected.

Risks Related to Our Industry

If product liability claims are brought against us, we could face substantial liability and costs.

The manufacture and sale of medical devices exposes us to product liability claims and product recalls, including those that may arise from misuse or malfunction of, or design flaws in our products or the use of our products with incompatible components or systems. Any losses that we may suffer from future liability claims, and the effect that any product liability litigation may have upon the reputation and marketability of our technology and products, together with the corresponding diversion of the attention of our key team members, could adversely affect our business, financial condition and results of operations. Any product liability claims could be time-consuming and require significant cost and management resources and may subject us to significant damages. We currently have product liability insurance that we believe to be adequate, but we cannot be certain that it will be sufficient to cover all damages or claims. Furthermore, we may not be able to obtain or maintain insurance in the future at satisfactory rates or in adequate amounts to protect us against any product liability claims. There can be no assurance that existing insurance coverage will extend to other products in the future. A successful claim may prevent us from obtaining adequate product liability insurance in the future on commercially desirable items, if at all.

Our products may in the future be subject to product recalls that could harm our reputation, business operations and financial results.

The Food and Drug Administration, or FDA, and similar foreign governmental authorities have the authority to require the recall of commercialized products in the event of material deficiencies or defects in design, manufacture or labeling. In the case of the FDA, the authority to require a recall must be based on an FDA finding that there is a reasonable probability that the device would cause serious injury or death. In addition, foreign governmental bodies have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacture. Manufacturers may, under their own initiative, recall a product if any material deficiency in a device is found. A government-mandated or voluntary recall by us could occur as a result of component failures, manufacturing errors, design or labeling defects or other deficiencies and issues. Recalls of any of our products would divert managerial and financial resources and have an adverse effect on our financial condition and results of operations. We may initiate certain voluntary recalls involving our products in the future. Companies are required to maintain certain records of recalls, even if they are not reportable to the FDA. If we determine that certain of those recalls do not require notification of the FDA, the FDA may disagree with our determinations and require us to report those actions as recalls. A future recall announcement could harm our reputation with customers and negatively affect our sales. In addition, the FDA could take enforcement actions against us, which could impair our ability to produce our products in a cost-effective and timely manner in order to meet our customers’ demands. We may also be required to bear other costs or take other actions that may have a negative impact on our future sales and our ability to generate profits.

 

29


Table of Contents

If our marketed products cause or contribute to a death or a serious injury, or malfunction in certain ways, we will be subject to medical device reporting regulations, which can result in voluntary corrective actions or agency enforcement actions.

Under the FDA’s Medical Device Reporting regulations, or MDR regulations, we are required to report to the FDA any incident in which our product may have caused or contributed to a death or serious injury or in which our product malfunctioned and, if the malfunction were to recur, would likely cause or contribute to death or serious injury. In addition, all manufacturers placing medical devices in European Union markets are legally bound to report any serious or potentially serious incidents involving devices they produce or sell to the relevant authority in whose jurisdiction the incident occurred. In the future, we may experience events that may require reporting to the FDA pursuant to the MDR regulations. Any adverse event involving our products could result in future voluntary corrective actions, such as recalls or customer notifications, or agency action, such as inspection, mandatory recall or other enforcement action. Any corrective action, whether voluntary or involuntary, as well as defending ourselves in a lawsuit, will require the dedication of our time and capital, distract management from operating our business, and may harm our reputation and financial results. In addition, failure to report such adverse events to appropriate government authorities on a timely basis, or at all, could result in an enforcement action against us.

The medical device field is subject to stringent regulation and failure to obtain regulatory approval will prevent commercialization of our products.

Medical devices are subject to extensive and rigorous regulation by the FDA pursuant to the Federal Food, Drug, and Cosmetic Act, or FDCA, by comparable agencies in foreign countries and by other regulatory agencies and governing bodies. Under the FDCA and associated regulations, manufacturers of medical devices must comply with certain regulations that cover the composition, labeling, testing, clinical study, manufacturing, packaging and distribution of medical devices. In addition, medical devices must receive FDA clearance or approval before they can be commercially marketed in the U.S., and the FDA may require testing and surveillance programs to monitor the effects of approved products that have been commercialized and can prevent or limit further marketing of a product based on the results of these post-market evaluation programs. The process of obtaining marketing clearance from the FDA for new products could take a significant period of time, require the expenditure of substantial resources, involve rigorous pre-clinical and clinical testing, require changes to the products and result in limitations on the indicated uses of the product.

Our failure to obtain and maintain FDA clearances or approvals on a timely basis, or at all, would prevent us from commercializing our current or upgraded products in the U.S., which could severely harm our business.

Each medical device that we wish to market in the U.S. generally must first receive clearance from the FDA. Even if regulatory approval of a product is granted, the approval may be subject to limitations on the indicated uses for which the product may be marketed. We cannot assure you that the FDA will grant 510(k) clearance on a timely basis, if at all, for new products or uses that we propose for existing products. 510(k) clearance is a process required by the Food, Drug, and Cosmetic Act in which device manufacturers must register, to notify the Food and Drug Administration, or the FDA, of their intent to market a medical device at least 90 days in advance. This is also known as premarket notification, or PMN. The FDA’s 510(k) clearance process usually takes from four to twelve months, although it can take longer.

Modifications to our marketed devices may require new regulatory clearances, or may require us to cease marketing or recall the modified devices until clearances are obtained.

Any modifications to an FDA-cleared device that would significantly affect its safety or effectiveness or that would constitute a major change in its intended use would require a new 510(k)

 

30


Table of Contents

clearance. We may not be able to obtain such clearances in a timely fashion, or at all. Delays in obtaining future clearances would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would have an adverse effect on our business, financial condition and results of operations. We have made modifications to our devices in the past and we may make additional modifications in the future, some of which we may determine do not require additional clearances. If the FDA disagrees and requires new clearances for the modifications, we may be required to recall and to stop marketing the modified devices, which could have an adverse effect on our business, financial conditions and results of operations.

Off-label promotion of our products or promotional claims deemed false or misleading could subject us to substantial penalties.

Obtaining 510(k) clearance only permits us to promote our products for the uses cleared by the FDA. Although we may request additional cleared indications for our current products, the FDA may deny those requests, require additional expensive clinical data to support any additional indications or impose limitations on the intended use of any cleared product as a condition of clearance. We must have adequate substantiation for our product performance claims. If the FDA determines that we have promoted our products for off-label use, or have made false or misleading or inadequately substantiated promotional claims, we could be subject to fines, injunctions or other significant penalties or restrictions.

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

Our products, along with the manufacturing processes and promotional activities for such products, are subject to continual review and periodic inspections by the FDA and other regulatory bodies. In particular we and our suppliers are required to comply with the quality system regulation, or QSR, which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our products. The FDA enforces the QSR through unannounced inspections. We are also subject to similar state requirements and licenses. Failure by us or one of our suppliers to comply with statutes and regulations administered by the FDA and other regulatory bodies, discovery of previously unknown problems with our products (including unanticipated adverse events or adverse events of unanticipated severity or frequency), manufacturing problems, or failure to comply with regulatory requirements, or failure to adequately respond to any FDA observations concerning these issues, could result in, among other things, any of the following actions:

 

   

issuance of public warning letters;

 

   

a shut-down or interruption of our manufacturing operations;

 

   

withdrawal or suspension of clearance or approval by the FDA or other regulatory bodies;

 

   

product recall, detention or seizure;

 

   

fines and civil penalties;

 

   

unanticipated expenditures;

 

   

operating restrictions;

 

   

injunctions; and

 

   

criminal prosecution.

If any of these actions were to occur, it would harm our reputation and adversely affect our business, financial condition and results of operations. Furthermore, our key component suppliers may not currently be, or may not continue to be, in compliance with applicable regulatory requirements.

 

31


Table of Contents

Failure to obtain regulatory approval in foreign jurisdictions will prevent us from marketing our products abroad.

We currently market, and intend to continue to market, our products internationally. Outside the U.S., we can market a product only if we receive a marketing authorization and, in some cases, pricing approval, from the appropriate regulatory authorities. The approval procedure varies among countries and can involve additional testing, and the time required to obtain approval may differ from that required to obtain FDA approval. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval in addition to other risks. We may not obtain foreign regulatory approvals on a timely basis, if at all. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or by the FDA. If we fail to receive necessary approvals to commercialize our products in foreign jurisdictions on a timely basis, or at all, our business, financial condition and results of operations could be adversely affected.

We may be subject to or otherwise affected by federal and state health care laws, including fraud and abuse and health information privacy and security laws, and could face substantial penalties if we are unable to fully comply with such laws.

Although we do not provide health care services, nor receive payments directly from Medicare, Medicaid, or other third-party payors for our products or the procedures in which our products are used, health care regulation by federal and state governments will impact our business. Health care fraud and abuse and health information privacy and security laws potentially applicable to our operations include, but are not limited to:

 

   

the Federal Health Care Programs’ Anti-Kickback Law, which prohibits, among other things, knowingly and willfully soliciting, receiving, offering or providing remuneration intended to induce the purchase, order or recommendation of an item or service reimbursable under a federal health care program (such as the Medicare or Medicaid programs);

 

   

federal false claims laws which prohibit, among other things, knowingly and willfully presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third-party payors that are false or fraudulent;

 

   

the federal Health Insurance Portability and Accountability Act of 1996, or HIPAA, and its implementing regulations, which established new federal crimes that prohibit knowingly and willfully executing a scheme to defraud any healthcare benefit program or making false statements in connection with the delivery of or payment for healthcare benefits, items or services, as well as imposed certain requirements relating to the privacy, security and transmission of individually identifiable health information; and

 

   

state laws analogous to each of the above federal laws, such as anti-kickback and false claims laws that may apply to items or services reimbursed by non-governmental third-party payors, including commercial insurers, and state laws governing the privacy of certain health information.

If we were found to be in violation of any of such laws or other similar governmental regulations to which we are directly or indirectly subject, and as a result we may be subject to penalties, including civil and criminal penalties, damages, fines, exclusion of our products from reimbursement under Medicare, Medicaid, and other federal health care programs, and the curtailment or restructuring of our operations. Any penalties could adversely affect our ability to operate our business and our financial results. Any action against us for violation of these laws, even if we successfully defend against them, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business.

 

32


Table of Contents

Legislative and regulatory changes in the health care industry could have a negative impact on our financial performance. Furthermore, our business, financial condition, results of operations and cash flows could be significantly and adversely affected by recently enacted health care reform legislation in the U.S. or if reform programs are adopted in our key markets.

Changes in the health care industry in the U.S. and elsewhere could adversely affect the demand for our products as well as the way in which we conduct our business. Significantly, President Obama signed health care reform legislation into law that will require most individuals to have health insurance, establish new regulations on health plans, and create insurance pooling mechanisms and other expanded public health care measures. This legislation also will reduce Medicare spending on services provided by hospitals and other providers and, effective January 1, 2013, impose a 2.3% tax on the sale of taxable medical devices by the manufacturer, producer or importer. Our operating results will be adversely affected by this new excise tax.

Many details of the recently enacted health care reform legislation will be addressed in the implementing regulations. We cannot predict the effect any future legislation or regulation will have on us or what health care initiatives, if any, will be implemented at the state level.

In general, an expansion in government’s role in the U.S. health care industry may lower reimbursements for our products, reduce demand for innovative products, reduce medical procedure volumes and adversely affect our business and results of operations, possibly materially.

Furthermore, many private payors look to Medicare’s coverage and reimbursement policies in setting their coverage policies and reimbursement amounts such that federal reforms could influence the private sector as well. Finally, many states also may attempt to reform their Medicaid programs such that either coverage for certain items or services may be narrowed or reimbursement for them could be reduced. These health care reforms may adversely affect our business.

Consistent with or in addition to Congressional or state reforms, the Centers for Medicare and Medicaid Services, or CMS, the federal agency that administers the Medicare and Medicaid programs, could change its current policies that affect coverage and reimbursement for our products. Each year however, CMS re-examines the reimbursement rates for hospital inpatient and outpatient and physician office settings and could either increase or decrease the reimbursement rate for procedures utilizing our products. We are unable to predict when legislation or regulation that affects our business may be proposed or enacted in the future or what effect any such legislation or regulation would have on our business. Any such legislation, regulation or policies that affect the coverage and reimbursement of our current or future products, or the procedures utilizing our current or future products, could cause our sales to decrease and our revenue to decline.

In addition, the requirements or restrictions imposed on us or our products may change, either as a result of administratively adopted policies or regulations or as a result of the enactment of new laws. Any new regulations or statutory provisions could result in delays or increased costs during the period of product development, clinical trials, and regulatory review and approval, as well as increased costs to assure compliance.

Further, our success in international markets also depends upon the eligibility of reimbursement for our products through government-sponsored health care payment systems and other third-party payors. Outside of the U.S., reimbursement systems vary by country. These systems are often subject to the same pressures to curb rising health care costs and control health care expenditures as those in the U.S. In addition, as economies of emerging markets develop, these countries may implement changes in their health care delivery and payment systems. If adequate levels of reimbursement from third-party payors outside of the U.S. are not obtained, sales of our products outside of the U.S. may be adversely affected.

 

33


Table of Contents

Inadequate levels of coverage or reimbursement from governmental or other third-party payors for our products, or for procedures using our products, may cause our revenues to decline.

Sales of our products depend in part on the reimbursement and coverage policies of governmental and private health care payors. The ability of our health care provider customers, including hospitals, to obtain adequate coverage and reimbursement for our products, or for the procedures in which our products are used, may impact our customers’ purchasing decisions and, therefore, could have a material adverse effect on our business.

Third-party payors have adopted, and are continuing to adopt, health care policies intended to curb rising health care costs. These policies include:

 

   

controls on reimbursement for health care services and price controls on medical products and services;

 

   

limitations on coverage and reimbursement for new medical technologies and procedures; and

 

   

the introduction of managed care and prospective payment systems in which health care providers contract to provide comprehensive health care for a fixed reimbursement amount per person or per procedure.

These trends could lead to pressure to reduce prices for our current products and product candidates and could cause a decrease in the size of the market or a potential increase in competition that could adversely affect our business, financial condition and results of operations.

Risks Related to the Auction Process for this IPO

The auction process for this public offering may result in a phenomenon known as the “winner’s curse,” and, as a result, investors may experience significant losses.

The auction process for this offering may result in a phenomenon described as the “winner’s curse.” At the conclusion of the auction, bidders that receive allocations of shares in this offering (successful bidders) may infer that there is little incremental demand for our shares above or equal to the initial public offering price. This effect may be exacerbated due to the relatively small number shares that are being offered by the selling stockholders in this offering, meaning that bidders that offer a higher price in the auction for a small number of shares could have a disproportionate effect on the clearing price established by the underwriter as compared to a larger offering that would include a more typical percentage of the issuer’s outstanding shares. As a result, successful bidders may conclude that they paid too much for our shares and could seek to immediately sell their shares to limit their losses should our stock price decline. In this situation, other investors that did not submit successful bids may wait for this selling to be completed, resulting in reduced demand for our Class B common stock in the public market and a significant decline in our stock price. Therefore, we caution investors that submitting successful bids and receiving allocations may be followed by a significant decline in the value of their investment in our Class B common stock shortly after this offering.

The auction process for this offering may result in a situation in which less price-sensitive investors play a larger role in the determination of the offering price and constitute a larger portion of the investors in this offering, and, therefore, the offering price may not be sustainable once trading of our Class B common stock begins.

In a typical initial public offering, a majority of the shares sold to the public are purchased by professional investors that have significant experience in determining valuations for companies in connection with initial public offerings. These professional investors typically have access to, or conduct their own independent research and analysis regarding, investments in initial public offerings. Other investors typically have less access to this level of research and analysis or may be motivated by other factors in making their investment decisions and, as a result, may be less sensitive to price when

 

34


Table of Contents

participating in the auction process in this offering. Because of the auction process and the other risk factors associated with this offering described in this section of the prospectus, these less price-sensitive investors may have a greater influence in setting the initial public offering price and may have a higher level of participation in this offering than is normal for initial public offerings. This, in turn, could cause the auction process to result in an initial public offering price that is higher than the price professional investors would be willing to pay for our shares. As a result, our stock price may decrease significantly and rapidly once trading of our Class B common stock begins. Also, because professional investors may have a substantial degree of influence on the trading price of our shares over time, the price of our Class B common stock may decline and not recover after this offering is completed. Furthermore, if the initial public offering price is above the level that investors determine is reasonable for our shares, some investors may attempt to short-sell (a transaction in which the investor profits if our stock price declines) our stock after trading begins, which would create additional downward pressure on the trading price of our Class B common stock.

The initial public offering price may have little or no relationship to the price that would be established using traditional valuation methods, and therefore, the initial public offering price may not be sustainable once trading begins.

The underwriter and the selling stockholders may set the initial public offering price near or equal to the auction clearing price. The offering price of the shares of Class B common stock offered by the selling stockholders may have little or no relationship to, and may be significantly higher than, the price that otherwise would be established using traditional indicators of value, such as:

 

   

our future prospects and those of our industry in general;

 

   

our sales, earnings, and other financial and operating information;

 

   

multiples of revenue, earnings, cash flows, and other operating metrics;

 

   

market prices of securities and other financial and operating information of companies engaged in activities similar to ours; and

 

   

the views of research analysts.

The underwriter did not consult with our management team or board of directors prior to estimating the initial public offering price range. Accordingly, the underwriter’s estimate of the initial public offering price range may not have taken into account the risks and challenges that we expect to affect our business, the risks associated with this offering and the auction process described in these risk factors. As a result, the initial public offering price of the shares sold by the selling stockholders may not be sustainable once trading begins, and the price of our Class B common stock may decline, significantly and rapidly, following completion of this offering.

Some bids made at or above the initial public offering price may not receive an allocation of shares.

The underwriter may require that bidders confirm their bids before the auction for the initial public offering closes. If a bidder is requested to confirm a bid and fails to do so within a required time frame, that bid may be rejected and may not receive an allocation of shares even if the bid is at or above the initial public offering price. Further, if the auction process leads to a pro rata reduction in allocated shares and a rounding down of share allocations pursuant to the rules of the auction, a bidder may not receive any shares in the offering despite having bid at or above the initial public offering price. Bids that are at or above the initial public offering price that are deemed to be manipulative of or disruptive to the bidding process, not creditworthy, or otherwise not deemed appropriate, may be rejected or reduced. For example, in previous transactions for other issuers in which the auction process was used, WR Hambrecht + Co has rejected or reduced bids when WR Hambrecht + Co, in its sole discretion, deemed the bids not creditworthy or had reason to question the bidder’s intent or means to fund its bid. In the absence of other information, the underwriter or a

 

35


Table of Contents

participating dealer may assess a bidder’s creditworthiness based solely on the bidder’s history with the underwriter or a participating dealer. WR Hambrecht + Co has also rejected or reduced bids that it deemed, in its sole discretion, to be potentially manipulative or disruptive or because the bidder had a history of alleged securities law violations. Other conditions for valid bids, including eligibility and account funding requirements of participating dealers, may vary. As a result of these varying requirements, a bidder may have its bid rejected by the underwriter or a participating dealer while another bidder’s identical bid is accepted.

Potential investors may receive a full allocation of the shares they bid for if their bids are successful and should not bid for more shares than they are prepared to purchase.

The underwriter and IVP may set the initial public offering price near or equal to the auction clearing price. In this event, the number of shares represented by successful bids will likely approximate the number of shares offered by the selling stockholders by this prospectus, and successful bidders may be allocated all or nearly all of the shares that they bid for in the auction. Therefore, we caution investors against submitting a bid that does not accurately represent the number of shares of our Class B common stock that they are willing and prepared to purchase.

Risks Related to this Offering

There is no existing market for our Class B common stock, and an active trading market may not develop.

Prior to this offering, there has been no public market for our Class B common stock. We cannot predict the extent to which investor interest in our company will lead to the development of a trading market or how liquid that trading market may become. An active and liquid trading market may not develop or be sustained following the closing of this offering. In addition, the underwriter is not required to sell any specific number or dollar amount of Class B common stock, but has agreed to use its best efforts to procure potential purchasers for the shares of Class B common stock offered pursuant to this prospectus. The initial public offering price for the shares of our Class B common stock sold in this offering will be determined by an auction process, and may not be indicative of the price that will prevail in the market following this offering. The market price for our Class B common stock may decline below the initial public offering price and our stock price is likely to be volatile. The lack of an active market may impair your ability to sell your shares at the time you wish or at a price that you consider reasonable. The lack of an active market may also reduce the value of your shares. The price of our Class B common stock in any market may be lower than the price you pay for our shares in this offering, and the price of our Class B common stock may not appreciate over time.

We expect that the price of our Class B common stock will fluctuate substantially.

The market price of our Class B common stock is likely to be subject to wide fluctuations in response to, among other things, the risk factors described in this section of the prospectus and other factors beyond our control, such as fluctuations in the operating performance or valuations of companies perceived by investors to be comparable to us. The market price of our Class B common stock is also likely to be volatile due to many other factors, including:

 

   

actual or anticipated fluctuations in our results of operations;

 

   

variance in our financial performance from the expectations of market analysts;

 

   

conditions and trends in the medical technology industry;

 

   

announcements of significant contracts by us or our competitors;

 

   

changes in our pricing policies or the pricing policies of our competitors;

 

   

the loss of one or more of our significant customers;

 

   

the introduction of new products or product enhancements by us or our competitors;

 

36


Table of Contents
   

any adverse outcome of intellectual property litigation that we may become involved in from time to time;

 

   

changes in market valuation or earnings of our competitors;

 

   

the trading volume of our Class B common stock and the number of shares of Class B common stock eligible for sale;

 

   

changes in the estimation of the future size and growth rate of our markets; and

 

   

general economic conditions.

In addition, the stock market in general has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of the particular companies affected. These broad market factors may materially harm the market price of our Class B common stock, regardless of our operating performance. These broad market and industry fluctuations, as well as general economic, political, and market conditions, such as recessions, interest rate changes or international currency fluctuations, may negatively affect the market price of our Class B common stock. In the past, following periods of volatility in the market price of a company’s securities, securities class-action litigation has often been instituted against that company. This type of litigation, if instituted against us and regardless of whether we prevail on the underlying claim, could result in substantial costs and a diversion of management’s attention and resources, which could materially harm our financial condition and results of operations.

If securities or industry analysts do not publish research or reports about our business, or if they adversely change their recommendations regarding our stock, our stock price and trading volume could decline.

Although the initial public offering price of the shares of Class B common stock offered for sale by the selling stockholder may have little or no relationship to the price that may have been established using traditional valuation methods, research analysts may rely upon these methods to establish target prices for our Class B common stock. If research analysts publish target prices for our Class B common stock that are below the initial public offering price or the then current trading market price of our shares, our stock price may decline. We do not currently have any research coverage by industry or securities analysts. If no or few analysts commence coverage of us, the trading price of our Class B common stock would likely decrease. We also do not expect analysts to have a reason to cover us. Since there is no minimum amount of shares of Class B common stock required to be sold by the selling stockholders in this offering, any reduction in the number of shares actually sold in the offering may also discourage analyst coverage. Even if we do obtain analyst coverage, we do not plan on giving guidance, and if one or more of the analysts who cover us downgrade our stock, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.

We do not anticipate paying cash dividends, and accordingly stockholders must rely on stock appreciation for any return on their investment.

We do not anticipate paying cash dividends in the future. Investors seeking cash dividends should not invest in our Class B common stock. See “Dividend Policy.”

Substantial future sales of our Class B common stock in the public market could cause our stock price to fall.

Additional sales of our Class B common stock in the public market after the consummation of this offering, or the perception that these sales could occur, could cause the market price of our Class B common stock to decline. The 729,798 shares of our Class B common stock sold in this

 

37


Table of Contents

offering will be freely transferable without restriction or additional registration under the Securities Act. After the consummation of this offering, an additional 77,910 shares of Class A common stock and 9,495,006 shares of Class B common stock (including 6,080,210 shares issuable upon conversion of preferred stock) will be available for immediate sale in the public market without restriction. Further, an additional 7,327,963 shares are held by our affiliates and may be sold in the public market if the sale is registered under the Securities Act or an exemption from registration such as Rule 144 under the Securities Act is available. Beginning 90 days after the offering, 7,325,963 of the shares held by affiliates will be tradable in the public market, subject only to the volume limitations under Rule 144. The remaining 1,829,856 shares of common stock will become freely tradeable over the course of the next six months as lock-up agreements or the applicable holding period under Rule 144 expire.

As soon as practicable after the closing of this offering, we also intend to file a registration statement covering all of the shares of our common stock issued or reserved for issuance under our equity incentive plans. Registration of the sale of these shares would generally permit their sale into the market immediately, subject to vesting restrictions. In addition, some of our stockholders holding approximately 61% of our outstanding stock after giving effect to this offering have registration rights pursuant to the Master Rights Agreement. See “Shares Eligible for Future Sale” for more information.

If you purchase shares in this offering, you may experience substantial dilution.

While the price you pay for shares of our Class B common stock sold in this offering is substantially higher than our net tangible book value per share, because this is a secondary offering of shares, the sale of shares to new investors will not result in a change to our net tangible book value per share. You will experience dilution in the future upon the exercise of options to purchase our common stock, including those options currently outstanding and those granted in the future, and the issuance of restricted stock or other equity awards under our stock incentive plans. To the extent we raise capital by issuing equity securities, our stockholders may experience substantial additional dilution. See “Dilution.”

If we are unable to assess favorably the effectiveness of our internal control over financial reporting, or if our independent registered public accounting firm is unable to provide an unqualified attestation report on our internal controls, our stock price could be adversely affected.

Section 404 of Sarbanes-Oxley and the related rules adopted by the SEC and the Public Company Accounting Oversight Board, or PCAOB, require annual management assessments of the effectiveness of our internal control over financial reporting, starting with the second annual report that we would expect to file with the SEC, and will likely require in the same report, a report by our independent auditors on the effectiveness of our internal control over financial reporting. However, as an “emerging growth company” as defined by the recently enacted JOBS Act, our independent auditors will not be required to furnish such an assessment until we no longer qualify as an emerging growth company. In connection with the implementation of the necessary procedures and practices related to internal control over financial reporting, we may identify deficiencies. We may not be able to remediate any future deficiencies in time to meet the deadline imposed by Sarbanes-Oxley for compliance with the requirements of Section 404. If we cannot timely and favorably assess the effectiveness of our internal control over financial reporting, or if our independent registered public accounting firm is unable to provide an unqualified attestation report on our internal control over financial reporting, investor confidence and our stock price could decline.

The obligations associated with being a public company will require significant resources and management attention, which may divert from our business operations.

As a result of this offering, we will become subject to the reporting requirements of the Exchange Act and Sarbanes-Oxley. The Exchange Act requires that we file annual, quarterly and current reports with respect to our business and financial condition. Sarbanes-Oxley requires, among

 

38


Table of Contents

other things, that we establish and maintain effective internal controls and procedures for financial reporting. As a result, we will incur significant legal, accounting and other expenses that we did not previously incur. Furthermore, the need to establish the corporate infrastructure demanded of a public company may divert management’s attention from implementing our growth strategy, which could prevent us from improving our business, results of operations and financial condition. We have made, and will continue to make, changes to our internal controls and procedures for financial reporting and accounting systems to meet our reporting obligations as a public company. However, the measures we take may not be sufficient to satisfy our obligations as a public company. In addition, we cannot predict or estimate the amount of additional costs we may incur in order to comply with these requirements. We anticipate that these costs will materially increase our selling, general and administrative expenses.

We are an emerging growth company within the meaning of the Securities Act, and if we decide to take advantage of certain exemptions from various reporting requirements applicable to emerging growth companies, our Class B common stock could be less attractive to investors.

We are an “emerging growth company” within the meaning of the Securities Act. For so long as we qualify as an emerging growth company, we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, reduced disclosure about our executive compensation and omission of compensation discussion and analysis, and an exemption from the requirement of holding a non-binding advisory vote on executive compensation. In addition, we will not be subject to certain requirements of Section 404(b) of Sarbanes-Oxley, including the additional level of review of our internal control over financial reporting as may occur when outside auditors attest as to our internal control over financial reporting. As a result, our stockholders may not have access to certain information they may deem important. Further, we are eligible to delay adoption of accounting standards newly issued or revised after April 5, 2012 applicable to public companies and we intend to take advantage of the benefits of this extended transition period. To the extent we choose to do so, our financial statements may not be comparable to companies that comply with such new or revised accounting standards. We will remain an emerging growth company for up to five years, though we may cease to be an emerging growth company earlier under certain circumstances. If we take advantage of any of these exemptions, investors may find our Class B common stock less attractive as a result. The result may be a less active trading market for our Class B common stock and our stock price may be more volatile.

Our status as a public company may expose us to competitive disadvantages that could harm our business operations and financial results.

The Exchange Act reports that we will be required to file with the SEC after this offering will contain detailed information regarding our financial condition, including margin and significant customer information, product development activities and executive compensation. We consider much of this information to be highly sensitive and have historically expended great effort maintaining its confidentiality. Our competitors, customers and suppliers may be able to leverage this information to our competitive disadvantage in their future strategic positioning and negotiations with us. For example, our competitors may be able more effectively to bundle their products to deter certain customers from buying our products. Our customers, distributors and suppliers may use publicly available information about our financial condition to demand more favorable contractual terms, both pricing and otherwise. Additionally, our competitors may seek to hire away members of our senior management team or other key employees, using as leverage the detailed compensation information in our Exchange Act filings. Our heightened profile as a public company may have additional, unforeseen adverse consequences to us and our financial condition.

 

39


Table of Contents

The sale of our Class B common stock in this offering may limit our senior management’s ability to manage our business effectively.

Our Class B common stock, which is the stock being offered and sold by the selling stockholders in this offering, has ten votes per share and our Class A common stock has one vote per share. Immediately after completion of this offering, the public holders of our Class B common stock, in the aggregate, will be entitled to exercise approximately 4% of the voting power of our outstanding shares. Having our Class B common stock voted by members of the public who may have only short-term goals for our business could exert undesirable pressure on the ability of our senior management team to maintain its collective, consultive style and may end up limiting our ability to manage our business effectively in the long term.

The concentration of ownership of our Class B common stock with our executive officers, directors and their affiliates will limit your ability to influence corporate matters.

As of June 30, 2012, our current executive officers and directors (and their affiliates) together owned approximately 60% of our Class B common stock, representing approximately 38% of the voting power of our outstanding shares. In addition, the holders of 10,150 shares of Class A common stock, 10,050,082 shares of Class B common stock and 185,961 shares of preferred stock have entered into a voting agreement pursuant to which they have agreed to vote their shares in accordance with the direction of a voting committee comprised of Said S. Hilal, Nabil Hilal and Stephen E. Stanley. Since February 24, 2011, the number of shares covered by the voting agreement has increased by 10,150 shares of Class A common stock and 786,423 shares of Class B common stock. As a result of the voting agreement, as of June 30, 2012, our executive officers and directors controlled approximately 53% of the voting power of our outstanding shares. Following this offering, our executive officers and directors will control approximately 77% of our outstanding Class B common stock, whether through direct or indirect beneficial ownership or their right to direct the voting of such shares in accordance with the voting agreement, representing approximately 53% of the voting power of our outstanding shares. Accordingly, since our executive officers and directors have and will have majority voting control before and after this offering, any reduction of Class B common stock sold by the selling stockholders in this offering would not affect the selling stockholders’ inability to influence corporate matters requiring stockholder approval. Our executive officers will therefore have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets, for the foreseeable future. This concentrated control will limit your ability to influence corporate matters. As a result, we may take actions that you do not view as beneficial, and the market price of our Class B common stock could be adversely affected.

If we were to list on a national securities exchange, it is likely that we would avail ourselves of the “controlled company” exception to the corporate governance rules for NYSE or NASDAQ listed companies, which could make our Class B common stock less attractive to some investors or otherwise harm our stock price.

Our Class B common stock will not be listed on a national securities exchange and we currently have no intention to do so. However, if we decide to list on a national securities exchange in the future, we may qualify as a “controlled company” under the corporate governance rules for NYSE or NASDAQ listed companies. If we elect to take advantage of this exemption, we would not be required to have a majority of our board of directors be independent, nor would we be required to have a compensation committee or an independent nominating function. Accordingly, should the interests of our controlling stockholders differ from those of other stockholders, the other stockholders may not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance rules for NYSE or NASDAQ listed companies. Our status as a controlled company could make our Class B common stock less attractive to some investors or otherwise harm our stock price.

 

40


Table of Contents

Provisions in our charter documents and under Delaware law and the voting agreement will limit your ability to influence and could negate a takeover that stockholders may consider favorable.

Provisions in our certificate of incorporation and bylaws, as amended and restated upon the closing of this offering, may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:

 

   

Our certificate of incorporation provides for two classes of common stock. Our Class B common stock, which is the stock that is being sold in this offering, is entitled to ten votes per share and our Class A common stock is entitled to one vote per share. As a result of this structure, our founders, executive officers, directors (and their affiliates) and team members will have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets. This concentrated control could discourage others from initiating any potential merger, takeover or other change of control transaction that other stockholders may view as beneficial.

 

   

Our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors.

 

   

Stockholders must provide advance notice to nominate individuals for election to the board of directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of our company.

As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us. See “Description of Capital Stock — Provisions of our Certificate of Incorporation and Bylaws and Delaware Law that May Have an Anti-takeover Effect.”

Also, provisions in the voting agreement may delay or prevent a transaction with respect to Applied that you may consider in your best interests. In particular, our stockholders party to the voting agreement can not tender any of their Applied securities into a tender offer with a third-party that may lead to a change of control of Applied unless the tender offer has been approved by the voting committee under the voting agreement. This limitation on the ability of certain of our stockholders to tender their shares may make it difficult for a third-party acquiror to acquire control of our company by means of a tender offer.

 

41


Table of Contents

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus includes forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends affecting the financial condition of our business. Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by, which such performance or results will be achieved. Forward-looking statements are based on information available at the time those statements are made and management’s good faith belief as of that time with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in or suggested by the forward-looking statements. Important factors that could cause such differences include, but are not limited to:

 

   

our belief that this offering is not in the best interests of Applied;

 

   

our ability to compete against those with greater resources;

 

   

our ability to keep pace with changes in technology and our competitors;

 

   

our ability to effectively implement our business strategies;

 

   

our ability to continue to develop and improve our products;

 

   

our relationships with GPOs and purchasers of our products;

 

   

our ability to sustain or grow the market position for our products;

 

   

the success of future products in the marketplace;

 

   

our dependence on the members of our senior management team;

 

   

our ability to preserve the Applied culture;

 

   

our ability to protect our intellectual property;

 

   

our ability to retain and attract highly skilled personnel;

 

   

acquisitions of other companies or technologies;

 

   

our ability to improve/expand our direct distribution capabilities;

 

   

our ability to satisfy the obligations of our outstanding indebtedness;

 

   

our reliance on disclosure exemptions available to “emerging growth companies”;

 

   

strategic relationships with, or investments in, other companies;

 

   

changes in general economic and business conditions, domestically and internationally;

 

   

foreign currency fluctuations;

 

   

disruptions of established supply channels;

 

   

availability and costs of raw materials;

 

   

changes in inflation;

 

   

changes in government regulations;

 

   

fluctuations in our operating results;

 

   

our ability to maintain and effectively manage our growth;

 

   

the impact of a natural disaster;

 

   

the costs of complying with laws and regulations applicable to public reporting companies; and

 

   

other risk factors included under “Risk Factors” in this prospectus.

 

42


Table of Contents

In addition, in this prospectus, the words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “predict,” “potential” and similar expressions, as they relate to our company, our business and our management, are intended to identify forward-looking statements. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this prospectus may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements.

Forward-looking statements speak only as of the date of this prospectus. You should not place undue reliance on any forward-looking statements. We assume no obligation to update forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information, except to the extent required by applicable laws. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.

 

43


Table of Contents

USE OF PROCEEDS

We will not receive any proceeds from the sale of Class B common stock by the selling stockholders. We expect to incur approximately $             million of expenses in connection with this offering, including those expenses of the selling stockholders that we are obligated to pay under the Master Rights Agreement.

DIVIDEND POLICY

We do not anticipate paying any cash dividends in the foreseeable future. Instead, we anticipate that all of our earnings, if any, in the foreseeable future will be used for working capital and to support our operations. Any future determination relating to dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including restrictions and preferences contained in our preferred stock, restrictions in our debt instruments, our future earnings, capital requirements, financial condition, future prospects, contractual restrictions, restrictions imposed by applicable law and other factors that the board of directors may deem relevant. For a more detailed description of the restrictions and preferences with respect to dividends on our preferred stock, see “Description of Capital Stock — Preferred Stock — Dividends.” We are also restricted from declaring or paying cash dividends under the senior secured credit facility. See “Description of Certain Indebtedness — Covenants and Other.”

We have an ongoing authorization, since February 2009, from our Board of Directors to repurchase up to 1,000,000 shares of our common stock and preferred stock from stockholders for a price and on such terms and conditions as management may determine appropriate in each case, subject to compliance with legal restrictions and covenants with our secured lenders. We expect to continue stock repurchase activity following completion of this offering in a manner consistent with past practices. Our senior secured credit facility includes provisions allowing us to repurchase shares of capital stock or pay dividends in aggregate amounts of up to $10 million per year and up to $50 million over the five-year term of the credit facility.

 

44


Table of Contents

CAPITALIZATION

The following table sets forth our capitalization as of June 30, 2012:

 

   

on an actual basis; and

 

   

on a pro forma basis to give effect to the conversion of 729,798 shares of preferred stock into 729,798 shares of Class B common stock in connection with this offering.

This table should be read together with “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus.

 

    June 30, 2012  
    Actual     Pro forma  
    (in thousands, except
share information)
 

Long-term debt (including current portion)

  $ 91,798      $ 91,798   

Redeemable convertible preferred stock, par value $0.001 per share, 7,009,998 shares authorized, 6,995,969 shares issued and outstanding at June 30, 2012, actual; 7,009,998 authorized, 6,266,171 issued and outstanding, pro forma (1)

    14,106        12,241   

Class A common stock, par value $0.001 per share, 25,000,000 shares authorized, 153,739 issued and outstanding (2)(4)

    —          —     

Class B common stock, par value $0.001 per share, 25,000,000 shares authorized, 12,310,825 shares issued and outstanding at June 30, 2012, actual; 25,000,000 shares authorized, 13,040,623 shares issued and outstanding, pro forma (1)(3)(4)

    12        13   

Additional paid-in capital

    35,308        37,172   

Retained earnings

    146,300        146,300   
 

 

 

   

 

 

 

Total capitalization

  $ 287,524      $ 287,524   
 

 

 

   

 

 

 

 

(1) Assumes the selling stockholders’ conversions of shares of preferred stock into shares of Class B common stock in connection with this offering are allocated among the series of preferred stock as follows

 

     Number of Shares  

Series A preferred stock

     257,795   

Series B preferred stock

     244,162   

Series D preferred stock

     35,000   

Series E preferred stock

     3,750   

Series F preferred stock

     189,091   
  

 

 

 
     729,798   
  

 

 

 

 

(2) Amounts issued and outstanding exclude 6,313 shares of Class A common stock which are held in treasury and include 45,531 shares of Class A common stock which were obtained with nonrecourse notes receivable or pursuant to an early exercise feature, which shares are not presented as outstanding in the accompanying consolidated financial statements.
(3) Amounts issued and outstanding exclude 36,640 shares of Class B common stock which are held in treasury and 37,950 shares of Class B common stock that we have repurchased from Mr. T. Peter Thomas, a former member of our board of directors, pending Mr. Thomas’ compliance with the repurchase provisions of the applicable stock option agreements. This issued and outstanding amount includes 1,066,856 shares of Class B common stock which were obtained with nonrecourse notes receivable or pursuant to an early exercise feature, which shares are not presented as outstanding in the accompanying consolidated financial statements.
(4) Amounts issued and outstanding exclude 43,600 shares of Class A common stock and 2,968,694 shares of Class B common stock issuable upon exercise of outstanding stock options that have been granted under our stock incentive plans and 2,535,871 shares of Class A common stock and Class B common stock available for future grant or issuance under our Third Amended and Restated 2008 Stock Incentive Plan.

 

45


Table of Contents

DILUTION

We calculate net tangible book value per share of our common stock by dividing the net tangible book value (total book value of tangible assets less total liabilities) by the number of shares of our Class A common stock and Class B common stock outstanding as of June 30, 2012 (assuming the conversion of all outstanding shares of our preferred stock).

As of June 30, 2012, we had a net tangible book value of $194.6 million, or approximately $10.00 per share. We will not receive any proceeds from the sale of Class B common stock by the selling stockholders in this offering, and the offering will not result in a change to the number of outstanding shares of our Class A common stock and Class B common stock (assuming conversion of all outstanding shares of our preferred stock). Accordingly, our net tangible book value per share as of June 30, 2012 would have remained $10.00 after giving effect to the sale of Class B common stock by the selling stockholders in this offering. Cash payments made by purchasers of the shares being offered will not result in a change in our net tangible book value per share.

The following table provides an illustration:

 

Assumed initial public offering price per share

   $ 32.00   

Net tangible book value per share at June 30, 2012

   $ 10.00   
  

 

 

 

Dilution per share to new investors

   $ 22.00   
  

 

 

 

As of June 30, 2012, persons who were officers, directors, promoters or affiliated persons during the five-year period ended June 30, 2012 purchased no shares of Class A common stock and 1,901,350 shares of Class B common stock from us for total consideration of $12.3 million. The average price per share paid by such persons was $6.49 for Class B common stock, as compared to an assumed initial public offering price of $32.00 (the midpoint of the price range set forth on the cover page of this prospectus).

You will experience dilution in the future upon the exercise of options to purchase our common stock, including those options currently outstanding and those granted in the future, and the issuance of restricted stock or other equity awards under our stock incentive plans. To the extent we raise capital by issuing equity securities, our stockholders may experience substantial additional dilution.

 

46


Table of Contents

SELECTED CONSOLIDATED FINANCIAL DATA

We derived the selected income statement data for the years ended December 31, 2010 and 2011 and the selected balance sheet data as of December 31, 2010 and 2011 from our audited consolidated financial statements and notes thereto included in this prospectus. We derived the selected income statement data for the six months ended June 30, 2011 and 2012 and the selected balance sheet data as of June 30, 2012 from our unaudited consolidated financial statements and notes thereto that are included in this prospectus. We have prepared this unaudited information on the same basis as the audited financial statements and have included all adjustments, consisting of normal recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results for such periods. Our historical results are not necessarily indicative of the results that may be expected in the future. The following financial data are only a summary and should be read together with our financial statements and the notes thereto, and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this prospectus.

 

     Year Ended December 31,     Six Months Ended June 30,  
         2010             2011         2011
(unaudited)
    2012
(unaudited)
 
     (in thousands)  

Consolidated Income Statement Data:

        

Product revenue

   $ 271,810      $ 338,453      $ 159,991      $ 178,975   

Royalties and license revenue

     10,365        11,631        6,859        3,029   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     282,175        350,084        166,850        182,004   

Cost of revenues

     55,041        69,634        32,139        36,959   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     227,134        280,450        134,711        145,045   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses:

        

Selling, general and administrative

     156,781        169,803        76,044        90,438   

Research and development

     38,308        48,340        21,975        29,782   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     195,089        218,143        98,019        120,220   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     32,045        62,307        36,692        24,825   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense):

        

Interest and other income

     1,007        1,299        617        904   

Interest expense

     (2,358 )     (2,069     (1,109     (2,038
  

 

 

   

 

 

   

 

 

   

 

 

 

Other expense, net 

     (1,351     (770     (492     (1,134
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     30,694        61,537        36,200        23,691   

Provision for income taxes

     9,809        17,162        10,279        8,559   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     20,885        44,375        25,921        15,132   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

        

Foreign currency translation adjustments

     680        (1,425     3,742        (1,842

Unrealized gain on long-term investments, net of tax

     —          —          —          479   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

     680        (1,425     3,742        (1,363
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 21,565      $ 42,950      $ 29,663      $ 13,769   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to common stockholders

   $ 11,667      $ 27,097      $ 15,853      $ 9,283   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

47


Table of Contents
     Year Ended December 31,      Six Months Ended June 30,  
         2010              2011          2011
(unaudited)
     2012
(unaudited)
 
     (in thousands, except per share information)  

Net income per share:

           

Basic

   $ 1.19       $ 2.30       $ 1.37       $ 0.75   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted

   $ 1.18       $ 2.20       $ 1.32       $ 0.74   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted-average number of common shares:

           

Basic

     9,785         11,793         11,611         12,370   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted

     9,901         12,305         12,021         12,596   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     As of December 31,      As of June 30, 2012  
     2010      2011      (unaudited)  
     (in thousands)  

Consolidated Balance Sheet Data:

        

Cash and cash equivalents

   $ 52,789       $ 59,870       $ 63,934   

Property, plant and equipment

     122,583         163,940         206,299   

Total assets

     235,652         315,098         377,767   

Total long-term liabilities

     61,910         75,006         92,848   

Redeemable convertible preferred stock

     14,118         14,106         14,106   

Total stockholders’ equity

     114,203         162,125         180,641   

 

48


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this prospectus. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this prospectus, particularly in “Risk Factors.”

Overview

Applied is a medical device company dedicated to improving clinical outcomes, enhancing choices and availability, and improving value and service in the surgical side of healthcare. We compete against highly established and powerful competitors by enhancing products and their clinical outcomes while, at the same time, reducing the ASPs in the marketplace. We believe that this is an efficient way of breaking into some highly contested and often foreclosed market segments.

One of the most significant trends currently underway in our markets is price compression. Although some observers believe that such pressures are tied to current economic conditions, uncertainties and unemployment, we believe that the causes are more fundamental. For example, most market ASPs for specialized surgical devices are highly inflated and have not been subject to true competitive environments. As a result, and in light of economic limitations, cutbacks and austerity measures throughout the world, we believe prices are likely to fall dramatically over the next five to ten years.

Another key trend is the reprocessing of single-use medical devices for reuse due to the high prices of the devices charged by suppliers, although these devices were designed, qualified and approved as single-use only devices. The FDA has recently begun to permit re-processors to clean and sterilize these devices for second and third uses. Hospitals pressed for savings tend to save their used products and, through re-processors, attempt to reuse these same devices a second or third time, usually for half the original prices. This trend has had more impact on suppliers with the highest market ASPs, although it has had a limited impact on our business because of the value we offer and our exceptionally competitive pricing strategies.

A third key trend currently underway in our business is the increased prices and related fees demanded by certain of our distributors in recent contract negotiations. We believe that the increased prices and related fees demanded by our distributors in such contract negotiations are attempts to capture an increasing portion of our revenues as a result of the public disclosure of our financial condition, including our margins. We are taking steps to enhance our own direct distribution capabilities to deliver our products and moving away from reliance on third-party distributors to distribute our products to our customers.

Although our research and development activities often translate into improved product offerings, we generally do not charge any premium for the improved versions of our products, even though improved products typically involve significant research and development expenditures and incremental production costs. Rather than pursuing premium pricing, we rely instead on the efficiencies created by our vertical integration, innovative processes and automation to cushion the impact of deteriorating market ASPs and mitigate the impact of lower product margins often associated with improved products in many situations.

Our operating margins are heavily impacted by the extent of our operating expenditures and investments. We believe we spend a considerably higher percentage of our revenues on research and development than our competitors do.

 

49


Table of Contents

Similarly, we spend a high percentage of our revenues on our selling efforts and we believe we have managed to build one of the larger sales forces in our market. We spend considerable amounts on training, educating and retaining our sales team and consider this investment critical to our success. We expect to continue to spend similar amounts for the foreseeable future.

Our general and administrative expenditures are usually increased by the cost of litigation expenses. We have spent considerable amounts to defend and enforce our patents and to ensure our markets are not foreclosed or subjected to predatory practices by our competitors. As we expand our product offerings and develop new products, we expect to experience an increase in litigation expenses to ensure such additional markets are not foreclosed or subjected to predatory practices by current and potential new competitors.

We have experienced and continue to experience growth in our operations, specifically since the foreclosed nature of the laporoscopic device market changed somewhat after 2003, in part as a result of the implementation of the carve-out by Ethicon Endo-Surgery, Inc. and Ethicon, Inc. Following the opening of this market in 2003, we have experienced compounded growth rates in excess of 20 percent. We believe the carve-out will expire in October 2015, after which time we expect it may become more difficult for our trocar products and surgical instruments to compete in the marketplace. However, we are unable to quantify the impact that the expiration of the carve-out may have on our sales of trocars and surgical instruments because the carve-out is only one factor that contributed to our product revenue growth. We believe the growth in our sales of trocars and surgical instruments can also be attributed to a number of other factors, including our product innovations, the efforts of our sales team, the economic environment and our competitive pricing policies, the availability of clinical studies supporting the efficacy of our products, and the expansion of our global distribution capabilities.

For many years prior to the current global financial crisis, we invested heavily in infrastructure, personnel, research and development, automation and distribution channels. For example, in 2006 and 2007 we spent approximately 20% and 19%, respectively, of our revenues on research and development, and $60.0 million and $16.7 million on capital expenditures. Principally as a result of the global financial crisis, our planned research and development expenditures were reduced to approximately 14%, 13% and 13% of our revenues in 2008, 2009 and 2010, respectively, and we reduced our planned levels of capital expenditures. We increased spending in our planned research and development expenses to approximately 14% and 16% of our revenues in 2011 and during the six months ended June 30, 2012, respectively. Similarly, we increased capital expenditures in 2011 as compared to 2010 by 21%, to $56.5 million and we have incurred capital expenditures of $51.5 million during the six months ended June 30, 2012. We intend to continue to significantly increase investments in research and development, sales and marketing and capital expenditures during the balance of 2012 and beyond. As a result of this increased spending and the industry factors described above, we expect our net income, gross margins and operating margins will be adversely impacted for the foreseeable future.

Results of Operations

The following describes the line items set forth in our consolidated income statements.

Revenues

We have two principal product lines, which consist of surgical access devices and surgical instruments. Surgical access devices include trocars used in laparoscopic procedures, GelPort® and GelPOINT® products used in hand-assisted laparoscopic and single-incision procedures, respectively, and Alexis® wound protectors/retractors for open surgical procedures. Surgical instrument product revenues are derived from sales of laparoscopic clip appliers, scissors, graspers, dissectors, retrieval systems, clips and clamps used in a variety of surgical procedures. Our product revenues consist primarily of sales of these surgical devices and instruments to hospitals and out-patient surgical centers for use by surgeons in operating rooms. We sell these surgical devices and instruments through our direct sales force and through distributors.

 

50


Table of Contents

Our total revenues consisted of the following:

 

     Year Ended December 31,     Six Months Ended
June 30,

(unaudited)
 
         2010             2011             2011             2012      

Surgical access devices

     67     67     66     66

Surgical instruments

     20     22     22     24

Other products

     9     8     8     8

Royalties and licensing

     4     3     4     2
  

 

 

   

 

 

   

 

 

   

 

 

 
     100     100     100     100
  

 

 

   

 

 

   

 

 

   

 

 

 

Our royalty revenue is primarily related to an agreement which expired in January 2012, pursuant to which we licensed certain technology to an unrelated licensee. Pursuant to this agreement, we received royalties at a specified per unit price for sales made by the licensee. Under this agreement, we recorded royalties aggregating approximately $9.3 million, $10.6 million, $6.3 million and $2.9 million for the years ended December 31, 2010 and 2011 and for the six months ended June 30, 2011 and 2012, respectively.

Cost of revenues

We manufacture all of the products we sell. Our cost of revenues consists of material and component costs, direct labor and other direct and indirect manufacturing overhead costs. We recognize cost of revenues when we recognize revenue for the transaction.

Selling, general and administrative

Selling, general and administrative expenses consist primarily of payroll and other compensation costs for sales and administrative personnel, which include the executive, finance, information technology, legal and human resources departments, sales commissions, travel costs, professional and consulting fees, legal fees, facilities and other indirect costs.

Research and development

Research and development expenses consist primarily of payroll and other compensation costs for personnel involved in product and technology research and development activities, prototyping and tooling costs and depreciation.

Interest income

Interest income consists of interest earned on our cash, cash equivalents and investment balances.

Interest expense

Interest expense consists primarily of interest charges on our short- and long-term borrowings.

Other income (expense)

Other income (expense) generally consists of income (expense) generated from non-operating transactions.

Provision for income taxes

Provision for income taxes is comprised of federal, state, local and foreign taxes based on income.

 

51


Table of Contents

Six Months Ended June 30, 2011 and 2012

Revenues

 

     Six Months Ended June 30,           
             2011                        2012                % Change  
     (unaudited, dollars in thousands)           

Product revenue

   $ 159,991         $ 178,975           12

Royalties and licensing revenue

     6,859           3,029           -56
  

 

 

      

 

 

      

Total revenues

   $ 166,850         $ 182,004           9
  

 

 

      

 

 

      

Total revenues increased by 9%, or $15.1 million, to $182.0 million for the six months ended June 30, 2012 compared to $166.9 million for the six months ended June 30, 2011.

Product revenue increased $19.0 million to $179.0 million for the six months ended June 30, 2012 compared to $160.0 million for the six months ended June 30, 2011. Of this increase, $10.2 million was attributable to increased unit sales of our surgical access devices and $7.5 million was attributable to increased unit sales of our surgical instruments. The increased product revenue was also due to an expansion of our sales force and our continued expansion in select European markets, primarily Germany, the United Kingdom, France and the Netherlands. The increase in unit sales of surgical access devices was primarily attributable to trocar ports, Alexis products, GelPort systems and GelPOINT platforms. Increases in unit sales of surgical instruments were primarily attributable to endo instruments and laparoscopic clip appliers. These increases in revenue include a $2.8 million unfavorable impact due to changes in foreign currency rates, primarily resulting from the weakening of the Euro.

Royalties and licensing revenue decreased $3.9 million to $3.0 million for the six months ended June 30, 2012 compared to $6.9 million for the six months ended June 30, 2011 due to a lower volume of trocars sold under royalty agreements, of which the primary licensing agreement expired on January 31, 2012. We anticipate our royalties and licensing revenue to be further reduced to an immaterial amount for the remainder of 2012 due to the expiration of our principal outbound technology license agreement in January 2012.

Revenues by geography

 

     Six Months Ended June 30,         
             2011                        2012              % Change  
     (unaudited, dollars in thousands)         

United States

   $ 106,451         $ 111,296         5

Percentage of total revenues

     64        61   

International

     60,399           70,708         17

Percentage of total revenues

     36        39   
  

 

 

      

 

 

    
   $ 166,850         $ 182,004         9
  

 

 

      

 

 

    

The growth in revenues from international markets was primarily due to increased direct business with hospitals from sales force expansion in select European markets, primarily Germany, the United Kingdom, France and the Netherlands.

 

52


Table of Contents

Cost of revenues and gross profit

 

     Six Months Ended June 30,         
             2011                        2012              % Change  
     (unaudited, dollars in thousands)         

Cost of revenues

   $ 32,139         $ 36,959         15

Percentage of total revenues

     19        20   

Gross profit

   $ 134,711         $ 145,045         8

Percentage of total revenues

     81        80   

Cost of revenues increased by $4.9 million to $37.0 million for the six months ended June 30, 2012 compared to $32.1 million for the six months ended June 30, 2011. Gross profit increased $10.3 million to $145.0 million for the six months ended June 30, 2012 compared to $134.7 million for the six months ended June 30, 2011. Our gross margin decreased by 1% to 80% for the six months ended June 30, 2012 from 81% for the six months ended June 30, 2011. This decrease was primarily attributable to increased labor and facility costs associated with added production capacity that grew at a slightly higher rate than the growth in revenues. The increase in production was primarily attributable to the increased inventory requirements of our new East Coast warehouse and distribution facility which commenced operations in the second quarter of 2012.

Our cost of revenues and corresponding gross profit as a percentage of revenue can be expected to fluctuate in future periods depending upon changes in our product sales mix and prices, distribution channels and geographies, manufacturing yields, period expenses, production volume and currency exchange rates. Based on management’s current expectations with respect to continued price compression and declining production volumes, we expect our gross profit margins to decrease in the foreseeable future.

Effective January 1, 2013, a 2.3% medical device excise tax will be imposed on the sale of taxable medical devices by the manufacturer, producer or importer. We are in the process of evaluating the impact of this medical device excise tax on our results of operations and financial position, but believe that there will be a materially adverse impact to our cost of revenues and gross profit as a percentage of revenue as a result of this medical device excise tax.

Selling, general and administrative

 

     Six Months Ended June 30,         
             2011                        2012              % Change  
     (unaudited, dollars in thousands)         

Selling, general and administrative

   $ 76,044         $ 90,438         19

Percentage of total revenues

     46        50   

Selling, general and administrative expenses increased by $14.4 million, or 19%, to $90.4 million in the six months ended June 30, 2012 from $76.0 million for the six months ended June 30, 2011. This increase was due to a $4.2 million increase in payroll and related costs, primarily due to an increase of approximately 77 team members as of June 30, 2012 as compared to June 30, 2011 and a $4.0 million increase in incentive plan and bonus expenses due to management’s ability to meet or exceed both company and individual performance objectives. Stock-based compensation expense increased by $2.5 million during the six months ended June 30, 2012, which was primarily attributable to a stock option repricing in March 2012 and to a lesser extent, to the timing and volume of stock option and restricted stock grants. Losses from foreign currency transactions were $1.9 million higher for the six months ended June 30, 2012 compared to the six months ended June 30, 2011 primarily due to the weakening of the Euro. Facility and related infrastructure expenses increased by $1.2 million

 

53


Table of Contents

as a result of costs incurred resulting from a fire in one of our properties in the second quarter of 2012 and as a result of multiple buildings acquired during the previous 12 months. Expenses related to our initial public offering were $0.7 million higher in the six months ended June 30, 2012 compared to the six months ended June 30, 2011. Product sample expense increased by $0.4 million for the six months ended June 30, 2012 compared to the six months ended June 30, 2011 as a result of an increase in the sales force and the introduction of new products and other sales and administrative expense increased $0.3 million. These increases were offset by a $0.8 million decrease in patent litigation expense.

As a percentage of revenue, selling, general and administrative expenses increased from 46% to 50% for the six months ended June 30, 2012 as compared to the same period in 2011, primarily as a result of our continued investment in our sales team and increased depreciation expense resulting from higher capital expenditures in 2012. We currently expect that our selling, general and administrative expenses will continue to increase in 2012 as we make further investments in recruiting and training our sales team members, increase our emphasis on clinical selling efforts, complete improvements to recently acquired real estate and continue our efforts with respect to our initial public offering.

Research and development

 

     Six Months Ended June 30,         
             2011                        2012              % Change  
     (unaudited, dollars in thousands)         

Research and development

   $ 21,975         $ 29,782         36

Percentage of total revenues

     13        16   

Research and development expenses increased by $7.8 million, or 36%, to $29.8 million for the six months ended June 30, 2012 compared to $22.0 million for the six months ended June 30, 2011. Approximately $4.2 million of this increase was due to increases in payroll and related costs, primarily due to an increase of over 80 research and development team members as of June 30, 2012 as compared to June 30, 2011. This increase in team members is a direct result of our continued effort to invest in technologies, processes, automation, products and advanced tooling. Expenses for prototyping, tooling and outside services for the six months ended June 30, 2012 increased $3.0 million compared to the six months ended June 30, 2011 due to increased development activity, outside consulting and testing of new devices. Depreciation expense increased by $0.4 million for the six months ended June 30, 2012 compared to the six months ended June 30, 2011 as a result of higher capital expenditures on development and tooling equipment. Stock-based compensation expense also increased by $0.1 million during the same period as a direct result of a stock option repricing in March 2012.

As a percentage of total revenues, research and development expenses increased from 13% during the six months ended June 30, 2011 to 16% during the six months ended June 30, 2012 as a result of our product development expenses growing at a slightly faster rate than our revenue and further investing in our processes, automation, products and advanced tooling. We expect our level of research and development expenses to continue at current or increased levels for the remainder of 2012 as we continue to invest in innovative processes and automation and accelerate our product development cycle.

 

54


Table of Contents

Other expense, net

 

     Six Months Ended June 30,           
             2011                        2012                % Change  
     (unaudited, dollars in thousands)           

Interest and other income

   $ 617         $ 904           47

Interest expense

     (1,109        (2,038       
84

  

 

 

      

 

 

      
   $ (492      $ (1,134     
  

 

 

      

 

 

      

Interest and other income increased by $0.3 million to $0.9 million for the six months ended June 30, 2012 compared to $0.6 million for the six months ended June 30, 2011 due to higher average cash and cash equivalents balances in 2012. Interest expense increased by $0.9 million to $2.0 million for the six months ended June 30, 2012 compared to $1.1 million for the six months ended June 30, 2011 primarily due to a loss on early extinguishment of debt of $0.9 million incurred in connection with the refinancing of our long-term indebtedness, which was completed based on substantially different terms, with our new senior secured credit facility in April 2012.

As a result of our anticipated borrowings under our new senior secured credit facility, as further discussed in “Description of Certain Indebtedness,” we expect interest expense to increase in the foreseeable future.

Provision for income taxes

 

     Six Months Ended June 30,           
             2011                        2012                % Change  
     (unaudited, dollars in thousands)           

Provision for income taxes

   $ 10,279         $ 8,559           -17
  

 

 

      

 

 

      

Our effective tax rate, which is calculated as the provision for income taxes as a percent of income before the provision for taxes, was 36% for the six months ended June 30, 2012 compared to 28% for the six months ended June 30, 2011. The increase in the effective tax rate during the six months ended June 30, 2012 was primarily due to the federal research and development tax credits which were not in effect during the six months ended June 30, 2012, and an increase in income of certain foreign subsidiaries subject to U.S. taxation and non-deductible expenses related to our initial public offering.

Fiscal Years ended December 31, 2010 and 2011

Revenues

 

     Year Ended December 31,         
             2010                      2011              % Change  
     (dollars in thousands)         

Product revenue

   $ 271,810       $ 338,453         25

Royalties and licensing revenue

     10,365         11,631         12
  

 

 

    

 

 

    

Total revenues

   $ 282,175       $ 350,084         24
  

 

 

    

 

 

    

Total revenues increased by 24%, or $67.9 million, to $350.1 million for the year ended December 31, 2011 compared to $282.2 million for the year ended December 31, 2010.

 

55


Table of Contents

Product revenue increased $66.7 million to $338.5 million for the year ended December 31, 2011 compared to $271.8 million for the year ended December 31, 2010. This increase was primarily caused by a $44.9 million increase in unit sales of our surgical access devices and a $20.1 million increase in unit sales of our surgical instruments, due to further expansion in select European markets, primarily Spain, Germany, Italy and the United Kingdom, combined with an expansion of our sales force. The increase in unit sales of surgical access devices was primarily attributable to trocar ports, GelPort systems, GelPOINT platforms and Alexis products. Increases in unit sales of surgical instruments were primarily attributable to increases in endo instruments and laparoscopic clip appliers. These increases in product revenues include a $5.6 million favorable impact due to changes in foreign currency rates resulting from the strengthening of the Euro and the Australian dollar.

Royalties and licensing revenues increased $1.2 million to $11.6 million for the year ended December 31, 2011 compared to $10.4 million for the year ended December 31, 2010 due to a higher volume of trocars sold under royalty agreements. We expect royalty and licensing revenues to be largely eliminated after January 2012 due to the expiration of our principal outbound technology license agreement.

Revenues by geography

 

     Year Ended December 31,        
          2010             2011         % Change  
     (dollars in thousands)        

United States of America

   $ 182,701      $ 217,155        19

Percentage of total revenues

     65     62  

International

     99,474        132,929        34

Percentage of total revenues

     35     38  
  

 

 

   

 

 

   

Total revenues

   $ 282,175      $ 350,084     
  

 

 

   

 

 

   

The growth in revenues from international markets was primarily due to increased direct business with hospitals, from sales force expansion in select European markets, primarily Spain and Italy, and to a lesser extent from changes in foreign currency rates resulting from the strengthening of the Euro and the Australian dollar during 2011.

Cost of revenues and gross profit

 

     Year Ended December 31,        
         2010             2011         % Change  
     (dollars in thousands)        

Cost of revenues

   $ 55,041      $ 69,634        27

Percentage of total revenues

     20     20  

Gross profit

   $ 227,134      $ 280,450        23

Percentage of total revenues

     80     80  

Cost of revenues increased by $14.6 million to $69.6 million for the year ended December 31, 2011 compared to $55.0 million for the year ended December 31, 2010. Gross profit increased by $53.3 million to $280.4 million for the year ended December 31, 2011 compared to $227.1 million for the year ended December 31, 2010. Our gross margin remained consistent at 80% for the years ended December 31, 2010 and 2011.

Our cost of revenues and corresponding gross profit as a percentage of revenue can be expected to fluctuate in future periods depending upon changes in our product sales mix and prices, distribution channels and geographies, manufacturing yields, period expenses, production volume and currency exchange rates. Based on management’s current expectations with respect to continued price compression, we expect our gross profit margins to decrease in 2012 and the foreseeable future.

 

56


Table of Contents

Selling, general and administrative

 

     Year Ended December 31,        
         2010             2011         % Change  
     (dollars in thousands)        

Selling, general and administrative

     $156,781        $169,803        8%   

Percentage of total revenues

     56     49  

Selling, general and administrative expenses increased by $13.0 million, or 8%, to $169.8 million for the year ended December 31, 2011 from $156.8 million for the year ended December 31, 2010. This increase was due to a $9.0 million increase in payroll and related costs, primarily due to an increase of approximately 90 team members during the year ended December 31, 2011 as compared to the year ended December 31, 2010, and a $7.5 million increase in incentive plan and bonus expenses due to management’s ability to meet or exceed both company and individual performance objectives in 2011. In addition, commission expense increased by $3.1 million, which was primarily attributable to expansion of our sales force, resulting in a higher revenue base. Consultant and outside service expenses increased by $2.9 million due to the growth of our operations, including $1.6 million incurred in relation to this offering. Expenses related to travel, meetings and conventions were $2.3 million higher as the cost of travel increased and we sponsored more conventions and physician training sessions in a continued effort to sustain our brand through clinical selling programs, including training and educational initiatives. Other sales and administrative expenses were $2.9 million higher, including $0.9 million from foreign currency transactions. These increases were offset by losses of $4.9 million incurred in the acquisition of a research and development facility previously under lease and $2.2 million incurred on disposal of fixed assets in 2010. Stock-based compensation expense decreased by $3.8 million during the year ended December 31, 2011, which was attributable to the timing and volume of grants of stock options and restricted stock awards, including a stock option repricing in March 2010, which resulted in $1.0 million of incremental stock compensation during the year ended December 31, 2010. Additionally, legal expenses decreased by $3.4 million as a result of the timing of trials related to patent and other competition-related litigation.

As a percentage of revenue, selling, general and administrative expenses decreased from 56% to 49% for the year ended December 31, 2011 as compared to the same period in 2010, primarily as a result of revenue growing at a faster rate than our non-variable selling expenses. We currently expect that our selling, general and administrative expenses will increase significantly in 2012 in absolute dollars as we make further investments in infrastructure to meet our reporting obligations as a public company, recruit and train additional sales team members, increase our emphasis on clinical selling efforts and incur additional costs associated with intellectual property litigation.

Research and development

 

     Year Ended December 31,        
         2010             2011         % Change  
     (dollars in thousands)        

Research and development

     $38,308        $48,340        26%   

Percentage of total revenues

     13     14  

Research and development expenses increased by $10.0 million, or 26%, to $48.3 million for the year ended December 31, 2011 as compared to $38.3 million for the year ended December 31, 2010. Of this increase, approximately $6.2 million was due to increased payroll and payroll related costs due to the addition of approximately 90 research and development team members. This increase in team members was part of our continued effort to invest in technologies, processes, automation, products and advanced tooling. An additional increase of $1.6 million in incentive plan and bonus

 

57


Table of Contents

expenses was primarily due to management’s ability to meet or exceed both company and individual performance objectives in 2011. Our increased spending was also attributable to a $1.3 million increase in prototype and tooling expenses and an additional $0.9 million increase in depreciation expense as a result of higher levels of capital expenditures.

As a percentage of total revenue, research and development expenses increased to 14% during the year ended December 31, 2011 from 13% during the year ended December 31, 2010, as a result of our product development expenses growing at a slightly faster rate than our revenue. We expect our level of research and development expenses to further increase in 2012 and the forseeable future as we continue to invest in innovative processes and automation and accelerate our product development cycle.

Other expense, net

 

     Year Ended December 31,        
         2010             2011         % Change  
     (in thousands)        

Interest and other income

   $ 1,007      $ 1,299        29

Interest expense

     (2,358     (2,069     -12
  

 

 

   

 

 

   
   $ (1,351   $ (770  
  

 

 

   

 

 

   

Interest and other income increased by $0.3 million to $1.3 million for the year ended December 31, 2011 compared to $1.0 million for the year ended December 31, 2010 due to higher interest yields realized on cash deposits in foreign bank accounts. Interest expense decreased by $0.3 million to $2.1 million for the year ended December 31, 2011 from $2.4 million for the year ended December 31, 2010 due to lower interest rates charged on our existing debt with variable interest rates.

Provision for income taxes

 

     Year Ended December 31,         
         2010              2011          % Change  
     (dollars in thousands)         

Provision for income taxes

   $ 9,809       $ 17,162         75
  

 

 

    

 

 

    

Our effective tax rate, which is calculated as the provision for income taxes as a percent of income before the provision for income taxes, was 28% for the year ended December 31, 2011 as compared to 32% for the year ended December 31, 2010. The decrease in the effective tax rate was primarily due to an increase of research tax credits of $1.3 million and the release of a liability for uncertain tax positions of $2.1 million related to foreign net operating losses in 2011, offset by anticipated income in jurisdictions in which we do business with different effective tax rates.

Liquidity and Capital Resources

We have funded our working capital requirements and expansion primarily with cash provided by our operating activities. Our principal sources of liquidity are our cash flows provided by operating activities, our existing cash and cash equivalents, and our credit facilities. Cash flow metrics, such as earnings before interest, taxes, depreciation and amortization, or EBITDA, for us are not comparable to the same metrics for other companies in our industry because of our vertically integrated and capital intensive business model. For example, we own rather than lease most of our facilities (unlike other companies in our industry), and have financed our acquisitions of real properties, improvements and

 

58


Table of Contents

equipment with borrowings under our credit facilities. We believe the resulting amounts of depreciation expense and interest expense are greater from period to period than the rent expense we otherwise would incur if we operated our facilities and equipment under operating leases. As of June 30, 2012, we had cash and cash equivalents of $63.9 million and short and long-term debt of $91.8 million. Included in our cash and cash equivalents were $15.3 million in cash and $48.6 million in cash equivalents, consisting of money market accounts and certificates of deposit with banking institutions. We entered into a new senior secured credit facility in April 2012 which provides (1) a $35 million senior secured revolving credit facility, (2) a $50 million senior secured term loan, and (3) a $65 million senior secured delayed draw term loan facility. Proceeds of the $50 million term loan were used to refinance $49.6 million aggregate principal amount of indebtedness, including $20 million of advances under our prior revolving line of credit which was replaced with the new $35 million senior secured revolving credit facility. In June 2012, we advanced $17.6 million under the senior secured delayed draw term loan facility, the proceeds of which were used for the acquisition of industrial facilities in Rancho Santa Margarita, California. In July 2012, we advanced an additional $8.0 million under the senior secured delayed draw term loan facility, the proceeds of which were used for construction related to recent real estate acquisitions and other capital investments.

Our new senior secured credit facility has financial and operational covenants that could limit our ability to transfer or dispose of assets, incur capital expenditures, merge with or acquire other companies, make investments, pay dividends, repurchase shares of capital stock, incur additional indebtedness and liens and conduct transactions with affiliates. Further, the new senior secured credit facility also includes financial covenants that require us to remain below a maximum leverage ratio and maintain a minimum fixed charge ratio. The new credit facilities also impose certain restrictions on our ability to pay dividends to, or repurchase shares of capital stock from, our stockholders. See “Description of Certain Indebtedness”.

From time to time we have responded to requests from stockholders for liquidity by repurchasing their shares of common stock or preferred stock and have provided opportunities for stockholders to sell their shares back to us. We have an ongoing authorization, since February 2009, from our Board of Directors to repurchase up to 1,000,000 shares of our common stock and preferred stock from stockholders for a price and on such terms and conditions as management may determine appropriate in each case, subject to compliance with legal restrictions and covenants with our secured lenders. We expect to continue stock repurchase activity following completion of this offering in a manner consistent with past practices. Our senior secured credit facility includes provisions allowing us to repurchase shares of capital stock or pay dividends in aggregate amounts of up to $10 million per year and up to $50 million over the five-year term of the credit facility.

The following table sets forth, for the periods indicated, our cash flow data:

 

    Year Ended
December 31,
    Six Months Ended
June 30,
 
    2010     2011     2011
(unaudited)
    2012
(unaudited)
 
    (in thousands)  

Cash provided by operating activities

  $ 50,488      $ 52,039      $ 24,956      $ 37,751   

Cash used in investing activities

    (44,327     (58,434     (20,026     (58,302

Cash provided by (used in) financing activities

    10,992        14,194        (759     25,722   

Effects of exchange rate changes on cash

    544        (718     3,561        (1,107
 

 

 

   

 

 

   

 

 

   

 

 

 

Net increase in cash and cash equivalents

  $ 17,697      $ 7,081      $ 7,732      $ 4,064   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

59


Table of Contents

Operating activities

Net cash provided by operating activities was $37.8 million for the six months ended June 30, 2012 compared to $25.0 for the six months ended June 30, 2011. Net cash provided by operating activities for the six months ended June 30, 2012 was comprised of $15.1 million in net income, net non-cash operating expenses of $13.8 million and an increase in operating liabilities net of operating assets of $8.9 million. Adjustments for non-cash items of $13.8 million consisted primarily of $8.5 million in depreciation expense on property, plant and equipment, $3.7 million of stock-based compensation, a $0.9 million loss from early extinguishment of debt, a $0.6 million increase in the provision for excess and obsolete inventory and a $0.2 million increase in the provision for accrued warranty costs. The increase in cash resulting from changes in operating liabilities net of operating assets primarily consisted of an increase of $9.6 million in accrued payroll and related benefits, mainly related to increase in amounts accrued under the Long-Term Strategic Bonus Plan, payable in December 2012, an increase of $6.4 million in other current liabilities primarily due to a $6.2 million increase in accrued income and other taxes payable and an increase of $1.8 million in deferred licensing and other revenue and $1.8 million in accounts payable. These increases were primarily offset by a $8.5 million increase in inventory which was attributable to management’s effort to meet increased demand in unit sales and in anticipation of increased inventory requirements resulting from our new East Coast warehouse and distribution facility which commenced operations in May 2012 and an increase of $2.3 million in our accounts receivable due to a 12% increase in product revenue in the six months ended June 30, 2012 as compared to the same period in 2011.

Net cash provided by operating activities of $25.0 million for the six months ended June 30, 2011 was comprised of $25.9 million in net income and net non-cash operating expenses of $8.6 million, offset by an increase in operating assets net of operating liabilities of $9.5 million. Adjustments for non-cash items of $8.6 million consisted primarily of $6.7 million in depreciation expense on property, plant and equipment, $0.6 of accrued warranty costs and $1.1 million of stock-based compensation. The decrease in cash resulting from changes in operating assets net of operating liabilities primarily consisted of a $5.3 million increase in our accounts receivable due to a $34.8 million, or 28%, increase in product revenue during the six months ended June 30, 2011 as compared to the same period in 2010 and a $7.9 million increase in inventories which was primarily attributable to management’s deliberate efforts to meet sales demand and to take advantage of lower prices by buying raw materials ahead of anticipated price increases. These increases to cash were offset by a $3.8 million increase in other non-current liabilities which was primarily attributable to the accrual of a long-term bonus plan which commenced in 2010.

Net cash provided by operating activities was $52.0 million for the year ended December 31, 2011 compared to $50.5 million for the year ended December 31, 2010. Net cash provided by operating activities for the year ended December 31, 2011 increased primarily as a result of $44.4 million in net income and net non-cash operating expenses of $21.1 million, offset by an increase in operating assets net of operating liabilities of $13.5 million. Adjustments for non-cash items of $21.1 million consisted primarily of $14.0 million in depreciation expense on property, plant and equipment, $2.2 million of stock-based compensation, $2.2 million in a deferred income tax provision, a $0.9 million increase in the provision for excess and obsolete inventory reserves, a $0.8 million increase in the provision for accrued warranty costs, a $0.6 million increase in the provision for doubtful accounts and a $0.6 million loss on disposal of fixed assets. The decrease in cash resulting from changes in operating assets net of operating liabilities primarily consisted of an $8.6 million increase in our accounts receivable due to a $66.7 million, or 25%, increase in product revenue during the year ended December 31, 2011 as compared to the same period in 2010, a $14.5 million increase in inventories which was primarily attributable to management’s effort to meet increased forecasted sales demand and to take advantage of lower prices by buying raw materials ahead of anticipated price increases, a $1.5 million increase in other current assets primarily related to prepaid expenses, a $10.4 million decrease in other non-current liabilities which was primarily attributable to a $7.6 million reclass

 

60


Table of Contents

of the long-term bonus plan, a $2.7 million decrease in the liability for unrecognized tax benefits and an increase of $0.5 million in other current liabilities. These decreases to cash were offset by an increase of $19.9 million (including a $7.6 million reclass from other non-current liabilities) in accrued payroll and related benefits primarily related to the long-term bonus plan which commenced in 2010 and an increase of $2.1 million in accounts payable.

Net cash provided by operating activities was $50.5 million for the year ended December 31, 2010 and was primarily a result of net income of $20.9 million, net non-cash operating expense of $25.3 million and an increase in operating liabilities net of operating assets of $4.3 million. Adjustments for non-cash items of $25.3 million consisted primarily of $12.6 million of depreciation on property, plant and equipment, $2.6 million of expenses in connection with the reconfiguration of a facility, $4.9 million of a loss on the purchase of a facility which was previously leased by Applied and $6.1 million of stock-based compensation. These increases were partially offset by a $2.2 million increase in a deferred tax benefit in 2010. The $4.3 million increase in operating liabilities net of operating assets consisted of a $5.1 million increase in accrued payroll and related benefits due to the increase in the number of team members, a $6.6 million increase in long-term liabilities which was primarily attributable to the accrual of a long-term bonus plan which commenced in 2010 and will be paid in 2013 and a $0.8 million increase in other current liabilities, a $0.6 million increase in accounts payable and a $0.7 million decrease in other current assets. These increases to cash were offset by a $7.0 million increase in accounts receivable which was primarily attributable to the $50.2 million, or 23%, increase in product revenues during 2010, a $2.7 million increase in inventories which was primarily attributable to management’s efforts to meet increased sales demand and to take advantage of lower prices by buying raw materials in bulk.

Investing activities

Net cash used in investing activities was $58.3 million for the six months ended June 30, 2012 due primarily to capital expenditures of $51.5 million, the purchase of a long-term investment for $5.4 million and the purchase of a secured note receivable for $1.5 million. Net cash used in investing activities was $20.0 million for the six months ended June 30, 2011 due to capital expenditures in the same amount.

Net cash used in investing activities of $58.4 million for the year ended December 31, 2011 was primarily due to capital expenditures of $56.5 million, an increase of $1.1 million in restricted cash, the $0.8 million purchase of a secured note receivable and the issuance of $0.3 million of notes receivable to employees offset by the collection of $0.2 million on notes receivable from employees.

Net cash used in investing activities totaled $44.3 million for the year ended December 31, 2010 and was primarily due to capital expenditures of $46.6 million and the issuance of notes receivable to team members and stockholders of $0.4 million, offset by a decrease in restricted cash of $1.8 million and proceeds from short-term investments of $0.9 million.

Our industry is capital intensive, particularly as it relates to manufacturing facilities. Historically, our capital expenditures have consisted principally of purchased manufacturing equipment and facilities, research and testing equipment and facilities, computer systems, office furniture and equipment. We expect our capital expenditures for facilities, machinery and equipment to remain significant for the foreseeable future.

Financing activities

Net cash provided by financing activities of $25.7 million for the six months ended June 30, 2012 was primarily due to $71.2 million of proceeds from long-term debt and $7.4 million of net proceeds from short-term borrowings resulting mainly from our new senior secured credit facility, which closed in April 2012, proceeds of $1.1 million from stock option exercises and $0.4 million from interest and principal collections on notes receivable from stockholders offset by $52.6 million of repayments of

 

61


Table of Contents

long-term debt primarily relating to the refinancing of substantially all of our indebtedness, with the exception of one mortgage note payable, with the new senior secured credit facility, $1.6 million of debt issuance costs paid in connection with our new senior secured credit facility and the repurchase of treasury stock for $0.2 million. Net cash used in financing activities of $0.8 million for the six months ended June 30, 2011 was primarily comprised of the repayment of $5.0 million of short-term debt, $2.4 million of long-term debt and repurchases of preferred stock for $0.2 million, offset by proceeds from new long-term debt of $4.4 million, proceeds from stock option exercises of $1.3 million and collections on notes receivable from stockholders of $1.1 million.

Net cash provided by financing activities of $14.2 million for the year ended December 31, 2011 was primarily due to the proceeds from new short-term borrowings of $21.4 million, proceeds from new long-term debt of $4.4 million, collection of $2.5 million of principal and $0.3 million of interest on nonrecourse notes receivable from stockholders, proceeds from stock option exercises of $1.7 million and $0.1 million from excess tax benefits from share-based payments offset by repayment of $10.0 million of short-term borrowings, $5.3 million of repayments on long-term debt, $0.5 million of amounts paid in connection with the voluntary conversion of Class B common stock to Class A common stock and repurchases of preferred and common stock for $0.6 million.

Net cash provided by financing activities of $11.0 million for the year ended December 31, 2010 was primarily due to $31.3 million in net proceeds from new long-term debt, $5.0 million in net proceeds from net short-term borrowings and $5.6 million in proceeds from the exercise of stock options, offset by repayments of $27.8 million on long-term debt and the repurchases of common stock for $ 2.7 million.

Future liquidity needs

During 2011, our operations were primarily funded from cash generated by operations. We anticipate significantly higher capital expenditures related to expanding our international operations, acquiring real estate in the United States and related construction and capital improvement activities and investing in other capital equipment. Our focus on international expansion will require both continuing and incremental investments in facilities and infrastructure in the U.S., Europe and Australia. For the next 12 months, we believe that our cash balances, cash flow from operations, and available borrowings under our new senior secured credit facility will be sufficient to fund our operations, our working capital requirements, and our presently planned capital investments.

We do not currently have any material commitments with respect to planned capital expenditures, other than the construction of our European headquarters in the Netherlands and construction related to recent real property acquisitions and capital improvement activities. We currently expect our planned capital expenditures in the next 12 months to be approximately $84.0 million. Our senior secured credit facility includes covenants limiting the aggregate amount of capital expenditures we may incur in any single calendar year to $100 million for 2012, $75 million for 2013 and 2014 and $55 million for 2015 and 2016. Through June 30, 2012, we have incurred approximately $51.5 million of capital expenditures, as we initiated certain real property acquisitions and other capital improvement programs at a faster rate than expected, and currently expect to incur an aggregate of approximately $100 million of capital expenditures in 2012. In the event that we require additional working capital to fund future operations, we could seek to obtain funding through debt financing arrangements. Our new senior secured credit facility also includes covenants restricting our ability to incur additional debt. There can be no assurance that any financing transaction will be available on terms acceptable to us, or at all. If we do not have, or are not able to obtain, sufficient funds, we may have to delay development or commercialization of our products, delay or cancel facilities projects or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize.

 

62


Table of Contents

Recently Adopted Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements (“ASU No. 09-13”). ASU No. 09-13 modifies the requirements that must be met for an entity to recognize revenue from the sale of a delivered item that is part of a multiple-element arrangement when other items have not yet been delivered. We adopted the updated guidance effective January 1, 2011. We did not enter into any revenue arrangements subject to this new guidance during 2011 and, therefore, the implementation of this new guidance did not have an impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (“ASU No. 10-06”). ASU No. 10-06 expands the interim and annual disclosure requirements of fair value measurements, including the information about transfers in and out of Level 1 and Level 2 fair value measurements and requires additional disclosure regarding purchases, sales, issuances and settlements of Level 3 measurements, effective for fiscal years beginning after December 15, 2010. The adoption of ASU No. 10-06 for Level 1 and Level 2 measurements effective January 1, 2010 and for Level 3 measurements effective January 1, 2011 did not have a material impact on our consolidated financial statements.

Effective January 1, 2012, we adopted ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, or ASU 11-04. ASU 11-04 provides a consistent definition of fair value and ensures that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards, or IFRS. The new guidance changes certain fair value measurement principles and enhances the disclosure requirements particularly for level 3 fair value measurements. The adoption of ASU No. 11-04 did not have a material impact on our consolidated financial statements.

Effective January 1, 2012, we adopted ASU 2011-05 Comprehensive Income (Topic 220): Presentation of Comprehensive Income, or ASU 11-05. ASU 11-05 requires us to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. The new standard eliminates the option to present items of other comprehensive income in the statement of changes in equity or in the notes to the financial statements. The new requirements do not change which components of comprehensive income are recognized in net income or other comprehensive income, or when an item of other comprehensive income must be reclassified to net income. We elected to present a single continuous statement of comprehensive income.

 

63


Table of Contents

Contractual Obligations and Commitments

The following table summarizes our outstanding contractual obligations as of December 31, 2011.

 

     Total      Less than
1 Year
     1-3
Years
     3-5
Years
     More than
5 Years
 
     (in thousands)  

Amounts reflected in
consolidated balance sheet:

              

Debt, including current portion

   $ 66,749       $ 5,696       $ 23,502       $ 8,529       $ 29,022 (1) 

Amounts not reflected in
consolidated balance sheet:

              

Construction contract obligations

     11,766         11,766         —           —           —     

Operating lease obligations

     3,287         1,462         1,638         187         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 81,802       $ 18,924       $ 25,140       $ 8,716       $ 29,022   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) As further discussed in “Description of Certain Indebtedness”, we entered into a new senior secured credit facility in April 2012 which consists of (1) a $35 million senior secured revolving credit facility, (2) a $50 million senior secured term loan, and (3) a $65 million senior secured delayed draw term loan facility. Proceeds of the $50 million term loan were used to refinance $49.6 million aggregate principal amount of indebtedness, including $16.4 million of advances under our prior revolving line of credit which were outstanding as of December 31, 2011 and are presented as long-term indebtedness in our balance sheet as of December 31, 2011 as a result of the refinancing.

In May 2011, we acquired real property in Amersfoort, Netherlands, for a purchase price of $3.8 million which was paid from available cash. Under the terms of the purchase agreement with the seller, we have agreed to construct office and warehouse facilities on this land within 18 months of the issuance of required building permits. We entered into a construction contract for this project in July 2011. As of December 31, 2011, the estimated cost of construction is $16.5 million. As of December 31, 2011 and June 30, 2012, we have incurred approximately $4.7 million and $11.1 million, respectively, of expenses related to the construction of these facilities. The construction was completed in the third quarter of 2012.

In the first half of 2012, we acquired four industrial facilities in Rancho Santa Margarita, California for an aggregate purchase price of $29.2 million, which was paid from borrowings under our credit facilities and available cash.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.

Critical Accounting Policies and Estimates

Our consolidated financial statements and the related notes included elsewhere in this prospectus are prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and any related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Changes in accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. We evaluate our estimates and assumptions on an ongoing basis. To the extent that there are material differences between these estimates and our actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected.

 

64


Table of Contents

We believe that the following accounting policies involve a greater degree of judgment and complexity than our other accounting policies and accordingly, represent our critical accounting policies. We have other key accounting policies, which involve the use of estimates, judgments and assumptions that are significant to understanding our results, which are included in note 2 to the consolidated financial statements included elsewhere in this prospectus.

Inventories

Inventories consist of finished goods, work-in-process, and raw materials, including components which are semi-finished goods. Product inventories are stated at the lower of cost or market. Cost is determined using a standard cost method (which approximates first-in, first-out) and includes material, labor and overhead. Inventory valuation allowances are recorded for materials that have become obsolete or are no longer used in current production and for inventory that has a market value less than the carrying value in inventory. We generally purchase raw materials in quantities that we anticipate will be fully used within one year. However, changes in operating strategy and customer demand, and frequent unpredictable fluctuations in market values for such materials can limit our ability to effectively utilize all of the raw materials purchased and sold through resulting finished goods to customers for a profit. We regularly monitor potential inventory excess, obsolescence and lower market values compared to standard costs and, when necessary, reduce the carrying amount of our inventory to its market value. Specific reserves are maintained to reduce the carrying value of inventory items on hand that we know may not be used in finished goods. Our inventory reserve was $0.7 million, $1.0 million and $1.2 million at December 31, 2010, December 31, 2011 and June 30, 2012, respectively. If our estimates for potential inventory losses prove to be too low, then our future earnings will be affected when the related additional inventory losses are recorded.

Revenue recognition

We derive revenues from various sources including direct sales to end user hospitals, other direct customers, sales to domestic and international distributors and sales to original equipment manufacturers. Domestic and international distributors will resell the products to end user hospitals and other customers in their assigned territories. Revenue is recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable, and (4) collectability is reasonably assured. We record revenue from product sales when title and risk of ownership have been transferred to the customer, which is typically upon delivery to the customer. When collectability is not reasonably assured, the recognition of revenue is deferred until payment is received as long as the remaining revenue recognition criteria are met.

Customers do not have a general right of return for credit or refund on product sales; however, we allow customers to return product upon approval within 30 days from original sale. We estimate and accrue for these returns as a reduction of product revenues and accounts receivable based on historical return rates. Accruals for sales returns were not material as of December 31, 2010 or 2011 or June 30, 2012.

We also sell certain products under an arrangement in which the end user hospitals participate in clinical product evaluations. The terms and conditions for these arrangements provide for customer return provisions which generally range from 30 to 90 days from the initial delivery of the product under evaluation. Due to the nature of the clinical product evaluations, our level of continuing involvement subsequent to delivery can be significant, and therefore, revenue recognition is deferred on these clinical product evaluations until the evaluation period is complete. Deferred revenue related to evaluation sales was $1.4 million, $0.4 million and $0.7 million as of December 31, 2010, December 31, 2011 and June 30, 2012, respectively.

Certain domestic distributors purchase products at specified distributor pricing and then resell the products to end user hospitals which may have separate pricing agreements with us or are

 

65


Table of Contents

members of GPOs which have contracts with us. In those situations when distributor prices are higher than the end user hospital contracted prices, we provide discounts or charge-backs to these distributors for the excess of the distributor prices above the end user hospital prices. We estimate and provide allowances for the discounts or charge-backs at the time of sale as a reduction to product revenues and accounts receivable. As of December 31, 2010, December 31, 2011 and June 30, 2012, we accrued charge-backs of $4.3 million, $4.8 million and $4.6 million, respectively.

Stock-based compensation

We measure and recognize compensation expense for all stock-based awards made to officers, team members, consultants and non-employee directors based on estimated fair values on the date of grant. Stock-based awards consist of stock options and restricted stock. Stock-based compensation cost is measured at the grant date based on the fair value of the award as determined using an acceptable option-pricing model and is recognized as expense over the requisite service period (vesting period), net of estimated forfeitures. Forfeitures are estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from those estimates.

We use the Black-Scholes option-pricing model to estimate the value of stock-based compensation expense for all stock-based awards. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant dates requires considerable judgment, including estimating the risk-free interest rate, expected option term, stock price volatility and dividend yield. Management develops estimates based on historical data and market information, which can change significantly over time. The risk-free interest rate is based on the implied yield on U.S. Treasury notes as of the grant date with a term approximating the expected life of the options. We utilize the average of the contractual term of the options and the weighted average vesting period for all options to calculate the expected option life. The expected stock price volatility is based on historical volatility of similar companies that are public and compete in the medical device industry. The use of this peer data to determine expected volatility will continue until sufficient information regarding the volatility of our share price is available and reliable. Applied has not historically declared dividends and therefore, the estimated annual dividend yield is 0%.

Beginning in 2010, we accepted promissory notes from certain team members as consideration for stock to be issued upon exercise of stock options. The total outstanding balance of these notes receivable was $7.7 million, $7.6 million and $8.4 million as of December 31, 2010, December 31, 2011 and June 30, 2012, respectively. These notes receivable are accounted for as nonrecourse loans. For accounting purposes, the nonrecourse notes are accounted for as the grant of new stock options. The estimated fair values of the newly granted stock options are recognized as compensation expense on the issuance date of the nonrecourse note. As a result, we recognized compensation expense related to these notes in the amount of $2.2 million, $0.6 million, $0.5 million and $0.3 million during the years ended December 31, 2010 and 2011, and the six months ended June 30, 2011 and 2012, respectively. The common stock underlying the notes receivable is not presented as outstanding in the consolidated balance sheet. As principal payments are made on the notes receivable, the Class B common stock is presented as outstanding on a pro-rata basis.

Common stock valuations

The fair value of the common stock underlying our stock options was determined by our board of directors, which intended that all options granted were exercisable at a price per share not less than the per share fair value of our common stock underlying those options on the date of grant. The assumptions used in the valuation model are based on future expectations combined with management judgment. In the absence of a public trading market, the board of directors, with input from management, exercised significant judgment and considered numerous objective and subjective

 

66


Table of Contents

factors to determine the fair value of our common stock as of the date of each stock-based award grant date, including the following factors:

 

   

the prices, rights, preferences and privileges of our preferred stock relative to our common stock;

 

   

our operating and financial performance;

 

   

current business conditions and projections;

 

   

the market performance of comparable publicly traded companies;

 

   

the U.S. and global capital market conditions; and

 

   

any adjustment necessary to recognize a lack of marketability for our common stock.

We granted restricted stock and stock options with the following exercise price ranges each quarter since August 20, 2010, at which time we completed a holding company reorganization.

 

Stock-based award grant period

   Number of
Shares
Underlying
Options
     Exercise
Price Per
Share
     Number of
Restricted
Stock
Awards
     Common
Stock Fair
Value Per
Share at
Grant Date
 

Quarter ended September 30, 2010

     —           —           —           —     

Quarter ended December 31, 2010
Class B common stock

     399,300       $ 7.67         —         $ 7.67   

Quarter ended March 31, 2011
Class B common stock

     558,900       $ 10.50         400       $ 10.46   

Quarter ended June 30, 2011

     —           —           —           —     

Quarter ended September 30, 2011

     —           —           —           —     

October 25, 2011(1)

           

Class A common stock

     1,000       $ 14.96         —           —     

Class B common stock

     1,316,800       $ 15.75         334,700       $ 15.75   

December 14, 2011(1)

           

Class A common stock

     8,000       $ 12.40         2,000       $ 12.40   

Class B common stock

     20,000       $  13.05         5,000       $ 13.05  

March 21, 2012

           

Class A common stock

     34,600       $ 7.94         8,400       $ 7.94   

Class B common stock

     150,000       $ 8.36         59,500       $ 8.36   

 

(1) In March 2012, we completed a stock option repricing to reduce the exercise price of the stock options granted in October and December 2011. See “Executive Compensation – Elements of Compensation – 2012 Option Repricing.”

There have been no other stock-based awards granted since March 21, 2012 through the date of this prospectus.

In order to determine the fair value of our Class A and Class B common stock underlying option grants and the fair value of the restricted stock, we first determined our business enterprise value, or BEV, and then allocated the BEV to each element of our capital structure (preferred stock, common stock, and options). Our BEV was estimated using a combination of two generally accepted approaches: the income approach using the discounted cash flow method, or DCF, and the market-based approach using the comparable company method. The DCF method estimates enterprise value based on the estimated present value of future net cash flows the business is expected to generate over a forecasted period and an estimate of the present value of cash flows beyond that period, which is referred to as terminal value. The estimated present value is calculated using a discount rate known

 

67


Table of Contents

as the weighted average cost of capital, which accounts for the time value of money and the appropriate degree of risk inherent in the business. The market-based approach considers multiples of financial metrics based on both revenues and earnings multiples of a selected peer group of companies. These multiples are then applied to our financial metrics to derive a range of indicated values. Once calculated, the discounted cash flow and comparable company methods are then weighted. In allocating the total equity value between preferred and common stock, we assumed that the preferred stock would convert to common stock. Estimates of the volatility of our common stock were based on available information on the volatility of common stock of comparable, publicly traded companies.

Significant factors considered by our board of directors in determining the fair value of our common stock at these grant dates include:

Quarter ended December 31, 2010

During the fall of 2010, the U.S. economy and the financial and stock markets continued their recovery and our business continued expanding domestically and internationally. We experienced sequential revenue growth of $70.7 million for the quarter ended September 30, 2010, compared to $65.9 million for the quarter ended June 30, 2010, and $60.5 million for the quarter ended September 30, 2009, and achieved record financial results during the nine months ended September 30, 2010. We performed a contemporaneous valuation of our Class B common stock as of September 30, 2010 and determined the fair value of our Class B common stock to be $7.67 per share. Our BEV reflected a non-marketability discount of 17.2% based on a liquidity event expected to occur within approximately two years, which was considered to be reasonable based on facts and circumstances at that time. The board of directors also considered whether there were any events or other factors to consider which would change the estimated fair value between the valuation date of September 30, 2010 and the grant date of December 10, 2010. Based on this valuation and the factors discussed above, our board of directors granted stock options with an exercise price of $7.67 per share.

Quarter ended March 31, 2011

In the first quarter of 2011, the U.S. economy and the financial and stock markets continued their recovery. We continued our sequential revenue growth of $81.1 million for the quarter ended December 31, 2010, compared to $70.7 million for the quarter ended September 30, 2010, and $63.4 million for the quarter ended December 31, 2009, and we continued to achieve record financial results during the year ended December 31, 2010 and continued that trend into the first quarter of 2011. We performed a contemporaneous valuation of our Class B common stock as of December 31, 2010 and determined the estimated fair value of our Class B common stock to be $8.31 per share. Our BEV reflected a non-marketability discount of 12.8% based on a liquidity event expected to occur approximately over a year from the valuation date, which was considered to be reasonable based on facts and circumstances at that time. Using the actual rate of increases in our Class B common stock based on the common stock valuations performed, we estimated the increase in the fair value of our Class B common stock from December 31, 2010, the date of the last common stock valuation, through March 18, 2011, the grant date of the stock options, to be approximately $2.19, resulting in an estimated Class B common stock fair value of $10.50 as of March 18, 2011. Accordingly, the board of directors granted stock options with an exercise price of $10.50 per share.

October 18, 2011

In the second and third quarter of 2011, our business continued to grow and we experienced sequential revenue growth of $85.8 million for the quarter ended June 30, 2011, compared to $81.1 million for the quarter ended March 31, 2011, and $65.9 million for the quarter ended June 30, 2010. We continued to achieve record financial results during the nine months ended September 30, 2011. We performed a contemporaneous valuation of our Class B common stock as of October 18, 2011,

 

68


Table of Contents

and determined the fair value of our Class B common stock to be $15.75 per share. Our BEV reflected a non-marketability discount of 15.1% based on a liquidity event expected to occur within approximately two years. Estimating the time to liquidity was carefully considered as of October 18, 2011. We placed significant weight on the volatility of the U.S. stock market and the reduction in the number of initial public offerings during the third quarter of 2011. Accordingly, we extended the time to a liquidity event from the last common stock valuation date. We also considered the demand registration rights exercised by certain of our stockholders on August 25, 2011, as further discussed under the “Risk Factors” section. At the time of the common stock valuation, the board of directors and management did not, and continue to not, believe that an initial public offering is currently in the best interests of our company. We did, however, consider the possibility that complying with our obligations under the registration rights provisions of the Master Rights Agreement could result in our undertaking an initial public offering earlier than the two year estimated time to a liquidity event, although we believe this possibility was limited due to the uncertain market for initial public offerings during the late summer and fall of 2011 and our uncertainty over the underwriter’s views as to the timing of this offering. We further considered that if we were compelled to register our Class B common stock, our liquidity would not increase significantly as compared to prior to the consummation of this offering. After carefully weighing the above noted factors, we based our Class B common stock valuation on October 18, 2011 on an estimated time to liquidity of approximately two years, which represented the board of director’s and management’s best estimate of a liquidity event given our uncertainty as to whether this offering will be completed successfully. Based on all of these factors, our board of directors granted stock options with an exercise price of $15.75 per share.

December 8, 2011

During the second and third quarter of 2011, our business continued to grow and we experienced sequential revenue growth of $88.4 million for the quarter ended September 30, 2011 compared to $85.8 million for the quarter ended June 30, 2011, and $70.7 million for the quarter ended September 30, 2010. We continued to achieve record financial results during the nine months ended September 30, 2011.

Despite these record financial results, we expect that our net income, gross margins and operating margins will be adversely impacted by price compression, decreases in sales volume and increased investments in research and development, sales and marketing and capital expenditures in 2012 and beyond. As a result, we have updated our five-year forecast to take into account these factors. These forecasts were used for purposes of performing our common stock valuation as of December 8, 2011. We performed a contemporaneous valuation of our Class A and Class B common stock as of December 8, 2011, and determined the fair value of our Class A common stock to be $12.40 and our Class B common stock to be $13.05 per share. Our BEV reflected a non-marketability discount of 16.6% based on a liquidity event expected to occur within approximately 1.5 years. Estimating the time to liquidity was carefully considered as of December 8, 2011. We placed significant weight on the volatility of the U.S. stock market and the continuing reduction in the number of initial public offerings during the fourth quarter of 2011.

At the time of the common stock valuation, the board of directors and management did not, and continue not to, believe that an initial public offering is currently in the best interests of our company. We did, however, consider the continued uncertainty of the timing of this offering. We further considered that even if the registration of our Class B common stock were to be effective, our liquidity would not increase significantly as compared to prior to the consummation of this offering. After carefully weighing the above noted factors, we based our Class A and Class B common stock valuation on December 8, 2011 on an estimated time to liquidity of approximately 1.5 years, which represented the board of director’s and management’s best estimate of a liquidity event given our uncertainty as to whether this offering will be completed successfully.

 

69


Table of Contents

March 14, 2012

We continued to experience sequential revenue growth which increased from $88.4 million for the quarter ended September 30, 2011 to $94.8 million for the quarter ended December 31, 2011. Our revenue declined to $91.0 million for the quarter ended March 31, 2012 from $94.8 million for the quarter ended December 31, 2011. Reduced operating spending levels in the first quarter of 2012 resulted in operating income of $11.8 million in the quarter ended March 31, 2012 as compared to $7.3 million in the quarter ended December 31, 2011. We continue to fully expect that price compression, decreases in sales volume and increased investments in research and development, sales and marketing and capital expenditures in 2012 will negatively impact our revenues, gross margins, operating margins and net income in 2012 and beyond. Our BEV reflected a non-marketability discount of 30.2% based on a liquidity event expected to occur within approximately 4 years. Estimating the time to liquidity was carefully considered by management and ultimately extended from approximately 1.5 years as of the December 8, 2011 valuation to approximately 4 years for purposes of performing the March 14, 2012 valuation. In extending the estimated time to liquidity, we considered not only the continued volatility of the U.S. stock market, but placed significant emphasis on our liquidity needs in the short and long term. In April 2012, we entered into a new $150 million senior secured credit facility, which management expects will meet our current liquidity needs through the maturity date of April 2017. Based on our current five-year forecast and other facts and circumstances, we anticipate that we would undertake a liquidity event in January 2016 to coincide with the maturity of the senior secured credit facility in April 2017.

Based on the above noted assumptions and factors, we performed a contemporaneous valuation of our Class A and Class B common stock as of March 14, 2012 and determined the fair value of our Class A common stock to be $7.94 and our Class B common stock to be $8.36. The board of directors considered whether there were any events or other factors to consider which would change the estimated fair value between the valuation date of March 14, 2012 and the grant date of March 21, 2012. Based on this valuation and the factors discussed above, our board of directors granted stock options using the common stock valuation as of March 14, 2012.

Income Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expenses and assessing temporary differences resulting from recognition of items for income tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must reflect this increase as an expense within the tax provision in our income statement.

Management’s judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We continue to monitor the realizability of our deferred tax assets and adjust the valuation allowance accordingly.

At December 31, 2011, we had state and foreign net operating loss carryforwards of $1.4 million and $0.5 million, respectively, which will begin to expire in 2019 and 2015, respectively. As of December 31, 2011, we had $5.4 million of California research and development tax credits available for use in future tax periods which may be carried forward indefinitely. Management considered all available positive and negative evidence, including scheduled reversals of liabilities, projected future taxable income, tax planning strategies and recent financial performance, and determined that a valuation allowance of $5.1 million was appropriate as of December 31, 2011 for those deferred tax assets that are not expected to provide future tax benefits.

 

70


Table of Contents

As of December 31, 2011 and June 30, 2012, the liability for income taxes associated with uncertain tax positions was $3.2 million and $3.7 million, respectively. The amount of unrecognized benefits which, if ultimately recognized, could favorably affect the tax rate in a future period was $2.6 million and $3.0 million as of December 31, 2011 and June 30, 2012, respectively. This amount is net of any federal and/or state benefits. It is reasonably possible that the amount of unrecognized tax benefits in various jurisdictions may change in the next 12 months due to the expiration of statutes of limitation or audit settlements. As of December 31, 2011, management estimates that the decrease in unrecognized tax benefits within the next 12 months will total approximately $0.3 million.

Interest and penalties related to unrecognized tax benefits are recognized in income tax expense. At December 31, 2011, we had accrued $0.3 million of interest and penalties (net of tax benefits of $0.1 million) related to uncertain tax positions.

We conduct business in multiple jurisdictions, and as a result, one or more of our subsidiaries files income tax returns in the U.S. federal, various state, local and foreign jurisdictions. We have concluded that we are no longer subject to U.S. federal, state and non-U.S. income tax examinations by taxing authorities prior to 2007.

JOBS Act

We qualify as an “emerging growth company” pursuant to the JOBS Act. The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for qualifying companies.

As defined in the JOBS Act, a company whose initial public offering of common equity securities occurred after December 8, 2011 and whose annual gross revenues are less than $1.0 billion will, in general, qualify as an “emerging growth company” until the earliest of:

 

   

the last day of the fiscal year following the fifth anniversary of its initial public offering of common equity securities;

 

   

the last day of the fiscal year in which it has annual gross revenue of $1.0 billion or more;

 

   

the date on which it has, during the previous three-year period, issued more than $1.0 billion in non-convertible debt; and

 

   

the date on which it is deemed to be a “large accelerated filer,” which will occur at such time as the company (a) has an aggregate worldwide market value of common equity securities held by non-affiliates of $700 million or more as of the last business day of its most recently completed second fiscal quarter, (b) has been required to file annual and quarterly reports under the Securities Exchange Act of 1934 for a period of at least 12 months, and (c) has filed at least one annual report pursuant to the Securities Act of 1934.

Under this definition, we will be an “emerging growth company” upon completion of this offering and could remain an “emerging growth company” until as late as December 31, 2017.

Pursuant to Section 107(b) of the JOBS Act, as an “emerging growth company” we are electing to delay adoption of accounting pronouncements newly issued or revised after April 5, 2012 applicable to public companies until such pronouncements are made applicable to private companies. As a result, our financial statements may not be comparable to the financial statements of issuers who are required to comply with the effective dates for new or revised accounting standards that are applicable to public companies. Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act.

Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company”, we choose to rely on such exemptions we may not be required to, among other things, (1) provide an

 

71


Table of Contents

auditor’s attestation report on our system of internal controls over financial reporting pursuant to Sarbanex-Oxley Section 404(b), (2) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (3) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (4) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation.

Quantitative and Qualitative Disclosure about Market Risk

While we manufacture all of our products in the U.S., we have sales and distribution facilities within the U.S. and internationally. Accordingly, we are exposed to market risks in the ordinary course of our business, including the effect of foreign currency fluctuations, interest rate changes and inflation. Information relating to quantitative and qualitative disclosures about these market risks is set forth below.

Foreign currency exchange risk

A majority of our assets and liabilities are maintained in the U.S. in U.S. dollars, and a majority of our sales and expenditures are transacted in U.S. dollars. We transact business in various foreign currencies other than the U.S. dollar which exposes us to foreign currency risk. For the year ended December 31, 2011 and the six months ended June 30, 2012, we derived approximately 38% and 39%, respectively, of our revenue from international customers. We expect the percentage of revenue derived from outside the U.S. to increase in future periods as we continue to expand globally. These foreign currency revenues, when converted into U.S. dollars, can vary depending on average exchange rates during a respective period. In addition, we are exposed to foreign currency gains or losses on outstanding foreign currency denominated receivables and cash balances maintained in foreign banks. We hold a large proportion of our cash and cash equivalents in Euros and Australian dollars. As of June 30, 2012, we held approximately 79% of our cash and cash equivalents in Euros and Australian dollars. Realized and unrealized foreign currency gains or losses on these transactions are included in our statements of income or equity as a component of accumulated other comprehensive income (loss) as incurred. Certain of our foreign sales support subsidiaries transact in their respective country’s local currency, which is also their functional currency. As a result, expenses of these foreign subsidiaries when converted into U.S. dollars can vary depending on average monthly exchange rates during a respective period. Certain intercompany transactions may give rise to realized and unrealized foreign currency gains or losses. These foreign currency gains or losses are included in our statements of income as incurred.

The balance sheets of our foreign subsidiaries whose functional currency is not the U.S. dollar are translated into U.S. dollars at the rate of exchange at the balance sheet date and the statements of income and cash flows are translated into U.S. dollars using the average monthly exchange rate during the period. Any foreign exchange gain or loss as a result of translating the balance sheets of our foreign subsidiaries whose functional currency is not the U.S. dollar is included in equity as a component of accumulated other comprehensive income (loss).

Our primary foreign currency exchange rate exposures are with the Euro, the British pound and the Australian dollar against the U.S. dollar. Foreign currency exchange rates have experienced significant movements recently and may continue in the future. We currently do not enter into forward exchange contracts to hedge exposures denominated in foreign currencies and do not use derivative financial instruments for trading or speculative purposes. The effect of a 10% change in foreign currency exchange rates could have a material effect on our future operating results or cash flows, depending on which foreign currency exchange rates change and depending on the directional change (either a strengthening or weakening against the U.S. dollar). We expect ongoing weakness in the

 

72


Table of Contents

Euro and to a lesser extent, the British pound and the Australian dollar, to exert significant negative pressure on our revenues and results of operations for the remainder of 2012 and beyond. As our foreign operations continue to grow, our exposure to foreign currency exchange rate risk may become more significant.

Inflation risk

Inflation and changing prices did not have a material effect on our financial condition or results of operations in 2010, 2011 or in the first half of 2012. However, because we are limited in our ability to raise prices as a result of our long-term GPO contracts, and because of our desire to maintain lower ASPs, increases in our raw materials, production and transportation costs may have a material adverse impact on our results of operations.

Interest rate risk

Our exposure to interest rate risk is primarily related to investments and fixed rate debt.

We maintain cash and cash equivalents, consisting of investments with original maturities of less than three months when acquired, with financial institutions in the U.S., Europe and Australia. Interest rate fluctuations did not have a material effect on our financial condition or results of operations in 2010, 2011 or in the first half of 2012.

As of June 30, 2012, we had $18.8 million of fixed-rate debt. In April 2012, we refinanced all of our existing debt into a senior secured term loan with a variable rate, except for a mortgage note payable with a principal balance of $18.8 million and a fixed rate of interest of 6.59% as of June 30, 2012. While changes in market interest rates may affect the fair value of our fixed-rate debt, we believe the effect, if any, of reasonably possible near-term changes in the fair value of such debt on our financial condition, results of operations or cash flows will not be material.

 

73


Table of Contents

DESCRIPTION OF CERTAIN INDEBTEDNESS

Senior Secured Credit Facility

This summary highlights the principal terms of the $150 million senior secured credit facility, or the senior secured credit facility, we entered into with Applied Medical Resources Corporation and Applied Medical Distribution Corporation, two of our wholly-owned subsidiaries, as co-borrowers, or the borrowers, on April 17, 2012 and amended on September 19, 2012. The senior secured credit facility consists of (1) a $35 million revolving credit facility, or the revolving credit facility, (2) a $50 million term loan facility, or the term loan facility, and (3) a $65 million delayed draw term loan facility, or the delayed draw term loan facility. This summary does not purport to be complete and is qualified in its entirety by the provisions of the final and executed documentation of the senior secured credit facility, a copy of which is filed with the SEC as an exhibit to the registration statement of which this prospectus forms a part.

Use of Proceeds

The proceeds from the term loan facility were used to refinance substantially all of the borrowers’ existing indebtedness (with the exception of one real estate loan). Borrowings under the revolving credit facility will be available for working capital needs and general corporate purposes, including the issuance of up to $15 million of letters of credit. Delayed draw term loans are available for the financing of equipment and real property purchases and related capital expenditures and, subject to certain conditions, future potential share repurchases.

Interest and Fees

The interest rates per annum applicable to loans under the senior secured credit facility are equal to the sum of (1) the applicable margin (determined on the basis of the borrowers’ compliance with certain debt to EBITDA ratios) plus, (2) at the borrowers’ option, either LIBOR or the Alternate Base Rate (in each case, as such terms are customarily defined in credit facilities of the same type). In addition, the borrowers are required to pay (1) commitment fees to the lenders under each of the revolving credit facility and delayed draw term loan facility in respect of unused commitments, (2) letter of credit fees to the lenders under the revolving credit facility in respect of outstanding letters of credit, and (3) certain other fees and expenses to the arranger and agents for providing the senior secured credit facility.

Guarantees and Collateral

The borrowers’ obligations under the senior secured credit facility are guaranteed by Applied Medical Corporation and by all existing and future domestic subsidiaries. All obligations under the senior secured credit facility and under any guaranty thereof are required to be secured by a first priority security interest on (1) all of the capital stock or other equity interests of the borrowers and each of their direct and indirect subsidiaries (limited, in the case of certain foreign subsidiaries, to a pledge of 66% of its equity interests) and (2) all other existing and future assets and properties of the Borrowers and their subsidiaries (excluding certain foreign subsidiaries and certain real property located in Irvine, California).

Prepayments

Voluntary prepayments of loans under the senior secured credit facility are permitted in whole or in part, at any time and without penalty, subject to certain conditions.

Maturity and Amortization

The senior secured credit facility will terminate and all amounts outstanding under the Senior secured credit facility will be due and payable in April 2017. The term loan facility amortizes each year

 

74


Table of Contents

in quarterly installments with a balloon payment due at maturity. The delayed draw term loan facility requires interest payments only for a period of six months subsequent to any loan advance, and after that period will amortize over a period between seven and fifteen years, based on the use of proceeds from the loan, with a balloon payment due at maturity.

Covenants and Other

The senior secured credit facility contains usual and customary covenants, including, without limitation:

 

   

delivery of financial statements, compliance certificates and notices of default, material litigation and material governmental and environmental proceedings;

 

   

compliance with laws and material contractual obligations;

 

   

payment of taxes;

 

   

maintenance of insurance;

 

   

limitation on liens, mergers, sales of assets and incurrence of debt;

 

   

limitation on dividends, stock redemptions and the redemption and/or prepayment of certain other debt;

 

   

limitation on investments, acquisitions, and capital expenditures;

 

   

limitations on fundamental changes and asset dispositions;

 

   

limitations on transactions with affiliates; and

 

   

limitations on activities of Applied.

In addition, the senior secured credit facility contains usual and customary negative and financial covenants, including, without limitation, a minimum fixed charge coverage ratio and a maximum total debt to EBITDA ratio.

The senior secured credit facility contains usual and customary representations and warranties and events of default for credit facilities of the same type.

 

75


Table of Contents

BUSINESS

Applied develops, manufactures and markets medical devices for general, colorectal, bariatric, vascular, gynecological, urological and pediatric surgical procedures. We generate revenue by delivering surgical devices that reduce the invasiveness of open procedures and minimize the likelihood of trauma and wound-site infections during these procedures.

Our Mission

Our mission is to improve clinical outcomes and enhance the choices available to end users while increasing the availability and affordability of healthcare in general. Our approach enables surgeons to deliver improved clinical outcomes while helping hospitals reduce the cost of care. We reduce the overall cost of the product and the procedure while delivering what we believe to be superior quality products, based on the results of numerous clinical studies, a large portion of which were conducted by independent researchers. We also strive to prevent cost increases, even when we introduce new generations of products, enhancements or additional benefits to our products.

Some of the key benefits we offer our customers include:

 

   

Innovation. We have a long history of investing significant portions of our revenues in research and development. As of September 30, 2012, we have compiled a portfolio of 389 issued and 274 pending patents in the U.S., Europe, Japan, Australia and Canada. We respect other parties’ intellectual property and resolutely defend ours from infringers.

 

   

Lower Cost. We strive to reduce the cost of surgical procedures and related supplies. We spend approximately half of our research and development budget on developing reliable processes and automation for manufacturing our products.

 

   

Choices. We are reluctant to eliminate a product choice or an option for the hospital or surgeon. Although we discontinue some older products from time to time, our process for phasing out products is elaborate and takes into consideration our customers’ needs.

 

   

Exceptional Service. We have dedicated considerable time, capital and resources to serve our customers, from training to servicing clinical teams. For example, we have devoted resources toward educating physicians about hand-access laparoscopy to encourage the technique’s use in urology and general surgery. We have also foregone opportunities for faster growth in order to dedicate time and effort towards updating our customers on the latest innovations and improvements.

 

   

Commitment to Science. We conduct basic scientific research in order to foster our product development. For example, our scientists have enhanced processes for incorporating titanium, gel and other materials into our products.

 

   

Commitment to Independent and Credible Research. We encourage independent clinical research by providing our products and sharing our knowledge regarding treatment protocols with researchers in order to foster better science, research design and implementation, as well as credible and accurate conclusions.

 

   

Commitment to Quality and Regulatory Compliance. We continue to strive towards unequivocal compliance with regulatory requirements, including quality system regulations and related policies and procedures.

While many of our competitors aspire to provide one or more of these benefits, we are committed to delivering all of them. This means that we strive to offer an improved product or outcome at a lower cost. We tend to price and sell our products at levels significantly below the prevailing average selling price, or ASP, in the marketplace. Although this approach may not be new in many

 

76


Table of Contents

markets, we believe it differentiates us in the medical device arena. We have remained committed to this approach throughout our 24 years. Our approach has tended to reduce ASPs and, to a great extent, meaningfully shrink the size, based on revenue, of the available markets which we target. We believe that this approach is an efficient way of breaking into some highly contested and often foreclosed market segments. In a third-party report entitled The U.S. Market for Laparoscopic Devices, iDATA recognized that we have been successful in our pricing strategy, putting us in the second-leading position after Ethicon in terms of market share of disposable trocars, on a market revenue basis.

Applied Medical Corporation was incorporated in Delaware in February 2010 to become the holding company for Applied Medical Resources Corporation, which was founded in California in 1987.

How We Generate Revenue

The majority of our revenues come from selling medical devices for surgical procedures to hospitals and out-patient surgical centers for use by surgeons in the operating room. Although we have had portions of our revenues associated with royalties in prior years, today a small and decreasing portion of our revenues comes from collecting royalties from licensed technologies, mainly to our competitors. We expect royalty and licensing revenues to be largely eliminated due to the expiration of our principal outbound technology license agreement in January 2012.

Despite the fact that we often offer advanced products, improvements and upgrades on a frequent basis, we do not pursue premium pricing for such enhancements. To the contrary, we offer our improved products at prices significantly below the ASPs prevalent in the marketplace. We have products that have not seen a price increase in a decade, and many have seen prices reduced, despite the absence of competitive price pressures. However, we maintain our margins through automation of our manufacturing practices and increased volume of our unit shipments.

Our Target Markets

The laparoscopy market consists of products that enable the surgeon to access certain anatomies without the need for an open incision. Instead, devices called trocars are used to facilitate the introduction of a carbon dioxide gas, a scope attached to a camera for visualization, and instruments for conducting the therapeutic procedure. The advantages of this less-invasive approach are well-established and documented. Still, not every open procedure is suitable for laparoscopy. We supply many products used in laparoscopy, including trocars for access, instruments for grasping or cutting, tissue bags for removing specimens and devices for clipping or closing ducts and blood vessels. The great majority of our laparoscopic devices are single-use devices, although some customers choose to reprocess and reuse these devices. We have not supported the practice of reprocessing our devices, as we feel doing so exposes patients to additional risks.

Not all laparoscopic procedures are done solely through trocars or without an incision. In some procedures, surgeons choose to use a hand-assisted approach, where a small incision is made to accommodate the introduction of a hand access device that maintains the carbon dioxide gas within the abdomen while allowing the surgeon to introduce a hand into the abdominal cavity. The advantages of such an approach have been studied, documented and published in peer-reviewed clinical papers. Applied’s trade name for its product in the hand-access market is GelPort® laparoscopic system.

A third and emerging technique is known by many names, including “scar-less” and “single access” technique. Here, one device replaces three, four or five trocars, and accommodates access of scopes and instruments through a single incision hidden underneath the navel. Applied’s trade name for its product in the single-access market is GelPOINT® advanced access system.

 

77


Table of Contents

Our Product Markets

Our products span the scope of surgical procedures, from general to cardiac. However, we categorize our products in terms of whether or not the market for the device is developed.

Developed Product Markets. In developed product markets, most of the potential procedures are already using our devices or a similar device of one of our competitors, and the challenge is to grow our market share. Developed product markets usually involve an entrenched competitor or competitors, established relations with customers, contracts that extend over a number of years and a variety of entry barriers. Other factors can require considerable time and perseverance to change, including overcoming existing customer preferences, the size and efficiencies of existing sales and distribution channels, manufacturing volumes and learning curves associated with new products.

Developing Product Markets. In developing product markets, the great majority of potential procedures are not using our new modality, technology or devices, or similar products of a competitor. In many situations, we may be the only company advocating the new approach or technology and there are many situations where the competition is non-existent, lagging in development, or adopting a wait-and-see attitude. Developing product markets have some distinct and, sometimes, decisive competitive advantages and disadvantages.

One advantage is being first to the market, setting the standard, training the surgeons and residents on the new approaches, building a track record of innovation and support, and establishing volumes necessary to support additional research and development and investments in training and support. Some companies prefer to avoid the risk and expense and go for being the second entrant, learning from mistakes and taking advantage of a relatively developed market and base. Another advantage is the opportunity for early recognition of needs and solutions, two key requirements for inventing and patenting valuable intellectual property.

One of the largest disadvantages and risks of market development is the investment in time and capital required to advocate, train and support a new clinical modality, technology or capabilities. The effort to develop new markets carries a much higher risk of missing the mark, taking much longer to succeed or simply not succeeding.

The unpredictable nature of developing markets is counterbalanced by the relative predictability of products in established and developed product markets. Our portfolio of products in the developed product market gives us the opportunity to support advancements in clinical modalities and technologies. By considering such opportunities, we also reduce our exposure to the market powers of our competitors who dominate many of the medical device segments. Our customers usually recognize and appreciate the commitment we have for advancing the clinical and technical states of the art.

Often within developed markets, we encounter a new technology or advancement that requires us to treat that portion of the market as a developing sub-segment. For example, among developed markets, our largest presence is in laparoscopy, and especially as that modality applies to general surgery, colorectal and bariatric procedures. In this segment, we sell trocars, instruments and access devices. Some of our trocars and access devices, however, employ new technologies requiring extensive investments in research and development, manufacturing methods and processes, training and education, both internally and externally.

Our Products

We are a leader in advanced surgical access devices for minimally invasive and traditional surgery.

 

78


Table of Contents

Surgical Access Products

We introduced the first universal seal trocar over 20 years ago. A trocar is an access port introduced into the patient’s abdomen in laparoscopic surgery, also known as “keyhole surgery,” which is a minimally invasive surgical technique performed in the abdomen through small incisions less than two centimeters, as opposed to open surgery using much larger incisions. We supply many products used in laparoscopy, including trocars for access, instruments for grasping or cutting, tissue bags for removing specimens, and devices for clipping or closing ducts and blood vessels.

Trocars are used in most laparoscopic procedures. Our trocars are packaged in a variety of configurations both standard and custom packaged to meet customers’ needs. Our Kii® abdominal access system combines our Universal seal technology with our advanced optical Separator® obturators and an enhanced cannula. The obturator is a stylus that is used to create a channel through tissue to provide access to the abdomen. The seal housing and cannula create a channel to allow for the introduction and exchange of instruments while preserving a carbon dioxide pressurized surgical environment in the abdomen. Kii® also comes equipped with advanced fixation, where the fixation balloon maintains superior cannula retention, reducing tissue trauma and reducing unintentional displacement of the trocar. Our extensive offering of trocar products includes a number of generational improvements that augment, often without obsolescing, our earlier offerings.

Our Separator® obturator, with its unique Sequential Helix technology, enables non-bladed access with minimal tissue injury and placement of trocars without the use of any cutting elements within the obturator. This approach significantly reduces abdominal wall and vessel trauma, while keeping muscle fibers uncut and allowing separated tissue to rejoin upon removal of the cannula.

We have also pioneered and introduced a new technology for the most critical entry of the abdomen, the first one. Upon immediate penetration of the peritoneum, the membrane that forms the lining of the abdominal cavity, our Kii® Fios® first-entry creates a space for the tip of the obturator. Under direct visualization of individual tissue layers during insertion, insufflation of the abdominal cavity with carbon dioxide gas can be rapidly achieved with only a 3 mm intrusion into the peritoneal cavity. This technology has the potential to significantly reduce the risk of injuries while establishing secure, controlled surgical environment for laparoscopic procedures.

For single incision surgery, our GelPOINT® access platforms enable minimally invasive surgery through a single access point by providing a flexible, air-tight fulcrum to facilitate triangulation of standard instrumentation. By offering an increased range of motion and significant retraction and exposure, the GelPOINT® platforms provide enhanced versatility and access for a wide range of abdominal and transanal procedures.

Our GelPort® laparoscopic system combines the speed and precision of open surgery with the clinical outcomes and patient benefits of minimally invasive surgery. The GelPort® system allows surgeons to rapidly alternate between a hand access, straight laparoscopic and open surgical technique to improve procedural efficiency and clinical outcomes.

For advanced access in traditional surgical procedures, our Alexis® wound protector/retractor provides 360 degrees of circumferential retraction with minimal tissue injury, while significantly decreasing wound infection and maintaining moisture at the incision site. The self-retaining design of the Alexis® wound protector/retractor effectively holds the incision site open, allowing the surgeon to easily access the operative field and enhance surgical assistance.

Surgical Instruments

Our instrument products complement our trocar products and include our Epix® instruments and Inzii® retrieval systems. Our Epix® universal laparoscopic clip applier is a technologically advanced

 

79


Table of Contents

blood vessel clamping, or occlusion, system which places a large format occlusion clip, traditionally placed with instruments 10 mm in diameter, with an instrument that is only 5 mm in diameter. The Epix® clip applier also utilizes a more substantial clip to provide strength and security upon placement. Similarly, the Epix® 5 mm scissors combine precision and strength through unique dual-edge blades that allow the surgeon to transect a broad range of tissue. The high grade stainless steel blades sustain sharpness, even over extensive use. Our Epix® laparoscopic grasper is designed to grasp the patient tissue while reducing the force on the tissue.

Our Epix® laparoscopic dissector contains a stainless steel curve jaw that allows visualization of the jaw tip. The teeth provide traction to engage tissue for the purpose of dissection and manipulation. The angled shaft allows for a triangulated view of the jaw and precise placement in the therapeutic field. Our Inzii® universal retrieval system is specifically designed to perform with our Kii® 5 mm and larger trocars. This system combined with our Epix® instruments provides a total 5 mm solution to many laparoscopic procedures.

Our Stealth® occlusion products are used in vascular surgical procedures to provide superior traction and reduced occlusion force with minimal tissue injury through a variety of low-profile clamp, insert and clip configurations.

The Applied Brand

We strongly believe in building and defending the Applied brand. Our brand is our reputation – it must be demonstrated and defended through consistent and faithful adherence to our promises to our customers.

Our brand is the sum total of all experiences, from how we manufacture and maintain quality, to how we price, ship, service, educate and participate in the community. Each Applied team member is an integral and important part of our brand, which ties our culture to everything else that we do. As a result, we place high emphasis on our recruiting practices, education, development of careers and rotation programs.

To help solidify the Applied brand, we frequently rely on an objective, education-based approach to promoting our products through our team of clinical development professionals. The mission of this team is to educate users, mainly surgeons, and their organizations on the advantages and limitations of any approach or device – and to avoid commercialization efforts that aim at simply selling the highest volume of products to healthcare providers and their patients. Our aim is to live up to the promises of our business model and brand.

Culture and Team Members

We consider our culture and team members to be one of our greatest strengths. Culture and team membership translate into grass root efficiencies for Applied. We are fortunate to have what we believe to be an exceptional group of team members, inclined to excel, and desirous of making a difference in their respective fields, improving healthcare and making it more available and cost effective.

For the casual observer, Applied appears to be a company prolific and adept in developing technologies and products. However, the Applied team will point out that we develop none of these things; instead, we develop team members who, in turn, develop technologies, products and market share, effectively, efficiently and prolifically.

Our culture is an almost equal mix of cultivation — the commitment to teach and mentor — and competency — the determination and skill of achieving results. Our workplace is also a place of continuing education. Those we invite to join the team are inclined to excel and, if they fit the Applied

 

80


Table of Contents

culture, together we can find them the position most conducive to their success. We look for mettle, drive, intellectual prowess, heart and curiosity, in that order, and with lesser concern for education, experience or expertise — those latter three can be supplied along the way; the first five have to be there already.

As of September 30, 2012, we had approximately 2,500 team members worldwide. We continue to add team members while keeping an eye on the impact to the overall culture.

Distribution

We distribute our products through direct and indirect channels of distribution. We have developed direct distribution channels in the U.S., select European countries and Australia. In other countries, we rely on independent distributors who understand our mission and the promise of our brand. We do not have a presence in many emerging markets, including China and India, and no current plans to address those markets. For fiscal years 2010 and 2011, approximately 65% and 62% respectively, of our revenues were attributable to sales in the U.S. Certain of our third-party distributors have recently sought to increase the prices and related fees that they charge us to distribute our products to our customers. One key distributor, Owens & Minor, terminated a distribution agreement with us, effective June 30, 2012, after we refused the distributor’s attempt to unilaterally increase service fees. This distributor accounted for approximately 13% and 9.5% of our total revenues in 2011 and during the six months ended June 30, 2012, respectively. We are taking steps to enhance our own direct distribution capabilities to deliver our products, including the construction or acquisition of storage and distribution facilities in geographic areas outside of Southern California. In April 2012, we entered into a lease for a warehouse and distribution facility in New York and began shipping product from this facility in June 2012.

Our distribution channels tend to be stratified, with different teams responsible for different contact points, phases of the selling process and functions. We have teams that address the initial administrative contacts, clinical contacts, clinical evaluations and continued services. We also have a global division dedicated to education, be it the education of our sales forces, Clinical Development and Research and Development teams, or the training of clinical personnel in regards to new procedures, technologies or devices.

We spend considerable time, effort and money on training and qualifying our team members. For example, we conduct a comprehensive sales training program. We also run numerous surgeon training sessions around the U.S. and outside the U.S., and train hundreds of surgeons to use our products every year.

We sell our full product portfolio in many international markets, concentrating our direct distribution operations in the Netherlands, the United Kingdom, France, Germany, Austria, Switzerland, Spain, Italy, and Australia. Our international indirect distribution system consists of approximately 70 distributors that sell our products in approximately 65 countries in Europe, Asia and the South Pacific, Central and South America and the Middle East. Our international distributors purchase products directly from us for resale to their local customers. As part of our strategy to grow internationally, we have selectively converted from distributors to direct sales representation in certain countries, as we did in Australia in 2004. As our penetration of these markets has increased, so has our hiring, training and development in these markets.

Research and Development

Our research and development efforts are an important part of our commitment to innovate. Our innovation objectives include:

 

   

Enhanced clinical outcomes;

 

   

Exceptional quality and consistency of products;

 

81


Table of Contents
   

Highly predictable, repeatable and reliable processes;

 

   

The fastest ability to respond to market changes, customer demands and needs, emergency situations in the marketplace, and the ability to keep our supply lines short and responsive;

 

   

The most versatile automation abilities, structure and systems in order to automate without lengthening the development process or reducing flexibility to change the product upon receipt of validated input from the marketplace;

 

   

The most responsive development process for tooling up, modifying or expanding tooling capacity; and

 

   

The lowest manufacturing costs possible, within the confines of meeting all the above requirements, and in ways that enable us to deliver the superior value promised by our brand.

These extensive and demanding requirements have also required us to commit a high percentage of our revenues to our research and development efforts. For fiscal years 2010 and 2011 and the six months ended June 30, 2012, we spent approximately $38.3 million, $48.3 million and $29.8 million, respectively, on research and development, which represented approximately 13%, 14% and 16%, respectively, of our revenues for such periods.

Manufacturing

We are a vertically integrated manufacturer, producing almost all our devices in-house. The great majority of our products start out as high quality, medical grade polymers, or medical grade stainless steel, and exit our facilities as fully manufactured and packaged medical devices.

As a result, we have a short supply line between our raw materials and finished goods which gives us greater control over our product quality.

The downside of this approach is the intensity of our capital expenditures and the requirements for facilities, power, and equipment. This approach also requires the high levels of long-term planning and the ability to predict future needs. Many of our processes are unique to us, and many preparations for additional capacities have to start two to three years ahead of the evolving needs.

We use a diverse and broad range of raw materials in the manufacturing of our products. We purchase all of our raw materials and select items, such as packaging, from external suppliers. In addition, we purchase some supplies from single sources for reasons of proprietary know-how, quality assurance, sole source availability, or due to regulatory qualification requirements. We work closely with our suppliers to ensure continuity of supply while maintaining high quality and reliability. To date, we have not experienced any significant difficulty locating and obtaining the materials necessary to fulfill our production requirements.

Clinical Development

We believe in delivering high quality, innovative and FDA compliant products that also encompass value and service to our customers. Our clinical development efforts focus on spreading reliable, supportable clinical testimonials, research, papers, and experiences to the users. We focus on increasing the awareness of the marketplace regarding Applied, its way of doing business and its innovative products. Customers recognize us for not just our innovations, products and prices, but also for our brand and our dedication to it and them.

Competition

In the medical devices market, we face intense competition from companies with dominant market positions such as Ethicon Endo-Surgery, a division of Johnson & Johnson, and Covidien,

 

82


Table of Contents

among others. These competitors have significantly greater financial, technical, marketing and other resources than we have and may be better able to:

 

   

respond to new technologies or technical standards;

 

   

react to changing customer requirements and expectations;

 

   

acquire other companies to gain new technologies or products that may displace our product lines;

 

   

manufacture, market and sell products;

 

   

devote resources to the development, production, promotion, support and sale of products; and

 

   

deliver a broad range of competitive products at lower prices.

Hospitals, GPOs, IHNs, and IDNs make contracting and purchasing decisions based on their desire to secure a broad array of surgical supplies, many of which are unique to our principal competitors. Our principal competitors are able to leverage their broader product portfolios and dominant market positions in some segments by, for example, bundling their products into specially priced packages that create strong financial incentives for their customers to purchase their products. These practices may negate savings customers would gain from buying select products from Applied and may deter such customers from buying Applied’s products. We expect competition in the markets in which we participate to continue to increase as existing competitors improve or expand their product offerings.

Intellectual Property

We rely on a combination of patent, trademark and trade secret laws in the U.S. and other jurisdictions to protect our proprietary technology and our brand. We also rely on confidentiality procedures and agreements, and contractual provisions to achieve the same. We do not pursue patent protection where the possibility for meaningful enforcement is limited.

Applied Medical is a registered trademark in the U.S. and several other countries. Other registered trademarks include: Separator® access system, Universal® seal, GelPort, GelPOINT, Alexis, Fios, Kii, Epix, Inzii, Stealth and the Applied Medical logo.

Circumstances outside our control could pose a threat to our intellectual property. For example, effective intellectual property protection may not be available in every country in which our products are distributed. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Any significant impairment of our intellectual property rights is costly and time consuming. Any increase in unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results.

Companies in the medical device arena own large numbers of patents, copyrights and trademarks, and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. Because we invest significant portions of our revenues in research and development, and because we have been inventive and effective, we have compiled a portfolio of 389 issued and 274 pending patents in the U.S., Europe, Japan, Australia and Canada as of September 30, 2012. We spend a sizeable amount every year to defend our intellectual property. As we expand our offerings into existing and new segments, the possibility of increased intellectual property conflicts and confrontations will grow. Our efforts may not always stop a third-party, and our technologies may not always withstand any third-party claims or rights against their use.

 

83


Table of Contents

Government Regulation

FDA Approval Requirements

Unless an exemption applies, each medical device that we wish to market in the U.S. must receive 510(k) clearance. The FDA’s 510(k) clearance process usually takes from four to twelve months, but it can last longer. We cannot be sure that 510(k) clearance will ever be obtained for any product we propose to market.

The FDA decides whether a device must undergo either the 510(k) clearance or PMA approval process based upon statutory criteria. These criteria include the level of risk that the agency perceives is associated with the device and a determination whether the product is a type of device that is similar to devices that are already legally marketed. Devices deemed to pose relatively less risk are placed in either Class I or II, which requires the manufacturer to submit a PMN requesting 510(k) clearance, unless an exemption applies. The premarket notification must demonstrate that the proposed device is “substantially equivalent” in intended use and in safety and effectiveness to a legally marketed predicate device, which is a pre-existing medical device to which equivalence can be drawn, that is either in Class I, Class II, or is a Class III device that was in commercial distribution before May 28, 1976, for which the FDA has not yet called for submission of a PMA application.

Class I devices are those for which safety and effectiveness can be assured by adherence to the FDA’s general regulatory controls for medical devices, or the General Controls, which include compliance with the applicable portions of the FDA’s quality system regulations, facility registration and product listing, reporting of adverse medical events, and appropriate, truthful and non-misleading labeling, advertising, and promotional materials. Some Class I devices also require premarket clearance by the FDA through the 510(k) premarket notification process described below. A small number of our products are Class I devices.

Class II devices are subject to the FDA’s General Controls, and any other special controls as deemed necessary by the FDA to ensure the safety and effectiveness of the device. Premarket review and clearance by the FDA for Class II devices is accomplished through the 510(k) premarket notification procedure. Pursuant to the Medical Device User Fee and Modernization Act of 2002, or MDUFMA, as of October 2002 unless a specific exemption applies, 510(k) premarket notification submissions are subject to user fees. Certain Class II devices are exempt from this premarket review process. A majority of our products, encompassing all of our significant product lines, are Class II devices.

Class III devices are those devices which have a new intended use, or use advanced technology that is not substantially equivalent to that of a legally marketed device. The safety and effectiveness of Class III devices cannot be assured solely by the General Controls and the other requirements described above. These devices almost always require formal clinical studies to demonstrate safety and effectiveness and must be approved through the premarket approval process described below. Premarket approval applications (and supplemental premarket approval applications) are subject to significantly higher user fees under MDUFMA than are 510(k) premarket notifications. None of our products are Class III devices.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or could require a PMA approval. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any decision. If the FDA disagrees with a manufacturer’s decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to seek 510(k) clearance or PMA approval. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or PMA approval is obtained. We have modified some of our 510(k) cleared devices, but have determined that, in our view,

 

84


Table of Contents

based on FDA guidance as to when to submit a 510(k) notification for changes to a cleared device, new 510(k) clearances or PMA approvals are not required. We cannot assure you that the FDA would agree with any of our decisions not to seek 510(k) clearance or PMA approval. If the FDA requires us to seek 510(k) clearance or PMA approval for any modification, we also may be required to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance or PMA approval.

A clinical trial may be required in support of a 510(k) submission. These trials generally require an Investigational Device Exemption, or IDE, application approved in advance by the FDA for a specified number of patients, unless the product is deemed a nonsignificant risk device eligible for more abbreviated IDE requirements. The IDE application must be supported by appropriate data, such as animal and laboratory testing results. Clinical trials may begin if the IDE application is approved by the FDA and the appropriate institutional review boards at the clinical trial sites.

Pervasive and Continuing FDA Regulation

A host of regulatory requirements apply to our marketed devices, including the quality system regulation (which requires manufacturers to follow elaborate design, testing, control, documentation and other quality assurance procedures), the MDR regulations (which require that manufacturers report to the FDA specified types of adverse events involving their products), labeling regulations, and the FDA’s general prohibition against promoting products for unapproved or “off-label” uses. Class II devices also can have special controls such as performance standards, postmarket surveillance, patient registries and FDA guidelines that do not apply to class I devices. Unanticipated changes in existing regulatory requirements or adoption of new requirements could hurt our business, financial condition and results of operations.

We are subject to inspection and market surveillance by the FDA to determine compliance with regulatory requirements. If the FDA finds that we have failed to comply, the agency can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions such as:

 

   

fines, injunctions and civil penalties;

 

   

recall, detention or seizure of our products;

 

   

the issuance of public notices or warnings;

 

   

operating restrictions, partial suspension or total shutdown of production;

 

   

refusing our requests for 510(k) clearance of new products;

 

   

withdrawing 510(k) clearance already granted; and

 

   

criminal prosecution.

The FDA also has the authority to request repair, replacement or refund of the cost of any medical device manufactured or distributed by us. Our failure to comply with applicable requirements could lead to an enforcement action that may have an adverse effect on our financial condition and results of operations.

Health Care Fraud and Abuse

In the United States, there are federal and state anti-kickback laws that generally prohibit the payment or receipt of kickbacks, bribes or other remuneration in exchange for the referral of patients or other health-related business. For example, the Federal Health Care Programs’ Anti-Kickback Law (42 U.S.C. § 1320a-7b(b)) prohibits anyone from, among other things, knowingly and willfully offering, paying, soliciting or receiving any bribe, kickback or other remuneration intended to induce the referral of patients for, or the purchase, order or recommendation of, health care products and services

 

85


Table of Contents

reimbursed by a federal health care program (including Medicare and Medicaid). Recognizing that the federal anti-kickback law is broad and potentially applicable to many commonplace arrangements, the Office of Inspector General within the Department of Health and Human Services, or OIG, has issued regulations, known as the safe harbors, which identify permissible practices. If all of the requirements of an applicable safe harbor are met, an arrangement will not be prosecuted under this law. Safe harbors exist for a number of arrangements relevant to our business, including, among other things, payments to bona fide employees, certain discount arrangements, and certain payment arrangements involving GPOs. The failure of an arrangement to fit precisely within one or more safe harbors does not necessarily mean that it is illegal. However, conduct that does not fully satisfy each requirement of an applicable safe harbor may result in increased scrutiny by government enforcement authorities, such as the OIG or the Department of Justice. Violations of this federal law can result in significant penalties, including imprisonment, monetary fines and assessments, and exclusion from Medicare, Medicaid and other federal health care programs. Exclusion of a manufacturer would preclude any federal health care program from paying for its products. In addition to the federal anti-kickback law, many states have their own kickback laws. Often, these state laws closely follow the language of the federal law. Some state anti-kickback laws apply regardless of whether federal health care program payment is involved. Federal and state anti-kickback laws may affect our sales, marketing and promotional activities, educational programs, pricing and discount practices and policies, and relationship with health care providers by limiting the kinds of arrangements we may have with hospitals, GPOs and others in a position to purchase or recommend our products.

Federal and state false claims laws prohibit anyone from presenting, or causing to be presented, claims for payment to third-party payors that are false or fraudulent. For example, the federal Civil False Claims Act (31 U.S.C. § 3729 et seq.) imposes liability on any person or entity who, among other things, knowingly presents, or causes to be presented, a false or fraudulent claim for payment by a federal health care program (including Medicaid and Medicare). Manufacturers, like us, can be held liable under false claims laws, even if they do not submit claims to the government, where they are found to have caused submission of false claims by, among other things, providing incorrect coding or billing advice about their products to customers that file claims, or by engaging in kickback arrangements with customers that file claims. A number of states also have false claims laws, and some of these laws may apply to claims for items or services reimbursed under Medicaid and/or commercial insurance. Sanctions under these federal and state laws may include civil monetary penalties, exclusion of a manufacturer’s products from reimbursement under government programs, and imprisonment.

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, created two new federal crimes: health care fraud and false statements related to healthcare matters. The health care fraud statute prohibits knowingly and willingly executing a scheme to defraud any health care benefit program, including private payors. A violation of this statute is a felony and may result in fines, imprisonment or exclusion from government sponsored programs. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for health care benefits, items or services. A violation of this statute is a felony and may result in fines or imprisonment.

Due to the breadth of some of these laws, it is possible that some of our current or future practices might be challenged under one or more of these laws. In addition, there can be no assurance that we would not be required to alter one or more of our practices to be in compliance with these laws. Evolving interpretations of current laws or the adoption of new federal or state laws or regulations could adversely affect many of the arrangements we have with customers and physicians. Our risk of being found in violation of these laws is increased by the fact that some of these laws are open to a variety of interpretations. If our past or present operations are found to be in violation of any of these laws, we could be subject to civil and criminal penalties, which could hurt our business, results of operations and financial condition.

 

86


Table of Contents

Foreign Regulation

Many foreign countries in which we market or may market our products have regulatory bodies and restrictions similar to those of the FDA. International sales are subject to foreign government regulation, the requirements of which vary substantially from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval and the requirements may differ. Companies are now required to obtain a CE Mark, which shows conformance with the requirements of applicable European Conformity directives, prior to sale of some medical devices within the European Union. During this process, the sponsor must demonstrate compliance with the International Organization for Standardization’s manufacturing and quality requirements. We have CE Marking on all our products that require such markings.

Third-Party Reimbursement

Health care providers, including hospitals, that purchase our products generally rely on third-party payors, including the Medicare and Medicaid programs, and private payors, such as indemnity insurers and managed care plans, to cover and reimburse all or part of the cost of the products and the procedures in which they are used. As a result, demand for our products is dependent in part on the coverage and reimbursement policies of these payors.

CMS, the federal agency responsible for administering the Medicare program, along with its contractors, establishes coverage and reimbursement policies for the Medicare program. In addition, private payors often follow the coverage and reimbursement policies of Medicare. We cannot assure you that government or private third-party payors will cover and reimburse the procedures using our products in whole or in part in the future or that payment rates will be adequate.

In general, Medicare will cover a medical product or procedure when the product or procedure is reasonable and necessary for the diagnosis or treatment of an illness or injury, or to improve the functioning of a malformed body part. Even if the medical product or procedure is considered medically necessary and coverage is available, Medicare may place restrictions on the circumstances where it provides coverage.

Our success in non-U.S. markets depends largely upon the availability of coverage and reimbursement from the third-party payors through which health care providers are paid in those markets. Health care payment systems in non-U.S. markets vary significantly by country, and include single-payor, government managed systems as well as systems in which private payors and government-managed systems exist side-by-side. Our ability to achieve market acceptance or significant sales volume in international markets will be dependent in large part on the availability of reimbursement for procedures performed using our products under health care payment systems in such markets. There can be no assurance that reimbursement for our products, or the procedures in which our products are used, will be obtained or that such reimbursement will be adequate.

Other U.S. Regulation

We must also comply with numerous federal, state and local laws relating to matters such as environmental protection, safe working conditions, manufacturing practices, fire hazard control and, among other things, the generation, handling, transportation and disposal of hazardous substances.

Legal Proceedings

On July 19, 2006, Tyco Healthcare Group LP, or Tyco, sued Applied in the U.S. District Court for the Eastern District of Texas alleging certain of our trocar products infringed patents owned by Tyco. In October 2009, the lawsuit was expanded to include U.S. Surgical Corp., or U.S. Surgical, as an additional plaintiff and to include certain additional trocar products of Applied. Tyco and U.S. Surgical sought monetary damages and injunctive relief. We asserted defenses of non-infringement and invalidity of the patent claims asserted by Tyco and U.S. Surgical. The matter was divided into two phases, the first

 

87


Table of Contents

involving products no longer manufactured by us and the second involving products currently manufactured by us. In March 2010, following trial in the first phase, a jury returned a verdict invalidating two claims of one of the asserted patents and finding we infringed one claim of another asserted patent. The jury awarded damages of $4.8 million against us. In September 2011, in the second phase of the case, the Court issued a summary judgment that asserted claims of two of the patents were invalid; the Court also allowed claims of two other patents to proceed to trial. In October 2011, a jury returned a verdict of non-infringement and invalidity on all asserted patent claims. The Court has not yet issued a final judgment and may not do so until sometime later in 2012. We intend to appeal the infringement verdict of the first phase to the U.S. Court of Appeals for the Federal Circuit; however, there can be no assurance that our efforts to reverse the jury verdict will be successful.

On May 17, 2011, Applied sued Tyco Healthcare Group LP, d/b/a Covidien, in the U.S. District Court for the Central District of California, alleging that certain of Tyco’s trocar products infringe a patent owned by Applied. Applied seeks damages and injunctive relief. Tyco has asserted counterclaims, including non-infringement, invalidity and unenforceability. In March 2012, the Court granted Tyco’s motion for summary judgment of non-infringement but denied Tyco’s motion for summary judgment for invalidity. The Court entered final judgment on April 20, 2012, dismissing Tyco’s counterclaims of invalidity and unenforceability without prejudice. Tyco has sought and been awarded costs of an immaterial amount but has not sought attorneys’ fees. Applied intends to appeal the summary judgment for non-infringement; however, there can be no assurance that efforts to reverse the Court’s decision will be successful.

On September 13, 2011, Applied sued Tyco Healthcare Group LP, d/b/a Covidien, in the U.S. District Court for the Central District of California, alleging that certain of Tyco’s single incision surgical access products infringe a patent owned by Applied. Applied seeks damages and injunctive relief. Tyco has asserted counterclaims, including non-infringement, invalidity and unenforceability. Tyco has also requested an award of costs and attorneys’ fees. Discovery has commenced in this action. Trial has been scheduled to commence in May 2013.

In February 2012, T. Peter Thomas, a former director affiliated with IVP, exercised vested stock options to purchase 37,950 shares of Class B common stock. On February 16, 2012, we exercised our right to repurchase all of such shares at a price per share of $13.05 pursuant to express terms of the applicable benefit plans and stock option agreements that govern the terms of Mr. Thomas’ options. The repurchase price reflects our compensation committee’s good faith determination of the fair market value of our Class B common stock. Our compensation committee made this determination in accordance with the our long-standing equity valuation process for equity transactions under our stock incentive plans, which also considers stock valuations received from a qualified and independent third party. Our equity valuation process uses a combination of the discounted cash flow and guideline public company models along with various other assumptions, including consideration of our estimated future financial performance and the financial performance of companies that are relatively comparable to us, to estimate fair value. Mr. Thomas, with the support of IVP, has questioned the determination of the fair market value of our Class B common stock in connection with the repurchase of these shares and asserted a valuation that is consistent with the estimated initial public offering price range shown on the front cover of this prospectus that was not based on, and did not take account of, our estimated future financial performance and, in our view, is based on the financial performance of certain companies that are not directly comparable to us, as well as certain other assumptions with which we disagree. We believe that Mr. Thomas’ and IVP’s assertions are without merit and intend to defend against them vigorously. On August 31, 2012, Applied filed a lawsuit against Mr. Thomas and IVP in the Superior Court for the State of California, County of Orange, asserting claims against Mr. Thomas and IVP relating to Mr. Thomas’ breach of stock option agreements in connection with the above-described exercise of our repurchase rights. We have asserted claims for breach of contract, breach of the implied covenant of good faith and fair

 

88


Table of Contents

dealing, conversion and declaratory relief against Mr. Thomas and claims for conversion and aiding and abetting conversion against IVP. We seek damages (including punitive damages) and certain declaratory relief. On September 11, 2012, Mr. Thomas delivered to us a stock transfer instrument to complete the transfer of the 37,950 shares of Class B common stock, but reserved the right to continue to challenge our compensation committee’s determination of fair market value and to request additional cash consideration from us for the repurchase of his shares. Resolution of this litigation matter to our satisfaction is expected to be costly and time-consuming and may have additional adverse effects on our financial condition and results of operations which we are unable to predict or quantify at the present time.

In the ordinary course of business, we are subject to various legal proceedings and claims, including employment disputes, disputes on agreements and other commercial matters. In addition, we operate in an industry susceptible to significant patent claims and, at any given time, may be involved as either a plaintiff or defendant in one or more patent infringement actions. If a patent infringement claim were to be determined against us, we may be required to make significant royalty and other payments or be subject to an injunction or other limitation on our ability to manufacture or distribute one or more products. While it is not feasible to predict the outcome of certain proceedings, based upon experience, current information and applicable law, we do not expect any current proceedings to have a material adverse effect on our consolidated financial position, results of operations or cash flows. However, one or more of the proceedings could be material to our business and results of operations in a future period.

Facilities

Our U.S. headquarters are located in a 96,000 square foot facility in Rancho Santa Margarita, California. Additional facilities in Orange County, California include manufacturing and production facilities, research and development facilities and facilities for sales, branding and various administrative functions, comprised of thirteen facilities with approximately 697,000 square feet. Our principal distribution warehouse facility is a 252,000 square foot facility in Irvine, California. Due to the highly specialized requirements of our operations, culture and expansion plans, we own all of our facilities located in Orange County, California. We also lease approximately 27,000 square feet of space in a warehouse and distribution facility located in Wawayanda, New York and sales and distribution facilities in the Netherlands and Australia. In May 2011, we acquired land in the Netherlands to construct our European headquarters. The construction was completed in the third quarter of 2012. We believe that our owned and leased facilities are adequate and suitable for their use.

 

89


Table of Contents

MANAGEMENT

Executive Officers and Directors

The following table sets forth certain information with respect to our executive officers and directors as of September 30, 2012.

 

Name

   Age     

Position

Said S. Hilal

     63       President and Chief Executive Officer; Director

Nabil Hilal

     62       Group President, Technology; Director

Stephen E. Stanley

     52       Group President, Distribution

Gary Johnson

     44       Group President, Surgical

Samir Tall

     53       Chief Financial Officer

Michael Vaughn

     51       Vice President, General Counsel and Secretary

Kari Moore

     49       Chief Accounting Officer

Dennis L. Fowler, M.D.

     64       Director

Mark P. de Raad

     53       Director

Leslee A. Temple, FASLA

     62       Director

Thomas M. Kasten

     70       Director

Said S. Hilal has been President and Chief Executive Officer of Applied since its inception in 1987. Mr. Hilal holds an M.B.A from the University of Southern California and M.S. and B.S. degrees in Mechanical Engineering from California State University, Long Beach. Mr. Hilal is a brother of Nabil Hilal and a brother-in-law of Samir Tall, other executive officers of Applied. Mr. Hilal brings to our board of directors 32 years of experience in the medical device and implant arena, and an aversion to financial leverage and debt. He is an advocate of paying for assets, costs and investments as early and as quickly as possible. Mr. Hilal is also an adamant supporter of local operations where communications, responsiveness and shortened supply lines prevail.

Nabil Hilal has been the Group President of our Technology Group, which includes Intellectual Property and Legal, Operations, Corporate Engineering and Automation, since March 2005. Mr. N. Hilal joined Applied in 1989 and holds an M.S. degree in Chemical Engineering from the University of Aston in Birmingham, England and a B.S. degree in Chemistry from the American University in Beirut. Mr. N. Hilal is a brother of Said S. Hilal and a brother-in-law of Samir Tall. Mr. N. Hilal brings 28 years of medical device experience and 37 years of technology-based operations to our board of directors. Mr. N. Hilal is a strong believer in the active weaving of technology, process and automation into every facet of operation. He is an advocate of vertical integration and heavy capital investments to improve quality, compliance and efficiencies.

Stephen E. Stanley has been the Group President of our Global Distribution Group since 2004, and has served in a variety of senior management and executive positions since 1990. Mr. Stanley holds an MBA from Pepperdine University and a B.S. degree in Biomedical/Mechanical Engineering from the University of California, San Diego. Mr. Stanley has extensive experience on the technical and clinical sides of our business. He brings balance to the forecasting and planning processes at Applied, due to his extensive experience in that field, and his knowledge of markets and selling process.

Gary Johnson has been the Group President of our Surgical Group, which includes the Surgical Divisions and Corporate Branding, since March 2007 and has been with Applied since 1992.

 

90


Table of Contents

Mr. Johnson holds a B.S. degree in Mechanical Engineering from Colorado State University. From 2004 to March 2007, Mr. Johnson was our Division President, General Surgery. Mr. Johnson has extensive experience in many facets of our business. His knowledge covers clinical and market environments, business conditions, competitors, contracting practices and trends affecting technologies.

Samir Tall has been our Chief Financial Officer since February 2011. Mr. Tall joined Applied in 1991 and has served in various capacities, with responsibilities for Information Technology, Strategic Procurement, and Personnel. Mr. Tall was our Chief Information Officer until July 2006 when he assumed the additional role of Vice President, Integrated Systems and Personnel. He was appointed Senior Vice President, Integrated Systems in August 2008 and added to his responsibility the role of Acting Senior Vice President, Finance in August 2009. In January 2010, he was promoted to acting Chief Financial Officer. Mr. Tall holds a B.S. degree in Business Administration from Saint Joseph University in Beirut. Mr. Tall is a brother-in-law of Said S. Hilal and Nabil Hilal. Mr. Tall has extensive experience in building teams to address emerging needs.

Michael Vaughn joined us in September 2008 as Vice President and General Counsel and was appointed as Secretary in December 2008. Mr. Vaughn served as Vice President and General Counsel of Quest Software, Inc., a publicly-held software provider, from April 2000 to September 2008, after 13 years of private practice engaged in mergers and acquisitions, corporate finance and corporate matters. Mr. Vaughn graduated from the University of Southern California Gould School of Law in 1987 and from Arizona State University with a B.S. degree in Accounting.

Kari Moore is our Chief Accounting Officer and joined us in September 2010. Prior to joining Applied, she worked as a senior executive consultant for us from June 2008 until September 2010. From 2006 to June 2008, Ms. Moore was an independent accounting consultant. She served PricewaterhouseCoopers LLP for over twenty years, becoming an audit partner in the consumer industrial products group in the Orange County, California office in 2001. Ms. Moore holds a B.S. degree in Business Administration from the University of Southern California and is a member of the American Institute of CPAs and the California Society of CPAs.

Board of Directors

Dennis L. Fowler, M.D., MPH, has served as a member of our board of directors since May 2009. Dr. Fowler has been Professor of Clinical Surgery at Columbia University College of Physicians and Surgeons since 2000. From 2004 to 2008, he was also Vice President, Medical Director for Perioperative Services, New York Presbyterian Hospital/Columbia. Since 2009, he has been Director of Outcomes Research, and, in 2010, he was Chief Projects Officer of the Center for the Integration of Medicine and Innovative Technology (CIMIT), in Boston, MA. Since 1990, as a pioneer in minimally invasive surgery, he has been on the clinical advisory boards of numerous startup companies engaged in commercializing healthcare technology. The board of directors believes Dr. Fowler’s in-depth knowledge of the healthcare industry and hospital operations provides him with a critical perspective regarding our products, technologies and prospects. In addition, Dr. Fowler brings to the board of directors his unique perspective as a physician.

Mark P. de Raad has served on our board of directors and as Chairman of our audit committee since February 2011. Mr. de Raad has served as the Executive Vice President and Chief Financial Officer of Masimo Corporation since June 2006. Masimo is a global medical technology company that develops, manufactures, and markets noninvasive patient monitoring products that help clinicians improve patient care. From November 2002 through May 2006, Mr. de Raad served as Vice President, Chief Financial Officer and Secretary for Avamar Technologies, Inc., a start-up enterprise software development company. Mr. de Raad is a Certified Public Accountant (inactive) and holds a B.S. in Accounting from the University of Santa Clara. Mr. de Raad brings the experience and

 

91


Table of Contents

seasoning of his position, combined with the special experience of the Masimo organization to the Applied board. Masimo has many similarities with Applied, including similar market, competitive and intellectual property challenges. Mr. de Raad has been able to anticipate and share future issues and needs based on his experiences with Masimo.

Leslee A. Temple, FASLA, has been a director since September 1, 2011. After 33 years with NUVIS, a landscape architecture and site planning firm founded in 1971 and based in Costa Mesa, CA, and having served as its Chief Financial Officer, Ms. Temple was elected in 2011 as its President. Ms. Temple is responsible for corporate strategic planning, transition integration, operations, administration, marketing, and the firm’s investment and 401k portfolios. During her 38 year professional career she has served on the boards of directors of several organizations, including Plaza Bank in Irvine, where she served as Chair of its Asset-Liability Management Committee. She earned a Bachelor of Science in Landscape Architecture from California State Polytechnic University, Pomona. She is one of approximately 1,100 people in the U.S. with the distinction of “Fellow” in the American Society of Landscape Architects (FASLA). Ms. Temple was the first woman to be Vice President of Finance and then President/Executive Director of the Landscape Architecture Foundation, based in Washington, DC. Ms. Temple brings extensive experience and expertise in the field of creating the type of specific organizational environments that are important to Applied and its culture. Ms. Temple’s progressive views on landscape design will benefit the ongoing development of our central Orange County campus. Her knowledge and contacts in the field of landscaping in Orange County, as well as her standing in the landscaping community, have already proven helpful and insightful to Applied.

Thomas M. Kasten has served a member of our board of directors since 2007 and as Chairman of our compensation committee since February 2011. Mr. Kasten currently serves as Mayor of the Town of Hillsborough, California and has served on its City Council since 2000. From 2008 to 2010, Mr. Kasten held the position of Chair of the City/County Association of Governments of San Mateo County, and continues to serve as chairman of its Finance Committee and Vice Chairman of its Legislative Committee. Mr. Kasten has also served in a variety of senior executive positions with Levi Strauss & Co., including President of the Jeanswear, Youthwear and Womenswear Divisions, Executive Vice President of New Business Development, Vice President of Information Technology for the United States and Vice President of Marketing for the Jeans Division. Mr. Kasten holds a B.S. degree in Business Administration and an M.B.A. from the University of California at Berkeley. Mr. Kasten brings to the board of directors the totality of his business and public service experience. Mr. Kasten’s extensive experience with public company issues while at Levi Strauss & Co. has been helpful to Applied’s team and board.

Composition of the Board of Directors; Director Independence

Our bylaws provide that our board of directors shall consist of at least one member, with the exact number of directors to be determined by resolution of our board of directors. Our board of directors currently consists of six members. Based upon information requested from and provided by each director concerning his or her background, employment and affiliations, including family relationships, with us, our senior management and our independent registered public accounting firm, our board of directors has determined that all but two of our directors, Messrs. S. Hilal and N. Hilal, are independent directors as defined under the rules of the Nasdaq Stock Market.

Our certificate of incorporation provides that our board of directors will be divided into three classes to be comprised of the directors in office, with each class serving for a staggered three-year term. Class I directors will serve an initial one-year term expiring at the first annual meeting of stockholders following this offering. Class II directors will serve an initial two-year term expiring at the second annual meeting of stockholders following this offering. Class III directors will serve an initial

 

92


Table of Contents

three-year term expiring at the third annual meeting of stockholders following this offering. Upon the expiration of the initial term of each class of directors, the directors in that class will be eligible to be elected for a new three-year term. Our directors will hold office until their successors have been elected and qualified or until their earlier death, resignation, disqualification or removal. Executive officers are appointed by and serve at the direction of our board of directors.

Board Committees

We currently have two standing committees: an audit committee and a compensation committee.

Audit Committee

Our audit committee consists of Mr. de Raad (Chairperson), Mr. Kasten and Dr. Fowler. Our board of directors has determined that each of these directors is independent as defined under the rules of the Nasdaq Stock Market and the applicable rules of the SEC, and that each member of the audit committee meets the financial literacy and experience requirements of the applicable SEC rules. In addition, our board of directors has determined that Mr. de Raad qualifies as an “audit committee financial expert” under the rules and regulations of the SEC. Our independent auditors and our internal finance personnel regularly meet privately with, and have unrestricted access to, our audit committee. We will adopt an audit committee charter to be effective upon the consummation of this offering.

Our audit committee charter requires that the audit committee oversee our corporate accounting and financial reporting processes. The primary duties of our audit committee are to, among other things:

 

   

Evaluate our independent registered accounting firm’s qualifications, independence and performance;

 

   

Determine the engagement and compensation of our independent registered accounting firm;

 

   

Approve the retention of our independent registered accounting firm to perform any proposed, permissible non-audit services;

 

   

Monitor the rotation of partners and managers of the independent registered accounting firm on our engagement team as required;

 

   

Review our consolidated financial statements;

 

   

Review our critical accounting policies and estimates;

 

   

Meet periodically with our management and internal audit team to consider the adequacy of our internal controls and the objectivity of our financial reporting;

 

   

Establish procedures for the receipt, retention and treatment of complaints regarding internal accounting controls or auditing matters and the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters;

 

   

Review on an ongoing basis and approve related party transactions, as defined in SEC rules;

 

   

Prepare the reports required by the rules of the SEC to be included in our annual proxy statement, if we are subject to the proxy rules under the Exchange Act; and

 

   

Discuss with our management and our independent registered accounting firm the results of our annual audit and the review of our quarterly consolidated financial statements.

 

93


Table of Contents

Compensation Committee

Our compensation committee consists of Mr. Kasten (Chairperson), Ms. Temple and Dr. Fowler. Our board of directors has determined that each of these directors is independent and qualifies as an outside director for purposes of Section 162(m) of the U.S. Internal Revenue Code of 1986, as amended, or the Code. We will adopt a compensation committee charter to be effective upon the consummation of this offering. The primary duties of the compensation committee are to:

 

   

Establish overall employee compensation policies and recommend to our board of directors major compensation programs;

 

   

Review and approve the compensation of our executive officers and directors, including salary and bonus awards;

 

   

Administer our various employee benefit, pension and equity incentive programs; and

 

   

Prepare an annual report on executive compensation for inclusion in our proxy statement.

Other Committees

Our board of directors may establish other committees as it deems necessary or appropriate from time to time.

Compensation Committee Interlocks and Insider Participation

None of the members of our compensation committee is or has at any time during the past fiscal year been an officer or employee of Applied. None of the members of the compensation committee has formerly been an officer of Applied. None of our executive officers serve, or in the past fiscal year has served, as a member of the board of directors or compensation committee of any other entity that has one or more executive officers serving as a member of our board of directors or compensation committee.

Indemnification of Directors and Executive Officers and Limitations of Liability

Our certificate of incorporation provides that, subject to certain limitations, we shall indemnify our directors and officers against all expenses, including legal fees, and against all judgments, fines and amounts paid in settlement and reasonably incurred in connection with legal, administrative or investigative proceedings to the fullest extent authorized by Delaware law. In addition, our certificate of incorporation provides that our directors will not be personally liable for monetary damages to us for breaches of their fiduciary duty as directors, unless they violated their duty of loyalty to us or our stockholders, acted in bad faith, knowingly or intentionally violated the law, authorized unlawful payments of dividends, unlawful stock purchases or unlawful redemptions, or derived an improper personal benefit from their actions as directors. Such indemnity only applies if the person acted honestly and in good faith with a view to the best interests of Applied and, in the case of criminal proceedings, the person had no reasonable cause to believe that their conduct was unlawful. The decision of the directors as to whether the person acted honestly and in good faith and with a view to the best interests of Applied and as to whether the person had no reasonable cause to believe that his conduct was unlawful and is, in the absence of fraud, sufficient for the purposes of our certificate of incorporation, unless a question of law is involved. The termination of any proceedings by any judgment, order, settlement, conviction or the entering of a nolle prosequi does not, by itself, create a presumption that the person did not act honestly and in good faith and with a view to the best interests of Applied or that the person had reasonable cause to believe that his conduct was unlawful.

We will enter into agreements with our officers and directors to provide contractual indemnification in addition to the indemnification provided for in our certificate of incorporation. Our bylaws also permit us to purchase and maintain insurance on behalf of any officer or director for whom

 

94


Table of Contents

at our request is or was serving as a director or officer of, or in any other capacity is or was acting for, another company or a partnership, joint venture, trust or other enterprise, against any liability asserted against the person and incurred by the person in that capacity, whether or not we have or would have had the power to indemnify the person against the liability as provided in the amended and restated certificate of incorporation and regardless of the whether Delaware law would permit indemnification. In addition, we have purchased a policy of directors’ and officers’ liability insurance that insures our officers and directors against the cost of defense, settlement or payment of a judgment in some circumstances and insures us against our obligations to indemnify our officers and directors.

These provisions may discourage stockholders from bringing a lawsuit against our directors for breach of their fiduciary duty. These provisions also may have the effect of reducing the likelihood of derivative litigation against officers and directors, even though such an action, if successful, might otherwise benefit us and our stockholders. Furthermore, a stockholder’s investment may be adversely affected to the extent we pay the costs of settlement and damage awards against officers and directors pursuant to these indemnification provisions.

We believe that these provisions of our certificate of incorporation and bylaws, and the insurance and the indemnity agreements are necessary to attract and retain talented and experienced officers and directors.

Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers or persons controlling us pursuant to the foregoing provisions, we have been informed that in the opinion of the SEC such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.

 

95


Table of Contents

EXECUTIVE COMPENSATION

The following is a summary of certain key elements of the compensation programs and policies in place for our named executive officers, or NEOs, during 2011. For fiscal year 2011, we had five NEOs, as follows:

 

   

Said S. Hilal, our President and Chief Executive Officer;

 

   

Nabil Hilal, our Group President, Technology;

 

   

Stephen E. Stanley, our Group President, Distribution;

 

   

Gary M. Johnson, our Group President, Surgical; and

 

   

Samir Tall, our Chief Financial Officer.

Specifically, this section provides an overview of our executive compensation philosophy, the overall objectives of our executive compensation program and each compensation component that we provide. Our compensation plans, agreements and arrangements are designed to be flexible and complementary and to collectively serve the principles and objectives of our executive compensation and benefits program.

We expect that the specific direction, emphasis and components of our executive compensation program will continue to evolve. During 2011, and in recognition of the leadership and performance of the executive team, the increasing size and complexity of Applied, the potential of being compelled to complete an initial public offering at the demand of IVP, ongoing and potential litigation, increasingly hostile competitive conditions and challenging economic conditions, the compensation committee approved and implemented a retention program designed to ensure that compensation for our NEOs and other key team members is, and will remain, competitive. The compensation committee determined that our NEOs and key team members were being compensated at below competitive levels and adopted an approach to gradually increase their compensation to competitive levels. The retention program approach to gradually increase compensation for our NEOs and key team members includes three elements: increased base salary, increased annual bonus plan target amounts and grants of long-term equity-based compensation. The compensation committee considered a number of factors in determining to implement the retention program approach, including: (1) the paramount importance of retaining our NEOs and key team members to maintain Applied’s culture and vertical integration efficiency, (2) the significant expansion of our NEOs’ and key team members’ responsibilities, given the recent additions of team members and the commensurate increase in the sizes of programs, budgets and communications, (3) Applied’s status as a public company, the increased responsibilities of our NEOs and key team members associated therewith and the possible adverse changes to the Applied working place, culture and success associated therewith, and (4) the increase in worldwide training and mentoring requirements for our NEOs and key team members, including more frequent engagement with international Applied team members and international travel. The retention program reflects Applied’s commitment to recruit and retain the best team members and compensate them at the best levels possible.

Elements of 2011 Compensation

During fiscal year 2011, our NEOs’ total direct compensation included both fixed components (base salary, other executive benefits and perquisites) and variable components (discretionary annual and other cash bonuses and equity awards). The following describes each component of compensation, the rationale for that component and how the compensation amounts were determined.

 

96


Table of Contents

Base Salary

Base salaries historically have constituted a smaller portion of total compensation for our executive officers, and this remained true in fiscal year 2011. Base salaries support our retention objective by providing our executive officers with steady cash flow during the course of the fiscal year that is not contingent on short-term variations in our corporate performance.

In February 2012, for the reasons described above as the first element of the retention program implemented by our compensation committee, the base salary levels for our NEOs were set at the following levels:

 

   

Said Hilal: $875,000;

 

   

Nabil Hilal: $675,000;

 

   

Mr. Stanley: $525,000;

 

   

Mr. Johnson: $485,000; and

 

   

Mr. Tall: $450,000.

The base salary level adjustments were effective as of January 1, 2012, other than Mr. Tall’s which was retroactive to November 1, 2011. In May 2012, the compensation committee approved increases to Mr. Tall’s and Mr. Johnson’s base salaries to $525,000, effective July 1, 2012.

Annual Bonus Plan

We maintain an annual bonus plan under which all team members are eligible to receive discretionary cash bonuses. Under the annual bonus plan, the overall bonus pool and amounts to be awarded to our NEOs and other team members have been determined on the basis of our achievement of certain performance objectives and, for each individual team member, his or her achievement of individual performance objectives for the applicable period based upon subjective considerations of individual performance and other factors.

For the 2011 annual bonus plan, the target bonus amounts for each of our NEOs were established in October 2010 with the approval of the compensation committee. In September 2011, the 2011 annual bonus plan target bonus levels were increased, effective July 1, 2011, as the second element in connection with the retention program described above. Performance objectives for the 2011 annual bonus plan were based upon total revenues, gross margins and operating earnings, with each of the gross margin and operating earnings factors weighted at 40% and the total revenue factor weighted at 20%. Key organizational objectives for the 2011 annual bonus plan emphasized sales force expansion, stratification, training and development, together with continued exceptional levels of high quality, compliance, availability, capacity and manufacturing cost control, as well as continued improvements and product line extensions in existing product lines, accelerated efforts to ensure access to our product markets in the competitive environment and expanded efforts in all aspects of our global training and education program. In November and December, 2011, the compensation committee approved payments of cash bonuses to the NEOs under the 2011 annual bonus plan, based upon our results of operations for the three quarterly periods ended September 30, 2011 and projected results for the remaining period of the full fiscal year, and determined that Applied’s actual performance for the full year was likely to significantly exceed the performance objectives established for the 2011 period. Specifically, the percentage achievement of the performance objectives were estimated to range from 124% to 129% of the total revenues objective, from 189% to 209% of the gross margin objective and from 319% to 329% of the operating earnings objective. After applying the weighting factors for the three objectives, and a range of outcomes from 228% to 241%, the compensation

 

97


Table of Contents

committee approved cash bonus payments in the amount of 235% of each NEOs’ average target 2011 annual bonus amounts, as follows:

 

    

 

   Target Bonus
Amount-
Initial
     Target Bonus
Amount-
Adjusted
    2011 Annual Bonus
Amount
 

Said S. Hilal

      $ 700,000       $ 850,000      $ 1,821,250   

Nabil Hilal

        330,000         400,000        857,750   

Stephen E. Stanley

        297,000         400,000        818,975   

Gary Johnson

        264,000         325,000        692,075   

Samir Tall

        250,000         325,000        675,625   

In February 2012, the compensation committee approved target bonus amounts and performance objectives for the 2012 annual bonus plan. Performance objectives for the 2012 annual bonus plan are based upon total revenues, operating earnings and certain product roll-out targets, with the total revenues factor weighted at 50% and each of the operating earnings and product roll-out factors weighted at 25%. The compensation committee approved target annual cash bonus payments for our NEOs as follows:

 

   

Said Hilal: $1,000,000;

 

   

Nabil Hilal: $575,000;

 

   

Mr. Stanley: $475,000;

 

   

Mr. Johnson: $475,000; and

 

   

Mr. Tall: $475,000.

Long-Term Strategic Bonus Plan

Effective January 1, 2010, we adopted a Long-Term Strategic Bonus Plan, or the Bonus Plan. The Bonus Plan, which is administered by the compensation committee, provides for the establishment of bonus pools for executives and team members contingent on achieving certain performance objectives over a defined period. The Applied Participation Points Program, or the APP Program, has been established as award schedules under the Bonus Plan, covering a three-year performance period commencing on January 1, 2010 and ending on December 31, 2012. Performance objectives for the APP Program are based on aggregate revenues and aggregate operating income during the three-year performance period, subject to certain adjustments for excluded expenses. Other potential performance criteria which may be used in the future are cash flow; earnings per share; earnings before interest, taxes and amortization; return on equity; total stockholder return; share price performance; return on capital; return on assets or net assets; revenue, product revenue or licensing revenue; income or net income; operating income or net operating income; operating profit or net operating profit; operating margin or profit margin; return on operating revenue; return on invested capital; or market segment shares. The APP Program provides for an aggregate bonus pool of up to $16.0 million, payable in December 2012, if we achieve the targeted performance objectives, with additional amounts potentially payable if our actual achievement exceeds the performance objectives. As of June 30, 2012, we have accrued $26.5 million for payment of long-term bonuses under the Bonus Plan. One of the award schedules in the APP Program was established for strategic bonus plan awards to six members of our senior management team, including the NEOs, under which a bonus pool of $6.0 million was created, with additional amounts potentially payable if our actual achievement exceeds the performance objectives.

 

98


Table of Contents

The following table sets forth the allocation of potential cash bonus awards to each of the NEOs under the APP Program:

 

     Potential Strategic Bonus Plan
Award at 100% Achievement
     Potential Strategic Bonus Plan
Award at 165.8% Achievement
 

Said S. Hilal

   $ 1,600,000       $ 2,652,800   

Nabil Hilal

     1,100,000         1,823,800   

Stephen E. Stanley

     900,000         1,492,200   

Gary M. Johnson

     900,000         1,492,200   

Samir Tall

     900,000         1,492,200   

On August 9, 2012, our compensation committee established new APP Program award schedules under the Bonus Plan covering a three-year performance period commencing on January 1, 2013 and ending on December 31, 2015. Performance objectives for the new award schedules remain based on aggregate revenues and aggregate operating income during the three-year performance period subject to certain adjustments for excluded expenses. The new award schedules under the APP Program provide for an aggregate bonus pool of up to $25.625 million, payable in March 2016, if we achieve the targeted performance objectives, with additional amounts potentially payable if our actual achievement exceeds the performance objectives. One of the new award schedules in the APP Program was established for strategic bonus plan awards to six members of our senior management team, Including the NEOs, under which a bonus pool of $10.625 million was created, with additional amounts potentially payable if our actual achievement exceeds the performance objectives.

The following table sets forth the allocation of potential cash bonus awards to each of the NEOs under the APP Program for the three year period ending December 31, 2015:

 

     Potential Strategic Bonus Plan
Award at 100% Achievement
 

Said S. Hilal

   $ 3,125,000   

Nabil Hilal

     1,875,000   

Stephen E. Stanley

     1,562,500   

Gary M. Johnson

     1,562,500   

Samir Tall

     1,562,500   

Long-Term Equity-Based Compensation

In addition to our performance-based cash bonus awards, we provide long-term stock-based incentive awards to our executive officers. These stock-based incentive awards generally consist of options to purchase shares of our common stock and awards of restricted stock. We believe that equity awards help further our compensation objectives by encouraging our executives to remain with us through at least the vesting period applicable to the award and by providing our executives with incentives to continue to focus on our financial performance and increasing stockholder value.

In October 2011, the compensation committee approved awards of stock options and restricted shares to each of the NEOs, as the third element in connection with the retention program described above. We granted options to purchase 320,000 shares of Class B common stock to Said Hilal and options to purchase 140,000 shares of Class B common stock to each of Nabil Hilal and Messrs. Stanley, Johnson and Tall, at an exercise price of $15.75 per share. The exercise price was reduced to $8.36 in 2012. The compensation committee also made restricted stock awards of 80,000 shares of Class B common stock to Said Hilal and 35,000 shares to each of Nabil Hilal and Messrs. Stanley, Johnson and Tall. These equity awards vest over a 46-month period, with vesting commencing on November 1, 2011, with 25% of the options or restricted shares vesting on September 1, 2012 and the remaining shares and options vesting in equal monthly increments over the

 

99


Table of Contents

following 36 months. The compensation committee also approved tax gross-up payments to all team members receiving restricted share awards in this round of awards, including the NEOs. We believe that the 46-month vesting schedule aligns the interests of our executive officers with our stockholders in achieving our long-term objectives and facilitating executive retention.

Stock Option Exercise Loan Program

We are not party to any loan arrangements with our executive officers or directors. However, under the terms of our stock incentive plans and the stock option agreements relating to grants of stock options thereunder, holders of stock options desiring to acquire our shares by exercising those stock options may satisfy the exercise price of such options by delivering a full recourse promissory note to us in respect of the aggregate exercise price on terms approved by the board of directors. In July 2010, we initiated, and the board approved, a stock option exercise loan program authorizing the acceptance of promissory notes from our team members (other than executive officers or directors) in connection with the exercise of stock options granted under our stock incentive plans. The board determined, in light of the general economic conditions, that allowing team members to deliver promissory notes to pay the exercise price of stock options would enhance their ability to exercise stock options by providing financial flexibility to make their option exercise decisions in a way consistent with their individual tax planning strategies. Promissory notes bear interest at annual rates determined by our finance department to reflect market rates, have terms ranging from one to four years and must be secured by a pledge of the shares issued upon exercise of the stock options. For accounting purposes, the notes receivable are treated as nonrecourse loans and accounted for as the grant of new stock options. The estimated fair values of the newly-granted stock options are recognized as compensation expense on the issuance date of the nonrecourse note. See note 12 to our consolidated financial statements.

In December 2010, our board of directors approved a limited extension of our stock option exercise loan program to our NEOs, enabling them to use promissory notes to pay the exercise price and related income tax withholding obligations in connection with the exercise of stock options under our stock incentive plans until December 31, 2010. The board’s approval limited the principal amount of executive officers stock option exercise loans to $250,000 for Said Hilal and $500,000 for each of our four other NEOs, and provided that the maturity date of executive officer stock option exercise loans must be the earlier of December 31, 2012 or prior to the date as of which the prohibition on personal loans to executive officers of an issuer under Section 13(k) of the Exchange Act becomes applicable to us or our executive officers.

In December 2010, our NEOs exercised stock options and participated in the stock option exercise loan program, as summarized below. The principal amount and accrued interest on all stock option exercise loans provided to our executive officers were paid in full prior to November 14, 2011.

 

   

Said Hilal delivered a full-recourse promissory note in the principal amount of $250,000 in connection with the exercise of stock options to purchase 160,000 shares of Class B common stock, together with cash in the aggregate amount of $870,000. No interest or principal on this promissory note was paid in 2010. On November 4, 2011, the entire outstanding principal amount of $250,000 and accrued and unpaid interest in the amount of $7,911 on Said Hilal’s promissory note was paid in full.

 

   

Nabil Hilal delivered a full-recourse promissory note in the principal amount of $500,000 in connection with the exercise of stock options to purchase 160,500 shares of Class B common stock, together with cash in the aggregate amount of $623,500. No interest or principal on this promissory note was paid in 2010. On November 4, 2011, the entire remaining outstanding principal amount of $250,000 and accrued and unpaid interest in the amount of $8,039 on Nabil Hilal’s promissory note was paid in full.

 

   

Stephen E. Stanley delivered a full-recourse promissory note in the principal amount of $499,999 in connection with the exercise of stock options to purchase 82,261 shares of

 

100


Table of Contents
 

Class B common stock. No interest or principal on this promissory note was paid in 2010. On February 7, 2011, the entire outstanding principal amount of $499,999 and accrued and unpaid interest in the amount of $1,951 on Mr. Stanley’s promissory note was paid in full.

 

   

Gary Johnson delivered a full-recourse promissory note in the principal amount of $402,650 in connection with the exercise of stock options to purchase 71,000 shares of Class B common stock. No interest or principal on this promissory note was paid in 2010. On November 8, 2011, the entire outstanding principal amount of $402,650 and accrued and unpaid interest in the amount of $12,741 on Mr. Johnson’s promissory note was paid in full.

 

   

Samir Tall delivered a full-recourse promissory note in the principal amount of $150,010 in connection with the exercise of stock options to purchase 59,360 shares of Class B common stock, together with cash in the aggregate amount of $265,510. No interest or principal on this promissory note was paid in 2010. On November 4, 2011, the entire outstanding principal amount of $150,010 and accrued and unpaid interest in the amount of $4,747 on Mr. Tall’s promissory note was paid in full.

2010 Option Repricing

In March 2010, we completed a stock option repricing. Eligible directors, officers, employees and non-employees were provided an opportunity to elect to amend certain eligible outstanding stock options with stated exercise prices at or above $10 per share. Eligible option holders elected to amend stock options to purchase an aggregate of 1,328,475 shares of Class B common stock, some of which were held by our NEOs. For further information regarding the re-pricing of such stock options, see note 12 to our consolidated financial statements included elsewhere in this prospectus.

2012 Option Repricing

In March 2012, our compensation committee repriced options to purchase 9,000 shares of Class A common stock and options to purchase 1,330,800 shares of Class B common stock which had been granted at exercise prices of $15.75 per share for options to purchase Class B common stock granted in October 2011, $13.05 per share for options to purchase Class B common stock granted in December 2011, $14.96 per share for options to purchase Class A common stock granted in October 2011 and $12.40 per share for options to purchase Class A common stock granted in December 2011. In light of the compensation committee’s determination of fair market value in March 2012, these stock options were repriced to $8.36 per share of Class B common stock and $7.94 per share of Class A common stock. The repriced stock options included options granted to our NEOs in October 2011. For further information regarding the repricing of such stock options, see note 12 to our consolidated financial statements included elsewhere in this prospectus.

The Stock Incentive Plans under which equity awards have been granted to our executives are described below.

Third Amended and Restated 2008 Stock Incentive Plan

The Applied Medical Corporation 2008 Stock Incentive Plan, or the Plan, was adopted by the board of directors of Applied and approved by our stockholders on December 19, 2008. It was most recently amended and restated effective October 18, 2011, or the Effective Date. The Plan was intended to be the successor to the Applied Medical Resources Corporation 1998 Stock Incentive Plan, or the AMRC 1998 Plan, which was assumed by Applied effective August 20, 2010. Following the Effective Date, no additional stock awards will be granted under the AMRC 1998 Plan. Unless sooner terminated, the Plan will terminate on October 18, 2021.

Awards; Eligibility. The Plan provides for the granting of incentive stock options within the meaning of Section 422 of the Code to employees of Applied or a subsidiary and the granting of nonqualified stock options and stock appreciation rights, or SARs, and the granting or sale of restricted shares to employees, non-employee directors and consultants of Applied or a subsidiary.

 

101


Table of Contents

Administration. The Plan provides that our board of directors will administer the Plan, but our board of directors may delegate any or all administrative functions under the Plan to one or more committees, each of which must consist of at least two directors of the board of directors who have been appointed by the board of directors. The compensation committee of our board of directors currently administers the Plan, including determining the recipient of an award, the number of shares subject to each award, whether an option is to be classified as an incentive stock option or nonqualified stock option, and the terms and conditions of each award, including the exercise and purchase prices and the vesting or duration of the award.

Authorized Shares. Under the Plan, 6,241,202 shares of our Class A Common Stock and Class B Common Stock have been authorized for issuance. In addition, the number of shares that have been authorized for issuance under the Plan will be automatically increased on the first day of each fiscal year ending in 2021, in an amount equal to the least of (1) 500,000 shares, (2) 2.5% of the outstanding shares on the last day of the immediately preceding year or (3) another smaller amount determined by our board of directors. The number of shares that may be delivered upon the exercise of incentive stock options granted under the Plan may not exceed 10,000,000. The number of shares available for issuance under the Plan will be reduced by one share issued pursuant to an award. Shares subject to awards granted under the Plan that are forfeited or terminated before being exercised or settled will again become available for issuance under the Plan. Shares not delivered because they are tendered to satisfy exercise price, because the award is exercised through a reduction of shares subject to the award, or because they are withheld for payment of taxes will again become available for issuance under the Plan. In addition, shares subject to outstanding options under our AMRC 1998 Plan that expire or that are subsequently forfeited or terminated for any reason before being exercised will again become available for awards under our Plan.

From and after the date on which Applied first becomes subject to the reporting obligations of the Exchange Act (that date to be extended, as applicable, to the end of any transition period under applicable law, no participant may receive options, restricted shares or SARs under the Plan totaling more than an aggregate of 500,000 shares in any calendar year, except that, in a participant’s first year of service, the participant may receive equity awards under the Plan totaling up to an aggregate of 1,000,000 shares.

Stock Options. A stock option is the right to purchase a certain number of shares of stock in the future at a certain exercise price that is determined on the date of grant. Under the Plan, incentive stock options and nonqualified stock options must be granted with an exercise price of at least 100% of the fair market value of our common stock on the date of grant. As provided under applicable law, incentive stock options granted to any holder of more than 10% of the voting shares of our company must have an exercise price of at least 110% of the fair market value of our common stock on the date of grant. No incentive stock option can be granted to an employee if as a result of the grant, the employee would have the right in any calendar year to exercise for the first time one or more incentive stock options for shares having an aggregate fair market value in excess of $100,000.

The compensation committee will determine, and the stock option agreement will specify, the date when all or any installment of the option is to become exercisable. The compensation committee may, in its sole discretion, provide for accelerated exercisability in the event of a change in control (as defined in the Plan) or other events. Each stock option agreement will set forth the term of the options, which is prohibited from exceeding 10 years from the date of grant (five years from the date of grant in the case of an incentive stock option granted to any holder of more than 10% of our voting shares), and the extent to which the optionee will have the right to exercise the option following termination of the optionee’s service with Applied.

Shares purchased on exercise of options will be subject to those forfeiture conditions, rights of repurchase, rights of first refusal and transfer restrictions as the compensation committee may determine, as set forth in the applicable stock option agreement. During an optionee’s lifetime, his or her options will

 

102


Table of Contents

be exercisable only by the optionee or the optionee’s guardian or legal representatives, and will not be transferable other than by beneficiary designation, will or the laws of descent and distribution; provided, however, that to the extent permitted by our board of directors in its sole discretion, a nonqualified stock option may, to the extent permitted by applicable law, be transferred by the optionee to (1) a revocable trust, (2) one or more family members or (3) a trust established for the benefit of the optionee and/or one or more family members. Each stock option agreement will set forth the extent to which the optionee will have the right to exercise the option following termination of the optionee’s service.

Each stock option agreement will provide the optionee with the right to exercise the option following the optionee’s termination of service during the option term, to the extent the option was exerciseable for vested shares upon termination of service, for at least 30 days if the optionee’s termination of service is due to any reason other than cause, death or disability and for at least six months if the optionee’s termination is due to death or disability, but in no event later than the expiration of the option term. To the extent the option was not exercisable for vested shares on an optionee’s termination of service, the option will terminate when the optionee’s service terminates. If the optionee’s service is terminated for cause, the stock option agreement may provide that the optionee’s right to exercise the option terminates immediately on the effective date of the optionee’s termination. Payment of the exercise price may be made in cash or cash equivalents or by any other form (including full-recourse promissory notes) approved by the board of directors that is consistent with applicable laws, regulations and rules.

Restricted Shares. Restricted shares are share awards that may be subject to vesting conditioned upon continued service, the achievement of performance objectives or the satisfaction of any other condition as specified in a restricted share agreement. Participants who are granted restricted share awards generally have all of the rights of a stockholder with respect to such shares, other than the right to transfer such shares prior to vesting. Subject to the terms of the Plan, our compensation committee will determine the terms and conditions of any restricted share award, including any vesting arrangement, which will be set forth in a restricted share agreement to be entered into between us and each recipient. Each award or sale of shares will be subject to those forfeiture conditions, rights of repurchase, rights of first refusal and other transfer restrictions as the compensation committee may determine, as set forth in the applicable restricted share agreement. Restricted shares may be awarded for such consideration as our compensation committee may determine, including without limitation cash, cash equivalents, full-recourse promissory notes, future services or services rendered prior to the award, without cash payment by the recipient, surrender of stock owned by the recipient for at least six months, and cancellation of indebtedness of Applied owing to the recipient. Any right to acquire shares will automatically expire if not exercised by the purchaser within 30 days after our compensation committee approves the award or sale of those shares.

Stock Appreciation Rights. SARs typically will provide for payments to the recipient based upon increases in the price of our common stock over the exercise price of the SAR. The underlying agreement will specify the exercise price, which may be determined in accordance with a predetermined formula while the SAR is outstanding. Each agreement will specify the date when all or an installment of the SAR is to become exercisable. The agreement will also specify the term of the SAR. The agreement may provide for accelerated exercisability in the event of the holder’s death, disability or retirement or other events, and may provide for expiration prior to the end of its term in the event of the termination of the SAR holder’s service. SARs may be awarded in combination with options, and may provide that the SARs will not be exercisable unless the related options are forfeited. A SAR may be included in an incentive stock option only at the time of grant but may be included in a nonqualified stock option at the time of grant or thereafter. A SAR granted under the Plan may provide that it will be exercisable only in the event of a change in control (as defined in the Plan) or an initial public offering of our stock. When a SAR is exercised, our compensation committee may elect to pay the holder (or any person having the right to exercise a SAR after the holder’s death) in cash, common

 

103


Table of Contents

stock or a combination of cash and common stock. Our compensation committee may at any time (a) offer to buy out for a payment in cash or cash equivalents of a SAR previously granted, or (b) authorize a holder to elect to cash out a SAR previously granted, in either case at the time and based on the terms and conditions that our compensation committee establishes. Shares issued on settlement of SARs will be subject to the forfeiture conditions, rights of repurchase, rights of first refusal and other transfer restrictions as the compensation committee may determine, as may be set forth in the applicable agreement.

Other Plan Features. We will have the right to repurchase shares that have been acquired through an award or sale of shares or the exercise or settlement of an award upon termination of the participant’s service if provided in the applicable restricted share agreement, stock option agreement or SAR agreement. The compensation committee in its sole discretion will determine when the right to repurchase will lapse as to all or any portion of the shares, and may, in its discretion, provide for accelerated vesting in the event of a change in control (as defined in the Plan) or other events.

The shares or other benefits granted, issued, retainable or vested under an award may be made subject to the attainment of performance goals for a specified period of time relating to one or more of the following performance criteria, either individually, alternatively or in any combination, applied to either Applied as a whole or to a business unit or subsidiary, either individually, alternatively or in any combination, and measured either annually or cumulatively over a period of years, on an absolute basis or relative to a pre-established target, to previous years’ results or to a designated comparison group or index: (a) cash flow, (b) earnings per share, (c) earnings before interest, taxes and amortization, (d) return on equity, (e) total stockholder return, (f) share price performance, (g) return on capital, (h) return on assets or net assets, (i) revenue, product revenue or licensing revenue, (j) income or net income, (k) operating income or net operating income, (l) operating profit or net operating profit, (m) operating margin or profit margin, (n) return on operating revenue, (o) return on invested capital, or (p) market segment shares. The board of directors or compensation committee may appropriately adjust any evaluation of performance under any such criteria to exclude any of the following events that occurs during a performance period: (1) asset write-downs, (2) litigation or claim judgments or settlements, (3) the effect of changes in tax law, accounting principles or other such laws or provisions affecting reported results, (4) accruals for reorganization and restructuring programs and (5) any extraordinary nonrecurring items as described in Accounting Principles Board Opinion No. 30 or in managements’ discussion and analysis of financial condition and results of operations appearing in our annual report to stockholders for the applicable year. The board of directors or compensation committee may grant an award with other performance-based vesting criteria where such award is not intended to be exempt from the provisions of Section 162(m) of the Code.

Our board of directors or compensation committee may permit a participant to satisfy all or part of his or her withholding or income tax obligations by having Applied withhold all or a portion of any shares that would otherwise be issued to him or her by surrendering all or a portion of any shares that he or she previously acquired, subject to certain limitations. If our shares are publicly traded at the time of exercise, our board of directors or compensation committee may permit participants to meet the withholding obligation by cashless exercise or pledge. Our board of directors or compensation committee may permit any other means of tax withholding as it deems appropriate.

In the event of a recapitalization, stock split or similar capital transaction, our compensation committee will make appropriate and equitable adjustments to the number of shares reserved for issuance under the Plan, including the share number in the formula for automatic annual increases, the limitation regarding the total number of shares underlying awards given to an individual participant in any calendar year and other adjustments in order to preserve the benefits of outstanding awards under the Plan. In the event we are a party to a merger or other consolidation, or in the event of a transaction providing for the sale of all or substantially all of our stock or assets,

 

104


Table of Contents

outstanding awards will be subject to the agreement of merger, consolidation or sale, which may provide for treatment of those awards in one or more of the following ways without the recipients’ consent: (1) continuation of outstanding awards by Applied, (2) assumption of the Plan and outstanding awards by the surviving corporation or its parent, (3) substitution by the surviving corporation or its parent of options or rights with substantially the same terms for such outstanding awards, (4) immediate exercisability of such outstanding awards followed by the cancellation of such awards, or (5) settlement of the intrinsic value of the outstanding awards (whether or not then exerciseable) in cash, cash equivalents or equity (including cash or equity subject to deferred vesting and delivery consistent with the vesting schedules applicable to such awards or the underlying shares) followed by the cancellation of such awards.

Our board of directors may amend or terminate the plan at any time and for any reason, subject to stockholder approval where required by applicable law. Any amendment or termination may not materially impair the rights of holders of outstanding awards without the holders’ consent.

1998 Stock Incentive Plan

The Applied Medical Resources Corporation 1998 Stock incentive Plan, or the AMRC 1998 Plan, was adopted by the board of directors of Applied and subsequently approved by our stockholders. The terms of the AMRC 1998 Plan continue to govern awards previously granted under that plan.

Awards; Eligibility. The AMRC 1998 Plan provides for the granting of incentive stock options to officers and other key employees of Applied or an affiliated company, and nonqualified stock options and rights to purchase shares to officers and other key employees of Applied or an affiliated company, members of the board of directors and consultants to Applied or an affiliated company.

Administration; Authorized Shares. The AMRC 1998 Plan is administered by the Board, which may delegate its authority to a committee. A total of 6,325,036 shares of common stock may be issued under the AMRC 1998 Plan.

Stock Options. A stock option is the right to purchase a certain number of shares of stock in the future at a certain exercise price that is determined on the date of grant. All stock options granted under the AMRC 1998 Plan were granted with an exercise price that was no less than fair market value on the date of grant. Payment of the exercise price may be made by such means as is determined by the plan administrator. Each stock option vests and becomes exercisable in one or more installments at such time or times and subject to such conditions, including without limitation the achievement of specified performance goals or objectives, as is determined by the plan administrator; provided that in no event will any stock option granted to an employee who is not an officer or director vest as to less than 20% of the shares represented thereby in each of the five years following the date of grant. No option may be exercisable more than ten years after it is granted. Generally, no option will be assignable or transferable except by will or the laws of descent and distribution, and during the life of the optionee will be exercisable only by the optionee. In the event of a termination of a participant’s employment (or service as a director or consultant), the agreement may provide for the right of Applied to repurchase the underlying shares.

Rights to Purchase. A right to purchase is the right to purchase, for a purchase price determined by the plan administrator, shares of common stock subject to such terms, restrictions and conditions as the plan administrator may determine at the time of grant, which may include continued employment or the achievement of specified performance goals or objectives. Payment of the purchase price may be made by such means as is determined by the plan administrator. If payment is made by promissory note, any cash dividends paid with respect to the stock may be applied, in the discretion of the plan administrator, to repayment of such note. The stock purchase agreement will specify the date or dates, the performance goals or objectives which must be achieved, and any other

 

105


Table of Contents

conditions on which the stock may vest, provided that in no event will stock issued to an employee who is not an officer or director vest as to less than 20% per year for each of the five years following issuance. No right to purchase will be assignable or transferable except by will or the laws of descent and distribution or as otherwise provided by the plan administrator. In the event of a termination of a participant’s employment or service as a director or consultant, the agreement may provide for the right of Applied to repurchase the shares.

Change in Control. In the event of a change in control (as defined in the AMRC 1998 Plan), if options and rights to purchase are not assumed by the acquiror, the number of shares otherwise vested as of such date will be doubled (but not above the number of shares subject to the award) and each participant will be given at least 15 days’ notice of the proposed transaction.

Amendment and Termination. The board of directors may alter, amend, suspend or terminate the AMRC 1998 Plan, so long as such action does not affect or impair the rights of participants under existing awards.

Other Executive Benefits and Perquisites

We provide health insurance, holiday, vacation and sick day benefits to our executive officers on the same basis as other eligible employees. The vacation benefit for executive officers is determined on an individual basis. We believe these benefits are generally consistent with those offered by other companies in our industry.

In addition, during fiscal year 2011, certain of the NEOs received additional benefits in the form of income tax gross-up payments in connection with restricted share awards, special 20-year service cash bonus payments, 401(k) matching contributions, payments in consideration of accrued and unused vacation days, and payments of professional fees for tax and estate planning services.

Retirement Savings

We have established a 401(k) retirement savings plan for our employees, including the NEOs, who satisfy certain eligibility requirements. Under the 401(k) plan, eligible employees may elect to contribute pre-tax amounts, up to a statutorily prescribed limit, to the 401(k) plan. In addition, we match pre-tax contributions on behalf of eligible employees, up to a certain percentage of the individual’s contribution. We believe that providing a vehicle for tax-preferred retirement savings through our 401(k) plan adds to the overall desirability of our executive compensation package and further incentivizes our employees, including our NEOs, in accordance with our compensation policies.

Tax and Accounting Considerations

Section 162(m) of the Internal Revenue Code

Generally, Section 162(m) of the Code disallows a tax deduction to any publicly held corporation for any individual remuneration in excess of $1.0 million paid in any taxable year to its chief executive officer and each of its other NEOs, other than its chief financial officer. However, remuneration in excess of $1.0 million may be deducted if, among other things, it qualifies as “performance-based compensation” within the meaning of the Code.

As we are not currently publicly-traded, we have not previously taken the deductibility limit imposed by Section 162(m) of the Code into consideration in setting compensation. Following this offering, and at such time as Section 162(m) applies to us, we expect that, where reasonably practicable, the compensation committee may seek to qualify the compensation paid to our NEOs for the “performance-based compensation” exemption under Section 162(m) of the Code. As such, in

 

106


Table of Contents

approving the amount and form of compensation for our NEOs in the future, the compensation committee will consider all elements of the cost to us of providing such compensation, including the potential impact of Section 162(m) of the Code. The compensation committee may, in its judgment, authorize compensation payments that do not comply with the exemption from the deductibility limit in Section 162(m) of the Code when it believes that such payments are appropriate to attract and retain executive talent.

Furthermore, we do not expect Section 162(m) of the Code to apply to awards under our 2008 Plan until the earliest to occur of our annual stockholders’ meeting in 2015, a material modification of the 2008 Plan or exhaustion of the share supply under the 2008 Plan. However, qualified performance-based compensation performance criteria may be used with respect to performance awards that are not intended to constitute qualified performance-based compensation under Section 162(m) of the Code.

Section 280G of the Internal Revenue Code

Section 280G of the Code disallows a tax deduction with respect to excess parachute payments to certain executives of companies which undergo a change in control. In addition, Section 4999 of the Code imposes a 20% excise tax on the individual with respect to the excess parachute payment. Parachute payments are compensation linked to or triggered by a change in control and may include, but are not limited to, bonus payments, severance payments, certain fringe benefits, and payments and acceleration of vesting from long-term incentive plans including stock options and other equity-based compensation. Excess parachute payments are parachute payments that exceed a threshold determined under Section 280G of the Code based on the executive’s prior compensation. In approving the compensation arrangements for our NEOs in the future, our compensation committee will consider all elements of the cost to us of providing such compensation, including the potential impact of Section 280G of the Code. However, our compensation committee may, in its judgment, authorize compensation arrangements that could give rise to loss of deductibility under Section 280G of the Code and the imposition of excise taxes under Section 4999 of the Code when it believes that such arrangements are appropriate to attract and retain executive talent.

Section 409A of the Internal Revenue Code

Section 409A of the Code requires that “nonqualified deferred compensation” be deferred and paid under plans or arrangements that satisfy the requirements of the statute with respect to the timing of deferral elections, timing of payments and certain other matters. Failure to satisfy these requirements can expose employees and other service providers to accelerated income tax liabilities, penalty taxes and interest on their vested compensation under such plans. Accordingly, as a general matter, it is our intention to design and administer our compensation and benefits plans and arrangements for all of our employees and other service providers, including our NEOs, so that they are either exempt from, or satisfy the requirements of, Section 409A.

 

107


Table of Contents

2010 / 2011 SUMMARY COMPENSATION TABLE

The following table summarizes information concerning the compensation awarded to, earned by, or paid for services rendered in all capacities by our NEOs during the years ended December 31, 2010 and 2011. The compensation described in this table does not include medical, group life insurance, or other benefits which are available generally to all of our team members.

 

Name and Principal Position

  Year     Salary
($)
    Bonus
($)
    Option
awards

($)(1)
    Stock
awards

($)(2)
    All other
compensation

($)(3)
    Total
compensation
($)
 

Said S. Hilal

    2010        550,000        1,894,140        363,821        627,000        543,828        3,978,789   

President and Chief Executive Officer

    2011        636,181        1,821,250        1,798,976        1,260,000        1,115,425        6,631,832   

Nabil Hilal

    2010        450,000        892,680        444,114        378,000        298,267        2,463,061   

Group President, Technology

    2011        521,569        857,750        787,052        551,250        521,881        3,239,502   

Stephen E. Stanley

    2010        380,000        799,412        381,022        157,500        130,053        1,847,987   

Group President, Distribution

    2011        447,159        818,975        787,052        551,250        452,248        3,056,684   

Gary Johnson

    2010        350,000        716,144        542,135        157,500        120,493        1,886,272   

Group President, Surgical

    2011        406,958        692,075        787,052        551,250        452,248        2,889,583   

Samir Tall

    2010        300,000        640,120        273,355        630,000        484,843        2,328,318   

Chief Financial Officer

    2011        361,423        675,625        787,052        551,250        463,528        2,838,878   

 

(1) Amounts represent the aggregate grant date fair value of option awards granted during 2010 and 2011, as well as any incremental fair value of previously granted options that were repriced on March 24, 2010, computed in accordance with Accounting Standards Codification Topic 718, Stock Compensation, or ASC Topic 718. Amounts also include incremental fair value of stock option exercise loans for stock options exercised in 2010 using full recourse promissory notes to pay the exercise price of the shares acquired. Grant date fair value was determined using a generally accepted option valuation methodology referred to as the Black-Scholes option pricing model. Information regarding assumptions used in calculating the value of stock option awards made to executive officers is provided in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” above. For further discussion of the 2010 stock option repricing and the Stock Option Exercise Loan Program, see “— 2010 Option Repricing”, “— Stock Option Exercise Loan Program,” and note 12 to our consolidated financial statements included elsewhere in this prospectus. For a discussion of valuation assumptions for the 2010 and 2011 option and stock grants, see “Management’s Discussion and Analysis of Financial Condition and Result of Operations — Critical Accounting Policies and Estimates — Common stock valuations.”
(2) Amounts disclosed in this column relate to awards of restricted shares made under the 2008 Plan. With respect to each restricted share award, the amounts disclosed reflect the grant date fair market value of the shares awarded, determined in good faith by the board of directors and in a manner consistent with Section 409A of the Code.
(3) Amounts disclosed in this column include income tax gross-up payments in connection with restricted share awards described in footnote (2) above, special 20-year service cash bonus payments, 401(k) matching contributions, payments in consideration of accrued and unused vacation days, and payments of professional fees for tax and estate planning services, as set forth below:

 

Name   Year     Income
tax
gross-up
payments
    20 year
service
bonus
    401(k)
matching
contribution
    Professional
service
fees
    Payment
for
unused
vacation
    Total
all other
compensation
 

Said S. Hilal

    2010        473,048        10,000        1,225        2,440        57,115        543,828   
    2011        1,030,909        —          1,225        4,810        78,481        1,115,425   

Nabil Hilal

    2010        285,187        10,000        —          3,080        —          298,267   
    2011        451,023        —          —          2,060        68,798        521,881   

Stephen E. Stanley

    2010        118,828        10,000        1,225        —          —          130,053   
    2011        451,023        —          1,225        —          —          452,248   

Gary Johnson

    2010        118,828        —          1,225        440        —          120,493   
    2011        451,023