-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Iln2Lfl0ft5reMduDsevAOoJfn/l9yzkm83II4L+3F0uB32+TMajSKVWFF4jtxzz Wh6U+HaTeao7C4wGeqJ4CQ== 0000950134-98-002674.txt : 19980331 0000950134-98-002674.hdr.sgml : 19980331 ACCESSION NUMBER: 0000950134-98-002674 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980330 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: QUEST MEDICAL INC CENTRAL INDEX KEY: 0000351721 STANDARD INDUSTRIAL CLASSIFICATION: SURGICAL & MEDICAL INSTRUMENTS & APPARATUS [3841] IRS NUMBER: 751646002 STATE OF INCORPORATION: TX FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-10521 FILM NUMBER: 98579225 BUSINESS ADDRESS: STREET 1: ONE ALLENTOWN PKWY CITY: ALLEN STATE: TX ZIP: 75002 BUSINESS PHONE: 2143909800 MAIL ADDRESS: STREET 1: ONE ALLENTOWN PARKWAY CITY: ALLEN STATE: TX ZIP: 75002 10-K 1 FORM 10-K FOR YEAR ENDED DECEMBER 31, 1997 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------------ FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER: 0-10521
------------------------ QUEST MEDICAL, INC. (Exact name of registrant as specified in its charter) TEXAS 75-1646002 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 201 ALLENTOWN PARKWAY, ALLEN, TEXAS 75002 (Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (972) 390-9800 SECURITIES REGISTERED UNDER SECTION 12(b) OF THE EXCHANGE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED ------------------- ----------------------------------------- NONE NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE EXCHANGE ACT: TITLE OF CLASS ----------- Common Stock, $.05 Par Value ------------------------ Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of the S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Aggregate market value of the registrant's Common Stock held by non-affiliates of the registrant as of March 25, 1998: $70,906,127. Number of shares outstanding of the registrant's Common Stock as of March 25, 1998: 8,679,470 ------------------------ DOCUMENTS INCORPORATED BY REFERENCE PORTIONS OF THE REGISTRANT'S DEFINITIVE PROXY STATEMENT FOR THE REGISTRANT'S ANNUAL MEETING OF STOCKHOLDERS TO BE HELD ON MAY 28, 1998, ARE INCORPORATED BY REFERENCE INTO PART III. ================================================================================ 2 QUEST MEDICAL, INC. ANNUAL REPORT FORM 10-K YEAR ENDED DECEMBER 31, 1997 PART I ITEM 1. BUSINESS GENERAL Quest Medical, Inc., a Texas corporation ("Quest" or the "Company"), designs, develops, manufactures and markets electronic spinal cord stimulation ("SCS") devices used to manage chronic intractable pain. The Company's operating activities are conducted through its wholly-owned subsidiary, Advanced Neuromodulation Systems, Inc., a Texas corporation ("ANS"). References to "Quest" or the "Company" in this Form 10-K include ANS, and vice versa, unless otherwise indicated. As SCS devices gain acceptance as a viable, efficacious and cost-effective treatment alternative for relieving chronic intractable pain, the Company is continuing its effort to expand its product line in the high growth market of neuromodulation. The neuromodulation market is comprised of implantable stimulators and drug pumps that modulate the body's nervous system by delivering either electricity or pharmaceuticals directly to nerve fibers. In 1997, the Company completed a full U.S. market release of PainDoc(R), a pen-based computer system that works in tandem with the Company's CompuStim devices to assist physicians and their patients in optimizing the performance of the Company's SCS devices both pre- and post-operatively. The Company believes that its CompuStim products, which are powered by radio frequency transmitters external to the body, are the technological leaders in the field. RECENT DEVELOPMENTS On January 30, 1998, the Company completed the sale of substantially all of the assets of its cardiovascular and intravenous fluid product lines (the "CVS Operations") to Atrion Corporation ("Atrion"). The CVS Operations designed, developed, manufactured and marketed cardiovascular products (including pressure control valves, filters and surgical retracting tapes), specialized intravenous fluid delivery tubing sets and accessories and pressure monitoring kits used primarily in labor and delivery. The cardiovascular products of the CVS Operations also included the Quest MPS(R) myocardial protection system, a sophisticated system designed to manage the delivery of solutions to the heart during open-heart surgery. Revenue for the CVS Operations was $14.3 million, $14.7 million and $14.9 million for the years ended December 31, 1997, 1996 and 1995, respectively. The Company received approximately $24 million in cash for the assets of the CVS Operations, subject to post-closing adjustments as defined in the purchase agreement, which assets included accounts receivable, inventories, furniture and fixtures, manufacturing tooling and equipment and intangible assets including patents, trademarks and purchased technology. -1- 3 The CVS Operations have been accounted for as discontinued operations in the Consolidated Statements of Operations for the years ended December 31, 1997, 1996 and 1995. Net assets of the CVS Operations have been presented on the Consolidated Balance Sheets as net assets of discontinued operations. See Item 7: "Management's Discussion and Analysis of Financial Condition and Results of Operation" and Note 11 - "Sale of CVS Operations/Discontinued Operations" of the Notes to Consolidated Financial Statements. PRODUCTS BACKGROUND SCS devices employ neuromodulation, which includes the process of electrically stimulating nerve fibers along the spinal cord to reduce chronic severe neuropathic pain by "masking" the pain signals sent to the brain. Neuropathic pain usually arises from nerve damage. SCS device implantation manages the pain associated with failed back surgery syndrome (FBSS), peripheral neuropathy, phantom limb or stump pain, ischemic pain and reflex sympathetic dystrophy (RSD), also known as complex regional pain syndrome (CRPS). The market for SCS devices is currently divided between Radio Frequency (RF) stimulators, which use an external power source, and stimulators that utilize implantable battery driven systems known as implantable pulse generators (IPGs). According to Montgomery Securities (Vol. 27, December 5, 1996 report), lPG devices account for 80 percent of the number of SCS procedures performed, with RF-coupled devices accounting for the remainder. The Company currently designs, develops, manufactures and markets RF SCS devices and is in the process of developing an IPG device. The primary advantage of the RF device revolves around the benefits of the system's external battery. An external battery system allows the patient to recharge the device by simply changing out a special nine volt battery. The IPG requires surgical intervention, revision and replacement after two to four years. Due to its inexpensive power system, the RF device can be programmed with a wide range of amplitude, frequency and pulse width settings for a variety of programs controlled by the patient. These features make the RF devices the most cost efficient for long-term SCS treatment. On the other hand, IPG devices provide the convenience of a completely internalized system, although they involve added long-term cost when repeat surgeries are required to replace the IPG power source. Both RF and IPG systems have their place in the pain physician's device armamentarium. RF systems are most often prescribed for patients who have complex bilateral pain syndromes or large pain topographies that require high power levels. IPGs are most often prescribed for patient's with simple unilateral and single extremity pain complaints or indications with low power requirements. SCS DEVICES The Company's RF SCS systems consist of three primary components: leads, a receiver and a transmitter. The leads are most commonly placed percutaneously through the skin into the epidural space of the spinal column. This procedure for lead placement is similar to that employed by anesthesiologists in routine epidural procedures. Typically, one or two leads are inserted, each of which has multiple electrodes that can be used to stimulate the targeted nerve roots of the spinal cord. Laminotomy style (paddle) leads are also available for neurosurgeons or orthopedic surgeons who prefer to insert leads in an open surgical -2- 4 procedure approach. The leads are then connected to a passive receiver, which is implanted under the skin on the side of the abdomen. The receiver contains electronics that receive RF energy and data from a source (the transmitter) outside the body, and delivers the prescribed electrical pulses to the leads. The transmitter is approximately the size of a pager, and is typically worn on a belt. Since it is external to the body, the transmitter can be easily programmed and serviced as needed, and its battery can be simply recharged or replaced. ANS's predecessor, Neuromed, Inc. ("Neuromed"), introduced its first product, the Multiprogrammable Spinal Cord Stimulator, or Multistim(R), in 1979. Since that time, the Company has played a significant role in the development of SCS products. Multistim incorporated a quadrapolar electrode system within a single lead, and was considered a major innovation in the field of neuromodulation because it significantly reduced surgical time, cost and risk. Since the launch of Multistim, the Company has developed and introduced a wide range of RF SCS systems with a variety of options to accommodate different applications and degrees of pain. The Company's CompuStim systems include four, seven, eight and sixteen electrode leads; simple and complex receivers; and an external battery powered transmitter. The Company believes that the CompuStim product line's multi-electrode leads and advanced multiprogrammable technology have changed the manner in which neuromodulation is performed worldwide. For example, the Company's "Dual Octrode" device, a system of dual leads with eight electrodes introduced in 1995, creates a targeted current density that appears to be especially effective in relieving chronic axial (or body trunk) pain. Previously, quadrapolar SCS systems only relieved the leg pain associated with FBSS. Industry sources support the view that the Dual Octrode device provides improved pain relief to both the legs and the back. Consequently, although the Dual Octrode device has only been on the United States market since February 1995, it now accounts for approximately 62 percent of the Company's current units sold and, in the Company's judgment, is the technological leader in the SCS field. The Company believes that the long term results of SCS in the treatment of pain have improved as a result of the technological superiority of ANS products. Moreover, the ease of use of the system has expanded the potential market for these products. The Company believes its RF-coupled SCS devices represent a strong base for penetration of the broader neuromodulation market. The Company has begun development of an IPG system and a constant rate implantable drug pump to better serve the broad needs of the pain management market. By offering an IPG and implantable drug pump, the Company can serve the largest segments of the pain management market, leverage its sales and marketing capabilities and address a number of new indications such as chronic intractable angina, urinary urge incontinence, spasticity, essential tremor and tremor associated with Parkinson's disease. PAINDOC In early 1997 the Company began marketing PainDoc, a pen-based computer system that is designed to assist physicians and their patients in optimizing the performance of the Company's SCS devices both pre- and post-operatively. PainDoc interfaces with the Company's CompuStim transmitters to optimize SCS therapy and document treatment outcomes. PainDoc allows the physician to input information regarding the patient's description of the location and intensity of the patient's pain. The resulting "pain map" is then -3- 5 analyzed by the computer to assess and select the most effective stimulation sets, or combination of multi-electrode stimulation arrays, to treat the pain. The selected arrays are uploaded into the patient's CompuStim transmitter. After a trial period, the patient reports to the physician the location and level of pain relief. These trial results are uploaded back into PainDoc for the physician's objective review and analysis. The physician can visually compare the patient's pain map against a stimulation map and assess whether desired levels of pain relief have been obtained and whether excess stimulation has been delivered. PainDoc enables the physician to program up to 24 different stimulation sets delivering electrical stimulation every 50 milliseconds to expand pain area coverage and relief. The Company believes that PainDoc should also allow physicians to create a broad based database tool that, by using a standardized methodology, will enable physicians to share and compare outcomes data, which can then be used to deliver more efficacious pain relief to individual patients. The Company believes that PainDoc and CompuStim devices used in tandem should significantly enhance the effectiveness, flexibility and precision of managing chronic neuropathic pain. The Company expects PainDoc to promote the selection of the Company's CompuStim devices for SCS procedures, especially as SCS devices become more complex and the pain management process becomes more refined. In October 1995, the Company received 510(k) approval from the FDA to market PainDoc as an interactive medical treatment device. See Item 1: "Business-Other Business Matters-Government Regulation." OTHER BUSINESS MATTERS MARKETING AND MAJOR CUSTOMER ANS historically relied on specialty distributors to market its SCS devices. During 1996, however, the Company made the strategic decision to replace certain distributors in specified geographic markets with commissioned sales agents. Currently, the Company has ten specialty distributors who employ thirty personnel to market the SCS devices. In addition, the Company has ten commissioned sales agents and two direct sales representatives who sell the Company's SCS devices. The Company employs three regional sales managers who oversee the distributors, sales agents and direct representatives. Internationally, the Company sells product to 16 specialty distributors who represent ANS in 21 countries. The primary medical specialists the Company targets in its marketing efforts are anesthesiologists, neurosurgeons and orthopedic surgeons. Although neurosurgeons were the first practitioners to use SCS applications, anesthesiologists now account for a greater percentage of sales as the relative number of these practitioners has grown and as the understanding and acceptance of SCS treatment has increased. The Company derives 92 percent of net revenues attributable to its SCS devices from domestic sales and approximately 8 percent from export sales. During 1997, 1996 and 1995, the Company had one major customer that accounted for 10 percent or more of its net revenue. Sun Medical, Inc., a specialty distributor of ANS products, accounted for $3.7 million, $2.6 million and $2.7 million, or 25 percent, 22 percent and 26 percent of ANS's net revenue for the years ended December 31, 1997, 1996 and 1995, respectively. While the Company believes its relations with Sun Medical are good, the loss of this customer could have a material adverse effect on the Company's business, financial condition and results of operations. -4- 6 RESEARCH AND DEVELOPMENT In 1997, the Company focused its research and development efforts on the continued development of SCS devices and ongoing research and development of new products in the neuromodulation market, such as an IPG system and a constant rate implantable drug pump. The Company expended $977,000 (6.6 percent of net revenue) on SCS-related research and development activities in 1997, compared to $1.3 million (11.5 percent of net revenue) in 1996. The Company expects to increase its investment in research and development during 1998 and has budgeted expenditures of $2.7 million. These expenditures will be directed toward development of next generation RF SCS systems, an implantable constant rate drug pump, and development of an IPG system. The Company has entered into a development and manufacturing contract with Hi-tronics Design, Inc., a premier contract engineering and manufacturing firm, to develop an IPG. IPG systems currently account for 80 percent of the SCS units sold worldwide. Management expects the IPG system to be ready for clinical trials in the United States and market introduction internationally in early 1999. The IPG system will not only allow the Company to compete in the largest segment of the SCS market but potentially expand the markets for the Company's products for use in applications such as deep brain stimulation to treat essential tremor and tremor associated with Parkinson's disease, epilepsy, urinary incontinence, angina and peripheral vascular disease. The Company is pursuing strategic alliances that may partially fund research and development expenditures during 1998. As of March 1998, ANS had an in-house research and development staff of 13 engineers, technicians and designers, as compared to 10 in March 1997. The Company anticipates hiring 3 additional personnel during the remainder of 1998 for its research and development efforts. MANUFACTURING The Company manufactures and packages its SCS products at its manufacturing facility in Allen, Texas. This facility received ISO 9001 certification (for design and manufacturing processes) in July 1995. See Item 1. "Business-Other Business Matters-Government Regulations." The Company's manufacturing processes consist of the assembly of standard and custom component parts and the testing of completed products. The Company subcontracts with various suppliers to provide it with the quantity of component parts necessary to assemble its products. Almost all of these components are available from a number of different suppliers, although certain components are purchased from single sources. For example, the Company currently relies on a single supplier for a computer chip used in the receiver and transmitter of its SCS systems. The supplier of this computer chip has indicated its desire to cease manufacturing and supplying the computer chip in the future, but to date, has not determined when this will occur. The supplier has agreed to notify the Company once a date has been determined and allow the Company to place a final one-time purchase order for the computer chip. In the interim, the Company is maintaining a higher than normal inventory of the computer chip. In addition, the Company is developing a custom computer chip under its development agreement with Hi-tronics Design, Inc. to replace the existing computer chip and expects such chip to be available during the latter half of 1999. A sudden disruption in supply from the computer chip supplier or another single-source supplier could adversely affect the Company's ability to deliver finished products on time. -5- 7 The Company devotes significant attention to quality control. Its quality control measures begin at the manufacturing level where components are assembled in a "clean room" environment designed and maintained to reduce product exposure to particulate matter. Products are tested throughout the manufacturing process for adherence to specifications. Finished components are shipped to outside processors for ethylene oxide gas sterilization. Skills of assembly workers required for the manufacture of medical products are similar to those required in typical assembly operations. The Company believes that workers with these skills are readily available in the Dallas area. COMPETITION In marketing its SCS products, the Company competes with one other significant supplier, Medtronic, Inc. Medtronic has substantially greater financial resources and engages in substantially greater research and development and marketing efforts. Medtronic also holds a substantial majority share of the market and sells both RF-coupled systems and IPG devices. The Company believes that the principal competitive factors in the neuromodulation market are cost-effectiveness, impact on patient outcomes, product performance, quality and ease of use, technical innovation and customer service. The Company intends to continue to compete on the basis of its high performance products, innovative technologies, manufacturing capability, close customer relations and support and its strategy to increase its offerings of products within the neuromodulation market. PATENTS, TRADEMARKS AND PROPRIETARY INFORMATION The Company currently owns four United States patents and also owns three foreign patents. In management's view, these patents offer reasonable coverage of its SCS devices' electrode, receiver and transmitter technology. These patents cover both RF-coupled devices and IPG systems, although the Company currently manufactures only RF-coupled devices. Pending patent applications concern the PainDoc computer system and the Company's innovative Multistim technology. The Company also licenses four United States patents and one foreign patent from the University of Minnesota relating to the implantable constant rate drug pump the Company is currently developing. The validity of any patents issued to the Company may be challenged by others and the Company could encounter legal and financial difficulties in enforcing its patent rights against infringers. In addition, there can be no assurance that other technologies cannot or will not be developed or that patents will not be obtained by others which would render the Company's patents obsolete. The loss of any one patent would not have a material adverse effect on the Company's current revenue base. Although the Company does not believe that patents are the sole determinant in the commercial success of its products, the loss of a significant percentage of its patents or its patents relating to the SCS product line could have a material adverse effect on the Company's business, financial condition and results of operations. -6- 8 The Company has developed technical knowledge which, although non-patentable, is considered by the Company to be significant in enabling it to compete. However, the proprietary nature of such knowledge may be difficult to protect. The Company has entered into an agreement with each key employee prohibiting such employee from disclosing any confidential information or trade secrets of the Company and prohibiting that employee from engaging in any competitive business while the employee is working for the Company and for a period of one year thereafter. In addition, these agreements also provide that any inventions or discoveries relating to the business of the Company by these individuals will be assigned to the Company and become the Company's sole property. Claims by competitors and other third parties that the Company's products allegedly infringe the patent rights of others could have a material adverse effect on the Company. The interventional pain management market is characterized by extensive patent and other intellectual property claims, which can create greater potential than in less developed markets for possible allegations of infringement, particularly with respect to newly developed technology. Intellectual property litigation is complex and expensive and the outcome of this litigation is difficult to predict. Any future litigation, regardless of outcome, could result in substantial expense to the Company and significant diversion of the efforts of the Company's technical and management personnel. An adverse determination in any such proceeding could subject the Company to significant liabilities to third parties, or require the Company to seek licenses from third parties or pay royalties that may be substantial. Furthermore, there can be no assurance that necessary licenses would be available to the Company on satisfactory terms or at all. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent the Company from manufacturing or selling certain of its products, which could have a material adverse effect on the Company's business, financial condition and results of operations. MULTISTIM, PAINDOC, UNISTIM and OCTRODE are among the Company's registered trademarks and COMPUSTIM is among its nonregistered trademarks. Registration applications are pending for various trademarks the Company believes have value in the marketplace, including Advanced Neuromodulation Systems and ANS. GOVERNMENT REGULATION The manufacture and sale of the Company's products are subject to regulation by numerous governmental authorities, principally the FDA and corresponding foreign agencies. The research and development, manufacturing, promotion, marketing and distribution of the Company's products in the United States are governed by the Federal Food, Drug and Cosmetic Act and the regulations promulgated thereunder (the "FDC Act and Regulations"). The Company is subject to inspection by the FDA for compliance with such regulations and procedures. The FDA has traditionally pursued a rigorous enforcement program to ensure that regulated entities such as the Company comply with the FDC Act and Regulations. A company not in compliance may face a variety of regulatory actions, including warning letters, product detentions, device alerts, mandatory recalls or field corrections, product seizures, injunctive actions or civil penalties and criminal prosecutions of the Company or responsible employees, officers and directors. The Company was last inspected in the summer of 1996, with no major violations found. -7- 9 Under the FDA's requirements, a new medical device cannot be released for commercial use until a pre-market approval application (a "PMA") has been filed with the FDA and the FDA has approved the device's release. If a manufacturer can establish that a newly developed device is "substantially equivalent" to a legally marketed device, the manufacturer may seek marketing clearance from the FDA to market the device by filing a 510(k) premarket notification with the FDA, which usually takes less time than a PMA. The process of obtaining FDA clearance can be lengthy, expensive and uncertain. Both a 510(k) and a PMA, if granted, may include significant limitations on the indicated uses for which a product may be marketed. FDA enforcement policy strictly prohibits the promotion of approved medical devices for unapproved uses. In addition, product approvals can be withdrawn for failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial marketing. Although all of the Company's currently marketed products have been the subject of successful 510(k) submissions, the Company believes that because the products the Company currently has in development are more innovative, most of these products will require the PMA submission process, which is lengthier and more costly than the 510(k) process. The Company is also subject to regulation in each of the foreign countries in which it sells its products with regard to product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of the regulations applicable to the Company's products in such countries are similar to those of the FDA. The national health or social security organizations of certain countries require the Company's products to be qualified before they can be marketed in those countries. To date, the Company has not experienced significant difficulty in complying with these regulations. To position itself for access to European and other international markets, Quest sought and obtained certification under the ISO 9000 Series of Standards. ISO 9000 is a set of integrated requirements, which when implemented, form the foundation and framework for an effective quality management system. These standards were developed and published by the ISO, a worldwide federation of national standard bodies, founded in Geneva, Switzerland in 1946. ISO has over 92 member countries. ISO certification is widely regarded as essential to enter Western European markets. The Company obtained certification and was registered as an ISO 9001 compliant company on July 1, 1995. The ISO 9001 registration is the most stringent standard in the ISO series and lasts for three years. The German notified body, Landesgewerbeanstalt Bayern ("LGA") issued the certificate. The ISO 9001 standards cover design, production, installation and servicing of products. The Company is subject to an annual audit by the notified body to maintain the registration. The Company was then certified to be in compliance with the Medical Device Directive ("MDD") as well as ISO 9001 by the notified body TUV Rheinland ("TUV") in July 1996. Subsequently, in December 1996, ANS's implantable products were certified to be in compliance with the Active Implantable Medical Directive ("AIMD") by TUV product services, another notified body. These certifications were sought and obtained for the purpose of getting the CE mark which represents product approval throughout the European Union. As a result, the CE mark is maintained on all ANS products. The financial arrangements through which the Company markets, sells and distributes its products may be subject to certain federal and state laws and regulations in the United States -8- 10 with respect to the provision of services or products to patients who are Medicare or Medicaid beneficiaries. The "fraud and abuse" laws and regulations prohibit the knowing and willful offer, payment or receipt of anything of value to induce the referral of Medicare or Medicaid patients for services or goods. In addition, the physician anti-referral laws prohibit the referral of Medicare or Medicaid patients for certain "Designated Health Services" to entities in which the referring physician has an ownership or compensation interest. Violations of these laws and regulations may result in civil and criminal penalties, including substantial fines and imprisonment. In a number of states, the scope of fraud and abuse or physician anti-referral laws and regulations, or both, have been extended to include the provision of services or products to all patients, regardless of the source of payment, although there is variation from state to state as to the exact provisions of such laws or regulations. In other states, and on a national level, several health care reform initiatives have been proposed which would have a similar impact. The Company believes that its operations and its marketing, sales and distribution practices currently comply in all respects with all current fraud and abuse and physician anti-referral laws and regulations, to the extent they are applicable. Although the Company does not believe that it will need to undertake any significant expense or modification to its operations or its marketing, sales and distribution practices to comply with federal and state fraud and abuse and physician anti-referral regulations currently in effect or proposed, financial arrangements between manufacturers of medical devices and other health care providers may be subject to increasing regulation in the future. Compliance with such regulation could adversely affect the Company's marketing, sales and distribution practices, and may affect the Company in other respects not presently foreseeable, but which could have an adverse impact on the Company's business, financial condition and results of operations. THIRD PARTY REIMBURSEMENT AND COST CONTAINMENT The Company's products are purchased primarily by hospitals and other users, which then bill various third party payers for the services provided to the patients. These payers, which include Medicare, Medicaid, private insurance companies, managed care and worker's compensation organizations, reimburse part or all of the costs and fees associated with the procedures performed with these devices. Medicare and Medicaid reimbursement for hospitals is based on a fixed amount for admitting a patient with a specific diagnosis. Because of this fixed reimbursement method, hospitals have incentives to use less costly methods in treating Medicare and Medicaid patients, and will frequently make capital expenditures to take advantage of less costly treatment technologies. Frequently, reimbursement is reduced to reflect the availability of a new procedure or technique, and as a result hospitals are generally willing to implement new cost saving technologies before these downward adjustments take effect. Likewise, because the rate of reimbursement for certain physicians who perform certain procedures has been and may in the future be reduced in the event of further changes in the resource-based relative value scale method of payment calculation, physicians may seek greater cost efficiency in treatment to minimize any negative impact of reduced reimbursement. Any amendments to existing reimbursement rules and regulations which restrict or terminate the reimbursement eligibility (or the extent or amount of coverage) of medical procedures using the Company's products or the eligibility (or the extent or amount of coverage) of the Company's products could have an adverse impact on the Company's business, financial condition and results of operations. Third party payers are increasingly challenging the prices charged for medical -9- 11 products and services and may deny reimbursement if they determine that a device was not used in accordance with cost-effective treatment methods as determined by the payer, was experimental or was used for an unapproved application. The Company's SCS devices, while cost-effective compared to repeat back surgeries, have encountered some resistance to third party reimbursement. Although Medicare, Medicaid and many private insurers reimburse for the SCS device and procedure, especially after repeat back surgeries have failed to relieve the chronic pain, some managed care and private payers occasionally refuse to reimburse for SCS devices or restrict reimbursement. There can be no assurance that in the future, third party payers will continue to reimburse for the Company's products, or that their reimbursement levels will not adversely affect the profitability of the Company's products. In addition, the cost of health care has risen significantly over the past decade, and there have been and will continue to be proposals by legislators and regulators to curb these costs. Legislative action limiting reimbursement for certain procedures could have a material adverse effect on the Company's business, financial condition and results of operations. In response to the focus of national attention on rising health care costs, a number of changes to reduce costs have been proposed or have begun to emerge. There have been, and may continue to be, proposals by legislators and regulators and third party payers to curb these costs. There has also been a significant increase in the number of Americans enrolling in some form of managed care plan. It has become a typical practice for hospitals to affiliate themselves with as many managed care plans as possible. Higher managed care penetration typically drives down the prices of health care procedures, which in turn places pressure on medical supply prices. This causes hospitals to implement tighter vendor selection and certification processes, by reducing the number of vendors used, purchasing more products from fewer vendors and trading discounts on price for guaranteed higher volumes to vendors. Hospitals have also sought to control and reduce costs over the last decade by joining group purchasing organizations or purchasing alliances. The Company cannot predict what continuing or future impact existing or proposed legislation, regulation or such third party payer measures may have on its future business, financial condition or results of operations. Changes in reimbursement policies and practices of third party payers could have a substantial and material impact on sales of certain of the Company's products. The development or increased use of more cost-effective treatments could cause such payers to decrease or deny reimbursement to favor these other treatments. EMPLOYEES As of March 16, 1998, the Company employed 100 full-time employees, 13 in research and development, 21 in sales and marketing, 53 in manufacturing and related operations, and the remainder in executive and administrative positions. None of the Company's employees is represented by a labor union and the Company considers its employee relations to be good. ADVISORY BOARDS The Company has established the Advanced Neuromodulation Systems Advisory Board (the "ANSAB"), which is comprised of individuals with substantial expertise in neuromodulation and pain management. Members of the Company's management and scientific and technical -10- 12 staff consult closely with the ANSAB to identify specific areas where techniques are changing and where existing products do not adequately fulfill the needs of the pain physician. The ANSAB helps management evaluate new product ideas and concepts and once a product is approved for development, its subsequent design and development. The ANSAB may also participate in the clinical testing of products developed. Certain members of the ANSAB are employed by academic institutions and may have commitments to or consulting or advisory agreements with other entities that may limit their availability to the Company. The members of the ANSAB may also serve as consultants to other medical device companies. No members of the ANSAB are expected to devote more than a small portion of their time to the Company. ITEM 2. PROPERTIES The Company owns and occupies a manufacturing facility and executive office in Allen, Texas (located north of Dallas). The facility covers approximately 107,000 square feet and was constructed during 1993 on a 19.2 acre tract that the Company acquired in 1985. The Company borrowed $4.4 million from MetLife Capital Corporation to construct and outfit this facility. This financing is collateralized by the Allen land, the Allen facility and certain equipment of the Company (see Note 5 of the "Notes to Consolidated Financial Statements"). In connection with the sale of the CVS Operations, the Company agreed to lease space in the Allen facility to Atrion for up to one year for $24,606 per month, and also granted Atrion a nine-month option to purchase the facility for $6.5 million. If Atrion purchases the facility, the Company would receive another $2.7 million in net proceeds after paying off the mortgage. If Atrion exercises its option, the Company would lease a facility for its manufacturing, storage and executive offices in the general vicinity of the Allen, Texas facility. Management believes that leasing and moving to a new facility would not have a material adverse effect on the Company. If Atrion does not purchase the facility, the Company believes it should be able to locate a suitable replacement tenant to defray a portion of the corporate overhead otherwise associated with the Allen facility. ITEM 3. LEGAL PROCEEDINGS The Company is a party to product liability claims related to ANS's SCS devices. Product liability insurers have assumed responsibility for defending the Company against these claims, subject to reservation of rights in certain cases. While historically product liability claims for ANS SCS devices have not resulted in significant monetary liability for the Company beyond its insurance coverage, there can be no assurances that the Company will not incur significant monetary liability to the claimants if such insurance is unavailable or inadequate for any reason, or that the Company's current SCS business and future ANS neuromodulation products will not be adversely affected by these product liability claims. While the Company seeks to maintain appropriate levels of product liability insurance with coverage that the Company believes is comparable to that maintained by companies similar in size and serving similar markets, there can be no assurance that the Company will avoid significant future product liability claims relating to its SCS devices. Except for such product liability claims and other ordinary routine litigation incidental or immaterial to its business, the Company is not currently a party to any other pending legal -11- 13 proceeding. The Company maintains general liability insurance against risks arising out of the normal course of business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Inapplicable. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is currently quoted on the Nasdaq Stock Market under the symbol "QMED." The Company intends to submit to its shareholders a proposal to change its name to "Advanced Neuromodulation Systems, Inc." and in connection with that name change, intends to change its trading symbol to "ANSI" on or about May 28, 1998. On March 16, 1998, there were approximately 763 holders of record of the Company's common stock. The following table sets forth the quarterly high and low closing sales prices for the Company's common stock. These prices do not include adjustments for retail mark-ups, mark-downs or commissions.
1996: HIGH LOW ----- ---- --- First Quarter $ 14.50 $ 10.25 Second Quarter $ 14.38 $ 6.00 Third Quarter $ 9.13 $ 5.63 Fourth Quarter $ 8.25 $ 5.75 1997: HIGH LOW ----- ---- --- First Quarter $ 8.13 $ 5.94 Second Quarter $ 9.22 $ 5.75 Third Quarter $ 10.50 $ 8.25 Fourth Quarter $ 10.00 $ 6.38 1998: HIGH LOW ----- ---- --- First Quarter $ 8.75 $ 6.50 (through March 16, 1998)
To date, the Company has not declared or paid any cash dividends on its common stock and the Board of Directors does not anticipate paying cash dividends on the Company's common stock in the foreseeable future. During January 1998, the Board of Directors approved a stock repurchase program of up to 500,000 shares of the Company's common stock. The Company's purchases may be effected through open market purchases, block transactions, privately negotiated purchases or otherwise. Purchases of the Company's common stock will be effected at prices and terms to be determined in light of then current circumstances, are completely discretionary and may be temporarily or permanently suspended at any time without notice. Through March 16, 1998, the Company has repurchased 73,000 shares of its common stock at an aggregate cost of $508,000 (including commissions). -12- 14 ITEM 6. SELECTED FINANCIAL DATA
- ----------------------------------------------------------------------------------------- Years Ended December 31 1997 1996 1995(1) 1994 1993(2) ----------- ---------- -------- --------- -------- (in thousands, except per share data) Statement of Operations Data: (3) Net revenue $ 14,718 $ 11,403 $ 10,434 $ -- $ -- Gross profit 9,878 8,088 7,682 -- -- Research and development expense 977 1,316 808 -- -- Purchased research and development -- -- 10,500 -- -- Marketing, general and administrative and amortization expenses 6,815 6,257 3,796 -- -- Earnings (loss) from operations 2,086 515 (7,421) -- -- Net earnings (loss) from continuing operations 818 115 (8,906) -- -- Earnings (loss) from discontinued operations (93) (527) (1,199) (1,719) 647 Net earnings (loss) $ 724 $ (412) $(10,374) $ (1,719) $ 816 Diluted earnings (loss) per share per share:(4) Continuing operations $ .09 $ .01 $ (1.42) $ -- $ -- Discontinued operations $ (.01) $(.06) $ (.19) $ (.33) $ .12 Extraordinary item (1995) and change in accounting principle (1993) $ -- $ -- $ (.05) $ -- $ .03 Net earnings (loss) $ .08 $(.05) $ (1.66) $ (.33) $ .15
-13- 15
- --------------------------------------------------------------------------------- Years Ended December 31 1997 1996 1995 1994 1993 -------- ------- ------- ------- ------- (in thousands) Balance Sheet Data: Cash, cash equivalents and marketable securities $ 2,204 $ 2,206 $ 3,914 $ 5,262 $ 6,594 Working capital 14,128 11,088 12,183 7,411 9,566 Total Assets 48,982 47,188 44,496 24,235 26,739 Short-term notes payable and current maturities of long-term notes payable 8,257 2,084 1,616 2,759 2,297 Notes payable, excluding current maturities 3,635 11,912 8,558 4,124 4,101 Stockholders' equity $33,906 $30,993 $30,870 $15,931 $18,252
- ---------------------- (1)Includes results of ANS from March 31, 1995. The net loss for 1995 reflects a charge of $10,500, or $(1.68), for purchased in-process research and development incurred in connection with the ANS acquisition and an extraordinary charge of $269, or $(.05) per share, for the write-off of capitalized debt issuance costs due to early repayment of bank debt with the proceeds from a public offering completed in November 1995. (2)Net earnings include a positive cumulative effect of a change in accounting principle of $169, or $.03 per share, from adoption of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." (3)On January 30, 1998, the Company sold its cardiovascular and intravenous fluid delivery product lines (CVS Operations). The CVS Operations have been accounted for as discontinued operations. See Note 11 of the Notes to Consolidated Financial Statements. (4)Per share amounts for 1993 restated to reflect 3 percent stock dividend. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the Consolidated Financial Statements of the Company and the related Notes. OVERVIEW On January 30, 1998, the Company sold the assets of the CVS Operations, including its MPS(R) myocardial protection system product line, to Atrion (see Note 11 - "Sale of CVS Operations/Discontinued Operations"). The Company received approximately $24 million in cash from the sale, subject to post-closing adjustments as defined in the purchase agreement. The Company also granted Atrion a nine-month option to acquire the Company's principal office and manufacturing facility in Allen, Texas for $6.5 million. During the option period, the Company will lease space to Atrion for the CVS Operations for $24,606 per -14- 16 month. In turn, the Company is leasing certain office and computer equipment from Atrion for $13,175 per month. Assets of the CVS Operations sold to Atrion primarily consisted of accounts receivable, inventories, furniture and fixtures, manufacturing tooling and equipment, and intangible assets including patents, trademarks and purchased technology. The Company expects to report a pretax gain on the transaction of $8.3 to $8.5 million, which will be included in the Company's results for the quarter ended March 31, 1998. This pretax gain is net of $1,005,000 compensation expense recorded as a result of changes made to the stock options held by employees of the CVS Operations (see Note 7 - "Stockholders' Equity"). The Company utilized $9 million of the proceeds from the sale to retire debt and pay expenses related to the transaction. The Company intends to utilize the remaining proceeds for working capital for its expanding ANS business or for the repurchase of issued and outstanding shares. On January 20, 1998, the Company's Board of Directors authorized the repurchase of up to 500,000 shares of the Company's common stock at prices and terms to be determined in light of then current circumstances. Through March 16, 1998, the Company has repurchased 73,000 shares of its common stock at an aggregate cost of $508,000 (including commissions). The CVS Operations have been accounted for as discontinued operations in the Consolidated Financial Statements for the years ended December 31, 1997, 1996, and 1995. RESULTS OF OPERATIONS Comparison of the Years Ended December 31, 1997 and 1996 Revenues. Net revenue from continuing ANS operations of $14.7 million for the year ended December 31, 1997, was $3.3 million, or 29 percent, above the level for the comparable 1996 period of $11.4 million. This increase during 1997 was the result of higher unit sales volume, principally in the United States. During 1996 and into the first quarter of 1997, the Company dedicated significant engineering and marketing resources to build the infrastructure at ANS and improve the current products of ANS to transform ANS into an industry leader and compete effectively in the SCS market. Management believes these measures account for the increase in net revenue during the 1997 period compared to the same period during 1996. Management expects that ANS revenue during 1998 will continue to increase from 1997 levels and is actively exploring strategic alliances that will improve its market position through new technologies, additional product offerings, and enhanced distribution channels. Gross Profit. Gross profit increased during 1997 to $9.9 million compared to $8.1 million in 1996. As a percentage of net revenue, however, gross profit decreased to 67.1 percent in 1997 compared to 70.9 percent during 1996. This decrease in gross profit margin during 1997 was due, for the most part, to a $479,000 expense for the write-off of ANS inventory of previous designs. As mentioned above, during 1996 the Company dedicated a significant amount of time and effort to improve the design and performance of ANS products. Due to the acceptance and superior performance of the current design of ANS products, management decided that inventories of previous designs should be written off and recorded such expense during the second quarter of 1997. -15- 17 Operating Expenses. Total operating expenses of $7.8 million during 1997 increased slightly from the 1996 level of $7.6 million, although as a percentage of net revenue, such expenses decreased to 52.9 percent during 1997 from 66.4 percent in 1996. Research and development expense decreased to $977,000 in 1997, or 6.6 percent of 1997 net revenue, from $1.3 million during 1996, or 11.5 percent of 1996 net revenue. This decrease during 1997 compared to 1996 was the result of lower salary and benefit expense from personnel reductions, lower consulting expense, and lower regulatory expense. The Company expects to increase its investment in research and development during 1998 and has budgeted expenditures of $2.7 million. These expenditures will be directed toward development of next generation RF SCS systems, an implantable constant rate drug pump, and development of an IPG system. The Company has entered into a development and manufacturing contract with Hi-tronics Design, Inc., a premier contract engineering and manufacturing firm, to develop an IPG. IPG systems currently account for 80 percent of the SCS units sold worldwide. Management expects the IPG system to be ready for clinical trials in the United States and market introduction internationally in early 1999. The IPG system will not only allow the Company to compete in the largest segment of the SCS market but potentially expand the markets for the Company's products for use in applications such as deep brain stimulation to treat essential tremor and tremor associated with Parkinson's disease, epilepsy, urinary incontinence, angina and peripheral vascular disease. The Company is pursuing strategic alliances that may partially fund research and development expenditures during 1998. Marketing expense, as a percentage of net revenue, decreased to 27.0 percent in 1997 from 29.3 percent in 1996, while the dollar amount increased from $3.3 million during 1996 to $4.0 million in 1997. This dollar increase during 1997 was attributable to additional expense related to higher commissions, clinical study and training expense for new users of ANS products. General and administrative expense decreased from $2.1 million during 1996 to $1.8 million in 1997 and as a percentage of net revenue, decreased to 12.0 percent in 1997 from 18.3 percent during 1996. This decrease in expense during 1997 was principally the result of a charge during 1996 of $198,000 to write off an accounts receivable from a former ANS distributor who filed bankruptcy. Amortization of ANS intangibles increased from $826,000 in 1996 to $1.1 million during 1997, mostly due to patents acquired during February 1997 from the former owner of Neuromed. Earnings From Operations. Earnings from operations for 1997 totaled $2.1 million compared to $515,000 in 1996 due to increased gross profit from higher sales of ANS products. Other Expense. Other expense increased to $536,000 in 1997 compared to $81,000 during 1996 as a result of three factors. First, the Company's interest expense increased by $207,000 during 1997 compared to 1996 as a result of higher levels of borrowing and higher overall interest rates on borrowed money. Second, the Company's interest income declined by $85,000 during 1997 compared to 1996 as a result of lower funds available for investment combined with overall lower rates of return. Finally, during 1996 the Company realized gains of $137,000 on the sale of marketable securities compared to a loss of $26,000 during 1997, a reduction of $163,000. -16- 18 Income Taxes. The Company's income tax expense increased to $733,000 during 1997 from $320,000 in 1996 due to higher earnings from operations. This represents effective tax rates of 47.3 percent in 1997 and 73.6 percent in 1996. The Company's expense for amortization of costs in excess of net assets acquired (goodwill) is not deductible for tax purposes, thus explaining the higher effective tax rate during both 1997 and 1996 compared to the U.S. statutory rate for corporations of 34 percent. Net Earnings From Continuing Operations. Net earnings from continuing operations increased to $818,000 in 1997 from $115,000 during 1996 as a result of the higher earnings from operations due to increased gross profit from higher sales of ANS products. Loss From Discontinued Operations. The loss from discontinued operations decreased to $93,000 during 1997 from $527,000 in 1996. This decrease in the loss in 1997 compared to 1996 was solely the result of lower operating expenses which decreased from $7.4 million in 1996 to $6.2 million during 1997 primarily due to lower research and development expense and lower marketing expense (see Note 11 - "Sale of CVS Operations/Discontinued Operations"). Net Earnings. Net earnings increased to $724,000 during 1997 compared to a net loss during 1996 of $412,000 due to increased net earnings from continuing operations combined with a reduction in the loss from discontinued operations. Comparison of the Years Ended December 31, 1996 and 1995 Revenues. Net revenue from ANS products of $11.4 million for the year ended December 31, 1996, was $1.0 million above the level for the comparable 1995 period of $10.4 million. This increase during 1996 was attributable to including a full twelve months of revenue compared to only nine months of revenue in 1995 since ANS, formerly Neuromed, Inc. was acquired on March 31, 1995. Revenue during 1996 was impacted by several factors. First, the Company made the strategic decision in 1996 to market its ANS products through commissioned sales agents rather than distributors in certain geographical areas of the United States. This decision resulted in a decrease of approximately $300,000 in revenue during 1996 due to the return of inventories from those distributors whom the Company decided to replace with sales agents. Second, the Company introduced the next generation of multi-electrode leads in 1996, which prompted delays in purchase commitments. Finally, during early 1996, management announced plans to rebuild the infrastructure at ANS and improve the current products of ANS to transform ANS into an industry leader and compete effectively in the SCS market. Gross Profit. Gross profit during 1996 increased to $8.1 million compared to $7.7 million in 1995. As a percentage of net revenue, gross profit decreased to 70.9 percent in 1996 from 73.6 percent during 1995 due to higher manufacturing overhead expenses as a result of the relocation of ANS from Florida to the Company's larger Allen, Texas facility. Operating Expenses. Total operating expenses decreased to $7.6 million during 1996 from $15.1 million in 1995. In connection with the March 1995 acquisition of Neuromed, Inc., $10.5 million of the aggregate purchase price was identified as purchased in-process research and development, and in accordance with generally accepted accounting principles, was charged to expense with no related tax benefit during 1995. Excluding such expense, operating -17- 19 expenses increased during 1996 to $7.6 million from $4.6 million in 1995. Part of this increase during 1996 was the result of the 1995 period including only nine months of expense from the date of acquisition of March 31, 1995. Marketing expense, as a percentage of net revenue, increased to 29.3 percent in 1996 from 15.7 percent during 1995, and the dollar amount increased by $1.7 million related to additional salary, benefit, commission, travel, samples and promotional expense. The 1995 period included only nine months of expense. During 1996, the Company reorganized part of its ANS distribution network replacing several distributors in certain areas of the United States with eight commissioned sales agents and three direct regional managers. Also during 1996, the Company designed ANS training, customer support and sales and marketing materials and videos and continued those efforts into early 1997. During 1996, the Company reestablished relationships with key implanters who had discontinued using the ANS products prior to the Company's acquisition. Research and development expense increased to $1.3 million during 1996 from $808,000 in 1995 due to significant engineering resources devoted by the Company during 1996 to improve ANS products and the 1995 period including only nine months of expense. General and administrative expense increased to $2.1 million in 1996 from $1.7 million during 1995 due, for the most part, to an expense during 1996 of $198,000 to write-off an accounts receivable from a former ANS distributor who filed bankruptcy and the 1995 period including only nine months of expense. Amortization of intangibles increased to $826,000 during 1996 from $492,000 in 1995 due to additional goodwill expense. Earnings From Operations. Earnings from operations for 1996 totaled $515,000 compared to a loss from operations of $7.4 million in 1995. This increase during 1996 was primarily the result of the $10.5 million expense in 1995 for purchased in-process research and development. Excluding such expense, earnings from operations decreased from $3.1 million in 1995 to $515,000 in 1996, reflecting higher operating expenses discussed above. Other Expense. Other expense decreased during 1996 to $81,000 compared to $574,000 during 1995 due to lower interest expense since the 1995 period includes interest expense on borrowed money to finance the purchase of ANS, which was repaid during the fourth quarter of 1995 from the proceeds of a public offering. Interest income decreased $260,000 from 1995 levels due to reduced funds available for investment. This decrease was partially offset, however, by a $108,000 increase in gains on the sale of marketable securities. Income Taxes. The Company recorded income tax expense of $320,000 during 1996, an effective tax rate of 73.6 percent which is considerably higher than the U.S. statutory rate of 34 percent for corporations due to the nondeductibility of amortization of costs in excess of net assets acquired (goodwill). During 1995, the Company recorded income tax expense of $911,000 despite a net loss from continuing operations of $8.0 million as a consequence of the nondeductibility of the $10.5 million expense for purchased research and development and amortization of costs in excess of net assets acquired. -18- 20 Net Earnings From Continuing Operations. Net earnings from continuing operations increased to $115,000 in 1996 from a net loss of $8.9 million in 1995 primarily due to the $10.5 million expense during 1995 for purchased research and development incurred in connection with the Neuromed acquisition. Excluding this $10.5 million expense, the Company's net earnings from continuing operations decreased from $1.6 million in 1995 to $115,000 due to increased operating expenses discussed above. Loss From Discontinued Operations. The loss from discontinued operations decreased to $527,000 in 1996 from $1.2 million during 1995. This decrease in the loss in 1996 compared to 1995 was primarily the result of lower operating expenses, which decreased from $8.4 million in 1995 to $7.4 million during 1996 as a consequence of lower research and development expenditures in 1996 due to the completion of the development of the Company's Myocardial Protection System product. Net Loss. The net loss decreased from $10.4 million in 1995 to $412,000 in 1996 primarily due to the $10.5 million expense during 1995 for purchased research and development incurred in connection with the Neuromed acquisition. Excluding this $10.5 million expense, the Company's net loss of $412,000 in 1996 compared to net earnings of $126,000 in 1995 and resulted from increased ANS operating expenses discussed above. LIQUIDITY AND CAPITAL RESOURCES In the sale of assets of the CVS Operations to Atrion, the Company received cash proceeds of approximately $24 million, subject to post-closing adjustments as defined in the purchase agreement, which significantly enhanced the Company's financial position. The Company utilized approximately $9 million of the proceeds to retire short-term notes payable and related expenses of the transaction. After such repayment, the Company at January 31, 1998, had cash in excess of $17 million and no debt other than its Allen facility mortgage of $3.8 million (see Note 5 - "Notes Payable" and Note 11 - "Sale of CVS Operations/Discontinued Operations"). The Company also granted Atrion a nine-month option to purchase the Allen facility for $6.5 million and is leasing space in the Allen facility to Atrion under a lease agreement which expires on January 31, 1999. If Atrion exercises the purchase option on the Allen facility, the Company would receive another $2.7 million in net proceeds after paying off the mortgage. At December 31, 1997, prior to the CVS sale, the Company's working capital increased from $11.1 million at year-end 1996 to $14.1 million at year-end 1997. The ratio of current assets to current liabilities was 2.5:1 at December 31, 1997, compared to 4.0:1 at December 31, 1996. Cash, cash equivalents and marketable securities totaled $2.2 million at December 31, 1997, a slight increase from the 1996 year end's level of $2.1 million. During January 1998, the Board of Directors approved a stock repurchase program of up to 500,000 shares of the Company's common stock. During February 1998, the Company repurchased 73,000 shares of its common stock at an aggregate cost of $508,000. Management expects capital expenditures during 1998 of about $2.2 million. These expenditures primarily relate to manufacturing tooling and equipment for the new products that the Company is developing, including next generation RF SCS systems, an IPG system and a constant rate implantable drug pump. -19- 21 Management believes that its cash, cash equivalents and marketable securities after the sale of the CVS Operations and funds generated from operations will be sufficient to satisfy normal cash operating requirements, capital requirements and stock repurchases for the foreseeable future. CASH FLOWS Net cash provided by continuing operations increased to $2.1 million in 1997 compared to $168,000 in 1996 and a net use of cash during 1995 of $636,000. This improvement during 1997 compared to 1996 reflects the improved operating results of ANS. Primary uses of cash in continuing operations during 1997 were additional investments in inventories, prepaid expenses and other assets, and a reduction in the level of accounts payable. Primary uses of cash in continuing operations during 1996 were additional investments in inventories and a reduction in the level of accrued expenses. Primary uses of cash in continuing operations during 1995 were related to increased levels of accounts receivable and prepaid expenses and a reduction in accounts payable and accrued expenses. Net cash provided by discontinued operations increased to $391,000 in 1997 compared to net uses of cash during 1996 of $145,000 and $898,000 in 1995. Net cash used in investing activities was $5.7 million in 1997 compared to $956,000 in 1996 and $14.1 million during 1995. Primary uses of cash during 1997 were investments in property, plant and equipment of $1.3 million and payments to the former owner of Neuromed relating to patents and settlements of $4.5 million (see Note 3 - "Acquisition"). Primary uses of cash during 1996 were additions to property, plant and equipment of $1.9 million while during 1995 the Company used $16.0 million to acquire Neuromed and $1.5 million for additions to property, plant and equipment. Sources of cash from investing activities were $1.5 million in 1996 and $3.3 million in 1995 from the sale of certain of the Company's marketable securities. Net cash provided by financing activities was $3.3 million in 1997 compared to $305,000 in 1996 and $16.9 million during 1995. During 1997, cash was provided by the exercise of stock options ($922,000) and additional borrowings under short-term notes of $3.5 million. The Company used $1.2 million during 1997 to repay debt. During 1996, the primary source of cash from financing activities was the exercise of stock options ($559,000) while the Company used cash to repay $151,000 of mortgage debt and $103,000 utilized in the redemption of the Company's shareholder rights plan. Primary sources of cash during 1995 were $15 million provided from borrowings under a senior-term bank facility, $1.9 million of additional borrowings under the Company's working capital line of credit, $369,000 from the exercise of stock options, and $15.2 million of net proceeds provided by a public offering. Primary uses of cash during 1995 were repayment of the $15 million senior-term bank indebtedness and $108,000 of mortgage debt. -20- 22 YEAR 2000 The Year 2000 issue results from computer programs being written using two digits rather than four to identify an applicable year. Computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. Based on recent assessments of its computer systems and programs, the Company believes that its core manufacturing system software is fully Year 2000 compliant. Lesser internal applications may require minor modifications or replacement to attain full Year 2000 compliance and the Company intends to make certain investments in its software systems and applications to ensure the Company is Year 2000 compliant. Management believes, however, that the Year 2000 issue does not pose significant operational problems for the Company's computer systems and that the financial impact of the issue has not been and should not be material to the Company's financial position or results of operations in any given year. OUTLOOK AND UNCERTAINTIES The following is a "safe harbor" statement under the Private Securities Litigation Reform Act of 1995: The matters discussed in this Annual Report on Form 10-K contain statements that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. The words "expect," "estimate," "anticipate," "predict," "believe," "plan," "will," "should," "intend" and similar expressions and variations thereof are intended to identify forward-looking statements. Such statements appear in a number of places in this Annual Report on Form 10-K and include statements regarding the intent, belief or current expectations of the Company, its directors or its officers with respect thereto, among other things: (i) trends affecting the Company's financial condition or results of operations; (ii) the Company's financing plans; and (iii) the Company's business growth strategies. Readers are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks and uncertainties include, but are not limited to, the following: Product Development and Market Acceptance. The Company's growth depends in part on the development and market acceptance of new products, including next generation ANS products. There is no assurance that the Company will continue to develop successful products, that delays in product introduction will not be experienced, or that once such products are introduced, the market will accept them. Government Regulation. The Company's business is subject to extensive government regulation, principally by the FDA. The regulatory process, especially as it relates to product approvals, can be lengthy, expensive and uncertain. Single-Sourced Components. The Company relies on a single supplier for the computer chip used in two components of its SCS systems. The supplier of this computer chip has indicated its desire to cease manufacturing and supplying the computer chip in the future, but to date, has not determined when this will occur. The supplier has agreed to notify the Company once a date has been determined and allow the Company to place a final one-time purchase order for the computer chip. In the interim, the Company is maintaining a higher than normal -21- 23 inventory of the computer chip. In addition, the Company is developing a custom computer chip under its development agreement with Hi-tronics Design, Inc. to replace the existing computer chip and expects such chip to be available during the latter half of 1999. A sudden disruption in supply from the computer chip supplier or another single-source supplier could adversely affect the Company's ability to deliver finished products on time. Competition and Technological Change. The medical device market is highly competitive. The Company competes with many larger companies that have access to greater capital, research and development, marketing, distribution and other resources than the Company. In addition, this market is characterized by extensive research efforts and rapid product development and technological change, which could render the Company's products obsolete or noncompetitive. Intellectual Property Rights. The Company relies in part on patents, trade secrets and proprietary technology to remain competitive. It may be necessary to defend these rights or to defend against claims that the Company is infringing the rights of others. Intellectual property litigation and controversies are disruptive and expensive. Cost Pressures on Medical Technology. The overall escalating cost of medical products and healthcare results in significant cost pressure. Third party payers are under intense pressure to challenge the prices charged for medical products and services. The Company relies heavily on Medicare and Medicaid reimbursement. Any amendments to existing reimbursement rules and regulations which restrict or terminate the reimbursement eligibility (or the extent or amount of coverage) of medical procedures using the Company's products or the eligibility (or the extent or amount of coverage) of the Company's products could have an adverse impact on the Company's business, financial condition and results of operations. Potential Product Liability. The testing, manufacturing, marketing and sale of medical devices entail substantial risks of liability claims or product recalls. Reliance on Customer/Distributor. During 1997, ANS had one major customer that accounted for 10 percent or more of its net revenue. Sun Medical, Inc., a specialty distributor of ANS products, accounted for $3.7 million, or 25 percent, of ANS's net revenue for the year ended December 31, 1997. While the Company believes its relations with Sun Medical are good, the loss of this or any other major customer could have a material adverse effect on the Company's business, financial condition and results of operations. Other Uncertainties. Other operating, financial or legal risks or uncertainties are discussed in this Form 10-K in specific contexts and in the Company's other periodic SEC filings. The Company is, of course, also subject to general economic risks, the risk of interruption in the source of supply, dependence on key personnel and other risks and uncertainties. CURRENCY FLUCTUATIONS Substantially all of the Company's international sales are denominated in U.S. dollars. Fluctuations in currency exchange rates in other countries could reduce the demand for the ANS products by increasing the price of the ANS products in the currency of the countries in which the products are sold, although management does not believe currency fluctuations have had a material effect on the Company's results of operations to date. -22- 24 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Inapplicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is set forth in Appendices A, B and C. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is contained under the captions "Election of Directors" and "Executive Officers" in the definitive proxy material of the Company to be filed in connection with its 1998 annual meeting of stockholders, which information is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is contained under the captions "Compensation and Committees of the Board of Directors" and "Compensation of Executive Officers" in the definitive proxy material of the Company to be filed in connection with its 1998 annual meeting of stockholders, which information is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is contained under the caption "Security Ownership of Management and Principal Shareholders" in the definitive proxy material of the Company to be filed in connection with its 1998 annual meeting of stockholders, which information is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is contained under the caption "Certain Relationships and Related Transactions" in the definitive proxy material of the Company to be filed in connection with its 1998 annual meeting of stockholders, which information is incorporated herein by reference. -23- 25 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this report. 1. Financial Statements: See Index to Financial Statements on the second page of Appendix A. 2. Financial Statement Schedules:* Schedule II - Valuation and Qualifying Accounts. See Appendix B. * Those schedules not listed above are omitted as not applicable or not required. 3. Exhibits: See (c) below. (b) Reports on Form 8-K. The Company filed a Form 8-K on December 31, 1997 to report the press release announcing the Company's entering into a definitive agreement on December 29, 1997 to sell the CVS Operations to Atrion. On February 13, 1998 the Company filed a Form 8-K to report the consummation of the sale of the CVS Operations to Atrion on January 30, 1998. (c) Exhibit: 2.1 Agreement for the Purchase and Sale of All of the Issued Capital Stock of Neuromed, Inc. dated February 10, 1995, between Quest Medical, Inc. and William N. Borkan(5) 2.2 Amendment Agreement dated March 17, 1995, between Quest Medical, Inc. and William N. Borkan(5) 2.3 Letter Agreement dated as of September 23, 1995, by and between Quest Medical, Inc. and William N. Borkan(6) 2.4 Asset Purchase Agreement, dated December 29, 1997, by and among Quest Medical, Inc., QMI Medical, Inc. (formerly known as QMI Acquisition Corp.) and Atrion Corporation (including exhibits and schedules 2.1.1, 2.1.2, 2.3(a) and 2.3.(b))(9) 3.1 Articles of Incorporation, as amended(6) 3.2 Bylaws(1) 4.1 Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent(7) 10.1 Quest Medical, Inc. 1979 Amended and Restated Employees Stock Option Plan(2) 10.2 Form of 1979 Employees Stock Option Agreement(3) 10.3 Quest Medical, Inc. Directors Stock Option Plan (as amended)(2) 10.4 Form of Directors Stock Option Agreement(1) 10.5 Quest Medical, Inc. 1987 Stock Option Plan(6) -24- 26 10.6 Form of 1987 Employee Stock Option Agreement(6) 10.7 Quest Medical, Inc. 1995 Stock Option Plan(6) 10.8 Form of 1995 Employee Stock Option Agreement(6) 10.9 Form of Employment Agreement and Covenant Not to Compete, between the Company and key employees(1) 10.10 Promissory Note dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Financial Corporation(4) 10.11 Commercial Deed of Trust, Security Agreement and Assignment of Leases and Rents and Fixture Filing dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Financial Corporation(4) 10.12 Term Promissory Note dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Corporation(4) 10.13 Loan and Security Agreement dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Corporation(4) 10.14 Supplemental Security Agreement Number One dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Corporation(4) 10.15 Third Amended and Restated Credit Agreement dated as of March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas, N.A.(8) 10.16 Promissory Note (Facility A. Note) in the original principal amount of $5,650,000 dated March 3, 1997(8) 10.17 Promissory Note (Facility B. Note) in the original principal amount of $350,000 dated March 3, 1997(8) 10.18 First Amended and Restated Security Agreement dated March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas, N.A.(8) 10.19 First Amended and Restated Security Agreement dated March 3, 1997, between Advanced Neuromodulation Systems, Inc. and NationsBank of Texas, N.A.(8) 10.20 First Amended and Restated Intellectual Property Security Agreement and Assignment dated as of March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas N.A.(8) 10.21 First Amended and Restated Intellectual Property Security Agreement and Assignment dated as of March 3, 1997, between Advanced Neuromodulation Systems, Inc. and NationsBank of Texas, N.A.(8) 10.22 First Amended and Restated License Agreement dated as of March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas, N.A.(8) 10.23 First Amended and Restated License Agreement dated as of March 3, 1997, between Advanced Neuromodulation Systems, Inc. and NationsBank of Texas, N.A.(8) 10.24 Guaranty of Advanced Neuromodulation Systems, Inc. in favor of NationsBank of Texas, N.A. under the Third Amended and Restated Credit Agreement dated as of March 3, 1997(8) 10.25 Form of License Agreement, dated January 30, 1998, by and between Quest Medical, Inc. and QMI Medical, Inc. (formerly known as QMI Acquisition Corp.)(9) 10.26 Form of Lease Agreement, dated January 30, 1998, by and between Quest Medical, Inc. and QMI Medical, Inc. (formerly known as QMI Acquisition Corp.)(9) 10.27 Form of Option Agreement, dated January 30, 1998, by and between Quest Medical, Inc. and QMI Medical, Inc. (formerly known as QMI Acquisition Corp.)(9) 10.28 Agreement, dated December 31, 1997, by and among Quest Medical, Inc., its subsidiaries and affiliates and Thomas C. Thompson(10) 11.1 Computation of Earnings Per Share(10) -25- 27 21.1 Subsidiaries(10) 23.1 Consent of Independent Auditors(10) 27.1 Financial Data Schedule - December 31, 1997(10) 27.2 Restated Financial Data Schedule - December 31, 1996(10) 27.3 Restated Financial Data Schedule - December 31, 1995(10) - ----------------------------------- (1) Filed as an Exhibit to the Company's Registration Statement on Form S-18, Registration No. 2-71198-FW, and incorporated herein by reference. (2) Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. (3) Filed as an Exhibit to the Company's Registration Statement on Form S-1, Registration No. 2-78186, and incorporated herein by reference. (4) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year ended December 31, 1993, and incorporated herein by reference. (5) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year ended December 31, 1994, and incorporated herein by reference. (6) Filed as an Exhibit to the Company's Registration Statement on Form SB-2, Registration No. 33-62991, and incorporated herein by reference. (7) Filed as an Exhibit to the report of the Company on Form 8-K dated September 3, 1996, and incorporated herein by reference. (8) Filed as an Exhibit to the report of the Company on Form 10-K dated for the year ended December 31, 1996, and incorporated herein by reference. (9) Filed as an Exhibit to the report of the Company on Form 8-K dated February 13, 1998, and incorporated herein by reference. Upon request, the Company will furnish a copy of any omitted schedule to the Commission. (10) Filed herewith. -26- 28 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 30, 1998 QUEST MEDICAL, INC. By: /s/ F. ROBERT MERRILL III ----------------------------------------- F. Robert Merrill III, Chief Executive Officer, President, Executive Vice President-Finance, Treasurer and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Company and in the capacities and on the dates indicated:
Signature Title Date --------- ----- ---- /s/ F. ROBERT MERRILL III Chief Executive Officer, President, March 30, 1998 -------------------------------------- Executive Vice President-Finance, Treasurer and F. Robert Merrill III Secretary (Principal Executive Officer) /s/ F. ROBERT MERRILL III Chief Executive Officer, President, -------------------------------------- Executive Vice President-Finance, Treasurer and F. Robert Merrill III Secretary (Principal Financial and Accounting March 30, 1998 Officer) /s/ HUGH M. MORRISON Chairman of the Board and March 30, 1998 -------------------------------------- Director of Quest Medical, Inc. Hugh M. Morrison /s/LINTON E. BARBEE Director of Quest Medical, Inc. March 30, 1998 -------------------------------------- Linton E. Barbee
-27- 29 Signature Title Date --------- ----- ---- /s/ ROBERT C. EBERHART Director of Quest Medical, Inc. March 30, 1998 -------------------------------------- Robert C. Eberhart /s/ RICHARD D. NIKOLAEV Director of Quest Medical, Inc. March 30, 1998 -------------------------------------- Richard D. Nikolaev /s/ MICHAEL J. TORMA Director of Quest Medical, Inc. March 30, 1998 -------------------------------------- Michael J. Torma
-28- 30 APPENDIX A CONSOLIDATED FINANCIAL STATEMENTS INDEPENDENT AUDITORS' REPORT THREE YEARS ENDED DECEMBER 31, 1997 FORMING A PART OF THE ANNUAL REPORT FORM 10-K ITEM 8 OF QUEST MEDICAL, INC. AND SUBSIDIARIES (NAME OF ISSUER) FILED WITH THE SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 UNDER THE SECURITIES AND EXCHANGE ACT OF 1934 31 QUEST MEDICAL, INC. AND SUBSIDIARIES TABLE OF CONTENTS TO CONSOLIDATED FINANCIAL STATEMENTS FORM 10-K - ITEM 8 INDEPENDENT AUDITORS' REPORT CONSOLIDATED FINANCIAL STATEMENTS: Consolidated Balance Sheets - December 31, 1997 and 1996 Consolidated Statements of Operations - Three years ended December 31, 1997 Consolidated Statements of Stockholders' Equity - Three years ended December 31, 1997 Consolidated Statements of Cash Flows - Three years ended December 31, 1997 Notes to Consolidated Financial Statements 32 Report of Independent Auditors The Board of Directors Quest Medical, Inc. We have audited the accompanying consolidated balance sheets of Quest Medical, Inc. and subsidiaries (the Company) as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audit also included the financial statement schedule listed in the Index at Item 14A. These consolidated financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Quest Medical, Inc. and subsidiaries at December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ERNST & YOUNG LLP ------------------------ ERNST & YOUNG LLP Dallas, Texas February 25, 1998 33 QUEST MEDICAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1997 AND 1996
ASSETS 1997 1996 - ------ ----------- ----------- Current assets: Cash and cash equivalents $ 747,828 $ 696,196 Marketable securities 1,455,864 1,366,089 Receivables: Trade accounts, less allowance for doubtful accounts of $212,375 in 1997 and $160,000 in 1996 2,398,327 2,418,714 Interest and other 209,595 134,162 ----------- ----------- Total receivables 2,607,922 2,552,876 ----------- ----------- Inventories: Raw materials 1,056,718 1,181,147 Work-in-process 323,929 692,199 Finished goods 1,597,840 1,136,851 ----------- ----------- Total inventories 2,978,487 3,010,197 ----------- ----------- Deferred income taxes 2,288,192 317,276 Net assets, in 1997, and net current assets, in 1996, of discontinued operations sold in 1998 12,831,318 6,356,543 Prepaid expenses and other current assets 476,716 450,128 ----------- ----------- Total current assets 23,386,327 14,749,305 ----------- ----------- Property, plant and equipment: Land 1,927,900 1,930,289 Building and improvements 5,254,945 5,251,853 Furniture and fixtures 624,753 605,899 Machinery and equipment 920,879 407,254 ----------- ----------- 8,728,477 8,195,295 Less accumulated depreciation and amortization 1,317,362 889,841 ----------- ----------- Net property, plant and equipment 7,411,115 7,305,454 ----------- ----------- Cost in excess of net assets acquired, net of accumulated amortization of $1,178,014 in 1997 and $632,768 in 1996 9,633,650 10,103,659 Patents, net of accumulated amortization of $148,958 in 1997 2,851,042 3,000,000 Purchased technology from acquisitions, net of accumulated amortization of $733,334 in 1997 and $466,667 in 1996 3,266,666 3,533,333 Tradenames, net of accumulated amortization of $343,750 in 1997 and $218,750 in 1996 2,156,250 2,281,250 Noncurrent assets of discontinued operations sold in 1998 -- 6,213,632 Other assets 277,270 1,300 ----------- ----------- $48,982,320 $47,187,933 =========== ===========
See accompanying notes to consolidated financial statements. 34 QUEST MEDICAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1997 AND 1996
LIABILITIES AND STOCKHOLDERS' EQUITY 1997 1996 - ------------------------------------ -------------- ------------ Current liabilities: Accounts payable $ 240,249 $ 753,953 Short-term notes payable and current maturities of long-term notes payable 8,257,348 2,084,122 Accrued salary and employee benefit costs 381,735 747,573 Other accrued expenses 379,444 76,135 ------------ ------------ Total current liabilities 9,258,776 3,661,783 ------------ ------------ Notes payable 3,635,027 11,912,036 Deferred income taxes 2,182,580 620,631 Commitments and contingencies Stockholders' equity: Common stock, $.05 par value Authorized 25,000,000 shares in 1997 and 1996; issued 8,635,509 shares in 1997 and 8,338,510 shares in 1996 431,775 416,926 Additional capital 40,780,717 38,699,517 Retained earnings (deficit) (7,268,061) (7,992,082) Unrealized loss on marketable securities net of tax benefit of $19,831 in 1997 and $67,423 in 1996 (38,494) (130,878) ------------ ------------ Total stockholders' equity 33,905,937 30,993,483 ------------ ------------ $ 48,982,320 $ 47,187,933 ============ ============
See accompanying notes to consolidated financial statements. 35 QUEST MEDICAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31
1997 1996 1995 ------------ ------------ ------------ Net revenue $ 14,717,721 $ 11,403,144 $ 10,434,384 Cost of revenue 4,839,261 3,315,255 2,752,108 ------------ ------------ ------------ Gross profit 9,878,460 8,087,889 7,682,276 ------------ ------------ ------------ Operating expenses: General and administrative 1,760,061 2,083,763 1,662,788 Research and development 976,900 1,315,953 807,560 Amortization of intangibles 1,085,871 826,418 491,767 Purchased research and development -- -- 10,500,000 Marketing 3,969,320 3,346,450 1,641,043 ------------ ------------ ------------ 7,792,152 7,572,584 15,103,158 ------------ ------------ ------------ Earnings (loss) from operations 2,086,308 515,305 (7,420,882) Other income (expense): Gain (loss) on sale of marketable securities (25,659) 136,975 29,115 Interest expense (625,321) (418,246) (1,063,367) Investment and other income, net 115,197 200,322 460,282 ------------ ------------ ------------ (535,783) (80,949) (573,970) ------------ ------------ ------------ Earnings (loss) from continuing operations before income taxes 1,550,525 434,356 (7,994,852) Income taxes 733,014 319,842 911,480 ------------ ------------ ------------ Net earnings (loss) from continuing operations 817,511 114,514 (8,906,332) Loss from discontinued operations, net of income tax benefits of $15,909 in 1997, $236,967 in 1996 and $756,366 in 1995 (93,490) (526,671) (1,198,666) Extraordinary item - loss on early extinguishment of debt, net of income tax benefit of $138,599 -- -- (269,045) ------------ ------------ ------------ Net earnings (loss) $ 724,021 $ (412,157) $(10,374,043) ============ ============ ============ Basic earnings (loss) per share: Continuing operations $ .10 $ .01 $ (1.42) ============ ============ ============ Discontinued operations $ (.01) $ (.06) $ (.19) ============ ============ ============ Extraordinary item $ -- $ -- $ (.05) ============ ============ ============ Net earnings (loss) $ .09 $ (.05) $ (1.66) ============ ============ ============ Diluted earnings (loss) per share: Continuing operations $ .09 $ .01 $ (1.42) ============ ============ ============ Discontinued operations $ (.01) $ (.06) $ (.19) ============ ============ ============ Extraordinary item $ -- $ -- $ (.05) ============ ============ ============ Net earnings (loss) $ .08 $ (.05) $ (1.66) ============ ============ ============
See accompanying notes to consolidated financial statements. 36 QUEST MEDICAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31
1997 1996 1995 -------------- --------------- ------------ Cash flows from operating activities: Net earnings (loss) from continuing operations $ 817,511 $ 114,514 $ (8,906,332) Adjustments to reconcile earnings (loss) from continuing operations to net cash provided by (used in) operating activities: Depreciation 438,056 312,245 306,677 Amortization 1,085,871 826,417 563,203 Deferred income taxes 717,104 97,478 338,601 Non-operating loss (gains) included in net earnings (loss) 25,655 (139,030) (137,898) Purchased research and development -- -- 10,500,000 Increase in inventory reserve 534,619 -- -- Changes in assets and liabilities, net of effects of acquisition: Receivables (130,283) 658,980 (1,820,825) Inventories (500,835) (1,385,149) (62,403) Prepaid expenses and other assets (302,558) 239,755 (661,673) Accounts payable (513,704) 57,849 (416,074) Accrued expenses (62,529) (615,315) (349,221) Other -- -- 9,720 ------------ ------------ ------------ Net cash provided by (used in) continuing operations 2,108,907 (167,744) (636,225) Net cash provided by (used in) discontinued operations 391,096 (145,431) (897,653) ------------ ------------ ------------ Net cash provided by (used in) operating activities 2,500,003 22,313 (1,533,878) ------------ ------------ ------------ Cash flows from investing activities: Net proceeds from marketable securities transactions 24,542 1,480,924 3,317,881 Additions to property, plant and equipment, continuing operations (545,193) (391,832) (275,759) Additions to property, plant and equipment, discontinued operations (745,729) (1,580,468) (1,192,973) Acquisition, net of cash acquired (4,472,197) (468,767) (15,996,910) Other (594) 3,637 6,550 ------------ ------------ ------------ Net cash used in investing activities (5,739,171) (956,506) (14,141,211) ------------ ------------ ------------ Cash flows from financing activities: Net increase (decrease) in short-term obligations 3,531,763 -- -- Proceeds of long-term notes payable, net of debt issuance costs -- -- 16,431,233 Payment of long-term notes payable (1,163,349) (150,647) (15,108,486) Exercise of stock options 922,386 558,552 369,449 Net proceeds from public offering of common stock -- -- 15,218,815 Redemption of rights plan -- (103,146) -- Issuance (purchase) of treasury stock, net -- -- 1,745 ------------ ------------ ------------ Net cash provided by (used in) financing activities 3,290,800 304,759 16,912,756 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents 51,632 (629,434) 1,237,667 Cash and cash equivalents at beginning of year 696,196 1,325,630 87,963 ------------ ------------ ------------ Cash and cash equivalents at end of year $ 747,828 $ 696,196 $ 1,325,360 ============ ============ ============ Supplemental cash flow information is presented below: Income taxes paid $ -- $ -- $ -- ============ ============ ============ Interest paid (net of amounts capitalized) $ 994,294 $ 668,049 $ 1,571,553 ============ ============ ============
See accompanying notes to consolidated financial statements. 37 QUEST MEDICAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1997
UNREALIZED COMMON STOCK RETAINED LOSS ON ------------------------ ADDITIONAL EARNINGS MARKETABLE SHARES AMOUNT CAPITAL (DeFICIT) SECURITIES ----------- ---------- --------- ----------- ------------ Balance at December 31, 1994 7,982,498 $ 399,125 $19,514,171 $ 2,794,118 $(917,634) Shares issued upon exercise of stock options 160,422 8,021 361,429 -- -- Issuance of 245 common shares from treasury -- -- 1,216 -- -- Adjustment to unrealized losses on marketable securities -- -- -- -- 706,572 Issuance of 1,033,333 common shares from treasury for acquisition -- -- 6,779,285 -- -- Sale of treasury and new common shares in public offering, net of offering costs 4,429 221 11,597,569 -- -- Net loss -- -- -- (10,374,043) -- ------------ --------- ----------- ------------ --------- Balance at December 31, 1995 8,147,349 407,367 38,253,670 (7,579,925) (211,062) Shares issued upon exercise of stock options 159,178 7,959 479,207 -- -- Adjustment to unrealized losses on marketable securities -- -- -- -- 80,184 Issuance of 31,983 new common shares for employee bonuses and cancellation of a stock option 31,983 1,600 69,786 -- -- Redemption of rights plan dividend -- -- (103,146) -- -- Net loss -- -- -- (412,157) -- ------------ --------- ----------- ------------ --------- Balance at December 31, 1996 8,338,510 416,926 38,699,517 (7,992,082) (130,878) Shares issued upon exercise of stock options 296,999 14,849 907,537 -- -- Adjustment to unrealized losses on marketable securities -- -- -- -- 92,384 Tax benefit from employee stock option exercises -- -- 1,173,663 -- -- Net earnings -- -- -- 724,021 -- ------------ --------- ----------- ------------ --------- Balance at December 31, 1997 8,635,509 $ 431,775 $40,780,717 $ (7,268,061) $ (38,494) ============ ========= =========== ============ ========= TOTAL TREASURY STOCKHOLDERS' STOCK EQUITY -------- ---------- Balance at December 31, 1994 $ (5,858,800) $ 15,930,980 Shares issued upon exercise of stock options -- 369,450 Issuance of 245 common shares from treasury 529 1,745 Adjustment to unrealized losses on marketable securities -- 706,572 Issuance of 1,033,333 common shares from treasury for acquisition 2,237,246 9,016,531 Sale of treasury and new common shares in public offering, net of offering costs 3,621,025 15,218,815 Net loss -- (10,374,043) ------------ ------------ Balance at December 31, 1995 -- 30,870,050 Shares issued upon exercise of stock options -- 487,166 Adjustment to unrealized losses on marketable securities -- 80,184 Issuance of 31,983 new common shares for employee bonuses and cancellation of a stock option -- 71,386 Redemption of rights plan dividend -- (103,146) Net loss -- (412,157) ------------ ------------ Balance at December 31, 1996 -- 30,993,483 Shares issued upon exercise of stock options -- 922,386 Adjustment to unrealized losses on marketable securities -- 92,384 Tax benefit from employee stock option exercises -- 1,173,663 Net earnings -- 724,021 ------------ ------------ Balance at December 31, 1997 $ -- $ 33,905,937 ============ ============
38 - 1 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) BUSINESS CONTINUING OPERATIONS Quest Medical, Inc. (the "Company") designs, develops, manufactures and markets implantable neurostimulation systems through its wholly owned subsidiary Advanced Neuromodulation Systems, Inc. ("ANS"). ANS devices are used primarily to manage chronic severe pain. ANS revenues are derived primarily from sales throughout the United States, Europe and Australia. The neurostimulation systems business, described above, was acquired in March 1995 (see Note 3 -"Acquisition"). All other businesses of the Company were sold in January 1998 as described below under Discontinued Operations. The research and development, manufacture, sale and distribution of medical devices is subject to extensive regulation by various public agencies, principally the Food and Drug Administration and corresponding state, local and foreign agencies. Product approvals and clearances can be delayed or withdrawn for failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial marketing. In addition, ANS products are purchased primarily by hospitals and other users who then bill various third-party payers including Medicare, Medicaid, private insurance companies and managed care organizations. These third-party payers reimburse fixed amounts for services based on a specific diagnosis. The impact of changes in third-party payer reimbursement policies and any amendments to existing reimbursement rules and regulations that restrict or terminate the eligibility of ANS products could have an adverse impact on the Company's financial condition and results of operations. DISCONTINUED OPERATIONS On January 30, 1998, the Company sold its cardiovascular and intravenous fluid product lines ("CVS Operations"), including its MPS(R) myocardial protection system product line, to Atrion Corporation (see Note 11 - "Sale of CVS Operations/Discontinued Operations"). The CVS Operations have been accounted for as discontinued operations in the Consolidated Statements of Operations for the years ended December 31, 1997, 1996 and 1995. Net assets of the CVS Operations have been presented on the Consolidated Balance Sheets as net assets of discontinued operations. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Quest Medical, Inc. and all of its subsidiaries. All significant intercompany transactions and accounts have been eliminated in consolidation. 39 - 2 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. CASH EQUIVALENTS The Company considers temporary cash investments with maturities of three months or less from the date of purchase to be cash equivalents. REVENUE RECOGNITION The Company recognizes revenue from product sales when the goods are shipped to its customers. MARKETABLE SECURITIES The Company's marketable securities and debt securities are classified as available-for-sale and are carried at fair value with the unrealized gains and losses reported in a separate component of stockholders' equity. The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Realized gains and losses and declines in value judged to be other than temporary are included in other income. The cost of securities sold is based on the specific identification method. Interest and dividends are included in investment income. INVENTORIES Inventories are recorded at the lower of standard cost or market. Standard cost approximates actual cost determined on the first-in, first-out ("FIFO") basis. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Additions and improvements extending asset lives are capitalized while maintenance and repairs are expensed as incurred. Depreciation is provided using the straight-line method over the estimated useful lives of the various assets ranging from 3 to 30 years. INTANGIBLE ASSETS The excess of cost over the net assets of acquired businesses ("goodwill") is amortized on a straight-line basis over the estimated useful life of 20 years. The cost of purchased technology related to acquisitions is based on appraised values at the date of acquisition and is amortized on a straight-line basis over the estimated useful life (15 years) of such technology. The cost of purchased tradenames is based on appraised values at the date of acquisition and is amortized on a straight-line basis over the estimated useful life (20 years) of such tradenames. 40 - 3 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The cost of purchased patents is amortized on a straight-line basis over the estimated useful life (17 years) of such patents. Costs of patents that are the result of internal development are charged to current operations. The Company assesses the recoverability of all its intangible assets primarily based on its current and anticipated future undiscounted cash flows. At December 31, 1997, the Company does not believe there has been any impairment of its intangible assets. RESEARCH AND DEVELOPMENT Product development costs including start-up and research and development are charged to operations in the year in which such costs are incurred. ADVERTISING Advertising expense is charged to operations in the year in which such costs are incurred. Total advertising expense included in marketing expense from continuing operations was $14,746, $5,615 and $54,335 at December 31, 1997, 1996 and 1995, respectively. DEFERRED TAXES Deferred income taxes are recorded based on the liability method and represent the tax effect of the differences between the financial and tax basis of assets and liabilities other than costs in excess of the net assets of businesses acquired. STOCK-BASED COMPENSATION The Company has elected to follow APB No. 25, "Accounting for Stock Issued to Employees" in the primary financial statements and to provide supplementary disclosures required by FASB Statement No. 123, "Accounting for Stock-Based Compensation" (see Note 7 - "Stockholders' Equity"). EARNINGS PER SHARE In February 1997, the Financial Accounting Standards Board issued Statement No. 128, "Earnings Per Share," which is required to be adopted on December 31, 1997. The Company adopted provisions of Statement No. 128 at that time and accordingly has restated all prior periods. Under Statement No. 128, basic earnings per share is computed based only on the weighted average number of common shares outstanding during the period, and the dilutive effect of stock options and warrants is excluded. Diluted earnings per share is computed using the additional dilutive effect, if any, of stock options and warrants using the treasury stock method based on the average market price of the stock during the period. Basic earnings (loss) per share for 1997, 1996 and 1995 are based upon 8,428,393, 8,259,129 and 6,267,210 shares, respectively. Diluted earnings (loss) per share for 1997, 1996 and 1995 are based upon 8,858,086, 8,809,583 and 6,267,210 shares, respectively. For 1997 and 1996, the incremental shares used for dilutive earnings (loss) per share relate to stock options and warrants whose exercise price was less than the average market price in the 41 - 4 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS underlying quarterly computations. Options to purchase 148,313 shares at an average price of $10.80 per share were outstanding in 1997, and options to purchase 128,812 shares at an average price of $9.82 per share were outstanding in 1996 but were not included in the computation of diluted earnings (loss) per share because the options' exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. RECLASSIFICATION Certain prior period amounts have been reclassified to conform to current-year presentation. (3) ACQUISITION On March 31, 1995, the Company acquired for $15,403,263 cash (excluding $1,062,414 of related acquisition and financing costs) and 833,333 shares of Quest common stock valued at $6,458,331, all of the capital stock of Neuromed, Inc. ("Neuromed"). The transaction also provided for contingent consideration over the following two years depending on sales of Neuromed's products reaching certain objectives. In 1995, the Company recorded additional "earn-out" consideration of 200,000 shares of Quest common stock valued at $2,558,200 and a $1,500,000 liability. In 1996, the Company recorded a note payable in the amount of $3,370,000 for additional "earn out" consideration. In addition, the Company recorded a short-term note payable to the former owner of Neuromed in the amount of $972,197 related to certain purchase price adjustments (principally tax refunds and future tax credits) awarded through an arbitration. The Company paid the $972,197 obligation during January 1997. In February 1997, the Company and the former owner of Neuromed reached a settlement (the "Settlement") of all issues between them. Under the terms of the Settlement, the Company agreed to pay $500,000 in cash and deliver a promissory note in the amount of $1,000,000 payable on February 6, 1998, for full settlement of the contingent consideration liabilities net of claims made by the Company. The Company also agreed to pay $3,000,000 in cash to purchase certain patent rights from Neuromed's former owner. The acquisition was accounted for by the purchase method of accounting. Purchased in-process research and development was identified and valued. This resulted in $10,500,000 of purchased research and development which had not yet achieved technological feasibility and does not have alternative uses. Therefore, in accordance with generally accepted accounting principles, the $10,500,000, with no related tax benefit, was charged to expense during the year ended December 31, 1995. In connection with the purchase, the Company determined that the operations of Neuromed would be relocated to the Company's facility in Allen, Texas and recorded liabilities of $1,234,335 for relocation costs. The purchase price allocation for the acquisition of Neuromed, as of December 31, 1996, is summarized below: 42 - 5 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Tradenames $ 2,500,000 Purchased patents 3,000,000 Purchased technology 4,000,000 Cost in excess of net assets acquired 10,736,427 Purchased research and development 10,500,000 Excess of liabilities over tangible assets acquired (250,789) Deferred financing costs 468,767 ------------ $ 30,954,405 ============
(4) MARKETABLE SECURITIES The following is a summary of available-for-sale securities at December 31, 1997:
Gross Gross Unrealized Unrealized Estimated Cost Gains Losses Fair Value ---------- ---------- ---------- ---------- Investment grade preferred securities $ 557,596 $ 1,870 $ 4,802 $ 554,664 Publicly traded limited partnerships 51,875 -- 10,315 41,560 Real estate investment trusts 241,590 312 12,465 229,437 Other 663,128 -- 32,925 630,203 ---------- ---------- ---------- ---------- $1,514,189 $ 2,182 $ 60,507 $1,455,864 ========== ========== ========== ==========
At December 31, 1997, no individual security represented more than 25 percent of the total portfolio or 1 percent of total assets. The Company did not have any investments in derivative financial instruments at December 31, 1997. The following is a summary of available-for-sale securities at December 31, 1996:
Gross Gross Unrealized Unrealized Estimated Cost Gains Losses Fair Value ---------- ---------- ---------- ---------- Investment grade preferred securities $ 622,596 $ 4,503 $ 45,817 $ 581,282 Publicly traded limited partnerships 263,004 -- 44,019 218,985 Real estate investment trusts 297,695 3,498 41,688 259,505 Other 381,095 10 74,788 306,317 ---------- ---------- ---------- ---------- $1,564,390 $ 8,011 $ 206,312 $1,366,089 ========== ========== ========== ==========
At December 31, 1996, no individual security represented more than 20 percent of the total portfolio or 1 percent of total assets. The Company did not have any investments in derivative financial instruments at December 31, 1996. 43 - 6 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (5) NOTES PAYABLE Notes payable for the years ended December 31 consisted of the following:
1997 1996 ----------- ----------- Notes payable to banks $ 5,000,000 $ 4,550,000 Note payable to shareholder 2,000,000 -- Acquisition notes payable 1,000,000 5,472,197 Mortgage notes 3,810,612 3,973,961 Other 81,763 -- ----------- ----------- 11,892,375 13,996,158 Less current maturities 8,257,348 2,084,122 ----------- ----------- Long-term portion of notes payable $ 3,635,027 $11,912,036 =========== ===========
At December 31, 1997, the Company's notes payable to banks were under a $5,650,000 working capital line of credit and a $350,000 term loan facility (the "Facilities"). Borrowings under the Facilities bear interest at prime plus 100 basis points, or at the Company's option, LIBOR plus 225 or 275 basis points. The Facilities are collateralized by all of the Company's assets with the exception of the real property, building and equipment that collateralize the mortgage notes described below. The Company is subject to specified financial covenants and is prohibited from paying cash dividends. The Company is required to make monthly principal payments of $90,000 with interest payable quarterly. At December 31, 1997, the Company has advances in the amount of $4,650,000 outstanding under its working capital line with a weighted average interest rate of 7.50 percent and advances in the amount of $350,000 under the term loan facility with a weighted average interest rate of 8.25 percent. On January 30, 1998, the Company repaid all notes payable under the Facilities with proceeds from the sale of the assets of its CVS Operations (see Note 11 - "Sale of CVS Operations/Discontinued Operations") and the Facilities expired. In February 1997, the Company borrowed $2,000,000 from a nonaffiliate shareholder pursuant to a promissory note that bears interest at the rate of 6 percent per annum. The Company is required to make quarterly interest payments with the principal due at maturity in February 1998. The Company issued the shareholder five-year warrants to purchase 100,000 shares of common stock at an exercise price of $6.50 per share, the closing sales price on the date the indebtedness was incurred. Under the warrant agreement, the shareholder has the right to one demand registration in addition to piggyback registration rights. During November 1997, upon demand of the shareholder, the Company filed a registration statement on Form S-3. At February 25, 1998, the warrants remain unexercised. The loan is subordinated to the bank debt described above and the shareholder has a second lien on all of the assets collateralizing the bank debt. The Company repaid the note on January 30, 1998 with proceeds from the sale of the assets of its CVS Operations (see Note 11 - "Sale of CVS Operations/Discontinued Operations"). At December 31, 1996, the Company had a short-term, noninterest-bearing note payable in the amount of $972,197 due in connection with purchase price adjustments awarded through an arbitration to the former owner of Neuromed, Inc. (see Note 3 - "Acquisition"). The note was paid during January 1997. In February 1997, the Company issued the former owner of Neuromed a promissory note in the amount of $1.0 million that bears interest at the rate of 10 percent per annum with interest payable monthly and the principal due in February 1998. The loan is subordinated to the bank debt described above and is collateralized with a second lien that is pari passu with the shareholder's lien. The Company repaid the note on January 30, 1998, with 44 - 7 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS proceeds from the sale of the assets of its CVS Operations (see Note 11 - "Sale of CVS Operations/Discontinued Operations"). In 1993, the Company entered into two mortgage notes relating to its principal office and manufacturing facility. The first note, in the amount of $2,876,391 at December 31, 1997, bears interest at 8.59 percent and has a twenty-five year amortization. The Company has the option of prepaying this note during years six through ten subject to certain provisions. The loan is collateralized by the Allen facility and land. The second note, in the amount of $934,221 at December 31, 1997, is related to equipment and furnishings and bears interest at 7.94 percent. The note has a ten-year amortization and is collateralized by the equipment and furnishings. The carrying value of the Company's debt approximates its fair value. (6) FEDERAL INCOME TAXES The significant components of the net deferred tax liability at December 31, were as follows:
Deferred tax assets: 1997 1996 ----------- ----------- Tax credit and net operating loss carry forwards $ 2,488,573 $ 2,631,362 Accrued expenses and reserves 278,387 344,915 Unrealized loss on marketable securities 19,831 67,422 Valuation allowance -- (858,835) ----------- ----------- Total deferred tax asset 2,786,791 2,184,864 Deferred tax liabilities: Purchased intangible assets (1,843,792) (1,976,958) Excess of tax over book depreciation (566,296) (335,368) Other (271,091) (175,893) ----------- ----------- Total deferred tax liability (2,681,179) (2,488,219) ----------- ----------- Net deferred tax asset (liability) $ 105,612 $ (303,355) =========== ===========
At December 31, 1996, $688,895 of the total valuation allowance was attributable to stock option deductions. This amount was credited to additional capital in 1997 when the valuation allowance was removed. The remaining portion of the valuation allowance at December 31, 1996, was for tax credit carry forwards. During 1996, the valuation allowance increased by $587,068. The provision for income taxes on earnings (loss) from continuing operations for the years ended December 31 consists of the following:
1997 1996 1995 -------- -------- -------- Current $ -- $ -- $ -- Deferred 733,014 319,842 911,480 -------- -------- -------- $733,014 $319,842 $911,480 ======== ======== ========
45 - 8 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A reconciliation of the provision for income taxes on earnings (loss) from continuing operations to the expense (benefit) calculated at the U.S. statutory rate follows:
1997 1996 1995 --------------- --------------- --------------- Income tax expense (benefit) at statutory rate $ 527,179 $ 147,681 $ (2,718,250) Tax effect of: Nondeductible amortization of goodwill 185,200 147,999 67,326 Nondeductible write-off of purchased in-process research and development -- -- 3,570,000 Other 20,635 24,162 (7,596) --------------- --------------- --------------- Income tax expense $ 733,014 $ 319,842 $ 911,480 =============== =============== ===============
At December 31, 1997 net operating loss carry forwards of $4,354,724 are available to offset future taxable income. Such net operating loss carry forwards expire in various amounts beginning in 2009 through 2012. At December 31, 1997, general business credits of $855,347 and alternative minimum tax credits of $152,620 are available to offset future tax liabilities. If unused, the general business credits expire in various amounts beginning in 1998 through 2010. (7) STOCKHOLDERS' EQUITY The Company has a Shareholder's Rights Plan, adopted in August 1996, which permits shareholders to purchase shares of the Company's common stock at significant discounts in the event a person or group acquires more than 15 percent of the Company's common stock or announces a tender or exchange offer for more than 20 percent of the Company's common stock. Previously outstanding rights were redeemed in August 1996 at $.01 per share. The Company has various stock option plans pursuant to which stock options may be granted to key employees and officers (the "Employees' Plans") and one plan under which directors and advisory directors of the Company may be granted options (the "Directors' Plan"). The most recent of the Employees' Plans, which was adopted during 1995 (the "1995 Plan"), reserved 250,000 shares of common stock for options under the plan; provided, however, that on January 1 of each year (commencing in 1996), the aggregate number of shares of common stock reserved for options under the 1995 Plan shall be increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if such percentage is positive). On January 1, 1996 and 1997, pursuant to this provision, the Company added 136,000 and 575, respectively, to the shares available under the 1995 Plan. All options outstanding under the Employees' Plans and Directors' Plan are nonqualified stock options; however, the 1995 Plan allows for the grant of incentive stock options intended to qualify for preferential tax treatment under Section 422 of the Internal Revenue Code of 1986. Under all of the Company's plans, the exercise price of all options granted must equal or exceed the fair market value of the common stock at the time of the grant. Options granted under the Employees' Plans expire ten years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. Options under the Directors' Plan expire six years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. Certain options under both the Employees' Plans and Directors' Plan, however, have a special two-year vesting schedule. 46 - 9 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 1997, under all of the Company's stock option plans, 833,272 shares have been granted and are outstanding, 1,388,714 shares of common stock have been issued upon exercise, and 100,901 shares were reserved for future grants. Data with respect to stock option plans of the Company are as follows:
- ---------------------------------------------------------------------------------------------------------------------- Options Outstanding Exercisable Options - ------------------------------------------------------------------------ -------------------------------------- Weighted Average Weighted Average Exercise Price Shares Exercise Price Shares - ---------------------------- ----------------- ------------------------- -------------- ----------------------- January 1, 1995 1,088,003 $ 3.25 488,590 $ 2.50 Granted 239,520 $ 8.11 Exercised (160,422) $ 2.30 Rescinded (40,540) $ 4.11 - ---------------------------- ----------------- ------------------------- -------------- ----------------------- January 1, 1996 1,126,561 $ 4.33 622,226 $ 2.84 Granted 323,000 $ 8.12 Exercised (159,178) $ 3.06 Rescinded (115,195) $ 8.36 - ---------------------------- ----------------- ------------------------- -------------- ----------------------- January 1, 1997 1,175,188 $ 5.16 663,459 $ 3.51 Granted 66,500 $ 6.16 Exercised (296,999) $ 3.35 Rescinded (111,417) $ 6.36 -------------- ----------------------- - ---------------------------- ----------------- ------------------------- December 31, 1997 833,272 $ 5.68 568,285 $ 4.66 - ---------------------------- ----------------- ------------------------- -------------- -----------------------
--------------------------------------------------------------------------------------------------------------- Options Outstanding At Exercisable Options At December December 31, 1997 31, 1997 ------------------------------------------------------------------------- ----------------------------------- Weighted Average Weighted Weighted Average Remaining Life Average Exercise Range of (Years) Exercise Price Exercise Price Shares Price Shares - ------------------------------------------------------------------------ -------------------------------- $1.45--2.25 87,348 1.41 $ 1.90 87,348 $ 1.90 $2.25--3.50 65,593 1.64 $ 3.19 65,593 $ 3.19 $3.50--5.25 267,181 1.99 $ 4.01 263,319 $ 4.01 $5.25--8.00 270,150 6.13 $ 6.44 98,150 $ 6.44 $8.00--12.25 143,000 7.53 $ 10.79 53,875 $ 10.92 - -------------------------------------------------------------------------- -------------------------------- 833,272 4.19 $ 5.68 568,285 $ 4.66 - ------------------------------------------------------------------------------------------------------------
Exercisable options at December 31 included options for 306,297 shares with a weighted average exercise price of $4.22 per share, which are held by employees who terminated employment with the Company on January 30, 1998 in connection with the sale of the CVS Operations (see Note 11 - "Sale of CVS Operations/Discontinued Operations"). The Company accelerated the vesting of the unvested portion of these terminated employee options as a result of the sale. The Company also extended the normal 90-day exercise period subsequent to termination to one year for these options. In accordance with APB No. 25, the Company has not recorded compensation expense for its stock option awards. As required by SFAS No. 123, the Company provides the following disclosure 47 - 10 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS of hypothetical values for these awards. The weighted-average fair value of an option granted in 1997, 1996 and 1995 was $2.37, $3.09 and $3.01, respectively. For purposes of fair market value disclosures, the fair market value of an option grant was estimated using the Black-Scholes option pricing model with the following assumptions:
1997 1996 1995 ---- ---- ---- Risk-free interest rate 6.1% 6.0% 6.2% Average life of options (years) 3.0 3.0 3.0 Volatility 48.0% 48.4% 43.4% Dividend Yield -- -- --
Had the compensation expense been recorded based on these hypothetical values, pro forma net earnings (loss) for 1997, 1996 and 1995 would have been $519,731, $(541,855) and $(10,466,956), respectively, and pro forma diluted net earnings (loss) per common share for 1997, 1996 and 1995 would have been $.06, $(.06) and $(1.67), respectively. Because option grants prior to 1995 are not considered in the pro forma amounts, as permitted by SFAS No. 123, the pro forma effects on net earnings (loss) are not likely to be representative of the effects on reported amounts in future years. In the fourth quarter of 1995, the Company sold 1,676,667 shares in a public offering. Net proceeds to the Company were $15.2 million, of which $13.9 million was used to repay the senior-term bank debt incurred in connection with the Neuromed acquisition. Diluted net loss per share would have been ($1.28) if this transaction had occurred on March 31, 1995, the date at which the debt incurred in connection with the Neuromed acquisition was first outstanding. (8) COMMITMENTS AND CONTINGENCIES The Company has no material commitments under non cancelable operating leases. Total rent expense under operating leases included in continuing operations for the years ended December 31, 1997, 1996 and 1995 was $8,617, $32,493 and $113,815, respectively. The Company is a party to product liability claims related to ANS neurostimulation devices. Product liability insurers have assumed responsibility for defending the Company against these claims. While historically product liability claims for ANS neurostimulation devices have not resulted in significant monetary liability for the Company beyond its insurance coverage, there can be no assurances that the Company will not incur significant monetary liability to the claimants if such insurance is inadequate or that the Company's neurostimulation business and future ANS product lines will not be adversely affected by these product liability claims. Except for such product liability claims and other ordinary routine litigation incidental or immaterial to its business, the Company is not currently a party to any other pending legal proceeding. The Company maintains general liability insurance against risks arising out of the normal course of business. (9) FINANCIAL INSTRUMENTS, RISK CONCENTRATION, AND MAJOR CUSTOMERS In the United States, the Company's accounts receivable are due primarily from hospitals and distributors located throughout the country. Internationally, the Company's accounts receivable are 48 - 11 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS due primarily from distributors located in Europe and Australia. The Company generally does not require collateral for trade receivables. The Company maintains an allowance for doubtful accounts based upon expected collectibility. Any losses from bad debts have historically been within management's expectations. Net sales of implantable neurostimulation systems to a major customer for each of the three years ended December 31, as a percentage of net revenues from continuing operations, were as follows: 1997 - 25 percent, 1996 - 22 percent and 1995 - 26 percent. Foreign sales, primarily Europe and Australia, for the years ended December 31, 1997, 1996 and 1995 were approximately 8 percent, 15 percent and 16 percent of net revenues from continuing operations, respectively. (10) EMPLOYEE BENEFIT PLANS The Company has a defined contribution retirement savings plan (the "Plan") available to substantially all employees. The Plan permits employees to elect salary deferral contributions of up to 15 percent of their compensation and requires the Company to make matching contributions equal to 50 percent of the participants' contributions to a maximum of 6 percent of the participants' compensation. The Board of Directors may change the percentage of matching contribution at their discretion. The expense of the Company's contribution for continuing operations was $72,635 in 1997, $81,885 in 1996 and $66,968 in 1995. (11) SALE OF CVS OPERATIONS/DISCONTINUED OPERATIONS On January 30, 1998, the Company sold its cardiovascular and intravenous fluid product lines, including its Myocardial Protection System product line, to Atrion Corporation. The Company received approximately $24 million from the sale and utilized $8.0 million of the proceeds to retire debt. The remaining proceeds will be used for working capital for the expanding ANS business. Management expects to report a pretax gain from the sale of approximately $8.3 to $8.5 million. This gain is net of $1,004,654 of compensation expense recorded as a result of changes made to the options held by employees of the CVS Operations (see Note 7 - "Stockholders' Equity"). The Company also expects operating losses for the CVS Operations of approximately $250,000 in January 1998 prior to the sale. Operating results of the CVS Operations have been reclassified and reported as discontinued operations. Summary operating results for the years ended December 31, 1997, 1996 and 1995 for the CVS Operations were as follows:
1997 1996 1995 ----------------- ----------------- ----------------- Revenue $ 14,306,127 $ 14,670,664 $ 14,886,606 Gross profit 6,500,654 6,980,659 7,014,499 Earnings (loss) from operations 333,200 (415,115) (1,360,581) Interest expense (442,599) (348,523) (594,451) ----------------- ----------------- ----------------- Loss before income tax benefit (109,399) (763,638) (1,955,032) Income tax benefit (15,909) (236,967) (756,366) ----------------- ----------------- ----------------- Net loss $ (93,490) $ (526,671) $ (1,198,666) ================= ================= =================
49 - 12 - QUEST MEDICAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The above operating results of the CVS Operations reflect the revenues and expenses of the CVS Operations including direct and indirect expenses of the Operations that are paid by the Company and charged directly to the CVS Operations. Allocation of the general overhead from the Company includes charges for regulatory, general corporate management, accounting and payroll services, human resources, management information systems and facilities expenses based on revenues of the CVS Operations to total revenues of the Company. Management believes that the expenses charged to the CVS Operations on this basis are not materially different from the costs that would have been incurred had the CVS Operations borne such expenses on a direct basis. Interest expense on the Company's corporate facility has been allocated to the CVS Operations based on space utilization. Interest expense on the Company's general credit facilities was allocated to the CVS Operations based on the ratio of the net assets of the CVS Operations to the total net assets of the Company. Assets and liabilities of discontinued CVS Operations for the years ended December 31, 1997 and 1996 were as follows:
1997 1996 ------------------ ------------------ Current assets: Accounts receivable $ 2,481,278 $ 2,587,988 Inventories 5,208,676 5,354,397 Prepaid expenses 131,735 218,680 ------------------ ------------------ 7,821,689 8,161,065 ------------------ ------------------ Noncurrent assets: Net property, plant and equipment 3,633,855 3,879,076 Net intangible assets consisting of patents, purchased technology and costs in excess of net assets acquired 2,043,107 2,325,925 Other assets 8,631 8,631 ------------------ ------------------ 5,685,593 6,213,632 ------------------ ------------------ Total assets 13,507,282 14,374,697 ------------------ ------------------ Current liabilities: Accounts payable 410,483 1,515,316 Accrued liabilities 265,481 289,206 ------------------ ------------------ 675,964 1,804,522 ------------------ ------------------ Net assets of CVS Operations $ 12,831,318 $ 12,570,175 ================== ==================
50 APPENDIX B SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS FORMING A PART OF THE ANNUAL REPORT FORM 10-K ITEM 14 OF QUEST MEDICAL, INC. AND SUBSIDIARIES (NAME OF ISSUER) FILED WITH THE SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 UNDER THE SECURITIES AND EXCHANGE ACT OF 1934 51 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS QUEST MEDICAL, INC. AND SUBSIDIARIES DECEMBER 31, 1997
Balance at Charged to Balance at Beginning of Charged to Other End of Description Period Expenses Accounts Deductions Period - ------------------------------------------------------------------------------------------------------------------------------------ Year ended December 31, 1997: Continuing Operations: ---------------------- Allowance for doubtful accounts $ 160,000 $ 64,453 $ -- $ 12,078 $ 212,375 Reserve for obsolete inventory -- 534,619 -- 478,614 56,005 --------------------------------------------------------------------------------- Total $ 160,000 $ 599,072 $ -- $ 490,692 $ 268,380 ================================================================================= Discontinued Operations: ------------------------ Allowance for doubtful accounts $ 14,337 $ 54,098 $ -- $ 37,825 $ 30,610 Reserve for obsolete inventory 230,472 151,168 -- 227,293 154,347 --------------------------------------------------------------------------------- Total $ 244,809 $ 205,266 $ -- $ 265,118 $ 184,957 ================================================================================= Year ended December 31, 1996: Continuing Operations: ---------------------- Allowance for doubtful accounts $ 100,000 $ 60,000 $ -- $ -- $ 160,000 Reserve for obsolete inventory -- -- -- -- -- --------------------------------------------------------------------------------- Total $ 100,000 $ 60,000 $ -- $ -- $ 160,000 ================================================================================= Discontinued Operations: ------------------------ Allowance for doubtful accounts $ 14,337 $ -- $ -- $ -- $ 14,337 Reserve for obsolete inventory 238,679 12,100 -- 20,307 230,472 --------------------------------------------------------------------------------- Total $ 253,016 $ 12,100 $ -- $ 20,307 $ 244,809 ================================================================================= Year ended December 31, 1995: Continuing Operations: ---------------------- Allowance for doubtful accounts $ -- $ -- $100,000(1) $ -- $ 100,000 Reserve for obsolete inventory -- -- -- -- -- --------------------------------------------------------------------------------- Total $ -- $ -- $ 100,000 $ -- $ 100,000 ================================================================================= Discontinued Operations: ------------------------ Allowance for doubtful accounts $ 14,337 $ -- $ -- $ -- $ 14,337 Reserve for obsolete inventory -- 238,679 -- -- 238,679 --------------------------------------------------------------------------------- Total $ 14,337 $ 238,679 $ -- $ -- $ 253,016 =================================================================================
(1) Addition to reserve is result of purchase of Neuromed, Inc. 52 APPENDIX C QUARTERLY FINANCIAL DATA (UNAUDITED) FORMING A PART OF THE ANNUAL REPORT FORM 10-K ITEM 8 OF QUEST MEDICAL, INC. AND SUBSIDIARIES (NAME OF ISSUER) FILED WITH THE SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 UNDER THE SECURITIES AND EXCHANGE ACT OF 1934 53
1997 1st 2nd 3rd 4th - -------------------------------------------- ----------- ----------- ----------- ----------- Net revenue $ 3,135,581 $ 3,465,753 $ 4,220,002 $ 3,896,385 Gross profit 2,218,003 1,805,158 3,065,411 2,789,888 Earnings (loss) from operations 361,973 (149,343) 1,125,084 748,594 Earnings (loss) from continuing operations before income taxes 202,041 (269,154) 1,007,426 610,212 Net earnings (loss) from continuing operations 137,891 (222,013) 649,100 252,533 Earnings (loss) from discontinued operations (43,525) 187,265 (199,738) (37,492) - -------------------------------------------- ----------- ----------- ----------- ----------- Net earnings (loss) $ 94,366 $ (34,748) $ 449,362 $ 215,041 - -------------------------------------------- ----------- ----------- ----------- ----------- Basic earnings (loss) per share: Continuing operations $ 0.02 $ (0.03) $ 0.08 $ 0.03 Discontinued operations (0.01) 0.03 (0.03) -- - -------------------------------------------- ----------- ----------- ----------- ----------- Net earnings (loss) $ 0.01 $ -- $ 0.05 $ 0.03 - -------------------------------------------- ----------- ----------- ----------- ----------- Diluted earnings (loss) per share: Continuing operations $ 0.02 $ (0.03) $ 0.07 $ 0.03 Discontinued operations (0.01) 0.03 (0.02) (0.01) - -------------------------------------------- ----------- ----------- ----------- ----------- Net earnings (loss) $ 0.01 $ -- $ 0.05 $ 0.02 - -------------------------------------------- ----------- ----------- ----------- ----------- 1996 1st 2nd 3rd 4th - -------------------------------------------- ----------- ----------- ----------- ----------- Net revenue $ 2,444,685 $ 3,005,846 $ 2,894,539 $ 3,058,074 Gross profit 1,743,195 2,253,821 2,031,026 2,059,847 Earnings (loss) from operations 102,720 378,523 166,396 (132,334) Earnings (loss) from continuing operations before income taxes 84,489 371,586 166,986 (188,705) Net earnings (loss) from continuing operations 16,270 285,994 97,388 (285,138) Earnings (loss) from discontinued operations (110,842) (171,671) (90,640) (153,518) - -------------------------------------------- ----------- ----------- ----------- ----------- Net earnings (loss) $ (94,572) $ 114,323 $ 6,748 $ (438,656) - -------------------------------------------- ----------- ----------- ----------- ----------- Basic and diluted earnings (loss) per share: Continuing operations $ -- $ 0.03 $ 0.01 $ (0.03) Discontinued operations (0.01) (0.02) (0.01) (0.02) - -------------------------------------------- ----------- ----------- ----------------------------- Net earnings (loss) $ (0.01) $ 0.01 $ -- $ (0.05) - -------------------------------------------- ----------- ----------- ----------- -----------
54 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.1 Agreement for the Purchase and Sale of All of the Issued Capital Stock of Neuromed, Inc. dated February 10, 1995, between Quest Medical, Inc. and William N. Borkan(5) 2.2 Amendment Agreement dated March 17, 1995, between Quest Medical, Inc. and William N. Borkan(5) 2.3 Letter Agreement dated as of September 23, 1995, by and between Quest Medical, Inc. and William N. Borkan(6) 2.4 Asset Purchase Agreement, dated December 29, 1997, by and among Quest Medical, Inc., QMI Medical, Inc. (formerly known as QMI Acquisition Corp.) and Atrion Corporation (including exhibits and schedules 2.1.1, 2.1.2, 2.3(a) and 2.3.(b))(9) 3.1 Articles of Incorporation, as amended(6) 3.2 Bylaws(1) 4.1 Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent(7) 10.1 Quest Medical, Inc. 1979 Amended and Restated Employees Stock Option Plan(2) 10.2 Form of 1979 Employees Stock Option Agreement(3) 10.3 Quest Medical, Inc. Directors Stock Option Plan (as amended)(2) 10.4 Form of Directors Stock Option Agreement(1) 10.5 Quest Medical, Inc. 1987 Stock Option Plan(6) 10.6 Form of 1987 Employee Stock Option Agreement(6) 10.7 Quest Medical, Inc. 1995 Stock Option Plan(6) 10.8 Form of 1995 Employee Stock Option Agreement(6) 10.9 Form of Employment Agreement and Covenant Not to Compete, between the Company and key employees(1) 10.10 Promissory Note dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Financial Corporation(4) 10.11 Commercial Deed of Trust, Security Agreement and Assignment of Leases and Rents and Fixture Filing dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Financial Corporation(4) 10.12 Term Promissory Note dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Corporation(4) 10.13 Loan and Security Agreement dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Corporation(4) 10.14 Supplemental Security Agreement Number One dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Corporation(4) 10.15 Third Amended and Restated Credit Agreement dated as of March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas, N.A.(8) 10.16 Promissory Note (Facility A. Note) in the original principal amount of $5,650,000 dated March 3, 1997(8) 10.17 Promissory Note (Facility B. Note) in the original principal amount of $350,000 dated March 3, 1997(8) 10.18 First Amended and Restated Security Agreement dated March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas, N.A.(8) 10.19 First Amended and Restated Security Agreement dated March 3, 1997, between Advanced Neuromodulation Systems, Inc. and NationsBank of Texas, N.A.(8) 10.20 First Amended and Restated Intellectual Property Security Agreement and Assignment dated as of March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas N.A.(8)
55 10.21 First Amended and Restated Intellectual Property Security Agreement and Assignment dated as of March 3, 1997, between Advanced Neuromodulation Systems, Inc. and NationsBank of Texas, N.A.(8) 10.22 First Amended and Restated License Agreement dated as of March 3, 1997, between Quest Medical, Inc. and NationsBank of Texas, N.A.(8) 10.23 First Amended and Restated License Agreement dated as of March 3, 1997, between Advanced Neuromodulation Systems, Inc. and NationsBank of Texas, N.A.(8) 10.24 Guaranty of Advanced Neuromodulation Systems, Inc. in favor of NationsBank of Texas, N.A. under the Third Amended and Restated Credit Agreement dated as of March 3, 1997(8) 10.25 Form of License Agreement, dated January 30, 1998, by and between Quest Medical, Inc. and QMI Medical, Inc. (formerly known as QMI Acquisition Corp.)(9) 10.26 Form of Lease Agreement, dated January 30, 1998, by and between Quest Medical, Inc. and QMI Medical, Inc. (formerly known as QMI Acquisition Corp.)(9) 10.27 Form of Option Agreement, dated January 30, 1998, by and between Quest Medical, Inc. and QMI Medical, Inc. (formerly known as QMI Acquisition Corp.)(9) 10.28 Agreement, dated December 31, 1997, by and among Quest Medical, Inc., its subsidiaries and affiliates and Thomas C. Thompson(10) 11.1 Computation of Earnings Per Share(10) 21.1 Subsidiaries(10) 23.1 Consent of Independent Auditors(10) 27.1 Financial Data Schedule - December 31, 1997(10) 27.2 Restated Financial Data Schedule - December 31, 1996(10) 27.3 Restated Financial Data Schedule - December 31, 1995(10)
- -------------------------------------- (1) Filed as an Exhibit to the Company's Registration Statement on Form S-18, Registration No. 2-71198-FW, and incorporated herein by reference. (2) Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. (3) Filed as an Exhibit to the Company's Registration Statement on Form S-1, Registration No. 2-78186, and incorporated herein by reference. (4) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year ended December 31, 1993, and incorporated herein by reference. (5) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year ended December 31, 1994, and incorporated herein by reference. (6) Filed as an Exhibit to the Company's Registration Statement on Form SB-2, Registration No. 33-62991, and incorporated herein by reference. (7) Filed as an Exhibit to the report of the Company on Form 8-K dated September 3, 1996, and incorporated herein by reference. (8) Filed as an Exhibit to the report of the Company on Form 10-K dated for the year ended December 31, 1996, and incorporated herein by reference. (9) Filed as an Exhibit to the report of the Company on Form 8-K dated February 13, 1998, and incorporated herein by reference. Upon request, the Company will furnish a copy of any omitted schedule to the Commission. (10) Filed herewith. EX-10.28 2 AGREEMENT DATED DECEMBER 31, 1997 - T.C. THOMPSON 1 EXHIBIT 10.28 AGREEMENT This Agreement (this "Agreement") is made and entered into as of December 31, 1997 by and among Quest Medical, Inc., a Texas corporation, its subsidiaries and affiliates (other than Thomas C. Thompson) (collectively, the "Company"), and Thomas C. Thompson, a resident of the State of Texas ("Employee"). RECITALS Employee is presently employed by the Company and serves as an officer and director. The continuation of the employment, officer and director relationships is no longer desired by Employee, on the one hand, or the Company, on the other hand. Employee and the Company mutually wish to fully and finally resolve any potential existing or potential disputes arising out of the employment relationship among Employee and the Company. The Company desires to retain Employee as a Consultant for a two-year period. Employee agrees and acknowledges that the Company has special expertise in its businesses that has enabled it to provide unique career opportunities for its employees, and its growth depends, to a significant degree, on its possession of certain information that may not be available to its competitors concerning a number of matters, including but not limited to, medical device manufacturing, engineering, regulatory affairs, clinical testing and studies of healthcare products, the marketing of these products, management processes and other information not generally known to others in its industry. To obtain such information and use it successfully, the Company has made significant investments in research, business development, quality assurance, customer satisfaction methods and techniques, manufacturing and business process improvements and other developments in marketing methods and providing services to their customers. Employee agrees and acknowledges that a covenant not to compete and a restriction on disclosure of confidential information is essential to the continued growth and stability of the Company's businesses and to the continuing viability of such businesses as expressly permitted under the terms and limitations of this Agreement. NOW, THEREFORE, in consideration of the mutual acts, payments and promises described and agreed to be performed herein, Employee and the Company agree as follows: 1. Resignation. Employee hereby tenders his resignation from all positions that he holds with the Company and its subsidiaries and affiliates, including without limitation his position as Chairman of the Board, which will be effective on December 31, 1997 (such date being referred to as the "Resignation Date"). The Company accepts Employee's resignations. 2. Severance from Employment. It is understood and agreed that with the full and complete agreement of Employee and the Company, Employee's employment by the Company will cease as of the Resignation Date. Except as otherwise expressly provided for herein, as of the Resignation Date, Employee shall cease to accrue any rights under any pension or compensation plan of the Company (including without limitation any stock option plan, grant or agreement). 2 3. Payment of Wages and Earned Benefits. Employee acknowledges the receipt of all wages and sick pay to which Employee is entitled as of the Resignation Date, and further acknowledges that he has been fully paid for all hours worked with the exception of vacation accrued and outstanding expense reimbursements and other payments set forth below. Until the Resignation Date, Employee will continue to be paid at his annualized salary level of $183,980.00, payable in accordance with the Company's standard payroll practices (but not less than two times each month), and will be entitled to medical and dental benefits (including coverage for Employee's spouse) on the same terms and conditions as provided to Employee immediately prior to the Resignation Date. Employee will be paid for 15 days' vacation which he has accrued but not taken during his employment with the Company. Such accrued vacation shall be paid to Employee in January, 1998. Any outstanding reimbursable expenses will be paid to Employee upon submission and approval of those expenses in accordance with the Company's customary practices. 4. Consulting and Other Payments to Employee. (a) In consideration of this Agreement (including, without limitation, the services provided pursuant to Section 5 and the covenants and agreements made in Sections 6, 7 and 8), the Company agrees to pay Employee the sum of $191,056.20 per year, payable in equal monthly installments on the first of each month, at the address specified in Section 16 of this Agreement until the second anniversary of the Resignation Date. In addition, the Company shall pay to Employee the 1997 Company performance bonus, if any, in accordance with the Executive Bonus Plan currently in effect and consistent with bonuses paid to other executives. Such bonuses shall be less applicable withholding for social security, Medicare, and income taxes, however, all cash consideration paid to Employee after the Resignation Date shall be made without any withholdings or deductions, including without limitation, deductions or withholdings for social security, Medicare or income taxes, unless otherwise required to do so by law. (b) In the event the Company's cardiovascular, myocardial protection and pressuring business segment (the "CVS Business") is sold to Atrion Corporation pursuant to a purchase agreement acceptable to the Company (the "Purchase Agreement") and such sale closes by June 30, 1998, the Company agrees to pay to Employee a commission of $100,000.00. Provided, however, as a condition to the payment of such commission, Employee agrees to execute a covenant not to compete with Atrion Corporation in the CVS Business for a period of four (4) years as part of the Purchase Agreement or related transaction. (c) In the event the Purchase Agreement does not close and if Employee plays a substantial role in the sale of the Company's "M.D. Anderson" business, and if such sale is approved by the Company for a sale price of at least Three Million Dollars ($3,000,000.00) and is closed on or before June 30, 1998, then Employee shall receive a commission of Fifty Thousand Dollars ($50,000.00) on such sale. (d) In the event the Purchase Agreement does not close and if Employee plays a substantial role in the sale of the Company's myocardial protection system ("MPS") business, and if such sale is approved by Company at a price acceptable to the Company and is closed on or before June 30, 1998, the Employee shall receive a commission of Fifty Thousand Dollars ($50,000.00) on such sale. (e) To the extent available under the Company's current medical and dental plans, the Company shall provide Employee with medical and dental benefits (including coverage for Employee's spouse) until the second anniversary of the Resignation Date on the same terms and conditions as provided to 3 Employee immediately prior to the Resignation Date. If such medical and dental benefits are not available to Employee during such two year period, Employee shall be entitled to COBRA continuation benefits at the Company's expense for such two-year period. To the extent that Employee's life insurance benefits can be included in the Company's general benefit policy, the Company shall continue to pay the premiums for the life insurance provided to Employee under such policy. (f) The Employee and the Company have entered into stock option agreements (the "Option Agreements"), pursuant to which the Employee received options to purchase an aggregate of 141,170 shares of the Company's common stock (the "Options"). The Company hereby extends to March 31, 1998 the period during which the Employee and F. Robert Merrill III (the only remaining recipients) may exercise the options granted on or about December 22, 1987. If during the time period between the Resignation Date and March 31, 1998, Employee possesses material confidential information which would prohibit him from trading Company stock under the Securities and Exchange Commission's insider trading regulations, then the Company will, upon reasonable request, extend the time period for exercising such options for an additional three month period. Notwithstanding anything to the contrary in the Option Agreements and any stock option plans related thereto, all unvested Options shall immediately vest upon the Resignation Date and no Options shall lapse or terminate as a result of this Agreement, the transactions contemplated hereby or otherwise. 5. Consulting Agreement. Notwithstanding the foregoing, for the period from the Resignation Date to the second anniversary of the Resignation Date, Employee shall serve as a consultant to the Company; provided, however, Employee shall in no case be deemed to be an employee of the Company but instead shall serve as an independent contractor for all purposes. Employee agrees to be available for consulting upon the request of the Company by telephone and in person, during normal business hours, but in no event in excess of an average of fifty (50) hours per month during any consecutive three months. In connection with the services to be rendered by Employee to the Company as set forth in this Section 5 (the "Services"), Employee will not, without the consent or direction of the Company, act or attempt to act or represent himself; directly or by implication, as an agent of the Company or in any manner assume or create, or attempt to create, any obligation on behalf of; or in the name of the Company. In the event that the Company requests Employee to incur any expenses in connection with the Services, the Company agrees to pay, in accordance with the Company's normal reimbursement policies, all reasonable expenses actually incurred by Employee in connection with providing the Services, including without limitation, travel, meals and lodging expenses. Employee further agrees that following the Resignation Date, Employee will cooperate with and assist the Company in the prosecution or defense of any litigation, including providing truthful testimony as a witness upon reasonable request. Any time spent in excess of fifty hours per month in such work shall be compensated at a reasonable rate to be mutually agreed upon by the parties. The cash and other consideration paid to Employee under Section 4 shall also constitute sufficient consideration for the Services after the Resignation Date pursuant to this Section 5 and the covenants and agreements in Sections 6 and 7 and in other Sections of this Agreement, and the Company shall have no other compensation obligations to Employee with respect to the Services. 6. Non-Competition Agreement. Employee understands that during the course of his employment by the Company, Employee has had access to and the benefit of the information referred to in the Recitals above, and represented the Company and its affiliates and developed contacts and relationships with other persons and entities on behalf of such entities, including but not limited to 4 customers, potential customers and other employees of such entities. To protect such entities' interest in this information and in these contacts and relationships and in consideration of the promises made by the Company in this Agreement, Employee agrees and covenants that for a period beginning on the Resignation Date and ending on the fourth anniversary of the Resignation Date, without the prior written approval of the Company, Employee will not, in connection with any business that is engaged in, or is about to be engaged in, by the Company as of the date of execution of this Agreement, which is defined as the research, development, manufacture, sale or marketing of products, devices, instruments, methods or techniques (or any related services or activities) substantially similar to any products, devices, instruments, methods or techniques which the Company is engaged in the research of; development of; manufacture, selling, or marketing, or has under active consideration to do the same as to which the Employee has actual knowledge (the "Business"), directly or indirectly, either as an individual or as an employee, partner, officer, director, shareholder, advisor, or consultant or in any other capacity whatsoever, of any person (other than providing the services to the Company pursuant to Section 5 and the ownership of less than 5% of the issued and outstanding securities of an entity): (a) recruit, hire, assist others in recruiting or hiring, discuss employment with, or refer to others for employment any person who is, or within the three month period immediately preceding the date of any such activity was, an employee of the Company or its affiliates; or (b) conduct or assist others in conducting any business or activity that competes with the Business in the United States, its territories or possessions, Europe, Australia or the Pacific Rim. Provided, however, that in the event the Company sells any segment of its business to some purchaser, the foregoing shall not preclude Employee from being involved in the segment sold as an employee or consultant of such purchaser, except that Employee will still be bound by subparagraph (a) above. Employee understands and agrees that the scope of the foregoing covenant is reasonable as to time, area and persons and is necessary to protect the legitimate business interests of the Company and its affiliates. Employee further agrees that such covenant will be regarded as divisible and will be operative as to time, area and persons to the extent that it may be so operative, and if any part of such covenant is declared invalid, unenforceable, or void as to time, area or persons, the validity and enforceability of the remainder will not be affected. If Employee violates the restrictive covenants of this Section 6 and the Company brings legal action for injunctive or other relief; the Company shall not be deprived of the benefit of the full period of the restrictive covenant as a result of the time involved in obtaining the relief in the event the Company is successful in its actions. Accordingly, Employee agrees that the regularly scheduled expiration date of such covenant shall be extended by the same amount of time that Employee is determined to have violated such covenant. 7. Confidentiality. Employee acknowledges that he has learned and will learn Confidential Information (as defined below) relating to the Business. In consideration of the promises made in this Agreement by the Company, Employee agrees that he will not disclose or use or authorize any third party to disclose or use any such Confidential Information, without prior written approval of the Company, if such disclosure or use is reasonably likely to be materially detrimental to the Company or may give a material competitive advantage to a competitor or potential competitor. As used in this Section 7, "Confidential Information" shall mean information disclosed to or known to Employee as a direct or indirect consequence of or through his employment with the Company, about the Business, the Company's methods, business plans, operations, products, processes and services, including, but not limited to, information relating to research, development, inventions, recommendations, programs, systems, and systems analyses, flow charts, finances, and financial statements, marketing plans and 5 strategies, merchandising, pricing strategies, merchandise sources, client sources, system designs, procedure manuals, automated data programs, financing methods, financial projections, terms and conditions of arrangements of any business, computer software, terms and conditions of business arrangements with clients or suppliers, reports, personnel procedures, supply and services resources, names and addresses of clients, the Company's contacts, names of professional advisors, and all other information pertaining to clients and suppliers of the Business, including, but not limited to assets, business interests, personal data and all other information pertaining to the Business, clients or suppliers whatsoever, including all accompanying documentation therefor. All information disclosed to Employee, or to which Employee had access or will have access during the period of his employment with or consulting for the Company, for which there is any reasonable basis to be believed is, or which appears to be treated by the Company as Confidential Information, shall be presumed to be Confidential Information hereunder. Confidential Information shall not, however, include information that (a) is publicly known or becomes publicly known through no fault of Employee, or (b) is generally or readily obtainable by the public, or (c) constitutes general skills, knowledge and experience acquired by Employee during his employment with the Company and this provision shall terminate with respect to a particular portion of the Confidential Information when (i) (a) it enters the public domain through no fault of the Employee, (b) it is in the Employee's possession free of any confidentiality obligation, or (c) it was developed independently of and without reference to any Confidential Information or other information disclosed in confidence to any third party; or (ii) when it is communicated to a third party free of any confidentiality obligation, or (iii) in any event, three years after communication. Employee agrees that all documents of any nature pertaining to activities of the Company or its affiliates, or that include any Confidential Information, in his possession now or at any time during the term of his employment with or consulting for the Company, including without limitation, memoranda, notebooks, notes, data sheets, records and computer programs, are and shall be the property of such entity. All copies of such Confidential Information in Employee's possession shall be surrendered to the appropriate entity within thirty days of the Resignation Date and upon termination of his consulting services to the Company, as applicable. 8. Inventions Developments. Employee represents and warrants that he has notified and will notify the Company of all discoveries, inventions, innovations, or improvements which are related to the Business (collectively called "Developments") conceived or developed by Employee during the term of Employee's employment with or consulting for the Company. Developments shall include, without limitation, the Quest MPS(R) myocardial protection system and related disposables, ANS's electronic spinal cord stimulation devices and any or all other intellectual properties related to the Company's business. All Developments, including but not limited to all written documents pertaining thereto, shall be the exclusive property of the Company, as the case may be, and shall be considered Confidential Information subject to the terms of this Agreement. Employee agrees that within seven days of any request from the Company, he shall execute all requested assignments and conveyances necessary to vest in the Company all discoveries, inventions, innovations, patents, marks, copyrights, patent applications and any other intellectual property of whatever kind and character, any right, title or interest that he may hold in such property. Employee agrees that when appropriate, and upon written request of the Company, as the case may be, the Employee will acknowledge that Developments are "works for hire" and will file at the Company's expense for tradenames, trademarks, patents or copyrights with regard to any or all Developments and will sign documentation reasonably necessary to evidence ownership of Developments in the Company, as the case may be. Employee further agrees to cooperate fully, and at the expense of the Company, with the Company in connection with the filing, prosecution or obtaining of any patent, copyright, or trademark registration or application in any 6 country, existing as of the date of this Agreement. Employee further agrees to cooperate with and assist the Company at the expense of the Company in the prosecution or defense of any litigation involving any intellectual property claimed by the Company, including providing truthful testimony as a witness upon reasonable request. 9. Complete Releases. In consideration of the promises made in this Agreement, Employee RELEASES, ACQUITS, and FOREVER DISCHARGES the Company and each of its past and present parents, subsidiaries, affiliates, shareholders, directors, officers, attorneys, accountants, agents, employees and representatives, from ANY and ALL causes of action, claims, damages, including attorney's fees, Employee may have against the Company which could have arisen out of Employee's employment or separation from employment with the Company or his service as an officer or director of the Company or any other matter related to his association with the Company, whether known or unknown, existing as of the date of this Agreement. Employee hereby irrevocably, unconditionally and fully releases, acquits and forever discharges the Company, and its respective officers, directors, partners, shareholders, employees, attorneys, and agents, past and present, from any and all charges, complaints, claims, liabilities, obligations, costs, losses, debts, and expenses (including attorney's fees and costs actually incurred), of any nature whatsoever (excluding any felonious acts) known or unknown, suspected or unsuspected, including without limitation any rights arising out of alleged violations of any contract, express or implied, written or verbal, any covenant of good faith and fair dealing, express or implied, any tort, any legal restrictions on the right of the Company to terminate, discipline, or otherwise manage employees or any federal, state or other governmental statute, regulation, or ordinance. Notwithstanding the foregoing, nothing herein shall constitute a release of the Company from causes of action, claims or damages, including attorney's fees, that may arise from acts or omissions by the Company after the Resignation Date. These releases and waivers include, but are not limited to, Title VII of the Civil Rights Act of 1954, the Civil Rights Act of 1991, The Age Discrimination in Employment Act, the Employee Retirement Income Security Act of 1974, the Americans with Disabilities Act, the Rehabilitation Act of 1973, the Equal Pay Act, the False Claims Act, the Civil Rights Act of 1966, the Fair Labor Standards Act, the Occupational Safety and Health Act, the Family and Medical Leave Act, the Texas Commission on Human Rights Act, the Texas Payday Law, the Texas Workers' Compensation Act, any causes of action or claims arising under analogous state laws or local ordinances or regulations, any common law principle or public policy, including all suits in tort or contract, or under the Company's personnel policies or any contract of employment that may exist between Employee and the Company. Employee knowingly and voluntarily waives any existing rights he may have pursuant to the Age Discrimination in Employment Act of 1967 and the Older Workers Benefit Protection Act. Further, Employee acknowledges the receipt of good and valuable consideration set forth in this Agreement in exchange for this waiver of potential claims. In consideration of the promises made in this Agreement, the Company RELEASES, ACQUITS, and FOREVER DISCHARGES Employee from ANY and ALL causes of action, claims and damages, including attorney's fees, the Company may have against Employee which could have arisen out of Employee's employment or separation from employment with the Company or his service as an officer or director of the Company or any other matter related to his association with the Company, whether known or unknown. The Company hereby irrevocably, unconditionally and fully releases, acquits and forever discharges Employee from any and all charges, complaints, claims, liabilities, obligations, costs, losses, debts and expenses (including attorney's fees and costs actually incurred), of any nature 7 whatsoever (excluding any felonious acts) known or unknown, suspected or unsuspected, including without limitation any rights arising out of alleged violations of any contract, express or implied, written or verbal, any covenant of good faith and fair dealing, express or implied, or any tort, or any federal, state or other governmental statute, regulation, or ordinance. Notwithstanding the foregoing, nothing herein shall constitute a release of Employee from causes of action, claims, or damages, including attorney's fees, that may arise after the Resignation Date relating to Employee's service as a consultant to the Company pursuant to Section 5. It is expressly agreed and understood by Employee and the Company that this Agreement is a general release. The Company shall indemnify and hold harmless the Employee in respect of acts or omissions as a director, officer, employee or consultant occurring up to and including the Resignation Date to the same extent and with the same limitations as if he was an officer of the Company to the fullest extent permitted by the Texas Business Corporation Act, as amended, and the Company's articles of incorporation and bylaws in effect on the date of this Agreement, and will indemnify and hold harmless the Employee in respect of any claims, liabilities, obligations or expenses in respect of or relating to this Agreement and the transactions contemplated hereby. 10. Promise Not to Sue. Employee represents that Employee has not heretofore filed any charges or complaints against the Company with any federal, state or local governmental agencies. Employee further agrees that Employee will not file any charges or complaints against the Company based on Employee's employment with the Company or the severance therefrom. In consideration of the promises made by the Company in this Agreement, Employee promises and agrees never to voluntarily join in, or commence any action, or proceeding on behalf of himself; or any other person, or entity before any court, administrative agency, or other forum against the Company, pertaining in any way to or arising out of his employment or association with the Company, his resignation or employment, or any other event that occurs on or before the Resignation Date, except as may be necessary to enforce: (a) this Agreement; (b) Employee's rights under state worker's compensation laws (for occupational illness or injury only) or unemployment compensation laws; or (c) Employee's rights under the Company's medical or dental benefit plans. Further, Employee agrees to withdraw with prejudice any previously filed charges or suits arising out of his employment or association with or resignation and termination from the Company. Employee further agrees not to actively or materially encourage or aid any person in contemplating, filing, or prosecuting any action or proceeding against the Company in any way related to matters that occur during the course of Employee's employment or association with the Company prior to the Resignation Date, except to the extent the Employee is required to do so by Court, regulatory agency or similar order. The Company represents that it has not heretofore filed any charges or complaints against Employee with any federal, state or local governmental agencies. The Company further agrees that it will not file any charges or complaints against Employee based on Employee's employment with the Company or the severance therefrom. 8 In consideration of the promises made by Employee in this Agreement, the Company promises and agrees never to voluntarily join in, or commence any action, or proceeding on behalf of itself; or any other person, or entity before any court, administrative agency, or other forum against Employee, pertaining in any way to or arising out of Employee's employment or association with the Company, his resignation or employment, or any other event that occurs on or before the Resignation Date, except as may be necessary to enforce this Agreement. Further, the Company agrees to withdraw with prejudice any previously filed charges or suits arising out of Employee's employment or association with or resignation and termination from the Company. The Company further agrees not to actively or materially encourage or aid any person in contemplating, filing, or prosecuting any action or proceeding against Employee in any way related to matters that occur during the course of Employee's employment or association with the Company prior to the Resignation Date. 11. No Admission. Each of Employee and the Company understands and acknowledges that by entering into this Agreement, neither of Employee or the Company admits to any unlawful conduct or wrongdoing in connection with Employee's employment with the Company or the termination thereof. 12. Remedies for Breach. Notwithstanding Section 1 9(b)-(e) of this Agreement, each of the Company and Employee hereby acknowledges that a violation or attempted violation of any of the covenants contained in Sections 6, 7 and 8 of this Agreement will cause irreparable damage to the other parties, and accordingly each party agrees that the other parties shall be entitled as a matter of right to an injunction, out of any court of competent jurisdiction, restraining any violation or further violation of such agreements by the violating party or any employees, partners or agents of the violating party; such right to an injunction, however, shall be cumulative and in addition to whatever other remedies the injured party may have. 13. Nature of the Agreement. This Agreement and all its provisions are contractual, not mere recitals, and shall continue in permanent force and effect, unless revoked as provided herein. In the event that any portion of this Agreement is found to be unenforceable for any reason whatsoever, the unenforceable provision shall be severed and the remainder of the Agreement shall continue in full force and effect. 14. Reliance. The Company has advised Employee to seek the advice of legal counsel prior to signing this Agreement. The parties hereto acknowledge, warrant and represent that (a) they have relied solely on their own judgment and that of their attorneys and representatives regarding the consideration for, and the terms of this Agreement, (b) they have been given a reasonable period to consider this Agreement, (c) they have read and understand the Agreement, (d) they understand that it includes a general release of claims against each other, and (e) no statements made by the other have in any way coerced or unduly influenced the execution of this Agreement. Employee acknowledges that Hughes & Luce, L.L.P. represents the Company in connection with the negotiation and preparation of this Agreement and that he has been advised by Hughes & Luce and the Company's board of directors to obtain independent legal counsel regarding the legal, tax and other consequences of this Agreement. Employee further acknowledges that Linton E. Barbee, acting in his capacity as a member of the Company's board of directors and not as an attorney, is acting as the Board's intermediary in regard to this Agreement. Employee acknowledges that although Mr. Barbee is an attorney and a member of the 9 law firm of Fulbright & Jaworski, L.L.P., neither Mr. Barbee nor Fulbright & Jaworski are acting as the attorney for any party in this matter. Employee also hereby waives any potential conflict of interest claims against Mr. Barbee and/or Fulbright & Jaworski in connection with this Agreement even though Mr. Barbee and Fulbright & Jaworski have in the past represented Employee, individually, and the Company. The Company acknowledges that Wood, Exall & Bonnet, L.L.P. ("Wood, Exall & Bonnet") (i) has been retained by the Employee in connection with this Agreement and the transactions contemplated hereby, and (ii) that the partners and/or attorneys of Wood, Exall & Bonnet were formerly attorneys with Hughes & Luce, L.L.P. and may have in the past represented the Company. The Company hereby waives any potential conflicts of interest claims against Wood, Exall & Bonnet and the partners and attorneys of Wood, Exall & Bonnet in connection with this Agreement and otherwise, even though the partners and/or attorneys of Wood, Exall & Bonnet may have in the past represented the Company. Furthermore, Employee acknowledges that in accordance with the Age Discrimination in Employment Act and the Older Workers Benefit Protection Act, he has been given the opportunity to review this Agreement for at least twenty-one (21) days and if Employee executes this Agreement prior to the end of such twenty-one (21) day period, Employee knowingly and voluntarily waives any rights he may have with respect thereto. The Company further advises Employee that in accordance with the Age Discrimination in Employment Act and the Older Workers Benefit Protection Act, he has seven (7) days after execution of this Agreement to revoke this Agreement. 15. Attorneys Fees. Each party shall be responsible for his or its own expenses, including attorney's fees incurred in connection with the negotiation, preparation and execution of this Agreement. Provided, however, the Company agrees to reimburse the Employee for his legal and accounting fees incurred in connection with this Agreement up to a maximum amount of Five Thousand Dollars ($5,000.00). 16. Notices. Any notice, demand or request required or permitted to be given or made under this Agreement shall be in writing and shall be deemed given or made when delivered in person, when sent by United States registered or certified mail, or postage prepaid, or when faxed to a party at its address or facsimile number specified below: If to the Company: Quest Medical, Inc. 201 Allentown Parkway Allen, Texas 75002 Facsimile number: (972) 390-9687 Attention: F. Robert Merrill III with a copy to: Hughes & Luce, L.L.P. 1717 Main Street Suite 2800 Dallas, Texas 75201 Facsimile number: (214) 939-6100 Attention: James Hunter Birch If to Employee: Thomas C. Thompson 501 Lakewood Drive McKinney, Texas 75069 Facsimile number: (972) 562-0520 10 with a copy to: Wood, Exall & Bonnet, L.L.P. 12222 Merit Drive, Suite 880 Dallas, Texas 75251 Facsimile number: (972) 991-9261 Attention: David A. Wood The parties to this Agreement may change their addresses for notice in the manner provided above. 17. Counterparts and Photocopies. This Agreement may be executed in counterparts and each executed counterpart shall be as effective as a signed original. Photographic copies of such signed counterparts may be used in lieu of the originals for any purpose. 18. Paragraph Titles Not Binding. The use of section titles in this Agreement is for ease of reference only. Such titles are not to be considered terms of this Agreement. 19. Governing Law: Arbitration. (a) THIS AGREEMENT SHALL BE CONSTRUED IN ACCORDANCE WITH AND GOVERNED BY THE LAWS OF THE STATE OF TEXAS, WITHOUT REGARD TO THE PRINCIPLES OF CONFLICTS OF LAW. (b) The matters, claims, rights, and obligations subject to these arbitration provisions include all rights, claims and obligations arising out of or relating to this Agreement or to the employee's employment and/or its termination, including, without limitation, any and all claims, rights or causes of action which may ever arise or be asserted under any federal, state, local or foreign statutory, regulatory or common law, and including, without limitation, claims of discrimination under Title VII of the Civil Rights of 1964, Age Discrimination in Employment Act, the Americans with Disabilities Act, the Civil Rights Act of 1991 and the Texas Commission on Human Rights Act, wrongful discharge or termination, breach of contract, tort (such as intentional infliction of emotional distress, libel, slander, wrongful invasion of privacy or person injury), workers compensation or unemployment compensation. All of the foregoing types of matters, claims, rights and obligations subject to these arbitration provisions are herein called "Subject Claims." In the event of a dispute relating to any Subject Claim, then, upon notice by any party to the other parties (an "Arbitration Notice") and to American Arbitration Association ("AAA"), 13455 Noel Road, Suite 1750, Two Galleria Plaza, Dallas, Texas 75240 [telephone (972) 702-8222], the controversy or dispute shall be submitted to a sole arbitrator who is independent and impartial, for binding arbitration in Dallas, Texas, in accordance with AAA's National Rules for the Resolution of Employment Disputes (the "Rules") as modified or supplemented hereby. The parties agree that they will faithfully observe this agreement and the Rules and that they will abide by and perform any award rendered by the arbitrator. The arbitration shall be governed by the Federal Arbitration Act, 9 U.S.C. Section 1-16 (or by the same principles enunciated by such Act in the event it may not be technically applicable. The award or judgment of the arbitrator shall be final and binding on all parties and judgment upon the award or judgment of the arbitrator may be entered and enforced by any court having jurisdiction. If any party becomes the subject of a bankruptcy, receivership or other similar proceeding under the laws of the United States of America, any state or commonwealth or any other national or political subdivision thereof; then, to the extent permitted or not prohibited by applicable law, any factual or substantive legal issues arising in or during the pendency of any such 11 proceeding shall be subject to all of the foregoing mandatory mediation and arbitration provisions and shall be resolved in accordance therewith. The agreements contained herein have been given for valuable consideration, are coupled with an interest and are not intended to be executory contracts. The fees and expenses of the arbitrator will be shared equitably (as determined by the arbitrator) by all parties engaged in the dispute or controversy. (c) Promptly after the Arbitration Notice is given, AAA will select five possible arbitrators, to whom AAA will give the identities of the parties and the general nature of the controversy. If any of those arbitrators disqualifies himself or declines to serve, AAA shall continue to designate potential arbitrators until the parties have five to select from. After the panel of five potential arbitrators has been completed, a two-page summary of the background of each of the potential arbitrators will be given to each of the parties, and the parties will have a period of 10 days after receiving the summaries in which to attempt to agree upon the arbitrator to conduct the arbitration. If the parties are unable to agree upon an arbitrator, then one of the parties shall notify AAA and the other party, and AAA will notify each party that it has five days from the AAA notice to strike two names from the list and advise AAA of the two names stricken. After expiration of the strike period, if all but one candidate has been stricken, the remaining one will be the arbitrator, but, if two or more have not been stricken, AAA shall select the arbitrator from one of those not stricken. The decision of AAA with respect to the selection of the arbitrator will be final and binding in such case. (d) Unless and only to the extent mandatory arbitration is validly prohibited or limited by applicable statute or regulation, no litigation or other proceeding may ever be instituted at any time in any court or before any administrative agency or body for the purpose of adjudicating, interpreting or enforcing any of the rights, duties, liabilities or obligations of the parties hereto or any rights, duties, liabilities or obligations relating to any Subject Claim, whether or not covered by the express terms of this Agreement, or for the purpose of adjudicating a breach or determination of the validity of this Agreement, or for the purpose of appealing any decision of an arbitrator, except a proceeding instituted (i) for the purpose of having the award or judgment of an arbitrator entered and enforced or (ii) to seek an injunction or restraining order (but not damages in connection therewith) in circumstances where such relief is available. Unless and only to the extent a limitation of damages is validly prohibited or limited by applicable statute or regulation, no punitive, exemplary or consequential damages may ever be awarded by the arbitrator or anyone else, and each of the parties hereby waives any and all rights to make, claim or recover any such damages. (e) The arbitration and any discovery conducted in connection therewith will be conducted in accordance with the AAA's National Rules for the Resolution of Employment Disputes in effect at the time of the arbitration, including without limitation the expedited procedures set forth therein (the "AAA Rules"). The decision of the arbitrator will be final and binding on all parties and their successors and permitted assignees. The judgment upon the award rendered by the arbitrator may be entered by any court having jurisdiction thereof. The arbitration hearing will commence no later than 60 days after the arbitrator is selected. The arbitrator will render a decision no later than 30 days after the close of the hearing, in accordance with AAA Rules. 20. Death of Employee. In the event Employee should die before all of the payments referred to in Section 4 are paid, the Company shall continue to make such payments to Employee's spouse, or if the Employee's spouse predeceases Employee, to Employee's estate. 12 21. Assignment. The obligations and duties of the parties set forth in this Agreement may not be assigned or delegated; provided, however, that nothing in this Agreement shall preclude the Company from consolidating or merging with, or transferring all or substantially all of its assets to, another corporation, person or entity ("Entity"). Upon such a consolidation, merger or transfer of assets, the term the "Company" shall mean such other Entity or Entities that the Company consolidates or merges into or with, or transfer all or substantially all of the assets of the Company to, and in any such event, the Entity or Entities shall be bound and automatically assume, without any specific action on the part of the Entity or Entities, this Agreement and all obligations and undertakings of the Company set forth in this Agreement, and this Agreement shall continue in full force and effect, including but not limited to the obligation of the Company to make the payments set forth in Section 4. The obligations and duties of Employee hereunder shall be personal and not assignable or delegable by the Employee in any manner whatsoever. Notwithstanding the foregoing, the Company in its sole discretion shall have the right to assign its rights under Sections 6 7 and 8 of this Agreement to any entity or entities (including Atrion Corporation) which may purchase any part or all of the Company's business (whether by asset purchase, stock sale, merger or otherwise). 22. Entire Agreement. This Agreement constitutes the entire and exclusive statement of the agreement between the parties with respect to its subject matter and there are no oral or written representations, understandings or agreements relating to this Agreement which are not fully expressed herein. The parties agree that any other terms or conditions included in written or verbal exchanges or representations made by the parties shall not be incorporated herein or be binding unless expressly agreed upon in writing by authorized representatives of the parties subsequent to the date hereof. 23. Authorization. The Company represents and warrants to Employee that the persons executing this Agreement on behalf of the Company are duly authorized to act for and on behalf of the Company to execute and deliver this Agreement and that this Agreement is a valid, binding and enforceable agreement of the Company. PLEASE READ THIS AGREEMENT CAREFULLY. IT CONTAINS A RELEASE OF ALL KNOWN AND UNKNOWN CLAIMS. THE UNDERSIGNED ACKNOWLEDGE THAT WE HAVE CAREFULLY READ THE FOREGOING AGREEMENT, THAT WE UNDERSTAND ALL OF ITS TERMS, AND THAT WE ARE ENTERING INTO IT VOLUNTARILY. Executed at Dallas, Texas by Employee, acting in his individual capacity, and by an authorized representative of the Company as of the date first stated above. QUEST MEDICAL, INC. By: /s/ F. Robert Merrill III ------------------------------------ Name: F. Robert Merrill III ---------------------------------- Title: Senior Vice President/CFO -------------------------------- /s/ Thomas C. Thompson ---------------------------------------- Thomas C. Thompson EX-11.1 3 STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS 1 EXHIBIT 11.1 QUEST MEDICAL, INC. COMPUTATION OF EARNINGS PER SHARE YEARS ENDED DECEMBER 31
1997 1996 1995 ---- ---- ---- Basic earnings (loss) per share: Weighted average common shares outstanding 8,428,393 8,259,129 6,267,210 ------------ ------------ ------------ Net earnings (loss) from continuing operations $ 817,511 $ 114,514 $ (8,906,332) Loss from discontinued operations (93,490) (526,671) (1,198,666) Extraordinary item--loss on early extinguishment of debt -- -- (269,045) ------------ ------------ ------------ Net earnings (loss) $ 724,021 $ (412,157) $(10,374,043) ------------ ------------ ------------ Net earnings (loss) from continuing operations per share $ 0.10 $ 0.01 $ (1.42) Loss from discontinued operations per share (0.01) (0.06) (0.19) Extraordinary item per share -- -- (0.05) ------------ ------------ ------------ Net earnings (loss) per share $ 0.09 $ (0.05) $ (1.66) ------------ ------------ ------------ Diluted earnings (loss) per share: Weighted average common shares outstanding 8,428,393 8,259,129 6,267,210 Stock options and warrants--based on the treasury stock method using average market price 429,693 550,454 -- ------------ ------------ ------------ Diluted common and common equivalent shares outstanding 8,858,086 8,809,583 6,267,210 ------------ ------------ ------------ Net earnings (loss) from continuing operations $ 817,511 $ 114,514 $ (8,906,332) Loss from discontinued operations (93,490) (526,671) (1,198,666) Extraordinary item--loss on early extinguishment of debt -- -- (269,045) ------------ ------------ ------------ Net earnings (loss) $ 724,021 $ (412,157) $(10,374,043) ------------ ------------ ------------ Net earnings (loss) from continuing operations per share $ 0.09 $ 0.01 $ (1.42) Loss from discontinued operations per share (0.01) (0.06) (0.19) Extraordinary item per share -- -- (0.05) ------------ ------------ ------------ Net earnings (loss) per share $ 0.08 $ (0.05) $ (1.66) ------------ ------------ ------------
EX-21.1 4 SUBSIDIARIES OF THE REGISTRANT 1 EXHIBIT 21.1 SUBSIDIARIES Advanced Neuromodulation Systems, Inc. Texas EX-23.1 5 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS 1 EXHIBIT 23.1 Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statements (Form S-8 - Nos. 2-82414, 2-91410, 33-235312, and 33-00967, and Form S-3 - No. 33-40927) pertaining to the Quest Medical, Inc. 1979 Amended and Restated Employees' Stock Option Plan; the Quest Medical, Inc. Directors' Stock Option Plan; the Quest Medical, Inc. 1987 Employees' Stock Option Plan; the Quest Medical, Inc. 1995 Stock Option Plan; the Quest Medical, Inc. Sales and Marketing Employees Stock Option Plan; the Heaton Stock Option Plan; the registration of 100,000 shares of Common Stock issued pursuant to a Common Stock Purchase Warrant between Quest Medical, Inc. and Robert L. Swisher, Jr. and the related Prospectuses of our report dated February 25, 1998, with respect to the consolidated financial statements of Quest Medical, Inc. and Subsidiaries, included in the Annual Report (Form 10-K) for the year ended December 31, 1997. /s/ Ernst & Young LLP ----------------------------------- Ernst & Young LLP Dallas, Texas March 27, 1998 EX-27.1 6 FINANCIAL DATA SCHEDULE
5 YEAR DEC-31-1997 JAN-01-1997 DEC-01-1997 747,828 1,455,864 2,610,702 212,375 2,978,487 23,386,327 8,728,477 1,317,362 48,982,320 9,258,776 0 0 0 431,775 33,474,162 48,982,320 14,717,721 14,717,721 4,839,261 7,792,152 535,783 0 625,321 1,550,525 733,014 817,511 (93,490) 0 0 724,021 .09 .08
EX-27.2 7 FINANCIAL DATA SCHEDULE
5 YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 696,196 1,336,089 2,578,714 160,000 3,010,197 14,749,305 8,195,295 889,841 47,187,933 3,661,783 0 0 0 416,926 30,576,557 47,187,933 11,403,144 11,403,144 3,315,255 7,572,584 80,949 0 418,246 434,356 319,842 114,514 (526,671) 0 0 (412,157) (.05) (.05)
EX-27.3 8 FINANCIAL DATA SCHEDULE
5 YEAR DEC-31-1995 JAN-01-1995 DEC-31-1995 1,325,630 2,588,547 3,183,364 100,000 1,625,048 15,612,168 7,805,045 577,596 43,419,858 3,428,931 0 0 0 407,367 30,462,683 43,419,858 10,434,384 10,434,384 2,752,108 15,103,158 573,970 0 1,063,367 (7,994,852) 911,480 (8,906,332) (1,198,666) (269,045) 0 (10,374,043) (1.66) (1.66)
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