-----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, QVC2yb8nGE6IEQt6Ck3ugHazp7qDyMZch8rDSf6v6MQ3lus1jRkWI/jpAaKs7N2/ jV7nx+3Wq5HXOZ8/p8Ee5g== 0000950129-02-001131.txt : 20020415 0000950129-02-001131.hdr.sgml : 20020415 ACCESSION NUMBER: 0000950129-02-001131 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20020125 FILED AS OF DATE: 20020308 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CYBERONICS INC CENTRAL INDEX KEY: 0000864683 STANDARD INDUSTRIAL CLASSIFICATION: ELECTROMEDICAL & ELECTROTHERAPEUTIC APPARATUS [3845] IRS NUMBER: 760236465 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-19806 FILM NUMBER: 02569907 BUSINESS ADDRESS: STREET 1: 16511 SPACE CENTER BLVD STREET 2: SUITE 600 CITY: HOUSTON STATE: TX ZIP: 77058 BUSINESS PHONE: 7133321375 MAIL ADDRESS: STREET 1: 16511 SPACE CENTER BLVD STREET 2: SUITE 600 CITY: HOUSTON STATE: TX ZIP: 77058 10-Q 1 h94648e10-q.txt CYBERONICS, INC. - JANUARY 25, 2002 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended January 25, 2002 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 0-19806 CYBERONICS, INC. (Exact name of registrant as specified in its charter) Delaware 76-0236465 - ---------------------------------------------- ---------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 16511 Space Center Boulevard, Cyberonics Bldg. Houston, Texas 77058 - ---------------------------------------------- ---------------------- (address of principal executive offices) (zip code) Registrant's telephone number, including area code: (281) 228-7200 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
CLASS OUTSTANDING AT FEBRUARY 28, 2002 Common Stock - $0.01 par value 21,721,295
CYBERONICS, INC. INDEX
PAGE NO. -------- PART I. FINANCIAL INFORMATION Item 1 Financial Statements: Consolidated Balance Sheets January 25, 2002 (Unaudited) and April 27, 2001............. 3 Consolidated Statements of Operations and Comprehensive Income (Loss) (Unaudited) Three months and nine months ended January 25, 2002 and January 31, 2001............................................ 4 Consolidated Statements of Cash Flows (Unaudited) Nine months ended January 25, 2002 and January 31, 2001..... 5 Notes to Consolidated Financial Statements (Unaudited).......... 6 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations............................. 8 Item 3 Quantitative and Qualitative Disclosures About Market Risk............... 16 PART II. OTHER INFORMATION Item 6 Exhibits and Reports on Form 8-K......................................... 16
2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CYBERONICS, INC. CONSOLIDATED BALANCE SHEETS
JANUARY 25, APRIL 27, 2002 2001 ------------- ------------- (UNAUDITED) ASSETS Current Assets: Cash and cash equivalents ........................................ $ 43,329,286 $ 55,459,183 Securities held to maturity ...................................... 57,543 1,678,649 Accounts receivable, net ......................................... 9,953,585 6,641,249 Inventories ...................................................... 3,659,247 4,246,560 Other current assets ............................................. 1,799,381 1,376,874 ------------- ------------- Total Current Assets ........................................ 58,799,042 69,402,515 Securities held to maturity .......................................... 42,383 113,075 Property and equipment, net .......................................... 8,952,050 8,650,350 Other assets, net .................................................... 196,509 148,984 ------------- ------------- $ 67,989,984 $ 78,314,924 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable ................................................. $ 5,927,311 $ 4,868,288 Line of credit ................................................... 6,000,000 -- Accrued liabilities .............................................. 12,771,418 13,286,661 Current portion of long-term debt ................................ 121,757 115,927 ------------- ------------- Total Current Liabilities ................................... 24,820,486 18,270,876 Long-term debt ....................................................... 303,785 396,964 ------------- ------------- Total Liabilities ........................................... 25,124,271 18,667,840 Commitments and Contingencies Stockholders' Equity: Preferred stock, $.01 par value per share; 2,500,000 shares authorized; no shares issued and outstanding ................. -- -- Common stock, $.01 par value per share; 50,000,000 shares authorized; 21,714,822 and 21,474,022 shares issued and outstanding at January 25, 2002 and April 27, 2001, respectively ................................................. 217,148 214,740 Additional paid-in capital ....................................... 167,336,094 165,170,408 Deferred compensation ............................................ (1,614,375) (1,989,850) Accumulated other comprehensive income (loss) .................... (201,183) (117,971) Accumulated deficit .............................................. (122,871,971) (103,630,243) ------------- ------------- Total Stockholders' Equity .................................. 42,865,713 59,647,084 ------------- ------------- $ 67,989,984 $ 78,314,924 ============= =============
See accompanying Notes to Consolidated Financial Statements (Unaudited). 3 CYBERONICS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
FOR THE THREE MONTHS FOR THE NINE MONTHS ENDED ENDED ------------------------------- ------------------------------- JANUARY 25, JANUARY 31, JANUARY 25, JANUARY 31, 2002 2001 2002 2001 ------------ ------------ ------------ ------------ Net sales ........................................ $ 18,388,711 $ 13,730,074 $ 49,885,879 $ 41,269,073 Cost of sales .................................... 3,676,177 3,306,192 10,236,903 10,205,211 ------------ ------------ ------------ ------------ Gross Profit ................................ 14,712,534 10,423,882 39,648,976 31,063,862 Operating expenses: Selling, general and administrative ........... 14,289,366 9,979,889 41,388,921 28,782,711 Research & development ........................ 6,272,374 4,627,755 18,434,969 13,224,172 Non-recurring charges ......................... -- -- -- 6,467,415 ------------ ------------ ------------ ------------ Total Operating Expenses .................... 20,561,740 14,607,644 59,823,890 48,474,298 ------------ ------------ ------------ ------------ Loss From Operations ...................... (5,849,206) (4,183,762) (20,174,914) (17,410,436) Interest income .................................. 207,057 181,983 1,085,381 939,078 Interest expense ................................. 95,095 34,470 165,419 50,920 Other income (expense), net ...................... (37,987) 347,875 13,224 113,113 ------------ ------------ ------------ ------------ Net loss ......................................... $ (5,775,231) $ (3,688,374) $(19,241,728) $(16,409,165) ------------ ------------ ------------ ------------ Basic and diluted net loss per share ............. $ (0.27) $ (0.20) $ (0.89) $ (0.88) ------------ ------------ ------------ ------------ Shares used in computing basic and diluted net loss per share ............................. 21,676,808 18,818,292 21,628,759 18,712,737 ------------ ------------ ------------ ------------ Comprehensive loss: Net loss ....................................... $ (5,775,231) $ (3,688,374) $(19,241,728) $(16,409,165) Foreign currency translation adjustment ........ (7,661) 64,587 (83,212) 133,431 ------------ ------------ ------------ ------------ Comprehensive loss ............................. $ (5,782,892) $ (3,623,787) $(19,324,940) $(16,275,734) ============ ============ ============ ============
See accompanying Notes to Consolidated Financial Statements (Unaudited). 4 CYBERONICS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE NINE MONTHS ENDED ------------------------------- JANUARY 25, JANUARY 31, 2002 2001 ------------ ------------ CASH FLOW FROM OPERATING ACTIVITIES: Net loss ........................................... $(19,241,728) $(16,409,165) Non-cash items included in net loss: Depreciation ..................................... 2,758,415 1,111,487 Loss on disposal of assets ....................... 72,805 -- Amortization of deferred compensation and expense related to stock options ................ 375,475 -- Changes in operating assets and liabilities: Accounts receivable, net .......................... (3,312,336) 1,305,051 Inventories ....................................... 587,313 2,322,579 Other current assets .............................. (422,507) (440,784) Other assets, net ................................. (47,525) 16,333 Accounts payable and accrued liabilities .......... 543,780 8,249,122 ------------ ------------ Net cash used in operating activities .......... (18,686,308) (3,845,377) CASH FLOW FROM INVESTING ACTIVITIES: Purchases of property and equipment ............... (3,132,920) (3,023,117) Purchases of marketable securities ................ -- 10,209,794 Maturities of marketable securities ............... 1,691,798 (9,520,487) ------------ ------------ Net cash used in investing activities .......... (1,441,122) (2,333,810) CASH FLOW FROM FINANCING ACTIVITIES: Proceeds from line of credit ....................... 6,000,000 -- Proceeds from issuance of common stock ............. 2,168,094 3,631,820 Payments on long-term debt ......................... (87,349) (106,252) ------------ ------------ Net cash provided by financing activities ...... 8,080,745 3,525,568 Effect of exchange rate changes on cash and cash equivalents ........................................ (83,212) (133,431) ------------ ------------ Net decrease in cash and cash equivalents ...... (12,129,897) (2,787,050) Cash and cash equivalents at beginning of period ..... 55,459,183 16,484,945 ------------ ------------ Cash and cash equivalents at end of period ........... $ 43,329,286 $ 13,697,895 ============ ============ Supplemental Disclosure of Cash Flow Information: Cash paid for interest ......................... $ 136,952 $ 25,617 Non-cash purchase of assets under capital leases ........................................ $ -- $ 646,959
See accompanying Notes to Consolidated Financial Statements (Unaudited). 5 CYBERONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JANUARY 25, 2002 NOTE 1 -- BASIS OF PRESENTATION: The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information, and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended January 25, 2002 are not necessarily indicative of the results that may be expected for the full year ending April 26, 2002. The financial information presented herein should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the period ended April 27, 2001. NOTE 2 -- INVESTMENT SECURITIES: At January 25, 2002 and April 27, 2001, our entire investment portfolio consisted of cash equivalents and securities held to maturity that are reported at amortized cost. Cash equivalents and securities held to maturity are primarily commercial paper, corporate bonds and United States (US) treasury obligations with various maturity dates and have a fair market value of approximately $31,032,000 and a gross unrealized holding gain of approximately $4,200 at January 25, 2002. NOTE 3 -- INVENTORIES: Inventories consist of the following:
JANUARY 25, 2002 APRIL 27, 2001 ---------------- -------------- (UNAUDITED) Raw materials and components.. $ 1,530,795 $ 1,338,885 Work-in-process............... 1,123,629 1,257,784 Finished goods................ 1,004,823 1,649,891 ----------- ----------- $ 3,659,247 $ 4,246,560 =========== ===========
NOTE 4 -- OTHER CURRENT ASSETS: Other current assets consist of the following:
JANUARY 25, 2002 APRIL 27, 2001 ---------------- -------------- (UNAUDITED) Prepaid expenses.............. $1,794,992 $1,303,049 Interest receivable........... 4,389 73,825 ---------- ---------- $1,799,381 $1,376,874 ========== ==========
NOTE 5 -- ACCRUED LIABILITIES: Accrued liabilities are as follows:
JANUARY 25, 2002 APRIL 27, 2001 ---------------- -------------- (UNAUDITED) Clinical costs ....................... $ 6,837,238 $ 5,133,692 Payroll and other compensation ....... 2,688,768 2,354,101 Royalties ............................ 728,239 661,340 Business insurance ................... 530,036 141,128 Warranties ........................... 417,839 423,000 Professional services ................ 231,491 456,275 Financial advisor fees ............... -- 3,785,995 Other ................................ 1,337,807 331,130 ----------- ----------- $12,771,418 $13,286,661 =========== ===========
6 NOTE 6 - LINE OF CREDIT: In September 2001, the Company established a revolving credit facility for $10,000,000 which is collateralized by accounts receivable, inventory, equipment, documents of title, general intangibles, subsidiary stock and other collateral. Borrowings against the facility are based upon eligible accounts receivable. Interest is payable in the amount of the designated bank rate of 4.75% at January 25, 2002, plus 1.5% on the greater of $3,000,000 or the average of the net balances owed by the Company at the close of each day during the month. Under the terms of the revolving credit facility the Company agreed to maintain liquidity (being the aggregate of the availability under the credit facility and Company cash) equal to or greater than $5,000,000. An unused line of credit fee is payable at the rate of 0.5%. The term of the credit facility is three years, expiring on September 26, 2004. As of January 25, 2002, the Company had $6,000,000 in borrowings outstanding under the credit facility and an available borrowing capacity of approximately $456,000. NOTE 7 - CONTINGENCIES In January 2002, the Company entered into severance agreements with certain key employees. These agreements were entered into with approximately 62 management and key employees and obligate the Company, upon change of control and constructive termination of such employee, to pay an amount equal to salary and bonus for one year, together with any earned but unpaid compensation. NOTE 8 -- STOCKHOLDERS' EQUITY: Common Stock. In February 2001, the Company issued 2,518,000 shares of its common stock in a private offering for $18.00 per share. Proceeds from the issuance totaled approximately $42.5 million after deducting commissions and offering costs. Deferred Compensation. In June 2000, the Board of Directors granted 450,000 options at $18.00 per share to purchase shares of common stock under a proposed modification to the 1997 Stock Option plan that was subject to shareholder approval. On December 29, 2000, the shareholders approved the modification to the plan, and the Company recorded approximately $2.4 million in deferred compensation relating to these options. The charge reflects the difference between the exercise price and the fair market value of the stock on the date shareholder approval was received. The deferred compensation is being amortized to expense over the five year vesting period of the options. At January 25, 2002, approximately $748,000 of compensation expense has been recognized for the vested portion of the option grant. Stock Incentive and Purchase Plans. For the nine months ended January 25, 2002, the Company has reserved an additional 1,000,000 shares for issuance pursuant to its Stock Option Plans with an aggregate reserve of 10,150,000 shares as of January 25, 2002. For the nine months ended January 25, 2002, the Company has granted approximately 2,500,000 options at a weighted average exercise price of approximately $14.70, which were issued at market rate at the date of grant. Stock options to purchase approximately 6.9 million shares at a weighted average exercise price of $13.60 per share were outstanding as of January 25, 2002. NOTE 9 -- EARNINGS PER SHARE: SFAS No.128, "Earnings Per Share" requires dual presentation of earnings per share (EPS); basic EPS and diluted EPS. Basic EPS excludes dilution and is computed by dividing net income or loss applicable to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if options or other contracts to issue common stock were exercised or converted into common stock and would then share in net income or loss of the Company. For the purpose of computing diluted net loss per share for the three and nine months ended January 25, 2002, no exercise of options was assumed since the result would have been antidilutive. Options to purchase approximately 6.9 million shares of common stock at a weighted average exercise price of $13.60 per share were outstanding as of January 25, 2002 but were not included in the computation of diluted net loss per share. NOTE 10 -- NEW ACCOUNTING PRONOUNCEMENT: In August 2001, the Financial Accounting Standard Board (FASB) issued, SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. Under this Statement, the FASB established a single accounting model for valuation of long-lived assets. The provisions of SFAS No. 144 are required to be applied to the Company for the 2003 fiscal year and, as such, the Company will adopt the 7 statement on April 27, 2002. The Company believes that the adoption of SFAS No. 144 will not have a material impact on the Company's operating results or financial condition. NOTE 11 -- SEGMENT INFORMATION: The Company operates its business in three Indication Business Units (IBU's) which are aggregated into one reportable segment, that of designing, developing, manufacturing and marketing the NCP System using VNS for the treatment of epilepsy and other debilitating neurological, psychiatric diseases and other disorders. Each of the IBU's has similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, a similar regulatory environment and shared infrastructures. The following table presents certain financial information about the Company's Indication Business Units. For the nine months ended January 31, 2001, the Depression Business Unit and the Other Indications Business Unit expenses consisted primarily of pre-clinical, clinical and payroll expense. For the nine months ended January 25, 2002, the Depression Business Unit and the Other Indications Business Unit expenses consisted of pre-clinical, clinical, payroll and other costs allocated to each business unit based upon estimated resource utilization. Selling and other income/expense have been reported entirely in the Epilepsy Business Unit.
OTHER EPILEPSY DEPRESSION INDICATIONS BUSINESS UNIT BUSINESS UNIT BUSINESS UNIT TOTAL ------------- ------------- ------------- ------------ For the nine months ended January 25, 2002 External net sales ............... $ 49,885,879 $ -- $ -- $ 49,885,879 Net income (loss) ................ $ 9,336,927 $(23,829,619) $ (4,749,036) $(19,241,728) For the nine months ended January 31, 2001 External net sales ............... $ 41,269,073 $ -- $ -- $ 41,269,073 Net loss ......................... $ (6,815,503) $ (8,252,997) $ (1,340,665) $(16,409,165)
The net loss reported in the Depression and Other Indications Business Units increased significantly from January 31, 2001 to January 25, 2002 due to the expanded clinical study costs associated with the development of depression, anxiety, Alzheimer's Disease, obesity and other disorders using VNS Therapy and the additional allocation of overhead expenses associated with these activities. The Epilepsy Business Unit net income increased from January 31, 2001 to January 25, 2002 due to the significant increase in sales, the improvement in gross profit margin, the reduction of sales and marketing expenses as a percentage of sales and the reduced allocation of overhead expenses associated with these activities. The allocation of overhead expenses is based upon estimates of valuation and utilization by indication business units. Changes in the business valuation or estimated utilization of shared overhead resources would significantly impact the results of each indication business unit. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of important factors. For a discussion of important factors that could affect our results, please refer to the financial statement line item discussions set forth in Management's Discussion and Analysis of Financial Condition and Results of Operations and to the section entitled "Factors Affecting Future Operating Results." Readers are also encouraged to refer to our Annual Report on Form 10-K for the period ended April 27, 2001 for a further discussion of our business and its risks and opportunities. SUMMARY Cyberonics, Inc. designs, develops, manufactures and markets medical devices which provide a unique therapy, vagus nerve stimulation, for the treatment of epilepsy and other debilitating neurological, psychiatric diseases and other disorders. We operate our business in three business units. The three separate business units include the Epilepsy Business Unit, the Depression Business Unit and the Other Indications Business Unit. All three of these units are reported for accounting purposes as one segment and involve designing, developing, manufacturing and marketing our proprietary NCP System using Vagus Nerve Stimulation (VNS(TM)) for the treatment of epilepsy and other debilitating neurological, psychiatric diseases and other disorders. The identification and separation of 8 the Indication Business Units reflects the different phases of clinical development and product life cycle of our proprietary NCP System. However, each Indication Business Unit has similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, a similar regulatory environment and shared infrastructures. The Epilepsy Business Unit designs, develops, manufactures and markets the NCP System for the treatment of epilepsy. The NCP System was approved by the United States Food and Drug Administration, also referred to as FDA, on July 16, 1997 as an adjunctive therapy for reducing the frequency of seizures in patients over 12 years of age with partial onset seizures that are refractory or resistant to antiepileptic drugs. The NCP System has also received regulatory approval for sale in Canada, Europe, Australia and certain countries in the Far East with the broader indication of refractory epilepsy and without discrimination to patient age or seizure type. The Depression Business Unit is conducting clinical studies of the NCP System for the treatment of depression in patients with unipolar and bipolar depressive disorder. FDA has granted expedited review status for a future premarket approval application (PMA) for our NCP System for these patients. We are conducting a pivotal clinical study (D-02) of vagus nerve stimulation for the treatment of depression which includes 21 institutions and 235 implanted patients. The last patient exited the acute phase of the study in October 2001. In January 2002, the analyses of the acute results of the study were completed and the acute study results were unblinded. The acute results reported a response rate of 15% in the treatment group and 10% in the placebo group. These response rates do not represent a statistically significant difference between the treatment and placebo groups. Acute safety, tolerability and placebo response objectives were achieved as the study reported few treatment-related significant adverse events, 111 out of 114 (97%) treatment group patients completed the study and the study confirmed a 10% placebo group response rate for this previously unstudied, chronic, recurrent treatment-resistant patient population. We are currently reviewing the study data and are developing a revised depression clinical development and regulatory plan to obtain U.S. regulatory approval for the NCP System for the treatment of patients with chronic, treatment-resistant depression. We expect to finalize the revised depression clinical development and regulatory plan by May 2002. As a result of this review, we may adjust the magnitude or timing of research and development efforts for our depression business unit. In March 2001, the NCP System was approved by N.V. KEMA, an official notified body representing the European Union Countries, for the treatment of chronic or recurrent depression in patients that are in a treatment-resistant or treatment-intolerant depressive episode. This CE Mark approval, by definition, includes the treatment of depression in patients with depressive disorder, or so-called unipolar depression, as well as patients with bipolar disorder, or manic depression. In April 2001, the NCP System was approved by Health Canada for the treatment of chronic or recurrent depression in patients that are in a treatment-resistant or treatment-intolerant depressive episode. The Canadian approval is similar to CE Mark European approval in that depressed patients with unipolar depression and bipolar depression are included. The Other Indications Business Unit is engaged in expanding the range of treatable disorders for VNS in new indications as warranted by our extensive patent portfolio, expected or observed clinical outcomes from ongoing and future pre-clinical and clinical research studies and anecdotal reports of patient experience and market dynamics. The Other Indications Business Unit conducts all clinical research on indications that are in the pre-clinical and/or pilot study phases of research and have not progressed to a pivotal study. We currently have studies underway for the treatment of Alzheimer's Disease, anxiety disorders, chronic migraine headache and obesity. Due to the additional financial resources which may be required to complete the clinical development of the depression program, additional enrollments in these areas have been suspended pending the finalization of the depression clinical development and regulatory plan. We plan to continue study protocol activities with patients who are currently enrolled and implanted. We expect to finalize the revised depression and other new indications clinical development program by May 2002. For the period from inception through January 25, 2002, we incurred a cumulative net deficit of approximately $122.9 million. We have incurred substantial expenses, primarily for research and development activities that include product and process development and clinical trials and related regulatory activities, sales and marketing activities, system infrastructure development and manufacturing start-up. We expect to devote considerable financial resources for clinical studies in the development of depression and new indications for the NCP System. The clinical studies for depression and other indications are for investigational therapies that are not expected to generate significant sales prior to FDA approval, which is not anticipated before calendar 2006, if at all. As a result, we will continue to experience substantial operating losses at levels that may exceed the levels experienced in recent periods. Furthermore, the timing and nature of these expenditures are contingent upon several factors including some outside of our control and may exceed the current expectations of securities analysts and investors. We do not expect to be profitable before fiscal 2004, if at all. 9 CRITICAL ACCOUNTING POLICIES The Company's future success is dependent upon a number of factors which include, among others, achieving market acceptance and generating sufficient sales volume, obtaining and maintaining regulatory and reimbursement approvals for its products, the possibility of competition and technological changes, developing its sales, marketing and corporate infrastructures, maintaining an uninterrupted supply of certain sole source components and materials, adding sufficient manufacturing capacity to meet future possible product demand, possible product liability or recall, and reliance on key personnel. Use of Estimates. The preparation of the financial statements in conformity with accounting principles generally accepted in the United States 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 and Marketable Securities. The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. At January 25, 2002 and January 31, 2001, the Company's investment portfolios consisted of securities held to maturity that are reported at amortized cost. Securities held to maturity are primarily corporate bonds, commercial paper and United States (US) treasury obligations with various maturity dates and have a fair market value of approximately $31,032,000 and $4,551,000 as of January 25, 2002 and January 31, 2001, respectively. Accounts Receivable. The Company's allowance for doubtful accounts totaled $206,000 and $196,000 at January 25, 2002 and January 31, 2001, respectively. The Company provides allowance for doubtful accounts based upon specific customer risks and a general provision based upon historical trends. An increase in losses beyond that expected by management or that historically experienced by the Company would reduce earnings when they become known. Inventories. Cyberonics states its inventories at the lower of cost, first-in, first-out (FIFO) method, or market. Cost includes the acquisition cost of raw materials and components, direct labor and overhead. Management considers potential obsolescence at each balance sheet date. An acceleration of obsolescence could occur if consumer demand should differ from expectations. Property and Equipment. Property and equipment are carried at cost, less accumulated depreciation. Maintenance, repairs and minor replacements are charged to expense as incurred; significant renewals and betterments are capitalized. Effective July 1, 1999 for financial reporting purposes, the Company computes depreciation using the straight-line method over useful lives ranging from three to nine years. An unanticipated change in the utilization or expected life of property or equipment would result in an acceleration in the timing of expenses. Revenue Recognition. Revenue from product sales is generally recognized upon shipment to the customer, net of estimated returns and allowances. The Company's revenues are dependent upon sales to new and existing customers pursuant to the Company's policy. A change in this policy or sales terms could impact the amount and timing of revenue recognized. Research and Development. All research and development costs are expensed as incurred. The Company has entered into contractual obligations for the conduct of clinical studies. Costs are accrued primarily at the time of enrollment and paid under the terms of the contracts. Research and development expenses could vary significantly with changes in the timing of clinical activity. Warranty Expense. The Company provides at the time of shipment for costs estimated to be incurred under its product warranties. Provisions for warranty expenses are made based upon projected product warranties. Amounts actually paid could vary subject to certain factors as discussed in "Factors Affecting Future Operating Results" discussed below. RESULTS OF OPERATIONS Net Sales. Net sales for the three months ended January 25, 2002 were $18,389,000 reflecting an increase of $4,659,000 or 33.9% over $13,730,000 for the same period last year. Third quarter net sales included $16,781,000 from the U.S. market and $1,608,000 from international markets. U.S. net sales for the third quarter increased by $4,859,000, or 40.8% over the $11,922,000 for the same period last year. International net sales decreased by $200,000 or 11.0% below the $1,808,000 for the same period last year. Net sales for the nine months ended January 25, 2002 were $49,886,000 reflecting an increase of $8,617,000 or 20.9% over the $41,269,000 during the same period last year. Net sales for the nine months ended January 25, 2002 included $45,211,000 from the U.S. market and $4,675,000 from international markets. U.S. net sales for the nine months ended January 25, 2002 increased by $8,734,000 or 23.9% over the $36,477,000 over the same period last year. International net sales for the nine months ended January 25, 2002 decreased by $117,000 or 2.4% below the $4,792,000 for the same period during the previous year. The increase in net sales in the U.S. for the three and nine months ended January 25, 2002 is primarily due to higher volume driven by consumer demand, and price 10 increases driven by new product introductions. The decrease in international net sales for the three and nine months ended January 25, 2002 is primarily due to lower volumes primarily in the higher priced direct markets and a weaker Euro as compared to the U.S. Dollar. We expect to achieve 20% annual sales growth in the United States for the remainder of fiscal 2002 and 2003. We anticipate little to no growth in international markets due to the current economic conditions and the Company's limited investment in these markets. Gross Profit. Gross profit for the three months ended January 25, 2002 was $14,713,000 or 80.0% of net sales compared to $10,424,000 or 75.9% for the same period last year. Gross profit for the nine months ended January 25, 2002 was $39,649,000 or 79.5% of net sales compared to gross profit of $31,064,000 or 75.3% for the same period last year. The increase in gross profit margin for the three and nine months ended January 25, 2002 is due to a higher volume in sales, higher average selling price, product mix, and improvements in manufacturing efficiencies. We anticipate maintaining a gross profit margin of 80% for the remainder of fiscal year 2002 and fiscal year 2003, assuming we achieve our sales and production objectives. Selling, General and Administrative Expenses. Selling, general and administrative expenses for the three months ended January 25, 2002 totaled $14,289,000 or 77.7% of net sales compared to $9,980,000 or 72.7% of net sales for the same period last year. Selling, general and administrative expenses for the nine months ended January 25, 2002 were $41,389,000 or 83.0% of net sales compared to $28,783,000 or 69.7% of net sales for the same period last year. The increase in sales, general and administrative expenses for the three and nine months ended January 25, 2002 is primarily due to additional pre-launch marketing program costs in the Depression Business Unit, and additional expenses incurred by the Epilepsy sales force associated with the expansion of the sales force from approximately 70 people at April 27, 2001 to approximately 110 people at January 25, 2002. We have incurred certain direct administrative expenses in each Indication Business Unit, and we have allocated certain administrative expenses to the Indication Business Units based upon estimated resource utilization. Selling, general and administrative expenses for the three months ended January 25, 2002 in the Epilepsy Business Unit, the Depression Business Unit, and the Other Indications Business Unit were $9,558,000, $4,182,000 and $549,000 respectively as compared to $9,152,000, $578,000 and $250,000 respectively for the same period last year. Selling, general and administrative expenses for the nine months ended January 25, 2002 in the Epilepsy, Depression and Other Indications Business Units were $26,398,000, $13,232,000 and $1,759,000 respectively, as compared to $27,109,000, $1,292,000 and $382,000 respectively for the same period last year. Increases in allocated administrative expenses in the Depression and Other Indications Business Units are directly related to increased activities associated with the expanded clinical studies. Research and Development Expenses. Research and development expenses are comprised of both expenses related to our product and process development efforts and expenses associated with conducting clinical trials and certain regulatory activities. Research and development expenses for the quarter ended January 25, 2002 totaled $6,272,000 or 34.1% of net sales, compared to $4,628,000 or 33.7% of net sales for the same period last year. For the nine months ended January 25, 2002 research and development expenses were $18,435,000 or 37.0% of net sales compared to $13,224,000 or 32.0% of net sales for the same period last year. The increase in research and development expenses is primarily due to the result of expanded clinical programs in support of the NCP System to develop new indications, including depression, Alzheimer's Disease, anxiety, obesity and other indications covered by our proprietary patent portfolio. For the quarter ended January 25, 2002 the Epilepsy Business Unit research and development expenses were $1,470,000 or 8% of net sales compared to $1,842,000 or 13.4% of net sales for the same period last year. For the nine months ended January 25, 2002 the Epilepsy Business Unit research and development expenses were $4,847,000 or 9.7% of net sales compared to $5,304,000 or 12.9% of net sales for the same period last year. The decrease in research and development expenses for the quarter and the nine months ended January 25, 2002 as compared to last year is due to reduced engineering and regulatory resource utilization in Epilepsy. For the quarter ended January 25, 2002 the Depression Business Unit research and development expenses were $3,531,000 compared to $2,489,000 for the same period last year. For the nine months ended January 25, 2002 the Depression Business Unit research and development expenses were $10,598,000 compared to $6,961,000 for the same period last year. The increase in research and development expenses in the Depression Business Unit for the three and nine months ended January 25, 2002 is the result of expanded clinical studies of the NCP System for the treatment of chronic or recurrent depression in patients with unipolar and bipolar depressive disorders. We are conducting a pivotal clinical study (D-02) of vagus nerve stimulation for the treatment of depression which includes 21 institutions and 235 implanted patients. The last patient exited the acute phase of the study in October 2001. In January 2002, the analyses of the acute results of the study were completed and the acute study results were unblinded. The acute results reported a response rate of 15% in the treatment group and 10% in the placebo group. These response rates do not represent a statistically significant difference between the treatment and placebo groups. Acute safety, tolerability and placebo response objectives were achieved as the study reported few treatment-related significant adverse events, 111 out of 114 (97%) treatment group 11 patients completed the study and the study confirmed a 10% placebo group response rate for this previously unstudied, chronic, recurrent treatment-resistant patient population. We are currently reviewing the study data and are developing a revised depression clinical development and regulatory plan to obtain U.S. regulatory approval for the NCP System for the treatment of patients with chronic, treatment-resistant depression. We expect to finalize the revised depression clinical development and regulatory plan by May 2002. As a result of this review, we may adjust the magnitude or timing of research and development efforts for our Depression Business Unit. For the quarter ended January 25, 2002 the Other Indications Business Unit research and development expenses were $1,271,000 compared to $297,000 for the same period last year. For the nine months ended January 25, 2002 the research and development expenses in the Other Indications Business Unit were $2,990,000 compared to $959,000 for the same period last year. The increase in research and development expenses in the Other Indications Business Unit for the three and nine months ended January 25, 2002 is the result of expanded clinical programs and cost associated with investigational clinical studies of the NCP System for the treatment of various disorders, including Alzheimer's Disease, anxiety, obesity, and other indications treatable by VNS and covered by the Company's proprietary patent portfolio. Due to the additional financial resources which may be required to complete the clinical development of the depression program, additional enrollments in these areas have been suspended pending the finalization of the depression clinical development and regulatory plan. We plan to continue study protocol activities with patients who are currently enrolled and implanted. We expect to finalize the revised depression and other new indications clinical development program by May 2002. Interest Income. Interest income for the three months ended January 25, 2002 was $207,000 compared to $182,000 for the same period last year. For the nine months ended January 25, 2002 interest income was $1,085,000 compared to $939,000 for the same period last year. The increase in interest income for the three and nine months ended January 25, 2002 is due to an increase in average investment balances, offset by lower interest rates. Interest Expense. Interest expense for the three months ended January 25, 2002 was $95,000 compared to $34,000 for the same period last year. Interest expense for the nine months ended January 25, 2002 was $165,000 compared to $51,000 for the same period last year. The increase in interest expense for the three and nine months ended January 25, 2002 is primarily due to interest incurred as a result of borrowings under the line of credit facility entered into in September 2001. Other Income (Expense). Other income (expense) for the three months ended January 25, 2002 was ($38,000) compared to $348,000 for the same period last year. For the nine months ended January 25, 2002 other income (expense) was $13,000 compared to $113,000 for the same period last year. Other income (expense), net for the three and nine months ended January 25, 2002 is primarily due to transaction gains (losses) associated with currency exchange. Income Taxes. Due to our operating loss history, to date we have established a valuation allowance to fully offset deferred tax assets, including those related to tax carry-forwards, resulting in no income tax expense or benefit for financial reporting purposes. Current federal income tax regulations with respect to changes in ownership could limit the utilization of the operating loss carry-forwards. LIQUIDITY AND CAPITAL RESOURCES Since our inception, we have financed our operations primarily through public and private placements of our securities. In February 2001, we raised approximately $42.5 million from the sale of common stock in a private offering. On June 30, 2000, we entered into capital leases for the acquisition of manufacturing equipment valued at approximately $650,000 and used in the production of the NCP System. The capital leases bear interest of 6.56% and extend through April 2005. In September 2001 we established a revolving credit facility for $10,000,000 with a term of three years. The credit facility is collateralized by accounts receivable, inventory, equipment, documents of title, general intangibles, subsidiary stock and other collateral. Borrowings against the facility are based upon eligible accounts receivable. The available borrowing base at January 25, 2002 was $8,070,000. Interest is payable in the amount of the designated bank rate plus 1.5% on the greater of $3,000,000 or the average of the net balance owed by the Company at the close of each day during the period. Under the terms of the revolving credit facility we agreed to maintain liquidity (being the aggregate of availability under the credit facility and cash) equal to or greater than $5,000,000. An unused line of credit fee is payable at the rate of 0.5%. As of January 25, 2002, we had $6,000,000 in borrowings outstanding under the credit facility. During the nine months ended January 25, 2002, net cash used in operating activities was approximately $18,686,000. Accounts receivable increased $3,312,000 to $9,954,000 at January 25, 2002 from $6,641,000 at April 27, 2001. Inventories decreased $587,000 12 to $3,659,000 at January 25, 2002 from $4,247,000 at April 27, 2001. Current liabilities increased $6,550,000 to $24,821,000 at January 25, 2002 from $18,271,000 at April 27, 2001, primarily due to the establishment of a line of credit in September 2001. During the nine months ended January 25, 2002, we used approximately $3,133,000 in the purchase of property and equipment. During the same period we received approximately $2,168,000 in proceeds from the exercise of stock options and $1,692,000 from maturities of marketable securities. Our long-term contractual obligations as of January 25, 2002 consist of:
PAYMENTS DUE BY PERIOD (000'S) --------------------------------------------- LESS THAN AFTER FIVE CONTRACTUAL OBLIGATIONS TOTAL ONE YEAR 1-3 YEARS 4-5 YEARS YEARS ------ --------- --------- --------- ---------- Capital Lease Obligations ................ $ 426 $ 122 $ 304 $ -- $ -- Operating Leases ............. 7,857 1,658 3,174 2,751 274 ------ ------ ------ ------ ------ Total Contractual Cash Obligations ................ $8,283 $1,780 $3,478 $2,751 $ 274 ====== ====== ====== ====== ======
Our liquidity will continue to be reduced as funds are expended to support continuing clinical trials and related regulatory activities, epilepsy sales growth, and product and process development. We are a party to a number of contracts pursuant to which we are paying for clinical studies for which current operating obligations payable totaled $6.8 million as of January 25, 2002. Our current projections indicate that we have sufficient funds and cash flow resources to fund anticipated business activities through January 25, 2004, without additional financing. Our cash flow could, however, be adversely effected by the "Factors Affecting Future Operating Results" discussed below. We would consider reasonably priced additional financing which would provide funding for new indications development and unplanned or expanded clinical studies. Financing through debt or equity instruments may be available, although the availability of such financing will depend upon a number of important factors, including the strength of the United States capital markets and economy, the health care and medical device segments in particular and the status of our business activities, including epilepsy sales growth and clinical and regulatory activities. IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS See Note 10 of Notes to Consolidated Financial Statements for a discussion of the impact of new accounting pronouncements. FACTORS AFFECTING FUTURE OPERATING RESULTS In addition to the factors described above in this section the following additional factors could affect our future results. We currently rely on only one product for our revenues and if sales of this product are not achieved, our operating results will be severely harmed. We have only one product, the NCP System, which has been approved by the FDA for a single indication: as an adjunctive therapy in reducing the frequency of seizures in adults and adolescents over 12 years of age with partial onset seizures that are refractory to antiepileptic drugs. Although sales of our NCP System have been increasing, we cannot assure you that sales will continue to increase at the same rate or at all. We are currently requesting approval for the use of the NCP System for the treatment of chronic or recurrent depression in patients with unipolar and bipolar depressive disorder. Although we have received approval for VNS in the treatment of chronic recurrent depression in the European Union and Canada, we do not yet have the reimbursement approvals necessary to effectively commercialize the NCP System for the treatment of depression. In addition, we are evaluating our D-02 test results which indicated no significant difference between treatment and placebo response rates and evaluating our future studies in this area. We cannot assure you that any future studies will achieve favorable results. Moreover, we cannot assure you that any future approvals for the treatment of depression with the NCP System will be granted, nor can we assure you that even if the approval is granted, we will be successful in commercializing the NCP System for the treatment of depression. The same uncertainty surrounds our efforts in Alzheimer's Disease, anxiety, chronic migraine headache and obesity. Our inability to successfully commercialize the NCP System for depression, and other indications may severely harm our business. We may not be able to continue to expand market acceptance of the use of our NCP System to treat epilepsy, which could cause our sales to decrease. Continued market acceptance of our NCP System will depend on our ability to convince the medical community of the clinical efficacy and safety of vagus nerve stimulation and the NCP System. While the NCP System has been used in approximately 13,500 patients through January 25, 2002, many physicians are still unfamiliar with this form of therapy. We believe that existing antiepileptic drugs and surgery are the only other approved and currently available therapies competitive with the NCP 13 System in the treatment of epileptic seizures. These therapies may be more attractive to patients or their physicians than the NCP System in terms of efficacy, cost or reimbursement availability. We cannot assure you that the NCP System will achieve market acceptance for the treatment of epilepsy or for any other indication. Failure of the NCP System to gain market acceptance would severely harm our business, financial condition and results of operations. We may not be successful in our efforts to develop VNS for the treatment of depression, obesity, Alzheimer's Disease, anxiety, chronic migraine headache or any other indications. We are in the process of conducting studies to help us evaluate, and ultimately obtain FDA approval for, the use of VNS as a treatment for depression, obesity, Alzheimer's Disease, anxiety, chronic migraine headache and other indications. For example, we recently received results from our D-02 pivotal clinical study that indicated no significant difference between treatment and placebo groups. We cannot assure you that any test results from future studies will be positive or that we will receive FDA approval for the use of our product for the treatment of any other indication. Even if we receive FDA approval for another indication, we can provide no assurances with respect to market acceptance. If our test results prove to be disappointing, if we receive no additional FDA approvals or if alternative indications do not prove to be commercially viable, our revenues will not experience the growth we currently anticipate. Our quarterly operating results may fluctuate in the future, which may cause our stock price to decline. Our results of operations may fluctuate significantly from quarter to quarter and may be below the expectations of security analysts. If so, the market price of our shares may decline. Our quarterly revenues, expenses and operating results may vary significantly from quarter to quarter for several reasons including the extent to which our NCP System gains market acceptance, the timing of obtaining marketing approvals for our NCP System for other indications, the timing of any approvals for reimbursement by third-party payors, the rate and size of expenditures incurred as we expand our clinical, manufacturing, sales and marketing efforts, our ability to retain qualified sales personnel and the availability of key components, materials and contract services, which may depend on our ability to forecast sales. Our current and future expense estimates are based, in large part, on estimates of future sales, which are difficult to predict. We may be unable to, or may elect not to, adjust spending quickly enough to offset any unexpected sales shortfall. If our expenses were not accompanied by increased sales, our results of operations and financial condition for any particular quarter may be harmed. We may be unable to obtain or maintain adequate third-party reimbursement on our product. Our ability to commercialize the NCP System successfully depends in part on whether third-party payors, including private health care insurers, managed care plans, the United States government's Medicare and Medicaid programs and others, agree both to cover the NCP System and associated procedures and services and to reimburse at adequate levels for the costs of the NCP System and the related services we have in the United States or internationally. If we fail to achieve or maintain favorable coverage decisions for the NCP System in a timely manner, patients and their physicians could be deterred from using the NCP System, which could reduce our sales and severely harm our business. We may not be successful in our marketing and sales efforts, which could severely harm our business. We cannot assure you that our marketing and sales efforts will succeed in promoting the NCP System to patients, health care providers or third-party payors on a broad basis. In addition, due to limited market awareness of the NCP System, we believe that the sales process could be lengthy, requiring us to continue to educate patients, health care providers and third-party payors regarding the clinical benefits and cost-effectiveness of the NCP System. In certain international territories, we rely, and intend to continue to rely, upon independent distributors. We may not be able to recruit and retain skilled marketing and sales personnel or foreign distributors to support our marketing and sales efforts. Our failure to successfully market and sell our NCP System or to retain our sales force would severely impair our sales and our business. If our suppliers and manufacturers are unable to meet our demand for materials, components and contract services, we may be forced to qualify new vendors or change our product design which would impair our ability to deliver products to our customers on a timely basis. We rely upon sole source suppliers for certain key components, materials and contract services used in manufacturing the NCP System. We periodically experience discontinuation or unavailability of components, materials and contract services which may require us to qualify alternative sources or, if no such alternative sources are identified, change our product design. We believe that pursuing and qualifying alternative sources and/or redesigning specific components of the NCP System, when necessary, could consume significant resources. In addition, such changes generally require regulatory submissions and approvals. Any extended delays in or an inability to secure alternative sources for these or other components, materials and contract services could result in product supply and manufacturing interruptions, which could significantly harm our business. 14 Our products may be found to have significant defects that could harm the human body and result in product recalls. The NCP System includes a complex electronic device and lead designed to be implanted in the human body. Component failures, manufacturing or shipping errors or design defects could result in an unsafe condition in patients. The occurrence of such problems or other adverse reactions could result in a recall of our products, possibly requiring removal and potential reimplantation of the NCP System or a component of the NCP System. For example, in 1991, a failure of an NCP System caused permanent paralysis of one patient's left vocal cord. In addition, several patients experienced bipolar lead failures which, although not harmful to the patient, reduced the efficacy of the treatment and required lead replacement. Since the occurrence of these failures, changes have been made to our product designs and no similar failures have been reported. However in the future, we may experience similar or other product problems or may be required to recall products. Any product recall could severely harm our business, financial condition and results of operations. We may not be able to protect our technology from unauthorized use, which could diminish the value of our products and impair our ability to compete. Our success depends upon our ability to obtain and maintain patent and other intellectual property protection for the NCP System and its improvements, and for vagus nerve stimulation therapy. To that end, we have acquired licenses under certain patents and have patented and intend to continue to seek patents on our own inventions used in our products and treatment methods. The process of seeking patent protection can be expensive and time consuming and we cannot assure you that patents will issue from our currently pending or future applications or that, if patents are issued, they will be of sufficient scope or strength to provide meaningful protection of our technology, or any commercial advantage to us. Further, the protection offered by the licensed international patents is not as strong as that offered by the licensed United States patents due to differences in patent laws. In particular, the European Patent Convention prohibits patents covering methods for treatment of the human body by surgery or therapy. We may have to engage in litigation to protect our proprietary rights, or defend against infringement claims by third parties, causing us to suffer significant expenses or prevent us from selling our products. There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry. Litigation, which could result in substantial cost to and diversion of effort by us, may be necessary to enforce patents issued or licensed to us, to protect trade secrets or know-how owned by us or to defend ourselves against claimed infringement of the rights of others and to determine the scope and validity of the proprietary rights of others. Adverse determinations in litigation could subject us to significant liabilities to third parties, could require us to seek licenses from third parties and could prevent us from manufacturing, selling or using the NCP System, any of which could severely harm our business. Intense competition and rapid technological changes could reduce our ability to market our products and achieve sales. We believe that existing and future antiepileptic drugs will continue to be the primary competition for our NCP System. We may also face competition from other medical device companies that have the technology, experience and capital resources to develop alternative devices for the treatment of epilepsy. Medtronic, Inc., for example, continues to clinically assess an implantable signal generator used with an invasive deep brain probe, or thalamic stimulator, for the treatment of neurological disorders and has received FDA approval for the device for the treatment of essential tremor, including that associated with Parkinson's Disease. Many of our competitors have substantially greater financial, manufacturing, marketing and technical resources than we do and have obtained third-party reimbursement approvals for their therapies. In addition, the health care industry is characterized by extensive research efforts and rapid technological progress. Our competitors may develop technologies and obtain regulatory approval for products that are more effective in treating epilepsy than our current or future products. In addition, advancements in surgical techniques may make surgery a more attractive therapy for epilepsy. The development by others of new treatment methods with novel antiepileptic drugs, medical devices or surgical techniques for epilepsy could render the NCP System non-competitive or obsolete. We may not be able to compete successfully against current and future competitors, including new products and technology, which could severely harm our business, financial condition or results of operations. If we fail to effectively manage our growth, our ability to maintain our costs or capture new business could suffer. In connection with the commercialization of the NCP System in the United States and potential regulatory approval of VNS in the treatment of chronic or recurrent depression, we have begun and intend to continue to significantly expand the scope of our operations. Such activities have placed, and may continue to place, a significant strain on our resources and operations. Our ability to effectively manage such growth will depend upon our ability to attract, hire and retain highly qualified employees and management personnel. We compete for such personnel with other companies, academic institutions, government entities and other organizations and we may not be successful in hiring or retaining qualified personnel. Our success will also depend upon the ability of our officers and key employees to continue to implement and improve our operational, management information and financial control systems. If we fail to manage our growth effectively, our business would suffer. 15 We are subject to claims of product liability and we may not have the resources or insurance to cover the cost for losses under these claims. As an implantable medical device, the manufacture and sale of the NCP System entails the risk of product liability claims. Our product liability coverage may not be adequate to cover any of these claims. Product liability insurance is expensive and in the future may not be available on acceptable terms, if at all. A successful claim brought against us in excess of our insurance coverage could significantly harm our business and financial condition. If we do not continue to comply with changing government regulations, we could lose our ability to market and sell our product. The pre-clinical and clinical testing, manufacturing, labeling, sale, distribution and promotion of the NCP System are subject to extensive and rigorous regulation in the United States by federal agencies, primarily the FDA, and by comparable state agencies. In the future, it will be necessary for us to obtain additional government approvals for other applications of the NCP System and for modified or future-generation products. Commercial distribution in certain foreign countries is also subject to obtaining regulatory approvals from the appropriate authorities in such countries. The process of obtaining FDA and other required regulatory approvals is lengthy, expensive and uncertain. Moreover, regulatory approvals may include regulatory restrictions on the indicated uses for which a product may be marketed. Failure to comply with applicable regulatory requirements can result in, among other things, fines, suspension or withdrawal of approvals, confiscations or recalls of products, operating restrictions and criminal prosecution. Furthermore, changes in existing regulations or adoption of new regulations could prevent us from obtaining, or affect the timing of, future regulatory approvals. We may not be able to obtain additional future regulatory approvals on a timely basis or at all. Delays in receipt of or failure to receive such future approvals, suspension or withdrawal of previously received approvals, or recalls of the NCP System could severely harm our ability to market and sell our current and future products and improvements. Our international operations are subject to risks not generally associated with commercialization efforts in the United States. We may not be successful in increasing our international market sales or in obtaining reimbursement or any regulatory approvals required in foreign countries. The anticipated international nature of our business is also expected to subject us and our representatives, agents and distributors to laws and regulations of the foreign jurisdictions in which we operate or where the NCP System is sold. The regulation of medical devices in a number of such jurisdictions, particularly in the European Union, continues to develop and new laws or regulations may impair our ability to market and sell our products in those jurisdictions. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial and operational risks inherent in our international operations. We are subject to exposures that arise from foreign exchange rate fluctuations which are associated with transactions denominated in foreign currencies, primarily from translation of results of operations from outside the United States, intercompany loans and intercompany purchases of inventory. We are also exposed to interest rate risk. We adhere to a conservative investment policy, whereby its principal concern is the preservation of liquid funds while maximizing its yield on such assets. Cash, cash equivalents and marketable securities are invested in different types of investment-grade securities with the intent of holding these securities to maturity. Although the portfolio is subject to fluctuations in interest rates and market conditions, no gain or loss on any security would actually be recognized in earnings unless the instrument was sold. We are also exposed to interest rate risk on the revolving credit facility. We do not hedge interest rate exposure or invest in derivative securities. PART II - OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.1 Severance Agreement between Cyberonics, Inc. and Michael Cheney dated January 1, 2002. 10.2 Severance Agreement between Cyberonics, Inc. and David Erinakes dated January 1, 2002. 10.3 Severance Agreement between Cyberonics, Inc. and Richard Rudolph dated January 1, 2002. (b) Reports on Form 8-K none 16 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CYBERONICS, INC. Registrant BY: /s/ PAMELA B. WESTBROOK ------------------------------------------ Pamela B. Westbrook Vice President, Finance and Administration and Chief Financial Officer (principal financial and accounting officer) Dated: March 7, 2002 17 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 10.1 Severance Agreement between Cyberonics, Inc. and Michael Cheney dated January 1, 2002. 10.2 Severance Agreement between Cyberonics, Inc. and David Erinakes dated January 1, 2002. 10.3 Severance Agreement between Cyberonics, Inc. and Richard Rudolph dated January 1, 2002.
EX-10.1 3 h94648ex10-1.txt SEVERANCE AGREEMENT - MICHAEL CHENEY EXHIBIT 10.1 CLASS I SEVERANCE AGREEMENT THIS AGREEMENT (the "Agreement"), made and entered into effective as of January 1, 2002 (the "Effective Date"), is by and between CYBERONICS, INC., a Delaware corporation (the "Company"), and MICHAEL CHENEY (the "Employee"). WHEREAS, Employee is a key employee of the Company; and WHEREAS, the Company recognizes that the possibility of a Change of Control (as defined below) of the Company is unsettling and may result in the departure of key employees to the detriment of the Company and its stockholders; and WHEREAS, the Board of Directors of the Company (the "Board") has authorized this Agreement and certain similar agreements in order to retain key employees to ensure the continuity of its management; THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Company and Employee agree as follows: 1. TERM. This Agreement shall commence on the Effective Date and shall continue until April 30, 2003; provided, however, that commencing on April 30, 2002 and on each April 30th thereafter, the Term of this Agreement shall automatically be extended for one additional year, unless at least six months prior to such April 30 date the Board shall give written notice to Employee that the Term of this Agreement shall cease to be so extended; provided further, however, that if a Change of Control shall occur during the Term, the Term shall automatically continue in effect for a period of not less than one year from the date of such Change of Control. Notwithstanding the foregoing, except as provided in Section 3, this Agreement shall automatically terminate on Employee's termination of employment; provided, however, termination of this Agreement shall not alter or impair any rights of Employee arising hereunder on or prior to such termination. 2. CHANGE OF CONTROL. For purposes of this Agreement, a Change of Control of the Company shall mean: (i) the acquisition by any "person," as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), other than the Company, a subsidiary of the Company or a Company employee benefit plan, of "beneficial ownership" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing 50% or more of the combined voting power of the Company's then outstanding securities entitled to vote generally in the election of directors; or (ii) the consummation of a reorganization, merger, consolidation or other form of corporate transaction or series of transactions, in each case, with respect to which persons who were the shareholders of the Company immediately prior to such reorganization, merger or consolidation or other transaction do not, immediately thereafter, own more than 50% of the combined voting power entitled to vote generally in the election of directors of the reorganized, merged or consolidated company's then outstanding voting securities in substantially the same proportions as their ownership immediately prior to such event; or (iii) the sale or disposition by the Company of all or substantially all the Company's assets; or (iv) a change in the composition of the Board, as a result of which fewer than a majority of the directors are Incumbent Directors. "Incumbent Directors" shall mean directors who either (A) are directors of the Company as of October 2, 2000, or (B) are elected, or nominated for election, thereafter to the Board with the affirmative votes of at least a majority of the Incumbent Directors at the time of such election or nomination, but "Incumbent Director" shall not include an individual whose election or nomination is in connection with (i) an actual or threatened election contest (as such terms are used in Rule 14a-11 of Regulation 14A promulgated under the Exchange Act) or an actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board or (ii) a plan or agreement to replace a majority of the then Incumbent Directors; or (v) the approval by the Board or the stockholders of the Company of a complete or substantially complete liquidation or dissolution of the Company. 3. TERMINATION ON OR FOLLOWING A CHANGE OF CONTROL. If a Change of Control occurs during the Term, Employee shall be entitled to the benefits provided in Section 4 hereof if, during the Protected Period (as hereinafter defined), Employee becomes disabled or Employee's employment is terminated, unless such termination is (a) due to Employee's death, (b) by the Company either for Cause or Employee's Disability, or (c) by Employee for other than a Good Reason. Anything in this Agreement to the contrary notwithstanding, if Employee's employment with the Company is terminated during the Term and prior to the date on which a Change of Control occurs, and it is reasonably demonstrated that such termination (i) was at the request of a third party who has taken steps reasonably calculated to effect the Change of Control, or (ii) otherwise arose in connection with or anticipation of the Change of Control, then for all purposes of this Agreement the Change of Control shall be deemed to have occurred on the date immediately prior to the date of Employee's termination and Employee shall be deemed terminated by the Company during the Protected Period other than for Cause. For purposes of this Agreement, the "Protected Period" shall mean the period of time beginning with the Change of Control and ending on the first anniversary of such Change of Control or Employee's death, if earlier. (i) DISABILITY. If, as a result of Employee's incapacity due to physical or mental illness, Employee shall have been absent from Employee's duties with the Company on a full-time basis for 150 consecutive calendar days, and within 30 days after written Notice of Termination (as defined hereinafter) Employee shall not have returned to the full-time performance of Employee's duties, the Company may terminate Employee's employment for "Disability"; provided, however, a termination of Employee's employment for Disability 2 under this Agreement shall not alter or impair Employee's rights as a "disabled employee" under any of the Company's employee benefit plans. (ii) CAUSE. The Company may terminate Employee's employment for Cause. For the purposes of this Agreement, the Company shall have "Cause" to terminate Employee's employment hereunder only upon (A) the willful and continued failure by Employee to perform substantially Employee's duties with the Company, other than any such failure resulting from Employee's incapacity due to physical or mental illness, which continues unabated after a written demand for substantial performance is delivered to Employee by the Board that specifically identifies the manner in which the Board believes that Employee has not substantially performed Employee's duties or (B) Employee willfully engaging in gross misconduct that is materially and demonstrably injurious to the Company. For purposes of this paragraph, an act or failure to act on Employee's part shall be considered "willful" only if done or omitted to be done by Employee otherwise than in good faith and without reasonable belief that Employee's action or omission was in the best interest of the Company. Notwithstanding the foregoing, Employee shall not be deemed to have been terminated for Cause unless and until there shall have been delivered to Employee a copy of a resolution duly adopted by the affirmative vote of not less than three-quarters of the entire membership of the Board, at a meeting of the Board called and held for such purpose (after reasonable notice to Employee and an opportunity for Employee, together with Employee's counsel, to be heard before the Board), finding that in the good faith opinion of the Board Employee was guilty of conduct set forth in clauses (A) or (B) of this subsection (ii) and specifying the particulars thereof in reasonable detail. (iii) GOOD REASON. Employee may terminate Employee's employment for Good Reason. For purposes of this Agreement, "Good Reason" shall mean the occurrence of any of the following without Employee's express written consent: (A) an adverse change (as determined by Employee in good faith, which determination shall be controlling for all purposes under this Agreement) in Employee's (i) positions, duties, responsibilities or status with the Company from that in effect immediately prior to the Change of Control, or (ii) reporting responsibilities, titles or offices as in effect immediately prior to the Change of Control; or any removal of Employee from, or any failure to re-elect or appoint Employee to, any of such responsibilities, titles, offices or positions, except in connection with the termination of Employee's employment for Cause or Disability, or as a result of Employee's death, or by Employee for other than a Good Reason; (B) a reduction in Employee's annual rate of base salary as in effect immediately prior to the Change of Control or as the same may be increased from time to time thereafter (the "Base Salary"); (C) a failure by the Company to continue the Company's Annual Incentive Compensation Plan as the same may be modified from time to time, but substantially in the form in effect immediately prior to the Change of Control (the "Bonus Plan"), or a failure by the Company to continue Employee as a participant in the Bonus Plan 3 in at least the same amount (the "Bonus Amount" ) as Employee's target bonus amount under the Bonus Plan with respect to the fiscal year ending immediately prior to the Change of Control or with respect to the current fiscal year if Employee has been employed by the Company for a shorter period (Bonus Amounts related to less than a full fiscal year shall be annualized for this purpose); (D) the failure by the Company to continue in effect any other employee benefit or compensation plan program or policy, in which Employee is participating immediately prior to the Change of Control, unless the Company establishes such new plans, programs or policies as is necessary to provide Employee with substantially comparable benefits; the taking of any action by the Company not required by law that would adversely affect Employee's participation in or reduce Employee's benefits under any of such plans, programs or policies or deprive Employee of any material fringe benefit enjoyed by Employee immediately prior to the Change of Control; (E) the Company's requiring Employee to relocate to an office more than 25 miles from the Company's office to which Employee was assigned immediately prior to the Change of Control, except for required travel on the Company's business to an extent substantially consistent with Employee's business travel obligations immediately prior to the Change of Control; (F) the amendment, modification or repeal of any provision of the Company's Certificate of Incorporation, as amended, or the Bylaws of the Company which was in effect immediately prior to such Change of Control, if such amendment, modification or repeal would adversely effect Employee's right to indemnification by the Company; (G) the failure of the Company to obtain the assumption of this Agreement by any successor as contemplated in Section 6 hereof; or (H) any purported termination of Employee's employment that is not effected pursuant to a Notice of Termination satisfying the requirements of subparagraph (iv) below and, if applicable, subparagraph (ii) above; and for purposes of this Agreement, no such purported termination shall be effective. Employee's right to terminate employment for a Good Reason hereunder shall not be affected by Employee's incapacity due to a physical or mental illness nor shall Employee's continued employment following any circumstance that constitutes a Good Reason hereunder, regardless of the length of such continued employment, constitute a consent to or a waiver of Employee's rights hereunder with respect to such circumstance. (iv) NOTICE OF TERMINATION. Any termination by the Company pursuant to subparagraphs (i) or (ii) above, or by Employee pursuant to subparagraph (iii) above, shall be communicated by written Notice of Termination to the other party hereto. For purposes of this Agreement, a "Notice of Termination" shall mean a notice that shall indicate the 4 specific termination provision in this Agreement relied upon and shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of Employee's employment under the provision so indicated. (v) DATE OF TERMINATION. "Date of Termination" shall mean (A) if Employee is terminated for Disability, 30 days after Notice of Termination is given, provided that Employee shall not have returned to the performance of Employee's duties on a full-time basis during such 30-day period, (B) if Employee's employment is terminated pursuant to subparagraph (iii) above, the date specified in the Notice of Termination, (C) with respect to a termination prior to a Change of Control, which is deemed to be after such Change of Control as provided in Section 3, the date of such termination, and (D) if Employee's employment is terminated for any other reason on or after a Change of Control, the date of such termination. 4. COMPENSATION DURING DISABILITY OR UPON TERMINATION. (i) If, during the Protected Period, Employee fails to perform Employee's normal duties as a result of incapacity due to physical or mental illness, Employee shall continue during the period of such disability to receive Employee's full Base Salary and any awards, deferred and nondeferred, payable during such period under the Bonus Plan, less any amounts paid to Employee during such period of disability pursuant to the Company's short term disability or sick-leave program(s) until Employee's employment is terminated or such Disability ends. This Section 4(i) shall not reduce or impair Employee's rights to terminate employment for a Good Reason as otherwise provided herein. (ii) If, during the Protected Period, Employee's employment shall be terminated (x) by the Company for Cause, (y) by Employee's death, or (z) by Employee other than for a Good Reason, the Company shall pay Employee's earned but unpaid Base Salary through the Date of Termination and the Company shall have no further obligations to Employee under this Agreement. (iii) If, during the Protected Period, (1) the Company shall terminate Employee other than for Cause or Disability or (2) Employee shall terminate Employee's employment for a Good Reason, the Company shall pay to Employee, by certified or bank cashier's check or wire transfer within five business days after the Date of Termination, an amount equal to: (A) three times the sum of Employee's Base Salary and Bonus Amount; plus (B) that portion of Employee's Base Salary earned, and vacation pay vested for the prior year and accrued for the current year to the Date of Termination, but not paid or used, and all other amounts previously deferred by Employee or earned but not paid as of such date under all Company bonus or pay plans or programs. (iv) If any payment due under the terms of this Agreement is not timely made or otherwise withheld by the Company, its successors or assigns, interest shall accrue on such payment at the highest maximum legal rate permissible under applicable law from the date such payment first became due through the date of payment thereof. 5 (v) In the event that any payment or benefit received or to be received by Employee pursuant to the terms of this Agreement or any other plan, arrangement or agreement with (A) the Company, (B) any Person whose actions result in a "change in control" (for purposes of Section 280G of the Internal Revenue Code (the "Code")) or (C) any Person affiliated with the Company or such Person) (all such payments and benefits being hereinafter called "Total Payments") would be subject to the excise tax imposed under Section 280G of the Code, the Company shall pay to Employee such additional amount (the "Gross-Up Payment") such that the net amount retained by Employee, after deduction of any excise tax imposed under Section 4999 of the Code (the "Excise Tax") on the Total Payments and all federal, state and local taxes, including the Excise Tax, upon the Gross-Up Payment, shall be equal to the Total Payments. For purposes of determining the amount of the Gross-Up Payment, Employee shall be deemed to pay federal income tax at the highest marginal rate of federal income taxation in the calendar year in which the Gross-Up Payment is to be made and state and local income taxes at the highest marginal rate of taxation in the state and locality of Employee's residence on the date on which the Gross-Up Payment is calculated for purposes of this subparagraph. In the event that the Excise Tax is subsequently determined to be less than the amount taken into account hereunder, Employee shall repay to the Company, at the time that the amount of such reduction in Excise Tax is finally determined, the portion of the Gross-Up Payment attributable to such reduction (plus that portion of the Gross-Up Payment being repaid by Employee to the extent that such repayment results in a reduction in Excise Tax and/or a federal, state or local income tax deduction) plus interest on the amount of such repayment at the rate provided in Section 1274(b)(2)(B) of the Code. In the event that the Excise Tax is determined to exceed the amount taken into account hereunder (including by reason of any payment the existence or amount of which cannot be determined at the time of the Gross-Up Payment), the Company shall make an additional Gross-Up Payment in respect of such excess (plus any interest, penalties or additions payable by Employee with respect to such excess) at the time that the amount of such excess if finally determined. Employee and the Company shall each reasonably cooperate with the other in connection with any administrative or judicial proceedings concerning the existence or amount of liability for Excise Tax with respect to the Total Payments. The parties intend that the Gross-Up Payment be determined in a manner that is most favorable to Employee. 5. NO MITIGATION OR OFFSET. The provisions of this Agreement are not intended to, nor shall they be construed to, require that Employee mitigate the amount of any payment provided for in this Agreement by seeking or accepting other employment, nor shall the amount of any payment provided for in this Agreement be reduced by any compensation earned by Employee as the result of employment by another employer or otherwise. Without limitation of the foregoing, the Company's obligations to make the payments to Employee required under this Agreement shall not be affected by any set off, counterclaim, recoupment, defense or other claim, right or action that the Company may have against Employee. 6. SUCCESSORS; BINDING AGREEMENT. (i) The Company will require any successor, whether direct or indirect, by purchase, merger, consolidation or otherwise, to all or substantially all of the business and/or assets of 6 the Company, by agreement in form and substance reasonably satisfactory to Employee, expressly to assume and agree to perform this Agreement in the same manner and to the same extent as the Company would have been required if no such succession had taken place. Failure of the Company to obtain such agreement prior to the effectiveness of any such succession shall be a breach of this Agreement and shall entitle Employee to payment from the Company in the same amount and on the same terms as Employee would be entitled hereunder if Employee had terminated Employee's employment for Good Reason, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Date of Termination. As used in this Agreement, "Company" shall mean the Company as hereinbefore defined and any successor to its business and/or assets as aforesaid that executes and delivers the agreement provided for in this Section 6 or which otherwise becomes bound by all the terms and provisions of this Agreement by operation of law. (ii) This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If Employee should die while any amounts would still be payable to Employee hereunder if Employee had continued to live, all such amounts shall be paid in accordance with the terms of this Agreement to Employee's beneficiary as filed with the Company pursuant to this Agreement or, if there be no such designated beneficiary, to Employee's estate. 7. NOTICE. All notices, consents, waivers, and other communications required under this Agreement must be in writing and will be deemed to have been duly given when (a) delivered by hand (with written confirmation of receipt), (b) sent by facsimile (with confirmation of receipt), provided that a copy is mailed by certified mail, return receipt requested, or (c) when received by the addressee, if sent by a nationally recognized overnight delivery service, in each case to the appropriate addresses and facsimile numbers set forth below (or to such other addresses and facsimile numbers as a party may designate by notice to the other parties): If to the Company: Cyberonics, Inc. 16511 Space Center Blvd. Houston, Texas 77058 Facsimile No.: ____________ If to Employee: ------------------------- ------------------------- ------------------------- 7 8. MISCELLANEOUS. No provisions of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by Employee and by the Chairman of the Board or an authorized officer of the Company. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. 9. VALIDITY. The interpretation, construction and performance of this Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Texas without regard to conflicts of laws principles. The invalidity or unenforceability of any provisions of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, each of which shall remain in full force and effect. 10. COUNTERPARTS. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which together shall constitute one and the same instrument. 11. DESCRIPTIVE HEADINGS. Descriptive headings are for convenience only and shall not control or affect the meaning or construction of any provision of this Agreement. 12. CORPORATE APPROVAL. This Agreement has been approved by the Board, and has been duly executed and delivered by Employee and on behalf of the Company by its duly authorized representative. 13. DISPUTES. The parties agree to resolve any claim or controversy arising out of or relating to this Agreement by binding arbitration under the Federal Arbitration Act before one arbitrator in the City of Houston, State of Texas, administered by the American Arbitration Association under its Commercial Arbitration Rules, and judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. The Company shall reimburse Employee, on a current basis, for all legal fees and expenses incurred by Employee in connection with any dispute arising under this Agreement, including, without limitation, the fees and expenses of the arbitrator, unless the arbitrator finds Employee brought such claim in bad faith, in which event each party shall pay its own costs and expenses and Employee shall repay to the Company any fees and expenses previously paid on Employee's behalf by the Company. The parties stipulate that the provisions hereof shall be a complete defense to any suit, action, or proceeding instituted in any federal, state, or local court or before any administrative tribunal with respect to any controversy or dispute arising during the period of this Agreement and which is arbitrable as herein set forth. The arbitration provisions hereof shall, with respect to such controversy or dispute, survive the termination of this Agreement. 8 IN WITNESS WHEREOF, the Company and Employee have executed this Agreement in multiple counterparts effective for all purposes as of the Effective Date. CYBERONICS, INC. By: /s/ Robert P. Cummins ---------------------------- Name: Robert P. Cummins Title: President and Chief Executive Officer EMPLOYEE /s/ Michael Cheney ------------------------------- 9 EX-10.2 4 h94648ex10-2.txt SEVERANCE AGREEMENT - DAVID ERINAKES EXHIBIT 10.2 CLASS I SEVERANCE AGREEMENT THIS AGREEMENT (the "Agreement"), made and entered into effective as of January 1, 2002 (the "Effective Date"), is by and between CYBERONICS, INC., a Delaware corporation (the "Company"), and DAVID ERINAKES (the "Employee"). WHEREAS, Employee is a key employee of the Company; and WHEREAS, the Company recognizes that the possibility of a Change of Control (as defined below) of the Company is unsettling and may result in the departure of key employees to the detriment of the Company and its stockholders; and WHEREAS, the Board of Directors of the Company (the "Board") has authorized this Agreement and certain similar agreements in order to retain key employees to ensure the continuity of its management; THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Company and Employee agree as follows: 1. TERM. This Agreement shall commence on the Effective Date and shall continue until April 30, 2003; provided, however, that commencing on April 30, 2002 and on each April 30th thereafter, the Term of this Agreement shall automatically be extended for one additional year, unless at least six months prior to such April 30 date the Board shall give written notice to Employee that the Term of this Agreement shall cease to be so extended; provided further, however, that if a Change of Control shall occur during the Term, the Term shall automatically continue in effect for a period of not less than one year from the date of such Change of Control. Notwithstanding the foregoing, except as provided in Section 3, this Agreement shall automatically terminate on Employee's termination of employment; provided, however, termination of this Agreement shall not alter or impair any rights of Employee arising hereunder on or prior to such termination. 2. CHANGE OF CONTROL. For purposes of this Agreement, a Change of Control of the Company shall mean: (i) the acquisition by any "person," as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), other than the Company, a subsidiary of the Company or a Company employee benefit plan, of "beneficial ownership" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing 50% or more of the combined voting power of the Company's then outstanding securities entitled to vote generally in the election of directors; or (ii) the consummation of a reorganization, merger, consolidation or other form of corporate transaction or series of transactions, in each case, with respect to which persons who were the shareholders of the Company immediately prior to such reorganization, merger or consolidation or other transaction do not, immediately thereafter, own more than 50% of the combined voting power entitled to vote generally in the election of directors of the reorganized, merged or consolidated company's then outstanding voting securities in substantially the same proportions as their ownership immediately prior to such event; or (iii) the sale or disposition by the Company of all or substantially all the Company's assets; or (iv) a change in the composition of the Board, as a result of which fewer than a majority of the directors are Incumbent Directors. "Incumbent Directors" shall mean directors who either (A) are directors of the Company as of October 2, 2000, or (B) are elected, or nominated for election, thereafter to the Board with the affirmative votes of at least a majority of the Incumbent Directors at the time of such election or nomination, but "Incumbent Director" shall not include an individual whose election or nomination is in connection with (i) an actual or threatened election contest (as such terms are used in Rule 14a-11 of Regulation 14A promulgated under the Exchange Act) or an actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board or (ii) a plan or agreement to replace a majority of the then Incumbent Directors; or (v) the approval by the Board or the stockholders of the Company of a complete or substantially complete liquidation or dissolution of the Company. 3. TERMINATION ON OR FOLLOWING A CHANGE OF CONTROL. If a Change of Control occurs during the Term, Employee shall be entitled to the benefits provided in Section 4 hereof if, during the Protected Period (as hereinafter defined), Employee becomes disabled or Employee's employment is terminated, unless such termination is (a) due to Employee's death, (b) by the Company either for Cause or Employee's Disability, or (c) by Employee for other than a Good Reason. Anything in this Agreement to the contrary notwithstanding, if Employee's employment with the Company is terminated during the Term and prior to the date on which a Change of Control occurs, and it is reasonably demonstrated that such termination (i) was at the request of a third party who has taken steps reasonably calculated to effect the Change of Control, or (ii) otherwise arose in connection with or anticipation of the Change of Control, then for all purposes of this Agreement the Change of Control shall be deemed to have occurred on the date immediately prior to the date of Employee's termination and Employee shall be deemed terminated by the Company during the Protected Period other than for Cause. For purposes of this Agreement, the "Protected Period" shall mean the period of time beginning with the Change of Control and ending on the first anniversary of such Change of Control or Employee's death, if earlier. (i) DISABILITY. If, as a result of Employee's incapacity due to physical or mental illness, Employee shall have been absent from Employee's duties with the Company on a full-time basis for 150 consecutive calendar days, and within 30 days after written Notice of Termination (as defined hereinafter) Employee shall not have returned to the full-time performance of Employee's duties, the Company may terminate Employee's employment for "Disability"; provided, however, a termination of Employee's employment for Disability 2 under this Agreement shall not alter or impair Employee's rights as a "disabled employee" under any of the Company's employee benefit plans. (ii) CAUSE. The Company may terminate Employee's employment for Cause. For the purposes of this Agreement, the Company shall have "Cause" to terminate Employee's employment hereunder only upon (A) the willful and continued failure by Employee to perform substantially Employee's duties with the Company, other than any such failure resulting from Employee's incapacity due to physical or mental illness, which continues unabated after a written demand for substantial performance is delivered to Employee by the Board that specifically identifies the manner in which the Board believes that Employee has not substantially performed Employee's duties or (B) Employee willfully engaging in gross misconduct that is materially and demonstrably injurious to the Company. For purposes of this paragraph, an act or failure to act on Employee's part shall be considered "willful" only if done or omitted to be done by Employee otherwise than in good faith and without reasonable belief that Employee's action or omission was in the best interest of the Company. Notwithstanding the foregoing, Employee shall not be deemed to have been terminated for Cause unless and until there shall have been delivered to Employee a copy of a resolution duly adopted by the affirmative vote of not less than three-quarters of the entire membership of the Board, at a meeting of the Board called and held for such purpose (after reasonable notice to Employee and an opportunity for Employee, together with Employee's counsel, to be heard before the Board), finding that in the good faith opinion of the Board Employee was guilty of conduct set forth in clauses (A) or (B) of this subsection (ii) and specifying the particulars thereof in reasonable detail. (iii) GOOD REASON. Employee may terminate Employee's employment for Good Reason. For purposes of this Agreement, "Good Reason" shall mean the occurrence of any of the following without Employee's express written consent: (A) an adverse change (as determined by Employee in good faith, which determination shall be controlling for all purposes under this Agreement) in Employee's (i) positions, duties, responsibilities or status with the Company from that in effect immediately prior to the Change of Control, or (ii) reporting responsibilities, titles or offices as in effect immediately prior to the Change of Control; or any removal of Employee from, or any failure to re-elect or appoint Employee to, any of such responsibilities, titles, offices or positions, except in connection with the termination of Employee's employment for Cause or Disability, or as a result of Employee's death, or by Employee for other than a Good Reason; (B) a reduction in Employee's annual rate of base salary as in effect immediately prior to the Change of Control or as the same may be increased from time to time thereafter (the "Base Salary"); (C) a failure by the Company to continue the Company's Annual Incentive Compensation Plan as the same may be modified from time to time, but substantially in the form in effect immediately prior to the Change of Control (the "Bonus Plan"), or a failure by the Company to continue Employee as a participant in the Bonus Plan 3 in at least the same amount (the "Bonus Amount" ) as Employee's target bonus amount under the Bonus Plan with respect to the fiscal year ending immediately prior to the Change of Control or with respect to the current fiscal year if Employee has been employed by the Company for a shorter period (Bonus Amounts related to less than a full fiscal year shall be annualized for this purpose); (D) the failure by the Company to continue in effect any other employee benefit or compensation plan program or policy, in which Employee is participating immediately prior to the Change of Control, unless the Company establishes such new plans, programs or policies as is necessary to provide Employee with substantially comparable benefits; the taking of any action by the Company not required by law that would adversely affect Employee's participation in or reduce Employee's benefits under any of such plans, programs or policies or deprive Employee of any material fringe benefit enjoyed by Employee immediately prior to the Change of Control; (E) the Company's requiring Employee to relocate to an office more than 25 miles from the Company's office to which Employee was assigned immediately prior to the Change of Control, except for required travel on the Company's business to an extent substantially consistent with Employee's business travel obligations immediately prior to the Change of Control; (F) the amendment, modification or repeal of any provision of the Company's Certificate of Incorporation, as amended, or the Bylaws of the Company which was in effect immediately prior to such Change of Control, if such amendment, modification or repeal would adversely effect Employee's right to indemnification by the Company; (G) the failure of the Company to obtain the assumption of this Agreement by any successor as contemplated in Section 6 hereof; or (H) any purported termination of Employee's employment that is not effected pursuant to a Notice of Termination satisfying the requirements of subparagraph (iv) below and, if applicable, subparagraph (ii) above; and for purposes of this Agreement, no such purported termination shall be effective. Employee's right to terminate employment for a Good Reason hereunder shall not be affected by Employee's incapacity due to a physical or mental illness nor shall Employee's continued employment following any circumstance that constitutes a Good Reason hereunder, regardless of the length of such continued employment, constitute a consent to or a waiver of Employee's rights hereunder with respect to such circumstance. (iv) NOTICE OF TERMINATION. Any termination by the Company pursuant to subparagraphs (i) or (ii) above, or by Employee pursuant to subparagraph (iii) above, shall be communicated by written Notice of Termination to the other party hereto. For purposes of this Agreement, a "Notice of Termination" shall mean a notice that shall indicate the 4 specific termination provision in this Agreement relied upon and shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of Employee's employment under the provision so indicated. (v) DATE OF TERMINATION. "Date of Termination" shall mean (A) if Employee is terminated for Disability, 30 days after Notice of Termination is given, provided that Employee shall not have returned to the performance of Employee's duties on a full-time basis during such 30-day period, (B) if Employee's employment is terminated pursuant to subparagraph (iii) above, the date specified in the Notice of Termination, (C) with respect to a termination prior to a Change of Control, which is deemed to be after such Change of Control as provided in Section 3, the date of such termination, and (D) if Employee's employment is terminated for any other reason on or after a Change of Control, the date of such termination. 4. COMPENSATION DURING DISABILITY OR UPON TERMINATION. (i) If, during the Protected Period, Employee fails to perform Employee's normal duties as a result of incapacity due to physical or mental illness, Employee shall continue during the period of such disability to receive Employee's full Base Salary and any awards, deferred and nondeferred, payable during such period under the Bonus Plan, less any amounts paid to Employee during such period of disability pursuant to the Company's short term disability or sick-leave program(s) until Employee's employment is terminated or such Disability ends. This Section 4(i) shall not reduce or impair Employee's rights to terminate employment for a Good Reason as otherwise provided herein. (ii) If, during the Protected Period, Employee's employment shall be terminated (x) by the Company for Cause, (y) by Employee's death, or (z) by Employee other than for a Good Reason, the Company shall pay Employee's earned but unpaid Base Salary through the Date of Termination and the Company shall have no further obligations to Employee under this Agreement. (iii) If, during the Protected Period, (1) the Company shall terminate Employee other than for Cause or Disability or (2) Employee shall terminate Employee's employment for a Good Reason, the Company shall pay to Employee, by certified or bank cashier's check or wire transfer within five business days after the Date of Termination, an amount equal to: (A) three times the sum of Employee's Base Salary and Bonus Amount; plus (B) that portion of Employee's Base Salary earned, and vacation pay vested for the prior year and accrued for the current year to the Date of Termination, but not paid or used, and all other amounts previously deferred by Employee or earned but not paid as of such date under all Company bonus or pay plans or programs. (iv) If any payment due under the terms of this Agreement is not timely made or otherwise withheld by the Company, its successors or assigns, interest shall accrue on such payment at the highest maximum legal rate permissible under applicable law from the date such payment first became due through the date of payment thereof. 5 (v) In the event that any payment or benefit received or to be received by Employee pursuant to the terms of this Agreement or any other plan, arrangement or agreement with (A) the Company, (B) any Person whose actions result in a "change in control" (for purposes of Section 280G of the Internal Revenue Code (the "Code")) or (C) any Person affiliated with the Company or such Person) (all such payments and benefits being hereinafter called "Total Payments") would be subject to the excise tax imposed under Section 280G of the Code, the Company shall pay to Employee such additional amount (the "Gross-Up Payment") such that the net amount retained by Employee, after deduction of any excise tax imposed under Section 4999 of the Code (the "Excise Tax") on the Total Payments and all federal, state and local taxes, including the Excise Tax, upon the Gross-Up Payment, shall be equal to the Total Payments. For purposes of determining the amount of the Gross-Up Payment, Employee shall be deemed to pay federal income tax at the highest marginal rate of federal income taxation in the calendar year in which the Gross-Up Payment is to be made and state and local income taxes at the highest marginal rate of taxation in the state and locality of Employee's residence on the date on which the Gross-Up Payment is calculated for purposes of this subparagraph. In the event that the Excise Tax is subsequently determined to be less than the amount taken into account hereunder, Employee shall repay to the Company, at the time that the amount of such reduction in Excise Tax is finally determined, the portion of the Gross-Up Payment attributable to such reduction (plus that portion of the Gross-Up Payment being repaid by Employee to the extent that such repayment results in a reduction in Excise Tax and/or a federal, state or local income tax deduction) plus interest on the amount of such repayment at the rate provided in Section 1274(b)(2)(B) of the Code. In the event that the Excise Tax is determined to exceed the amount taken into account hereunder (including by reason of any payment the existence or amount of which cannot be determined at the time of the Gross-Up Payment), the Company shall make an additional Gross-Up Payment in respect of such excess (plus any interest, penalties or additions payable by Employee with respect to such excess) at the time that the amount of such excess if finally determined. Employee and the Company shall each reasonably cooperate with the other in connection with any administrative or judicial proceedings concerning the existence or amount of liability for Excise Tax with respect to the Total Payments. The parties intend that the Gross-Up Payment be determined in a manner that is most favorable to Employee. 5. NO MITIGATION OR OFFSET. The provisions of this Agreement are not intended to, nor shall they be construed to, require that Employee mitigate the amount of any payment provided for in this Agreement by seeking or accepting other employment, nor shall the amount of any payment provided for in this Agreement be reduced by any compensation earned by Employee as the result of employment by another employer or otherwise. Without limitation of the foregoing, the Company's obligations to make the payments to Employee required under this Agreement shall not be affected by any set off, counterclaim, recoupment, defense or other claim, right or action that the Company may have against Employee. 6. SUCCESSORS; BINDING AGREEMENT. (i) The Company will require any successor, whether direct or indirect, by purchase, merger, consolidation or otherwise, to all or substantially all of the business and/or assets of 6 the Company, by agreement in form and substance reasonably satisfactory to Employee, expressly to assume and agree to perform this Agreement in the same manner and to the same extent as the Company would have been required if no such succession had taken place. Failure of the Company to obtain such agreement prior to the effectiveness of any such succession shall be a breach of this Agreement and shall entitle Employee to payment from the Company in the same amount and on the same terms as Employee would be entitled hereunder if Employee had terminated Employee's employment for Good Reason, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Date of Termination. As used in this Agreement, "Company" shall mean the Company as hereinbefore defined and any successor to its business and/or assets as aforesaid that executes and delivers the agreement provided for in this Section 6 or which otherwise becomes bound by all the terms and provisions of this Agreement by operation of law. (ii) This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If Employee should die while any amounts would still be payable to Employee hereunder if Employee had continued to live, all such amounts shall be paid in accordance with the terms of this Agreement to Employee's beneficiary as filed with the Company pursuant to this Agreement or, if there be no such designated beneficiary, to Employee's estate. 7. NOTICE. All notices, consents, waivers, and other communications required under this Agreement must be in writing and will be deemed to have been duly given when (a) delivered by hand (with written confirmation of receipt), (b) sent by facsimile (with confirmation of receipt), provided that a copy is mailed by certified mail, return receipt requested, or (c) when received by the addressee, if sent by a nationally recognized overnight delivery service, in each case to the appropriate addresses and facsimile numbers set forth below (or to such other addresses and facsimile numbers as a party may designate by notice to the other parties): If to the Company: Cyberonics, Inc. 16511 Space Center Blvd. Houston, Texas 77058 Facsimile No.: ____________ If to Employee: ------------------------- ------------------------- ------------------------- 7 8. MISCELLANEOUS. No provisions of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by Employee and by the Chairman of the Board or an authorized officer of the Company. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. 9. VALIDITY. The interpretation, construction and performance of this Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Texas without regard to conflicts of laws principles. The invalidity or unenforceability of any provisions of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, each of which shall remain in full force and effect. 10. COUNTERPARTS. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which together shall constitute one and the same instrument. 11. DESCRIPTIVE HEADINGS. Descriptive headings are for convenience only and shall not control or affect the meaning or construction of any provision of this Agreement. 12. CORPORATE APPROVAL. This Agreement has been approved by the Board, and has been duly executed and delivered by Employee and on behalf of the Company by its duly authorized representative. 13. DISPUTES. The parties agree to resolve any claim or controversy arising out of or relating to this Agreement by binding arbitration under the Federal Arbitration Act before one arbitrator in the City of Houston, State of Texas, administered by the American Arbitration Association under its Commercial Arbitration Rules, and judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. The Company shall reimburse Employee, on a current basis, for all legal fees and expenses incurred by Employee in connection with any dispute arising under this Agreement, including, without limitation, the fees and expenses of the arbitrator, unless the arbitrator finds Employee brought such claim in bad faith, in which event each party shall pay its own costs and expenses and Employee shall repay to the Company any fees and expenses previously paid on Employee's behalf by the Company. The parties stipulate that the provisions hereof shall be a complete defense to any suit, action, or proceeding instituted in any federal, state, or local court or before any administrative tribunal with respect to any controversy or dispute arising during the period of this Agreement and which is arbitrable as herein set forth. The arbitration provisions hereof shall, with respect to such controversy or dispute, survive the termination of this Agreement. 8 IN WITNESS WHEREOF, the Company and Employee have executed this Agreement in multiple counterparts effective for all purposes as of the Effective Date. CYBERONICS, INC. By: /s/ Robert P. Cummins --------------------------- Name: Robert P. Cummins Title: President and Chief Executive Officer EMPLOYEE /s/ David Erinakes ------------------------------ 9 EX-10.3 5 h94648ex10-3.txt SEVERANCE AGREEMENT - RICHARD RUDOLPH EXHIBIT 10.3 CLASS I SEVERANCE AGREEMENT THIS AGREEMENT (the "Agreement"), made and entered into effective as of January 1, 2002 (the "Effective Date"), is by and between CYBERONICS, INC., a Delaware corporation (the "Company"), and RICHARD RUDOLPH (the "Employee"). WHEREAS, Employee is a key employee of the Company; and WHEREAS, the Company recognizes that the possibility of a Change of Control (as defined below) of the Company is unsettling and may result in the departure of key employees to the detriment of the Company and its stockholders; and WHEREAS, the Board of Directors of the Company (the "Board") has authorized this Agreement and certain similar agreements in order to retain key employees to ensure the continuity of its management; THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Company and Employee agree as follows: 1. TERM. This Agreement shall commence on the Effective Date and shall continue until April 30, 2003; provided, however, that commencing on April 30, 2002 and on each April 30th thereafter, the Term of this Agreement shall automatically be extended for one additional year, unless at least six months prior to such April 30 date the Board shall give written notice to Employee that the Term of this Agreement shall cease to be so extended; provided further, however, that if a Change of Control shall occur during the Term, the Term shall automatically continue in effect for a period of not less than one year from the date of such Change of Control. Notwithstanding the foregoing, except as provided in Section 3, this Agreement shall automatically terminate on Employee's termination of employment; provided, however, termination of this Agreement shall not alter or impair any rights of Employee arising hereunder on or prior to such termination. 2. CHANGE OF CONTROL. For purposes of this Agreement, a Change of Control of the Company shall mean: (i) the acquisition by any "person," as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), other than the Company, a subsidiary of the Company or a Company employee benefit plan, of "beneficial ownership" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing 50% or more of the combined voting power of the Company's then outstanding securities entitled to vote generally in the election of directors; or (ii) the consummation of a reorganization, merger, consolidation or other form of corporate transaction or series of transactions, in each case, with respect to which persons who were the shareholders of the Company immediately prior to such reorganization, merger or consolidation or other transaction do not, immediately thereafter, own more than 50% of the combined voting power entitled to vote generally in the election of directors of the reorganized, merged or consolidated company's then outstanding voting securities in substantially the same proportions as their ownership immediately prior to such event; or (iii) the sale or disposition by the Company of all or substantially all the Company's assets; or (iv) a change in the composition of the Board, as a result of which fewer than a majority of the directors are Incumbent Directors. "Incumbent Directors" shall mean directors who either (A) are directors of the Company as of October 2, 2000, or (B) are elected, or nominated for election, thereafter to the Board with the affirmative votes of at least a majority of the Incumbent Directors at the time of such election or nomination, but "Incumbent Director" shall not include an individual whose election or nomination is in connection with (i) an actual or threatened election contest (as such terms are used in Rule 14a-11 of Regulation 14A promulgated under the Exchange Act) or an actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board or (ii) a plan or agreement to replace a majority of the then Incumbent Directors; or (v) the approval by the Board or the stockholders of the Company of a complete or substantially complete liquidation or dissolution of the Company. 3. TERMINATION ON OR FOLLOWING A CHANGE OF CONTROL. If a Change of Control occurs during the Term, Employee shall be entitled to the benefits provided in Section 4 hereof if, during the Protected Period (as hereinafter defined), Employee becomes disabled or Employee's employment is terminated, unless such termination is (a) due to Employee's death, (b) by the Company either for Cause or Employee's Disability, or (c) by Employee for other than a Good Reason. Anything in this Agreement to the contrary notwithstanding, if Employee's employment with the Company is terminated during the Term and prior to the date on which a Change of Control occurs, and it is reasonably demonstrated that such termination (i) was at the request of a third party who has taken steps reasonably calculated to effect the Change of Control, or (ii) otherwise arose in connection with or anticipation of the Change of Control, then for all purposes of this Agreement the Change of Control shall be deemed to have occurred on the date immediately prior to the date of Employee's termination and Employee shall be deemed terminated by the Company during the Protected Period other than for Cause. For purposes of this Agreement, the "Protected Period" shall mean the period of time beginning with the Change of Control and ending on the first anniversary of such Change of Control or Employee's death, if earlier. (i) DISABILITY. If, as a result of Employee's incapacity due to physical or mental illness, Employee shall have been absent from Employee's duties with the Company on a full-time basis for 150 consecutive calendar days, and within 30 days after written Notice of Termination (as defined hereinafter) Employee shall not have returned to the full-time performance of Employee's duties, the Company may terminate Employee's employment for "Disability"; provided, however, a termination of Employee's employment for Disability under this Agreement shall not alter or impair Employee's rights as a "disabled employee" under any of the Company's employee benefit plans. (ii) CAUSE. The Company may terminate Employee's employment for Cause. For the purposes of this Agreement, the Company shall have "Cause" to terminate Employee's employment hereunder only upon (A) the willful and continued failure by Employee to perform substantially Employee's duties with the Company, other than any such failure resulting from Employee's incapacity due to physical or mental illness, which continues unabated after a written demand for substantial performance is delivered to Employee by the Board that specifically identifies the manner in which the Board believes that Employee has not substantially performed Employee's duties or (B) Employee willfully engaging in gross misconduct that is materially and demonstrably injurious to the Company. For purposes of this paragraph, an act or failure to act on Employee's part shall be considered "willful" only if done or omitted to be done by Employee otherwise than in good faith and without reasonable belief that Employee's action or omission was in the best interest of the Company. Notwithstanding the foregoing, Employee shall not be deemed to have been terminated for Cause unless and until there shall have been delivered to Employee a copy of a resolution duly adopted by the affirmative vote of not less than three-quarters of the entire membership of the Board, at a meeting of the Board called and held for such purpose (after reasonable notice to Employee and an opportunity for Employee, together with Employee's counsel, to be heard before the Board), finding that in the good faith opinion of the Board Employee was guilty of conduct set forth in clauses (A) or (B) of this subsection (ii) and specifying the particulars thereof in reasonable detail. (iii) GOOD REASON. Employee may terminate Employee's employment for Good Reason. For purposes of this Agreement, "Good Reason" shall mean the occurrence of any of the following without Employee's express written consent: (A) an adverse change (as determined by Employee in good faith, which determination shall be controlling for all purposes under this Agreement) in Employee's (i) positions, duties, responsibilities or status with the Company from that in effect immediately prior to the Change of Control, or (ii) reporting responsibilities, titles or offices as in effect immediately prior to the Change of Control; or any removal of Employee from, or any failure to re-elect or appoint Employee to, any of such responsibilities, titles, offices or positions, except in connection with the termination of Employee's employment for Cause or Disability, or as a result of Employee's death, or by Employee for other than a Good Reason; (B) a reduction in Employee's annual rate of base salary as in effect immediately prior to the Change of Control or as the same may be increased from time to time thereafter (the "Base Salary"); (C) a failure by the Company to continue the Company's Annual Incentive Compensation Plan as the same may be modified from time to time, but substantially in the form in effect immediately prior to the Change of Control (the "Bonus Plan"), or a failure by the Company to continue Employee as a participant in the Bonus Plan 3 in at least the same amount (the "Bonus Amount" ) as Employee's target bonus amount under the Bonus Plan with respect to the fiscal year ending immediately prior to the Change of Control or with respect to the current fiscal year if Employee has been employed by the Company for a shorter period (Bonus Amounts related to less than a full fiscal year shall be annualized for this purpose); (D) the failure by the Company to continue in effect any other employee benefit or compensation plan program or policy, in which Employee is participating immediately prior to the Change of Control, unless the Company establishes such new plans, programs or policies as is necessary to provide Employee with substantially comparable benefits; the taking of any action by the Company not required by law that would adversely affect Employee's participation in or reduce Employee's benefits under any of such plans, programs or policies or deprive Employee of any material fringe benefit enjoyed by Employee immediately prior to the Change of Control; (E) the Company's requiring Employee to relocate to an office more than 25 miles from the Company's office to which Employee was assigned immediately prior to the Change of Control, except for required travel on the Company's business to an extent substantially consistent with Employee's business travel obligations immediately prior to the Change of Control; (F) the amendment, modification or repeal of any provision of the Company's Certificate of Incorporation, as amended, or the Bylaws of the Company which was in effect immediately prior to such Change of Control, if such amendment, modification or repeal would adversely effect Employee's right to indemnification by the Company; (G) the failure of the Company to obtain the assumption of this Agreement by any successor as contemplated in Section 6 hereof; or (H) any purported termination of Employee's employment that is not effected pursuant to a Notice of Termination satisfying the requirements of subparagraph (iv) below and, if applicable, subparagraph (ii) above; and for purposes of this Agreement, no such purported termination shall be effective. Employee's right to terminate employment for a Good Reason hereunder shall not be affected by Employee's incapacity due to a physical or mental illness nor shall Employee's continued employment following any circumstance that constitutes a Good Reason hereunder, regardless of the length of such continued employment, constitute a consent to or a waiver of Employee's rights hereunder with respect to such circumstance. (iv) NOTICE OF TERMINATION. Any termination by the Company pursuant to subparagraphs (i) or (ii) above, or by Employee pursuant to subparagraph (iii) above, shall be communicated by written Notice of Termination to the other party hereto. For purposes of this Agreement, a "Notice of Termination" shall mean a notice that shall indicate the 4 specific termination provision in this Agreement relied upon and shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of Employee's employment under the provision so indicated. (v) DATE OF TERMINATION. "Date of Termination" shall mean (A) if Employee is terminated for Disability, 30 days after Notice of Termination is given, provided that Employee shall not have returned to the performance of Employee's duties on a full-time basis during such 30-day period, (B) if Employee's employment is terminated pursuant to subparagraph (iii) above, the date specified in the Notice of Termination, (C) with respect to a termination prior to a Change of Control, which is deemed to be after such Change of Control as provided in Section 3, the date of such termination, and (D) if Employee's employment is terminated for any other reason on or after a Change of Control, the date of such termination. 4. COMPENSATION DURING DISABILITY OR UPON TERMINATION. (i) If, during the Protected Period, Employee fails to perform Employee's normal duties as a result of incapacity due to physical or mental illness, Employee shall continue during the period of such disability to receive Employee's full Base Salary and any awards, deferred and nondeferred, payable during such period under the Bonus Plan, less any amounts paid to Employee during such period of disability pursuant to the Company's short term disability or sick-leave program(s) until Employee's employment is terminated or such Disability ends. This Section 4(i) shall not reduce or impair Employee's rights to terminate employment for a Good Reason as otherwise provided herein. (ii) If, during the Protected Period, Employee's employment shall be terminated (x) by the Company for Cause, (y) by Employee's death, or (z) by Employee other than for a Good Reason, the Company shall pay Employee's earned but unpaid Base Salary through the Date of Termination and the Company shall have no further obligations to Employee under this Agreement. (iii) If, during the Protected Period, (1) the Company shall terminate Employee other than for Cause or Disability or (2) Employee shall terminate Employee's employment for a Good Reason, the Company shall pay to Employee, by certified or bank cashier's check or wire transfer within five business days after the Date of Termination, an amount equal to: (A) three times the sum of Employee's Base Salary and Bonus Amount; plus (B) that portion of Employee's Base Salary earned, and vacation pay vested for the prior year and accrued for the current year to the Date of Termination, but not paid or used, and all other amounts previously deferred by Employee or earned but not paid as of such date under all Company bonus or pay plans or programs. (iv) If any payment due under the terms of this Agreement is not timely made or otherwise withheld by the Company, its successors or assigns, interest shall accrue on such payment at the highest maximum legal rate permissible under applicable law from the date such payment first became due through the date of payment thereof. 5 (v) In the event that any payment or benefit received or to be received by Employee pursuant to the terms of this Agreement or any other plan, arrangement or agreement with (A) the Company, (B) any Person whose actions result in a "change in control" (for purposes of Section 280G of the Internal Revenue Code (the "Code")) or (C) any Person affiliated with the Company or such Person) (all such payments and benefits being hereinafter called "Total Payments") would be subject to the excise tax imposed under Section 280G of the Code, the Company shall pay to Employee such additional amount (the "Gross-Up Payment") such that the net amount retained by Employee, after deduction of any excise tax imposed under Section 4999 of the Code (the "Excise Tax") on the Total Payments and all federal, state and local taxes, including the Excise Tax, upon the Gross-Up Payment, shall be equal to the Total Payments. For purposes of determining the amount of the Gross-Up Payment, Employee shall be deemed to pay federal income tax at the highest marginal rate of federal income taxation in the calendar year in which the Gross-Up Payment is to be made and state and local income taxes at the highest marginal rate of taxation in the state and locality of Employee's residence on the date on which the Gross-Up Payment is calculated for purposes of this subparagraph. In the event that the Excise Tax is subsequently determined to be less than the amount taken into account hereunder, Employee shall repay to the Company, at the time that the amount of such reduction in Excise Tax is finally determined, the portion of the Gross-Up Payment attributable to such reduction (plus that portion of the Gross-Up Payment being repaid by Employee to the extent that such repayment results in a reduction in Excise Tax and/or a federal, state or local income tax deduction) plus interest on the amount of such repayment at the rate provided in Section 1274(b)(2)(B) of the Code. In the event that the Excise Tax is determined to exceed the amount taken into account hereunder (including by reason of any payment the existence or amount of which cannot be determined at the time of the Gross-Up Payment), the Company shall make an additional Gross-Up Payment in respect of such excess (plus any interest, penalties or additions payable by Employee with respect to such excess) at the time that the amount of such excess if finally determined. Employee and the Company shall each reasonably cooperate with the other in connection with any administrative or judicial proceedings concerning the existence or amount of liability for Excise Tax with respect to the Total Payments. The parties intend that the Gross-Up Payment be determined in a manner that is most favorable to Employee. 5. NO MITIGATION OR OFFSET. The provisions of this Agreement are not intended to, nor shall they be construed to, require that Employee mitigate the amount of any payment provided for in this Agreement by seeking or accepting other employment, nor shall the amount of any payment provided for in this Agreement be reduced by any compensation earned by Employee as the result of employment by another employer or otherwise. Without limitation of the foregoing, the Company's obligations to make the payments to Employee required under this Agreement shall not be affected by any set off, counterclaim, recoupment, defense or other claim, right or action that the Company may have against Employee. 6. SUCCESSORS; BINDING AGREEMENT. (i) The Company will require any successor, whether direct or indirect, by purchase, merger, consolidation or otherwise, to all or substantially all of the business and/or assets of 6 the Company, by agreement in form and substance reasonably satisfactory to Employee, expressly to assume and agree to perform this Agreement in the same manner and to the same extent as the Company would have been required if no such succession had taken place. Failure of the Company to obtain such agreement prior to the effectiveness of any such succession shall be a breach of this Agreement and shall entitle Employee to payment from the Company in the same amount and on the same terms as Employee would be entitled hereunder if Employee had terminated Employee's employment for Good Reason, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Date of Termination. As used in this Agreement, "Company" shall mean the Company as hereinbefore defined and any successor to its business and/or assets as aforesaid that executes and delivers the agreement provided for in this Section 6 or which otherwise becomes bound by all the terms and provisions of this Agreement by operation of law. (ii) This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If Employee should die while any amounts would still be payable to Employee hereunder if Employee had continued to live, all such amounts shall be paid in accordance with the terms of this Agreement to Employee's beneficiary as filed with the Company pursuant to this Agreement or, if there be no such designated beneficiary, to Employee's estate. 7. NOTICE. All notices, consents, waivers, and other communications required under this Agreement must be in writing and will be deemed to have been duly given when (a) delivered by hand (with written confirmation of receipt), (b) sent by facsimile (with confirmation of receipt), provided that a copy is mailed by certified mail, return receipt requested, or (c) when received by the addressee, if sent by a nationally recognized overnight delivery service, in each case to the appropriate addresses and facsimile numbers set forth below (or to such other addresses and facsimile numbers as a party may designate by notice to the other parties): If to the Company: Cyberonics, Inc. 16511 Space Center Blvd. Houston, Texas 77058 Facsimile No.: ____________ If to Employee: ------------------------- ------------------------- ------------------------- 7 8. MISCELLANEOUS. No provisions of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by Employee and by the Chairman of the Board or an authorized officer of the Company. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. 9. VALIDITY. The interpretation, construction and performance of this Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Texas without regard to conflicts of laws principles. The invalidity or unenforceability of any provisions of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, each of which shall remain in full force and effect. 10. COUNTERPARTS. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which together shall constitute one and the same instrument. 11. DESCRIPTIVE HEADINGS. Descriptive headings are for convenience only and shall not control or affect the meaning or construction of any provision of this Agreement. 12. CORPORATE APPROVAL. This Agreement has been approved by the Board, and has been duly executed and delivered by Employee and on behalf of the Company by its duly authorized representative. 13. DISPUTES. The parties agree to resolve any claim or controversy arising out of or relating to this Agreement by binding arbitration under the Federal Arbitration Act before one arbitrator in the City of Houston, State of Texas, administered by the American Arbitration Association under its Commercial Arbitration Rules, and judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. The Company shall reimburse Employee, on a current basis, for all legal fees and expenses incurred by Employee in connection with any dispute arising under this Agreement, including, without limitation, the fees and expenses of the arbitrator, unless the arbitrator finds Employee brought such claim in bad faith, in which event each party shall pay its own costs and expenses and Employee shall repay to the Company any fees and expenses previously paid on Employee's behalf by the Company. The parties stipulate that the provisions hereof shall be a complete defense to any suit, action, or proceeding instituted in any federal, state, or local court or before any administrative tribunal with respect to any controversy or dispute arising during the period of this Agreement and which is arbitrable as herein set forth. The arbitration provisions hereof shall, with respect to such controversy or dispute, survive the termination of this Agreement. 8 IN WITNESS WHEREOF, the Company and Employee have executed this Agreement in multiple counterparts effective for all purposes as of the Effective Date. CYBERONICS, INC. By: /s/ Robert P. Cummins ------------------------------ Name: Robert P. Cummins Title: President and Chief Executive Officer EMPLOYEE /s/ Richard Rudolph --------------------------------- -----END PRIVACY-ENHANCED MESSAGE-----