10QSB 1 a38752.txt ORTEC INTERNATIONAL, INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------- FORM 10-QSB ---------- (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended September 30, 2004 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from ______________ to ______________ Commission file number 0-27368 ORTEC INTERNATIONAL, INC. (Exact name of small business issuer as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 11-3068704 (I.R.S. Employer Identification No.) 3960 Broadway New York, New York 10032 (Address of principal executive offices) (212) 740-6999 (Issuer's telephone number) ---------- Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 [ ] The number of shares outstanding of the issuer's common stock is 5,640,991 (as of November 11, 2004) ORTEC INTERNATIONAL, INC. INDEX TO QUARTERLY REPORT ON FORM 10-QSB FILED WITH THE SECURITIES AND EXCHANGE COMMISSION QUARTER ENDED September 30,2004 ITEMS IN FORM 10-QSB
Page ---- Facing page Part I - FINANCIAL INFORMATION Item 1. Condensed Financial Statements (Unaudited) 3 Item 2. Management's Discussion and Analysis of 19 Financial Condition and Results of Operation Item 3. Controls and Procedures 26 Part II - OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Changes in Securities 27 Item 3. Default Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K 28 SIGNATURES 29
Item 1. FINANCIAL STATEMENTS ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31, 2004 2003 ------------- ------------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 140,598 $ 1,328,387 Prepaid and other current assets 251,228 33,756 ------------- ------------- Total current assets 391,826 1,362,143 Property and equipment (net of accumulated depreciation: 2004 - $4,012,448; 2003 - $3,749,251) 392,408 589,840 Patent application costs (net of accumulated amortization: 2004 - $414,061; 2003 - $352,998) 601,144 620,513 Deposits and other assets (net of accumulated amortization: 2004 - $18,345; 2003 - $13,883) 180,313 159,775 ------------- ------------- Total assets $ 1,565,691 $ 2,732,271 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY/(DEFICIT) Current liabilities: Accounts payable and accrued expenses $ 4,273,699 $ 4,147,726 Due to founder 395,754 398,574 Insurance premium financing payable 50,675 -- Loan payable - current 199,771 168,668 Capital lease obligation, current (net of unamortized debt discount, 2004 - $14,900) 79,925 150,937 Advances payable -- 130,000 Promissory notes 9,141,481 2,869,000 Obligation under revenue interest assignment 22,995,109 18,553,856 ------------- ------------- Total current liabilities 37,136,414 26,418,761 Promissory notes - noncurrent 101,869 -- Loan payable - noncurrent 52,418 444,737 Long term payable 206,292 304,122 Capital lease obligation - noncurrent 32,445 41,058 ------------- ------------- Total liabilities 37,529,438 27,208,678 COMMITMENTS AND CONTINGENCIES Shareholders' equity/(deficit): Common stock, $.001 par value; authorized, 200,000,000 shares; shares issued and outstanding: 2004: 5,571,865 and 5,420,665; 2003: 5,233,165 and 5,231,165, respectively 5,571 5,233 Preferred stock, $.001 par value, authorized 1,000,000 shares: Redeemable convertible - Series B, stated value $10,000 per share; authorized 1,200 shares; 50 shares issued; liquidation preference $500,000 270,859 270,859 Series C, stated value $6,000 per share; authorized 2,000 shares; 948 shares issued, 930 shares outstanding; liquidation preference $5,581,600 3,597,180 3,667,041 Convertible - Series D, stated value $10,000 per share; authorized 2,000 shares; 483 shares issued; liquidation preference $4,828,850 2,628,602 2,628,602 Additional paid-in capital 73,709,368 72,437,243 Deficit accumulated during the development stage (115,997,682) (103,307,740) Treasury stock, 2,000 shares, at cost (177,645) (177,645) ------------- ------------- Total shareholders' equity (deficit) (35,963,747) (24,476,407) ------------- ------------- Total liabilities and shareholders' equity (deficit) $ 1,565,691 $ 2,732,271 ============= =============
See accompanying notes to condensed unaudited financial statements. 3 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED STATEMENTS OF OPERATIONS (Unaudited)
Cumulative from Three months ended Sept. 30, Nine months ended Sept. 30, March 12, 1991 ---------------------------- --------------------------- (inception) to 2004 2003 2004 2003 Sept. 30, 2004 ----------- ----------- ------------ ------------ --------------- Product revenue $ -- $ -- $ -- $ -- $ 265,665 ----------- ----------- ------------ ------------ ------------- Expenses Product and laboratory costs 775,729 731,401 2,083,740 1,615,084 26,235,864 Rent 120,748 120,115 363,456 456,687 3,853,968 Consulting 650 1,396 12,545 (27,735) 5,702,151 Personnel 936,172 928,629 2,900,083 2,949,064 36,228,518 General and administrative 530,505 763,955 1,362,429 1,884,103 18,733,486 Interest and other expense 2,022,725 1,221,485 5,771,818 3,443,768 18,807,720 Lease termination costs -- -- -- 1,119,166 1,119,166 Loss on extinguishment of debt and series A preferred stock -- -- -- -- 1,004,027 Interest and other income (236,000) (106) (262,819) (14,804) (2,534,804) ----------- ----------- ------------ ------------ ------------- 4,150,529 3,766,875 12,231,252 11,425,333 109,150,096 ----------- ----------- ------------ ------------ ------------- Net loss (4,150,529) (3,766,875) (12,231,252) (11,425,333) (108,884,431) Preferred stock dividends 154,190 140,600 458,690 1,119,272 2,844,251 Preferred stock deemed dividends and discounts -- 90,000 -- 4,269,000 4,269,000 ----------- ----------- ------------ ------------ ------------- Net loss applicable to common shareholders $(4,304,719) $(3,997,475) $(12,689,942) $(16,813,605) $(115,997,682) =========== =========== ============ ============ ============= Net loss per share Basic and diluted $ (0.76) $ (0.76) $ (2.30) $ (4.38) $ (106.90) =========== =========== ============ ============ ============= Weighted average shares outstanding Basic and diluted 5,697,182 5,263,628 5,518,194 3,842,933 1,085,119 =========== =========== ============ ============ =============
Shares outstanding and per share amounts adjusted to reflect one for ten reverse stock split declared on June 24, 2003 See accompanying notes to condensed unaudited financial statements. 4 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT)
Common Stock Preferred Stock ---------------- ------------------------------ Shares Amount Series B Series C Series D ------- ------ -------- -------- -------- March 12, 1991 (inception) to December 31, 1991 Issuance of stock Founders 155,382 $ 155 First private placement ($3.00 cash per share) 21,744 22 The Director ($11.50 and $53.00 cash per share) 14,902 15 Second private placement ($94.25 cash per share) 5,302 5 Share issuance expense Net loss ------- ----- Balance at December 31, 1991 197,330 197 Issuance of stock Second private placement ($94.25 cash per share) 4,932 5 Stock purchase agreement with the Director ($94.25 cash per share) 3,182 3 Share issuance expense Net loss ------- ----- Balance at December 31, 1991 205,444 205 Issuance of stock Third private placement ($100.00 cash per share) 13,215 13 Stock purchase agreement with Home Insurance Company ($90.00 cash per share) 11,112 11 Stock purchase agreement with the Director ($94.25 cash per share) 2,122 2 Shares issued in exchange for commission ($100.00 value per share) 60 1 Share issuance expenses Net loss ------- ----- Balance at December 31, 1993 (carried forward) 231,953 $ 232 Deficit accumulated Additional during the Total paid-in development Treasury shareholders' capital stage stock equity/(deficit) ---------- ------------ -------- ---------------- March 12, 1991 (inception) to December 31, 1991 Issuance of stock Founders $ 715 $ 870 First private placement ($3.00 cash per share) 64,978 65,000 The Director ($11.50 and $53.00 cash per share) 249,985 250,000 Second private placement ($94.25 cash per share) 499,995 500,000 Share issuance expense (21,118) (21,118) Net loss $ (281,644) (281,644) ---------- ----------- ----------- Balance at December 31, 1991 794,555 (281,644) 513,108 Issuance of stock Second private placement ($94.25 cash per share) 465,468 465,473 Stock purchase agreement with the Director ($94.25 cash per share) 299,995 299,998 Share issuance expense (35,477) (35,477) Net loss (785,941) (785,941) ---------- ----------- ----------- Balance at December 31, 1991 1,524,541 (1,067,585) 457,161 Issuance of stock Third private placement ($100.00 cash per share) 1,321,487 1,321,500 Stock purchase agreement with Home Insurance Company ($90.00 cash per share) 999,988 999,999 Stock purchase agreement with the Director ($94.25 cash per share) 199,998 200,000 Shares issued in exchange for commission ($100.00 value per share) 5,999 6,000 Share issuance expenses (230,207) (230,207) Net loss (1,445,624) (1,445,624) ---------- ----------- ----------- Balance at December 31, 1993 (carried forward) $3,821,806 $(2,513,209) $ 1,308,829
5 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT)
Common Stock Preferred Stock ---------------- ------------------------------ Shares Amount Series B Series C Series D ------- ------ -------- -------- -------- (brought forward) 231,953 $232 Issuance of stock Fourth private placement ($100.00 cash per share) 3,946 4 Stock purchase agreement with Home Insurance Company ($100.00 cash per share) 5,000 5 Share issuance expense Net loss ------- ---- Balance at December 31, 1994 240,899 241 Rent forgiveness Net loss ------- ---- Balance at December 31, 1995 240,899 241 Initial public offering 120,000 120 Exercise of warrants 3,389 3 Fifth private placement ($64.90 cash per share) 95,911 96 Share issuance expenses Stock options issued for services Net loss ------- ---- Balance at December 31, 1996 460,199 460 Exercise of warrants 115,878 116 Share issuance expenses Stock options and warrants issued for services Net loss ------- ---- Balance at December 31, 1997 (carried forward) 576,077 $576 Deficit accumulated Additional during the Total paid-in development Treasury shareholders' capital stage stock equity/(deficit) ----------- ------------ -------- ---------------- (brought forward) $ 3,821,806 $ (2,513,209) $ 1,308,829 Issuance of stock Fourth private placement ($100.00 cash per share) 397,708 397,712 Stock purchase agreement with Home Insurance Company ($100.00 cash per share) 499,995 500,000 Share issuance expense (8,697) (8,697) Net loss (1,675,087) (1,675,087) ----------- ------------ ----------- Balance at December 31, 1994 4,710,812 (4,188,296) 522,757 Rent forgiveness 40,740 40,740 Net loss (1,022,723) (1,022,723) ----------- ------------ ----------- Balance at December 31, 1995 4,751,552 (5,211,019) (459,226) Initial public offering 5,999,880 6,000,000 Exercise of warrants 33,882 33,885 Fifth private placement ($64.90 cash per share) 6,220,701 6,220,797 Share issuance expenses (1,580,690) (1,580,690) Stock options issued for services 152,000 152,000 Net loss (2,649,768) (2,649,768) ----------- ------------ ----------- Balance at December 31, 1996 15,577,325 (7,860,787) 7,716,998 Exercise of warrants 10,822,675 10,822,791 Share issuance expenses (657,508) (657,508) Stock options and warrants issued for services 660,000 660,000 Net loss (4,825,663) (4,825,663) ----------- ------------ ----------- Balance at December 31, 1997 (carried forward) $26,402,492 $(12,686,450) $13,716,618
6 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT)
Common Stock Preferred Stock ---------------- ------------------------------ Shares Amount Series B Series C Series D ------- ------ -------- -------- -------- (brought forward) 576,077 $576 Exercise of warrants 22,149 22 Stock options and warrants issued for services Sixth private placement 20,000 20 Warrants issued in Sixth private placement Share issuance expenses Purchase of 660 shares of treasury (at cost) Net loss ------- ---- Balance at December 31, 1998 618,226 618 Exercise of warrants 1,410 1 Stock options and warrants issued for services Seventh private placement ($87.50 cash per share) 38,916 39 Warrants issued in Seventh private placement Eighth private placement ($55.00 cash per share) 163,637 164 Share issuance expenses Purchase of 910 shares of treasury (at cost) Net loss ------- ---- Balance at December 31, 1999 822,189 822 Exercise of options and warrants 17,554 17 Stock options and warrants issued for services Ninth private placement ($150.00 cash per share) 6,667 7 Warrants issued in Ninth private placement Tenth private placement ($67.50 cash per share) 124,757 125 Share issuance expenses Purchase of 430 shares of treasury stock (at cost) Net loss ------- ---- Balance at December 31, 2000 (carried forward) 971,167 $971 Deficit accumulated Additional during the Total paid-in development Treasury shareholders' capital stage stock equity/(deficit) ----------- ------------ --------- ---------------- (brought forward) $26,402,492 $(12,686,450) $ 13,716,618 Exercise of warrants 1,281,935 1,281,957 Stock options and warrants issued for services 1,920,111 1,920,111 Sixth private placement 1,788,678 1,788,698 Warrants issued in Sixth private placement 211,302 211,302 Share issuance expenses (48,000) (48,000) Purchase of 660 shares of treasury (at cost) $ (67,272) (67,272) Net loss (8,412,655) (8,412,655) ----------- ------------ --------- ------------ Balance at December 31, 1998 31,556,518 (21,099,105) (67,272) 10,390,759 Exercise of warrants 14,102 14,103 Stock options and warrants issued for services 64,715 64,715 Seventh private placement ($87.50 cash per share) 3,168,746 3,168,785 Warrants issued in Seventh private placement 468,291 468,291 Eighth private placement ($55.00 cash per share) 8,999,838 9,000,002 Share issuance expenses (619,908) (619,908) Purchase of 910 shares of treasury (at cost) (75,518) (75,518) Net loss (10,040,509) (10,040,509) ----------- ------------ --------- ------------ Balance at December 31, 1999 43,652,302 (31,139,614) (142,790) 12,370,720 Exercise of options and warrants 327,265 327,282 Stock options and warrants issued for services 56,265 56,265 Ninth private placement ($150.00 cash per share) 999,998 1,000,005 Warrants issued in Ninth private placement 23,000 23,000 Tenth private placement ($67.50 cash per share) 8,420,946 8,421,071 Share issuance expenses (641,500) (641,500) Purchase of 430 shares of treasury stock (at cost) (34,855) (34,855) Net loss (12,129,663) (12,129,663) ----------- ------------ --------- ------------ Balance at December 31, 2000 (carried forward) $52,838,276 $(43,269,277) $(177,645) $ 9,392,325
7 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT)
Common Stock Preferred Stock ------------------ --------------------------------- Shares Amount Series B Series C Series D --------- ------ ----------- -------- -------- (brought forward) 971,167 $ 971 Stock options and warrants issued for services Net loss --------- ------ ----------- -------- -------- Balance at December 31, 2001 971,167 971 Exercise of options and warrants 35,723 36 Stock options and warrants issued for services Warrants issued with convertible debentures Warrants issued with convertible redeemable preferred stock Convertible debenture conversion benefit Redeemable convertible preferred stock conversion benefit Issuance of series B preferred stock (938 shares) ($10,000 cash per share) $ 9,382,742 Warrants issued and exercised with preferred stock 938,275 938 (3,479,043) Shares issuance costs - preferred stock (866,612) Preferred stock dividends 375,312 375 Net loss --------- ------ ----------- -------- -------- Balance at December 31, 2002 (carried forward) 2,320,477 $2,320 $ 5,037,087 Deficit accumulated Additional during the Total paid-in development Treasury shareholders' capital stage Stock equity/(deficit) ----------- ------------ --------- ---------------- (brought forward) $52,838,276 $(43,269,277) $(177,645) $ 9,392,325 Stock options and warrants issued for services 188,080 188,080 Net loss (15,885,377) (15,885,377) ----------- ------------ --------- ------------ Balance at December 31, 2001 53,026,356 (59,154,654) (177,645) (6,304,972) Exercise of options and warrants 321 357 Stock options and warrants issued for services 113,060 113,060 Warrants issued with convertible debentures 440,523 440,523 Warrants issued with convertible redeemable preferred stock 559,289 559,289 Convertible debenture conversion benefit 1,042,663 1,042,663 Redeemable convertible preferred stock conversion benefit 1,097,886 1,097,886 Issuance of series B preferred stock (938 shares) ($10,000 cash per share) 9,382,742 Warrants issued and exercised with preferred stock 3,485,443 7,338 Shares issuance costs - preferred stock 304,615 (561,997) Preferred stock dividends 1,125,559 (1,125,934) -- Net loss (21,578,021) (21,578,021) ----------- ------------ --------- ------------ Balance at December 31, 2002 (carried forward) $61,195,715 $(81,858,609) $(177,645) $(15,801,132)
8 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT)
Common Stock Preferred Stock ------------------ -------------------------------------- Shares Amount Series B Series C Series D --------- ------ ----------- ----------- ---------- (brought forward) 2,320,477 $2,320 $ 5,037,087 Exercise of options and warrants 398,750 399 Issuance of preferred stock: series B (200 shares), series C (948 shares) 2,000,000 $ 5,690,000 Warrants issued with preferred stock (490,567) (1,225,632) Warrants issued for services Share issuance costs - preferred stock (393,488) (797,327) Conversion of series B preferred stock (605 shares) into common stock 2,421,556 2,422 (3,253,571) Conversion of series B preferred stock into series D Preferred stock (483 shares) (2,628,602) $2,628,602 Preferred stock deemed dividends and discounts Preferred stock dividends 92,308 92 Common stock dividend to be distributed on series C preferred stock Common stock to be issued in connection with promissory notes Adjustment for one for ten reverse stock split 74 Net loss --------- ------ ----------- ----------- ---------- Balance at December 31, 2003 5,233,165 5,233 270,859 3,667,041 2,628,602 Common stock issued in connection with promissory notes 127,500 127 Common stock issued in connection with previously issued promissory notes 157,000 157 Conversion of series C preferred stock (18 shares) into common stock 54,200 54 (69,861) Common stock to be issued in connection with promissory notes Common stock dividend to be distributed on series B and C preferred stock Warrant issued for services Warrant to be issued in connection with lease Share issuance expenses Net loss --------- ------ ----------- ----------- ---------- Balance at September 30, 2004 5,571,865 $5,571 $ 270,859 $3,597,180 $2,628,602 ========= ====== =========== =========== ========== Deficit accumulated Additional during the Total paid-in development Treasury shareholders' capital stage Stock equity/(deficit) ----------- ------------- --------- ---------------- (brought forward) $61,195,715 $ (81,858,609) $(177,645) $(15,801,132) Exercise of options and warrants 12,567 12,966 Issuance of preferred stock: series B (200 shares), series C (948 shares) 7,690,000 Warrants issued with preferred stock 1,716,199 -- Warrants issued for services 87,000 87,000 Share issuance costs - preferred stock 359,078 (831,737) Conversion of series B preferred stock (605 shares) into common stock 3,251,149 -- Conversion of series B preferred stock into series D Preferred stock (483 shares) -- Preferred stock deemed dividends and discounts 4,269,000 (4,269,000) -- Preferred stock dividends 922,985 (923,077) -- Common stock dividend to be distributed on series C preferred stock 336,550 (336,550) -- Common stock to be issued in connection with promissory notes 287,000 287,000 Adjustment for one for ten reverse stock split Net loss (15,920,504) (15,920,504) ----------- ------------- --------- ------------ Balance at December 31, 2003 72,437,243 (103,307,740) (177,645) (24,476,407) Common stock issued in connection with promissory notes 325,123 325,250 Common stock issued in connection with previously issued promissory notes (157) -- Conversion of series C preferred stock (18 shares) into common stock 69,807 -- Common stock to be issued in connection with promissory notes 332,762 332,762 Common stock dividend to be distributed on series B and C preferred stock 458,690 (458,690) -- Warrant issued for services 94,000 94,000 Warrant to be issued in connection with lease 18,500 18,500 Share issuance expenses (26,600) (26,600) Net loss (12,231,252) (12,231,252) ----------- ------------- --------- ------------ Balance at September 30, 2004 $73,709,368 $(115,997,682) $(177,645) $(35,963,747) =========== ============= ========= ============
Common stock shares and amounts have been adjusted to reflect one for ten reverse stock split effective June 24, 2003. See accompanying notes to condensed unaudited financial statements. 9 ORTEC INTERNATIONAL INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)
Cumulative from Nine Months Ended Sept. 30, March 12, 1991 ---------------------------- (inception) to 2004 2003 Sept. 30, 2004 ------------ ------------ --------------- Cash flows from operating activities Net loss $(12,231,252) $(11,425,333) $(108,884,431) Adjustments to reconcile net loss to net cash used in operating activities Depreciation and amortization 1,288,805 477,051 6,096,711 Allowance for doubtful accounts -- -- 5,374 Unrealized loss on marketable securities -- -- 11,404 Realized loss on marketable securities -- -- 5,250 (Gain) Loss on sale of property and equipment (26,802) -- (58,642) Cost to terminate lease on New Jersey facility -- 1,130,243 836,032 Non-cash stock compensation 94,000 -- 3,335,231 Non-cash imputed interest 4,441,253 3,359,755 16,348,259 Gain on loan adjustment (236,000) -- (236,000) Loss on extinguishment of debt and series A preferred stock -- -- 1,004,027 Purchase of marketable securities -- -- (19,075,122) Sales of marketable securities -- -- 19,130,920 Changes in operating assets and liabilities Prepaid and other current assets 61,045 54,270 119,656 Accounts payable and accrued liabilities 862,792 (250,484) 5,741,541 ------------ ------------ ------------- Net cash used in operating activities (5,746,159) (6,654,498) (75,619,790) ------------ ------------ ------------- Cash flows from investing activities Purchases of property and equipment (64,184) (11,687) (4,529,904) Proceeds from sale of property and equipment 14,025 -- 145,926 Payments for patent applications (41,694) (60,376) (1,013,425) Organization costs -- -- (10,238) Deposits -- -- (806,273) Purchases of marketable securities -- -- (594,986) Sale of marketable securities -- -- 522,532 ------------ ------------ ------------- Net cash used in investing activities (91,853) (72,063) (6,286,368) ------------ ------------ -------------
10 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED STATEMENTS OF CASH FLOWS (continued) (Unaudited)
Cumulative from Nine Months Ended Sept. 30, March 12, 1991 --------------------------- (inception) to 2004 2003 Sept. 30, 2004 ----------- ---------- --------------- Cash flows from financing activities Proceeds from issuance of notes payable $ 5,545,000 $ -- $ 9,200,500 Proceeds from issuance of common stock -- 53,550,522 Proceeds from exercise of warrants -- 12,966 20,660 Share issuance and other financing costs (26,600) (831,737) (5,370,013) Purchase of treasury stock -- -- (177,645) Proceeds from issuance of loan payable -- -- 1,446,229 Proceeds from obligations under Revenue Interest Assignment -- -- 10,000,000 Proceeds from issuance of convertible debentures -- -- 5,908,000 Proceeds from issuance of redeemable preferred stock - series A -- -- 1,200,000 Proceeds from issuance of preferred stock - series B -- 2,000,000 3,070,000 Proceeds from issuance of preferred stock - series C -- 5,690,000 5,690,000 Advances received -- 130,000 130,000 Repayment of capital lease obligations (115,704) (97,945) (480,354) Repayment of loan payable (125,216) (115,497) (986,972) Repayment of obligations under Revenue Interest Assignment -- (265) (11,414) Repayment of insurance premium financing payable (229,325) -- (229,325) Repayment of notes payable (397,932) -- (913,432) ----------- ---------- ----------- Net cash provided by financing activities 4,650,223 6,787,522 82,046,756 ----------- ---------- ----------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1,187,789) 60,961 140,598 Cash and cash equivalents at beginning of period 1,328,387 826,227 -- ----------- ---------- ----------- Cash and cash equivalents at end of period $ 140,598 $ 887,188 $ 140,598 =========== ========== =========== Cash paid during the period for: Interest $ 58,984 $ 65,244 $ 707,865 =========== ========== =========== Income taxes $ 550 $ 750 $ 201,126 =========== ========== ===========
11 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED STATEMENTS OF CASH FLOWS (continued) (Unaudited)
Cumulative from Nine Months Ended Sept. 30, March 12, 1991 --------------------------- (inception) to 2004 2003 Sept. 30, 2004 -------- ---------- --------------- Supplemental disclosures of cash flow information: Noncash investing and financing activities Assets acquired under capital leases $ 52,462 $ -- $ 620,806 Deferred offering costs included in accrued professional fees -- -- 314,697 Financing costs - other long-term obligations 59,500 Forgiveness of rent payable -- -- 40,740 Share issuance expenses - warrants -- -- 255,000 Dividends on series B preferred stock paid in common shares 35,000 923,077 2,084,011 Dividends on series C preferred stock paid in common shares 423,690 -- 423,690 Accretion of discount on preferred stock -- 4,179,000 4,269,000 Share issuance expenses for series B preferred stock incurred through issuance of warrants -- 86,692 391,307 Share issuance expenses for series C preferred stock incurred through issuance of warrants -- 272,386 272,386 Share issuance of series D preferred stock in exchange for series B preferred stock 2,628,602 Conversion of series C preferred stock into common stock 69,807 -- 69,807 Warrant issued in connection with lease 18,500 -- 18,500 Equipment transferred in satisfaction of deposit 25,000 -- 100,000 Discount on promissory notes 658,012 -- 945,012 Insurance premium financing of prepaid insurance 280,000 -- 280,000 Accounts payable converted to promissory notes 837,468 -- 837,468 Advances converted to promissory notes 130,000 -- 130,000
See accompanying notes to condensed unaudited financial statements. 12 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) September 30, 2004 and 2003 1 - FINANCIAL STATEMENTS The condensed balance sheet as of September 30, 2004, and the condensed statements of operations for the three and nine-month periods ended September 30, 2004 and 2003, and for the period from March 12, 1991 (inception) to September 30, 2004, and statements of shareholders' equity (deficiency) for the period from March 12, 1991 (inception) to September 30, 2004, and the condensed statements of cash flows for the nine months ended September 30, 2004 and 2003, and for the period from March 12, 1991 (inception) to September 30, 2004, have been prepared by the Company and are unaudited. In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial position as of September 30, 2004, results of operations for the three and nine month periods ended September 30, 2004 and 2003, and stockholders equity (deficiency) for the period from March 12, 1991 (inception) through September 30, 2004, and cash flows for the nine month periods ended September 30, 2004 and 2003 and for the period from March 12, 1991 (inception) through September 30, 2004, have been made. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. It is suggested that these condensed financial statements be read in conjunction with the financial statements and notes thereto in the Company's December 31, 2003 annual report on Form 10-K filed with the Securities and Exchange Commission. The results of operations for the three and nine-month period ended September 30, 2004, are not necessarily indicative of the operating results for the full year or any other interim period. The condensed balance sheet as of December 31, 2003 has been derived from the Company's audited balance sheet as of that date. 2 - FORMATION OF THE COMPANY AND BASIS OF PRESENTATION Formation of the Company Ortec International, Inc. ("Ortec" or the "Company") was incorporated in March 1991 as a Delaware corporation to secure and provide funds for the further development of the technology developed by Dr. Mark Eisenberg of Sydney, Australia, to replicate in the laboratory, a tissue engineered skin substitute for use in skin regeneration procedures (the "Technology"). Pursuant to a license agreement dated September 7, 1991, Dr. Eisenberg had granted Ortec a license for a term of ten years, with automatic renewals by Ortec for two additional ten-year periods, to commercially use and exploit the Technology for the development of products. In April 1998, Dr. Eisenberg assigned his patent for the Technology to Ortec. Basis of Presentation Ortec is a development stage enterprise, which had no operating revenue prior to December 2001. During 2001, the Company received Food and Drug Administration ("FDA") approval for the use of its product, OrCel, for treatment of Epidermolysis Bullosa and donor sites in burn patients. The Company then began marketing and selling its product for use on patients with these indications. Revenues to date have not been significant, as the Company has been focusing its efforts and resources towards its clinical trial for use of OrCel for the treatment of venous stasis ulcers. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. The Company incurred a net loss of $12.2 million during the nine months ended September 30, 2004, and, as of that date, the Company's current liabilities exceeded its current assets by $36.7 million, its total liabilities exceeded its total assets by $36 million and the Company has a deficit accumulated in its development stage of $116 million. These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. We continue to explore and, as appropriate, enter into discussions with other companies regarding the potential for equity investment, collaborative arrangements, license agreements or other funding programs with the Company, in exchange for marketing, distribution or other rights to our products. However, we can give no assurances that our discussions with other companies will result in any additional investments, collaborative arrangements, agreements or other funding, or that the necessary additional financing through debt or equity will be available to the Company on acceptable terms, if at all. 13 We require substantial funding to continue our research and development activities, clinical trials, manufacturing, sales, distribution and administrative activities. We are continuing our equity financing efforts with an investment banking firm and we are currently exploring other potential collaborative arrangements with companies for sales and marketing and distribution of our product. We hope to raise additional funding to enable us to execute our production plan with our third party manufacturer and prepare for sales in 2005, pay a portion of our past due obligations, repay a portion of our short-term promissory note borrowings, initiate the pivotal clinical trial for the use of OrCel in its cryopreserved form for the treatment of diabetic foot ulcers, and provide for our general and corporate working capital requirements. We believe that our cash and cash equivalents on hand at September 30, 2004 (approximately $.1 million), together with the additional funds we hope to raise will enable us to continue our operations for the next twelve months. These financial statements have been prepared assuming that Ortec will continue as a going concern. Successful future operations depend upon the successful development and marketing of Ortec's OrCel product. Historically Ortec has funded its operating losses by periodically raising additional sources of capital. If additional funding is not available to Ortec when needed, Ortec may not be able to continue operations. No adjustments have been made to the accompanying financials as a result of this uncertainty. Reclassifications Certain reclassifications have been made to the 2003 amounts to conform to the 2004 presentation. Reverse Stock Split On June 24, 2003, the Company effected a reverse stock split of its common shares outstanding, whereby every stockholder received one new common share for every ten previously outstanding common shares. All share and per share data have been adjusted to give effect to the reverse stock split. 3 - NET LOSS PER SHARE As of September 30, 2004, an aggregate of 4,798,164 outstanding warrants and options and an aggregate of 4,922,339 shares of common stock issuable upon the conversion of the preferred stock outstanding, if converted at $2.50, $2.00, and $2.50 for the Series B, C, and D preferred respectively, were excluded from the weighted average share calculations, as the effect was antidilutive. Basic and diluted loss per share for the three and nine months ended September 30, 2004 includes warrants to purchase 32,462 shares of common stock, exercisable at $.01 per share reflected as outstanding from the date of grant. As of September 30, 2003, an aggregate of 4,657,185 outstanding warrants and options, and an aggregate of 4,976,539 shares of common stock issuable upon the conversion of the preferred stock outstanding, if converted at $2.50, $2.00, and $2.50 for the Series B, C, and D preferred respectively, were excluded from the weighted average share calculations, as the effect would be antidilutive. Basic and diluted loss per share, for the three and nine months ended September 30, 2003, includes warrants to purchase 32,462 shares of common stock, exercisable at $.01 per share reflected as outstanding from the date of grant. 14 4 - EMPLOYEES STOCK OPTIONS As permitted by SFAS 148, the Company continues to account for its employee stock options under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related Interpretations. No stock-based employee compensation cost is reflected in net loss for the quarter ended September 30, 2004, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net loss and loss per share for the quarter and nine months ended September 30, 2004 and 2003, if the Company had applied the fair value recognition provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation".
Nine Nine Quarter Ended Months Ended Quarter Ended Months Ended Sept. 30, 2004 Sept. 30, 2004 Sept. 30, 2003 Sept. 30, 2003 -------------- -------------- -------------- -------------- Net loss applicable to common shareholders, as reported $(4,304,719) $(12,689,942) $(3,997,475) $(16,813,605) Deduct: Total stock-based employee compensation expense determined under fair value based method (37,000) (215,000) (89,000) (1,275,000) Pro forma net loss applicable to common shareholders $(4,341,719) $(12,904,942) $(4,086.475) $(18,088,605) Loss per share: Basic and Diluted - as reported $ (0.76) $ (2.30) $ (0.76) $ (4.38) Basic and Diluted - pro forma $ (0.76) $ (2.34) $ (0.78) $ (4.71)
5 - OBLIGATION UNDER REVENUE INTEREST ASSIGNMENTS On August 29, 2001, as amended February 2003 and October 18, 2004, the Company entered into a Revenue Interests Assignment agreement with Paul Royalty Fund L.P. ("Paul Royalty"), which terminates on August 29, 2011. Under such agreement the Company was eligible to receive $10,000,000 during 2001. The Company received $6,000,000 during 2001 and the remaining $4,000,000 in January 2002. In February 2003, Paul Royalty and the Company signed an amendment to the agreement, restating and updating certain provisions of the original agreement, including removing additional funding requirements by Paul Royalty. February 26, 2003, Paul Royalty invested an additional $500,000 in Series B preferred stock, in concurrence with this amendment. In consideration for the $10,000,000, Paul Royalty will receive a minimum of 3.33% of end user sales of the Company's products in the U.S., Canada and Mexico. Such percentage may be further adjusted upward or downward, based on the volume of net sales to end users of the Company's products in those three countries. Beginning January 1, 2003, Paul Royalty was entitled to receive each year advances from the first proceeds to the Company from end user sales of its products in North America. The agreement provides for quarterly and annual accountings between Paul Royalty and the Company for those advance payments. Such annual amounts that Paul Royalty will be able to draw in advance range from $600,000 in 2003 to $7,500,000 in 2005 and thereafter. The Company has not paid Paul Royalty any advances, as there were no sales since we discontinued the commercial sale of OrCel in the second half of 2002 due to budgetary constraints resulting from a difficult investment climate. The amounts received from Paul Royalty have been classified as debt. At September 30, 2004, pursuant to the default provisions under the agreement which entitles Paul Royalty to compel us to repurchase its interest in our revenues, our revenue interest obligation to Paul Royalty is $22,995,109. This is equivalent to $10,000,000, the purchase price paid to Ortec by Paul Royalty, with interest accrued at 30% since the inception of the revenue interest obligation. For the nine months ended September 30, 2004 and 2003, the Company has accordingly recorded interest expense related to this obligation of $4,441,253 and $3,359,755, respectively. At such time when the default provisions are no longer applicable, the effective interest rate imputed on the obligation will be determined using the interest method and payments to Paul Royalty will be recorded as a reduction of the Company's obligation under the revenue interest assignment. This may result in an imputed interest rate, which is significantly below 30% and could have a potential material financial impact. However, no assurances can be given that such lower rate could be achieved. In the event of a change in control of the Company or upon the occurrence of certain other events, including insolvency, as defined in the agreement, Paul Royalty has the option to put its revenue interest back to the Company for an amount of cash flows which will generate a 30% internal rate of return to Paul Royalty. The Company also has the option to repurchase Paul Royalty's interest upon the occurrence of a change in control of the Company or a complete divestiture by the Company of its interests in its products, for an amount of cash flows that will generate a 35% internal rate of return to Paul Royalty. 15 At September 30, 2004, the Company's liabilities exceeded the value of its assets and as such, the Company was technically in default of the solvency requirement under the Paul Royalty agreement. Although Paul Royalty has had the right for well over a year to compel the Company to repurchase its interest in the Company's revenues at the price provided in the Company's agreement, Paul Royalty has so far not exercised that right. At September 30, 2004, since the Company was in default of the solvency requirement under the Revenue Interest Assignment agreement, the Company provided for an amount that approximated what it would have owed Paul Royalty had they exercised their repurchase option. To date, Paul Royalty has not exercised this option and has not indicated to the Company that they intend to compel it to repurchase its revenue interest. Once the Company is no longer insolvent and therefore no longer in breach of the agreement, Paul Royalty bears the risk of revenue interest paid to it being significantly less than the revenue interest liability, as well as the reward of revenue interest paid to it being significantly greater than the interest liability. The Company granted Paul Royalty a security interest in its United States and Canadian patents and trademarks relating to its technology for its OrCel product, to secure payments required to be made by the Company to Paul Royalty under this agreement. 6 - STOCK OPTIONS AND WARRANTS The following represents stock option and warrant activity during the nine months ended September 30, 2004:
Stock Options Warrants Total ------------- --------- --------- Balance at December 31, 2003 1,622,599 3,085,173 4,707,772 Granted 88,500 75,000 163,500 Exercised -- -- -- Expired or cancelled (35,930) (4,716) (40,646) --------- --------- --------- Balance at September 30, 2004 1,675,169 3,155,457 4,830,626 ========= ========= =========
The only equity compensation plan approved by our stockholders is our Third Amended and Restated 1996 Stock Option Plan. The above table includes 1,274,400 stock options outstanding as of September 30, 2004 that were granted outside of this plan. The Company accounts for its employee stock options under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related Interpretations. No stock-based employee compensation cost is reflected in net loss for the nine months ended September 30, 2004, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant. 7 - PROMISSORY NOTES Promissory notes consists of:
September 30, December 31, 2004 2003 ------------- ------------ 8% investor promissory notes: Due December 31, 2004 $ 8,765,000 $ 3,140,000 Due November 5, 2004 50,000 -- Discount on 8% investor notes (11,187) (271,000) ----------- ----------- 8,803,813 2,869,000 Promissory notes - Amarex, due through February, 2005 298,060 -- Promissory note - CUH2A, 4%, due through February, 2008 141,477 -- ----------- ----------- 9,243,350 2,869,000 Current portion 9,141,481 2,869,000 ----------- ----------- Noncurrent portion $ 101,869 $ -- =========== ===========
The Company records a fee payable in common stock to its placement agent equivalent to 50 shares for every $1,000 of the promissory notes as a note discount which is then amortized over the life of the note to interest expense. During 2004, the Company issued 284,500 shares of its common stock for $5,690,000 of investor promissory notes, which shares the Company 16 valued at $612,250. Through September 30, 2004 the Company is obligated to issue an additional 156,250 shares of its common stock for $3,125,000 of investor promissory notes ($8,815,000 of investor promissory notes less common shares on the $5,690,000 already issued), which shares the Company has valued at $332,762 and recorded as common stock to be issued in connection with promissory notes. At the Company's sole option, the Company may prepay the outstanding principal amount of the 8% investor promissory notes plus all accrued and unpaid interest at any time without penalty in cash or shares of the Company's equity securities subject to an equity financing resulting in at least $5,000,000 in gross proceeds during the term of the notes. The Company settled its lawsuit with Amarex by issuing Amarex a non-interest bearing promissory note. See Note 9. The CUH2A promissory note was a result of a structured payout of a previous vendor obligation. 8 - RELATED PARTY TRANSACTIONS The Company owes Dr. Mark Eisenberg, one of its directors, who is also one of our founders, an aggregate of $395,754 at September 30, 2004. Of such amount $304,478 was for consulting services Dr. Eisenberg had provided to the Company under an agreement the Company had with him, $63,425 was for payments Dr. Eisenberg made in the Company's behalf for the laboratory we maintained in Australia (including salaries and obligations to suppliers) and $27,851 for rent the Company owed him for the space occupied by our laboratory. The Company no longer operates a laboratory in Australia. The Company has reached an agreement in principal with Dr. Eisenberg to grant him a five-year option to purchase 100,000 shares of its common stock at an exercise price of $2.00 per share, as payment in full of all the amounts owed him. On November 2, 2004 the Board of Directors approved the issuance of the aforementioned option. 9 - COMMITMENTS AND CONTINGENCIES Warrant: In connection with a lease agreement dated February 27, 2004, the Company is obligated to issue a two-year warrant to purchase 14,052 shares of its common stock at $3.25 per share. The Company has valued the warrant utilizing a Black-Scholes valuation model at $18,500. On November 2, 2004 the Board of Directors approved the issuance of the aforementioned warrant. Legal Matters: In December 2002 Amarex LLC commenced an action against us in the Circuit Court for Montgomery County, Maryland. Amarex provided statistical programming and data management services for us for the data generated in our clinical trials. In March 2004 the Company settled the litigation by agreeing to pay Amarex $673,060. We are required to pay $60,000 each month thereafter until the obligation is paid in full. See Note 7. The settlement also provides that Amarex will release to us the work they previously performed for us in connection with our diabetic foot ulcer clinical trials. 10 - SUBSEQUENT EVENTS Financings: In October 2004 we received from previous investors additional aggregate proceeds of $626,000, all of which were 8% promissory notes. Of the total, $441,000 is due November 5, 2004, and $185,000 is due December 31, 2004. Additionally, in October 2004 we received a non-interest bearing advance of $102,293. In November 2004, we received additional aggregate proceeds of $334,134, all of which were 8% promissory notes, due December 31, 2004. Equity Transactions: In October 2004, we issued 5,806 shares of common stock in satisfaction of the accrued dividends due on the approximately 18 shares of preferred stock converted into common stock during the period ended September 30, 2004. In October 2004, a holder of approximately 17.5 shares of series C preferred stock converted such shares into 52,672 shares of common stock. Additionally we issued 7,937 shares of common stock for the accrued dividend due on the converted series C preferred stock. On November 4, 2004, a holder of a warrant exercised his right to purchase 4,711 shares of our common stock at $0.01. Collaboration Agreement: On October 11, 2004 we entered into a collaboration with Hapto Biotech, Inc., a company involved in the field of tissue engineering, for the purpose of further developing promising product leads identified through a research collaboration established in September 2002 between the two entities, utilizing each company's proprietary technologies. The activities of the two entities will be conducted in a new entity, Hapto / Ortec Collaboration, LLC. The collaboration may require an approximate projected capital contribution of $345,000 from each entity during its first twelve months of operation. The agreement provides for a license agreement to the Company if the collaboration is successful in developing other technology (as defined) which can be used to treat Hard to Heal Chronic Wounds (as defined). 17 Cambrex Sales Agency Agreement & Related Agreements: On October 18, 2004 we entered into a Sales Agency Agreement with Cambrex Bio Science Walkersville, Inc. ("Cambrex"), providing for Cambrex to be the exclusive sales agent in the United States for our OrCel product or any other future bi-layered cellular matrix product of ours for the treatment of venous stasis ulcers, diabetic foot ulcers or any other therapeutic indication for dermatological chronic or acute wound healing. The agreement is for a period of six years beginning sixty days after we receive clearance from the FDA for the commercial sale of our OrCel for the treatment of venous stasis ulcer, but the agreement's six year term will not commence before April 1, 2005. The agreement requires us to pay commissions to Cambrex ranging from initially at 40% of net sales and decreasing to 27% of net sales as the amount of sales increases. The agreement requires Cambrex to spend $4,000,000 for marketing efforts during the sixteen month period after the FDA clears our sale of OrCel for the treatment of venous stasis ulcers. Cambrex has the right to terminate the agreement if (a) we do not receive FDA clearance for commercial sale of OrCel for the treatment of venous stasis ulcers by April 1, 2005 or (b) if for any period of six consecutive months beginning in 2007, sales are less than 9,000 units. We may terminate the agreement if sales of OrCel are less in any twelve month period than amounts targeted in the agreement for that period (ranging from 10,000 units in the first twelve month period to 100,000 units in the sixth twelve month period). Concurrent with the Sales Agency Agreement we entered into a License Agreement pursuant to which we licensed certain intellectual property rights to Cambrex. We also entered into a Security Agreement with Cambrex to secure the performance of our obligations under the Manufacturing, License, and Sales Agreement. The secured collateral consists of all accounts, cash, contract rights, payment intangibles, and general intangibles arising out of or in connection with the sale of products pursuant to the sales agreement and / or license agreement, and all supporting obligations, guarantees and other security therefore, whether secured or unsecured, whether now existing or hereafter created. The lien and security interest under this security agreement are subordinate and junior in priority to the perfected lien and security interest granted to Paul Royalty as secured party under the Paul Royalty Security Agreement and are subject to the terms and provisions of the Consent and Agreement, described hereafter. Approximately one year ago we also entered an agreement with Cambrex for Cambrex to manufacture OrCel in its cryopreserved form in Cambrex's Walkersville, Maryland production facility. In connection with the Sales Agency Agreement we have just entered into with Cambrex, our manufacturing agreement with Cambrex was modified so that if Cambrex builds us a larger production facility the maximum amount we could be required to contribute to that construction was reduced from $2,500,000 to $1,000,000. In connection with the above agreements, together with Paul Royalty and Cambrex we entered into a Consent and Agreement ("C & A") under which the parties agreed to amend the existing agreement with Paul Royalty under which all cash collected from future sales of our product would first go into a lockbox controlled by Paul Royalty. Under the C & A the parties agreed that a new lockbox would be established controlled by both Cambrex and Paul Royalty. Pursuant to the C & A Paul Royalty agreed on a formula which provides for Paul Royalty to receive a percentage of collections made by Cambrex, subject to a reconciliation of the exact amount due from Ortec. Thereafter, Cambrex would offset all amounts due under the manufacturing and sales agreements and other amounts, as defined in the C & A, before sending the balance, considered to be the royalty payment under the aforementioned License Agreement to the Company. Extension of Promissory Notes: On October 27, 2004 holders of promissory notes aggregating $9,206,000, which included $8,765,000 outstanding at September 30, 2004, agreed to extend the maturity dates from November 5, 2004 to December 31, 2004. In consideration thereof, the holders will receive 12% interest (originally 8%) from September 30th thereon. In addition, each holder will receive 45,000 unregistered common shares with piggyback registration rights for each $1,000,000 of principal of notes held by each lender, or pro-rata portion thereof. One holder for $50,000 did not extend his note. This note was paid in full in November 2004. 18 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our financial statements and notes thereto. This discussion may be deemed to include forward-looking statements Forward Looking Information May Prove Inaccurate This Quarterly Report on Form 10-QSB contains certain forward looking statements and information relating to Ortec that are based on the beliefs of management, as well as assumptions made by and information currently available to us. When used in this document, the words "anticipate," "believe," "estimate," and "expect" and similar expressions, as they relate to Ortec, are intended to identify forward looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions, including those described in this discussion and elsewhere in this Quarterly Report on Form 10-QSB. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated or expected. We do not intend to update these forward-looking statements. General Since our inception we have been principally engaged in the research and development of our tissue engineered skin regeneration product, for use in the treatment of chronic and acute wounds, such as venous and diabetic skin ulcers and autograft donor site wounds for burn victims. We call our product OrCel'r'. In February 2001 we received FDA approval to make commercial sales of OrCel for use in reconstructive surgery on patients with recessive dystrophic epidermolysis bullosa, followed by FDA approval in September 2001 for use of the product in the treatment of donor site wounds on burn patients. With these approvals, though we are still a development stage enterprise, in December 2001 we began commercial sales of our product. During 2002, we engaged a sales force organization to actively pursue sales of our product, but due to a reduction in anticipated financing, we curtailed these activities in the second half of 2002 in order to focus our efforts and resources towards completing the clinical trials for the use of OrCel for the treatment of venous stasis ulcers. As a result of this curtailment, there have been no commercial sales of our product in the current quarter. In 2003, we completed a pivotal clinical trial for the use of OrCel in its cryopreserved form for the treatment of venous stasis ulcers. Venous stasis ulcers are open lesions on the legs, which result from the poor circulation of blood returning from the legs to the heart. The study was conducted at 19 clinical sites and 136 patients were treated in the trial. One half of the patients were a control group and were treated with standard of care currently being used for treatment of venous stasis ulcers. In December 2003, we initiated the filing of the Premarket Approval (PMA) application with the Food and Drug Administration (FDA) to market OrCel for the treatment of venous leg ulcers. We submitted the Manufacturing and Controls (CMC) section, the first of two modules of the application. The final section of the PMA, which included a summary of safety and effectiveness in the clinical studies and device labeling, was filed with the FDA in February 2004. We have received and fully responded to subsequent inquiries, and are awaiting a final disposition from the FDA. In June 2002, we received approval from the FDA to initiate a pivotal clinical trial using OrCel in the treatment of diabetic foot ulcers. Diabetic ulcers are open sores that remain after the destruction of surface tissue. We have deferred the implementation of the diabetic foot ulcers pivotal clinical trial until after FDA determination of whether we may make commercial sales of cryopreserved OrCel to treat venous stasis ulcers. From inception to date, we have incurred cumulative net losses of approximately $116 million. We expect to continue to incur substantial losses and may have to discontinue operations, unless we are able to secure FDA clearance for the sale of OrCel in its cryopreserved form to treat venous leg ulcers, and later diabetic foot ulcers, gain market acceptance for OrCel, and execute our production plans with our third party manufacturer. In October 2003, we entered into a contract manufacturing agreement for the production of OrCel with Cambrex Bio Science Walkersville, Inc, a subsidiary of Cambrex Corporation. Cambrex's current capacity is expected to meet our commercial manufacturing requirements for the first twelve months following the market launch of OrCel if and when we receive FDA approval for the sale of our product for use in the treatment of patients with venous stasis ulcers. This agreement will allow us to avoid the costlier plan of constructing our owned manufacturing facility. In October 2004, we entered into a six-year Sales Agency Agreement with Cambrex Bio Science Walkersville, Inc., the same entity with whom we have contracted to manufacture our product, providing for Cambrex to be the exclusive sales agent in the United States for our OrCel product or any other future bi-layered cellular matrix product of ours for the treatment of venous stasis ulcers, diabetic foot ulcers or any other therapeutic indication for dermatological chronic or acute wound healing. The 19 agreement begins sixty days after we receive clearance from the FDA for the commercial sale of our OrCel for the treatment of venous stasis ulcer, but not earlier than April 1, 2005. The agreement requires us to pay commissions to Cambrex ranging from initially at 40% of net sales and decreasing to 27% of net sales as the amount of sales increases. The agreement requires Cambrex to spend $4,000,000 for marketing efforts during the sixteen month period after the FDA clears our sale of OrCel for the treatment of venous stasis ulcers. We anticipate that future revenues and results of operations may continue to fluctuate significantly depending on, among other factors, the timing and outcome of applications for additional regulatory approvals, our ability to successfully manufacture, market and distribute OrCel and/or the establishment of collaborative arrangements for the marketing and distribution of our product. We anticipate that our operating activities will result in substantial net losses until we obtain FDA clearance to sell OrCel and we successfully market OrCel for the treatment of venous stasis ulcers. Critical Accounting Estimates Revenue Recognition. Product revenue is recognized upon shipment of OrCel when title and risk of loss pass to the customer, which occurs when the product is received by the end user hospital, clinic, or doctor. Royalties from licensees will be based on third-party sales of licensed products and will be recorded in accordance with contract terms when third-party results are reliably measurable and collectibility is reasonably assured. In accordance with EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, our accounting policy is to review each contract to determine if there are multiple revenue-generating activities that constitute more than one unit of accounting. Revenue is recognized for each unit of accounting based on revenue recognition criteria relevant to that unit. Up-front payments are deferred, if appropriate, and recognized into revenues over the obligation period. Research and Development Costs. As we are still engaged in clinical trials of our product and remain a development stage enterprise, the cost of producing product for clinical trials and for sale, is included in Research and Development costs. Additionally, all research and development costs, which comprise of product production and laboratory costs, rent, consulting, personnel and depreciation and amortization expenses, are expensed as incurred. Obligation under Revenue Interest Assignment Agreement. We account for our Revenue Interest Assignment Agreement with Paul Royalty Fund, L.P. in a manner similar to that of debt. Currently, our liabilities exceed the value of our assets and as such, we are technically in default of the solvency requirement under this agreement. Pursuant to the default provisions, which entitles Paul Royalty to compel us to repurchase its interest in our revenues at a price equal to the purchase price paid to Ortec by Paul Royalty, or $10,000,000, with interest which would yield a 30% internal rate of return to Paul Royalty. At such time when the default provisions are no longer applicable and a reasonable estimate of future revenues can be determined, the effective interest rate imputed on the obligation will be determined using the interest method and payments to Paul Royalty will be recorded as a reduction of our obligation under the revenue interest assignment agreement. This may result in an imputed interest rate, which is significantly below 30% and could have a potential material financial impact. However, we can give no assurances that such lower rate could be achieved. Additionally, we had no revenues in the nine months ended September 30, 2004 as we suspended sales of OrCel in 2002 to focus on completing a clinical trial for venous stasis ulcers and submitting the results to the FDA. We hope to obtain FDA approval to sell OrCel for the treatment of venous stasis ulcers in 2005; however approval cannot be assured. In addition, if approval is obtained from the FDA, the timing of such event may not be in line with our expectations. For these reasons, we may not be able to make a reasonable estimate of future revenues and payments that may become due to Paul Royalty under this financing agreement in 2004, if we are no longer in technical default of this agreement, and as such may not be able to determine an effective interest rate to apply to the debt. Therefore, given these uncertainties, once we are no longer in technical default, we will charge revenue interest expense as revenues subject to the revenue interest obligation are recognized. When we are able to make a reasonable estimate of our related revenue interest obligation, interest expense will be charged based upon the interest method. 20 FINANCIAL INFORMATION NOT IN CONFORMITY WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Throughout this report, we have presented income statement items in conformity with generally accepted accounting principles (GAAP). Yet, given the magnitude of the non-cash expenses, we utilize EBITDA (earnings before income taxes, depreciation and amortization) to evaluate and monitor the results of our operations. Although EBITDA is a non-GAAP financial measure, we believe that the information presented below when reviewed in conjunction with the Condensed Statements of Cash Flows will allow for an additional clarification of our performance and will allow the readers of our financial statements an additional tool to evaluate our comparative performance. Following, is a reconciliation of the comparative net loss to common shareholders to EBITDA utilized by the Company.
Three months ended Nine months ended September 30, September 30, ------------------------- --------------------------- 2004 2003 2004 2003 ----------- ----------- ------------ ------------ Net loss applicable to common shareholders $(4,304,719) $(3,997,875) $(12,689,942) $(16,813,605) Adjustments to reconcile net loss to common stockholders to EBITDA: Preferred dividends accrued 154,190 140,690 458,690 1,119,272 Preferred stock deemed dividends and discounts -- 90,000 -- 4,269,000 Non-cash imputed interest 1,616,569 1,187,591 4,441,253 3,359,755 Depreciation and amortization 329,227 159,875 1,288,805 477,051 Non-cash stock compensation 94,000 -- 94,000 -- ----------- ----------- ------------ ------------ EBITDA $(2,110,733) $(2,419,719) $ (6,407,194) $ (7,588,527) =========== =========== ============ ============
21 RESULTS OF OPERATIONS Three and Nine Months Ended September 30, 2004 and September 30, 2003. Revenues As previously discussed, our sales activities were curtailed in the second half of 2002, resulting in no product revenues generated in the quarter and nine months ended September 30, 2004 and 2003. Expenses Expenses increased by approximately $.4 million to $4.2 million in 2004 from approximately $3.8 million in 2003 for the comparable third quarter periods, and by approximately $.8 million to $12.2 million in 2004 from $11.4 million in 2003 for the comparable nine-month periods. Product and laboratory costs. Product and laboratory costs increased slightly to $.78 million in 2004 from .73 million in 2003 in the comparable third quarter periods but increased $.5 million to $2.1 million in 2004 from $1.6 million in 2003 for the comparable nine-month periods. In 2004 we paid fees to Cambrex totaling approximately $1.3 million for a production suite and costs associated with transferring the process of producing our product. In addition we incurred internal costs of approximately $.1 million associated with process improvement experimentation. This was offset by approximately $.9 million of higher clinical trial expenses in 2003 related to our venous stasis ulcer trials. Consulting. Consulting fees were insignificant and decreased negligibly during the third quarter of 2004. Consulting fees increased approximately $40,000 during the comparable nine-month period due to a credit reimbursement for $30,000 recorded in 2003. We did not incur any significant consulting expenses in 2004 because we had completed our venous stasis ulcer trials in late 2003. In the 2003 third quarter and nine-months, we did not incur any significant consulting expenses, as we had focused on completing the venous stasis clinical trial, and as such utilized primarily existing personnel. Personnel. Personnel costs were comparable at approximately $.9 million and $2.9 million in the comparable third quarter and nine-month periods, respectively. General and Administrative. General and administrative expenses decreased by approximately $.23 million to $.53 million in 2004 from $.76 million in 2003 for the comparable third quarter periods, primarily due to reductions in depreciation of $.06 million, Delaware franchise taxes of $.03 million, investor and public relations of $.03 million, and legal expenses of $.1 million. General and administrative expenses declined $.5 million to $1.4 million in 2004 from $1.9 million in 2003 for the comparable nine-month periods, primarily due to reductions in depreciation of $.12 million, investor and public relations of $.06 million, legal expenses of $.2 million, and $.11 million in insurance expenses. Rent and Lease Termination Costs. Rent expense was comparable at $.12 million in the comparable third quarter periods. Rent expense decreased by approximately $93,000 during the comparable nine-month periods to $363,456 in 2004 from $456,687 in 2003. The decline was primary a result of a reduction in space leased in our New Jersey laboratory. In 2004 we leased laboratory space in New Jersey covering 800 square feet compared to 26,000 square feet in the first quarter of 2003. Additionally, we moved out of our New Jersey facility at the end of July 2004. Lease termination costs of $1.1 million in 2003 included $.9 million in lease settlement costs we paid to the NJ Economic Development Authority, and $.2 million of other leasehold costs incurred directly by us. The lease was terminated in the second quarter of 2003. Interest and Other Expense. Interest and other expense increased by approximately $.8 million to $2 million in 2004 from $1.2 million in 2003 for the comparable third quarter periods. Interest and other expense increased by approximately $2.4 million to $5.8 million in 2004 from $3.4 million in 2003 for the comparable nine-month periods. The increase for the quarter and nine-months was attributable to interest charges related to our outstanding 8% promissory notes of approximately $.4 million and $1.3 million, respectively, and $.4 million and $1.1 million of the increase, for the quarter and nine-months respectively, was due to the non-cash 30% imputed interest accrued on the Paul Royalty revenue interest assignment obligation. Although interest was accrued at 30% per annum for both periods, for the quarter and nine-months ended September 30, 2004, interest was accrued on a higher level of debt outstanding. Due to the default provisions under the agreement, interest has been accrued at 30% per annum in 2004, which provision may be adjusted in the future if the default provisions are not longer applicable and interest will then be accrued based on the expected level of future revenues. Interest and Other Income. Interest and other income increased by approximately $.2 million during the comparable third quarter and nine month periods. The increase during both periods reflects a $.2 million gain resulting from an adjustment to a loan. 22 LIQUIDITY AND CAPITAL RESOURCES Since inception (March 12, 1991) through September 30, 2004, we have accumulated a deficit of approximately $116 million and we expect to continue to incur substantial operating losses until we obtain FDA approval to sell our product, OrCel, for the treatment of venous stasis ulcers and successfully market OrCel to the medical community. We have financed our operations primarily through private placements of our common stock, preferred stock, promissory notes payable and convertible debentures, our initial public offering, and the exercise of our publicly traded Class A warrants at the end of 1997. From inception to September 30, 2004, we received approximately $82 million from our financing activities. This consisted of cash proceeds from the sale of equity securities, net of share issuance expenses, of approximately $53.6 million, cash proceeds from the issuance of debentures, promissory notes and preferred stock of $18.4 million, and a total of $10.0 million from the sale of a percentage interest in our future revenues from the sale of our product in North America. For the nine months ended September 30, 2004, we used net cash for operating activities of approximately $5.7 million. Cash used in operating activities resulted primarily from our net loss of $12.2 million, offset by: depreciation and amortization of approximately $1.3 million, non-cash interest expense on the Paul Royalty revenue interest assignment obligation of approximately $4.4 million, and approximately $.8 million of changes in operating assets and liabilities. In the nine months ended September 30, 2004, we received gross proceeds of approximately $5.5 million consisting of 8% promissory notes primarily due November 5, 2004. During this period we utilized $.9 million to satisfy various outstanding loan, lease, and other financing obligations. Additionally we incurred approximately $.1 million in costs for investments in equipment and patent applications. In August 2001, as amended February 2003 and October 18, 2004, we entered into a Revenue Interests Assignment agreement with Paul Royalty Fund, L.P. pursuant to which we agreed in consideration of Paul Royalty paying us $10,000,000, to pay to Paul Royalty a minimum of 3 1/3% of the end user sales prices paid for our OrCel product in the United States, Canada and Mexico through the period ending in 2011. Such percentage interest in our revenues in those three countries may be further adjusted upward or downward based on the volume of sales to end users of OrCel in those three countries. In accordance with the terms of the Revenue Interest Agreement, beginning on January 1, 2003 we are required to make advance payments on the revenue interest obligation as follows: the first $0.6 million of annual net sales for the year ended December 31, 2003; the first $1.0 million of annual net sales for the year ended December 31, 2004 and the first $7.5 million of annual net sales for each subsequent calendar year thereafter through the year ending December 31, 2011. We did not pay Paul Royalty $0.6 million in 2003 as we discontinued the commercial sale of OrCel in the second half of 2002 due to budgetary constraints resulting from a difficult investment climate. We will not resume sales unless we obtain FDA approval for the use of OrCel in the treatment of venous stasis ulcers, which is not expected to occur before the last quarter of 2004. As security for the performance of our obligations to Paul Royalty, we have granted Paul Royalty a security interest in all of our U.S. patents, patent applications and trademarks. Our agreement with Paul Royalty provides that in certain events Paul Royalty may, at its option, compel us to repurchase the interest in our revenues that we sold to Paul Royalty for a price equal to the $10,000,000 Paul Royalty paid us plus an amount that would yield Paul Royalty a 30% internal rate of return on their investment. That repurchase price would have been approximately $22,995,109 as of September 30, 2004. Among the events that would entitle Paul Royalty to compel us to repurchase its interest in our revenues at that price is if we are insolvent or if we are unable to pay our debts as they become due. Our agreement with Paul Royalty provides that in determining such insolvency any amount we owe to Paul Royalty is excluded in calculating our net worth (or negative net worth). As defined in our agreement with Paul Royalty we are currently insolvent. In addition, although we are currently trying to manage our debt we are not paying our debts as they become due. Although Paul Royalty has had the right for well over a year to compel us to repurchase its interest in our revenues at the price provided in our agreement, Paul Royalty has so far not exercised that right. If Paul Royalty does exercise its right to compel us to repurchase its interest in our revenues we would be unable to pay the purchase price and Paul Royalty could foreclose its security interest in our U.S. patents, patent applications and trademarks and in such event we will have to discontinue our business operations. 23 In addition to the requirement that we remain solvent, as described above, the occurrence of certain events, including those set forth below, triggers Paul Royalty's right to require us to repurchase its revenue interest: o a change of control of our company; o the transfer of all or substantially all of our consolidated assets; o the transfer of all or any part of our respective interests in our products other than pursuant to any distribution agreements, license agreements and similar agreements; and o a judicial decision that has a material adverse effect on our business, operations, assets or financial condition as defined by the agreement. If a repurchase event occurred and Paul Royalty required us to repurchase their interest in our revenues, we may not have sufficient cash funds to pay Paul Royalty. As such, Paul Royalty could foreclose on certain assets that are essential to our operations. The exact amount of the repurchase price is dependent upon certain factors, including when the repurchase event occurs. At September 30, 2004, since we were in default of the solvency requirement under the Revenue Interest Assignment agreement, we provided for an amount that approximated what we would have owed Paul Royalty had they exercised their repurchase option. To date, Paul Royalty has not exercised this option and has not indicated to us that they intend to compel us to repurchase its revenue interest. Once we are no longer insolvent and therefore no longer in breach of the agreement, Paul Royalty bears the risk of revenue interest paid to it being significantly less than the revenue interest liability, as well as the reward of revenue interest paid to it being significantly greater than the interest liability. In February 2003, Paul Royalty amended its agreement with us, restating and updating certain provisions of the original agreement. The original agreement and modifications to the agreement terminate on December 31, 2011, unless terminated earlier by either party, as permitted by the terms of the agreement. The 50 shares of Series B preferred stock are held by Paul Royalty. The Series B preferred stock is convertible into common shares at any time at the option of Paul Royalty, based on a fixed conversion rate of the $10,000 per Series B preferred share liquidation amount of not less than $3.00 per common share, or at an alternative conversion rate of the $10,000 per Series B preferred share liquidation amount of 90% of the average of the five lowest volume weighted average prices for our common stock for the twenty trading days immediately prior to conversion, subject to a minimum conversion rate of $2.50 per common share of common stock. The 930 shares of Series C preferred stock are convertible at any time at the option of the holders into 2,790,799 shares of common stock (the $6,000 per Series C preferred share liquidation amount at a conversion rate of $2.00 per common share). The conversion rate may be reduced should we sell shares of our common stock at less than $2.00 per share in certain types of transactions. An accrued dividend of $760,240 (inclusive of $423,690 accrued during the nine months ended) at September 30, 2004 has been provided within stockholders' equity / (deficit) as it is our intent to issue common shares in payment of these dividends. The Series C convertible preferred stock shall automatically convert if the common stock of the Company trades at a price equal to or greater than $6.00 per share for a period of 10 consecutive trading days. Additionally, each investor was issued 1,800 five-year warrants for each Series C convertible preferred share purchased. The Series C warrants have an exercise price of $3.60 per common share. Beginning May and July 2005 the Company may redeem the Series C warrants for $.10 per warrant of our common stock closes above $10.80 per share for 10 consecutive trading days. The 483 Series D shares of preferred stock are convertible at any time at the option of the holders into 1,931,540 shares of common stock (the $10,000 per Series D preferred shares liquidation amount at a conversion rate of $2.50 per common share). The preferred stock has redemption provisions, where upon occurrences of certain events, the holders can require us to redeem the shares. Such provisions include: o the consolidation, merger or other business combination of the Company with or into another Person, except for a migratory merger effected solely for the purpose of changing jurisdiction of incorporation, or if the holders of the Company's voting power who were not shareholders prior to the transaction have the ability after the transaction is completed to elect a majority of members of the board of directors of the surviving entity or entities; o the sale or transfer of more than 20% of the Company's assets other than inventory in the ordinary course of business; or 24 o consummation of a purchase, tender or exchange offer made to the holders of more than 30% of the outstanding shares of Common Stock. The redemption price is payable, at the option of the Company, in cash or in common stock. If we do not have sufficient authorized shares to effect the redemption payment in common stock, we may pay the remainder of the redemption in non-redeemable preferred stock with a dividend rate of 18%. In October 2003, we entered into a cell therapy manufacturing agreement with Cambrex Bio Science Walkersville, Inc., a subsidiary of Cambrex Corporation, for the commercial manufacture of Ortec's tissue engineered product, OrCel. It is expected that Cambrex will begin production of OrCel in the second half of 2004 and this inventory may be used for sale if we receive FDA clearance to market OrCel for use on patients in the treatment of venous stasis ulcers. Pursuant to the terms of this agreement, we are required to pay Cambrex a monthly fee for the use of a production suite in their facility located in Walkersville, Maryland while we are in Phase I of the production plan, as defined by the agreement. During Phase I only, we may terminate this agreement by giving 6 months advance notice of the effective date of such termination. At any time during Phase I, we can elect to initiate Phase II of the agreement by written notice to Cambrex. The monthly payments we will make to Cambrex will increase if we require Cambrex to build us a larger production facility to meet our requirements for the production of OrCel. Such annual payments we are required to make will further increase by a small percentage each year. Such monthly payments include some services and overhead expenses provided and paid for by Cambrex. We are required to pay a portion of the cost of construction of that larger production facility. In October 2004, our manufacturing agreement with Cambrex was modified so that if Cambrex builds us a larger production facility the maximum amount we could be required to contribute to that construction was reduced from $2,500,000 to $1,000,000. However, the amount we contribute to the construction of that larger facility will be repaid to us by credits against a portion of the future monthly payments we are required to make to Cambrex after the larger facility is in use. We are also required to pay specified hourly charges for the Cambrex employees engaged in the production of OrCel as well as certain other charges. After construction of the larger production facility we are required to acquire from Cambrex virtually all of our requirements for OrCel that Cambrex can produce. Prior to our election to have Cambrex construct the larger production facility for us, either we, or Cambrex, may terminate the agreement on 6 months notice by us and twelve months notice by Cambrex. If we elect to have Cambrex construct the larger production facility for us the agreement will continue for six years after the larger production facility is constructed. However, even after such construction we, and Cambrex, may elect to scale down over the following three years the portion of our requirements for OrCel that Cambrex will produce for us. We may elect the scale down period at any time after one year after the larger production facility is constructed and in operation in which event there are additional payments we must make to Cambrex. Either Cambrex or we may elect the scale down period later than three years after that facility is in operation and neither of us will be required to make any additional payments to the other because of that election. If after the construction of the larger production facility, we breach a material term of our agreement with Cambrex, or elect to terminate the agreement, there are substantial payments we must make to Cambrex. In October 2004, we entered into a six-year Sales Agency Agreement with Cambrex Bio Science Walkersville, Inc., the same entity with whom we have contracted to manufacture our product, providing for Cambrex to be the exclusive sales agent in the United States for our OrCel product or any other future bi-layered cellular matrix product of ours for the treatment of venous stasis ulcers, diabetic foot ulcers or any other therapeutic indication for dermatological chronic or acute wound healing. The agreement begins sixty days after we receive clearance from the FDA for the commercial sale of our OrCel for the treatment of venous stasis ulcer, but not earlier than April 1, 2005. The agreement requires us to pay commissions to Cambrex ranging from initially at 40% of net sales and decreasing to 27% of net sales as the amount of sales increases. The agreement requires Cambrex to spend $4,000,000 for marketing efforts during the sixteen month period after the FDA clears our sale of OrCel for the treatment of venous stasis ulcers. As of September 30, 2004, payment of approximately $2.3 million of the approximately $2.9 million we owed to our trade creditors was past due. While we have arranged for payment of some our obligations over a period of time, and have to make some payments of past due obligations to our current and ongoing suppliers, our ability to make payments we have agreed to pay and to insure continued receipt of needed supplies, and to continue reducing our past due obligations, will depend on our ability to secure needed financing. Raising additional capital can be dependent on numerous factors, such as our ability to obtain regulatory approval for the commercial sale of OrCel to treat venous stasis ulcers, and, later diabetic foot ulcers as well as the general investment climate. We require substantial funding to continue our research and development activities, clinical trials, manufacturing, sales, distribution and administrative activities. We have raised funds in the past through the public or private sale of equity securities and debentures, the issuance of promissory notes to lenders most of whom were investors in our Series C Convertible Preferred Stock, and through the agreement with Paul Royalty. We will need to raise additional funds in the future through the sale of our securities to the public and through private placements, debt financing or short-term loans. We can give no 25 assurance of the total amount of financing that will be secured. We are continuing to use the services of an investment banking firm in raising capital in 2004. Our capital funding requirements depend on numerous factors, including: o the progress and magnitude of our research and development programs; o the time involved in obtaining regulatory approvals for the commercial sale of our OrCel product in its cryopreserved form to treat venous stasis ulcers, and later diabetic foot ulcers; o the costs involved in filing and maintaining patent claims; o technological advances; o competitive and market conditions; o the successful implementation of agreements we have entered into with Cambrex Bio Science Walkersville, Inc. for manufacturing and sales of our OrCel product in its cryopreserved form; and o the cost and effectiveness of commercialization activities and arrangements. We hope that proceeds from investment funds we may receive in the future will enable us to execute our production plan with our third party manufacturer and prepare for sales in 2005, pay a portion of our past due obligations, repay a portion of our short-term promissory note borrowings, initiate the pivotal clinical trial for the use of OrCel in its cryopreserved form for the treatment of diabetic foot ulcers, and provide for our general and corporate working capital requirements for the next twelve months. We believe that our cash and cash equivalents on hand at September 30, 2004 of $140,598, as well as the additional funds we hope to raise will enable us to continue our operations for the next twelve months. However, we can give no assurance that additional investment or other funds can be secured. We are also likely to continue to encounter difficulties which are common to development stage companies, including unanticipated costs relating to development, delays in the testing of products, regulatory approval and compliance and competition. In October 2004 we received from previous investors additional aggregate proceeds of $626,000, all of which were 8% promissory notes. Of the total, $441,000 is due November 5, 2004, and $185,000 is due December 31, 2004. Additionally, we receieved a non-interest bearing advance of $102,293. In November 2004, we received additional aggregate proceeds of $334,134, all of which were 8% promissory notes due December 31, 2004. We continue to explore and, as appropriate, enter into discussions for equity investment or other funding programs. However, we can give no assurance that discussions will result in any additional investments or that the necessary additional financing through debt or equity financing will be available to us on acceptable terms, if at all. Further, we can give no assurance that any arrangements resulting from these discussions will successfully reduce our funding requirements. If additional funding is not available to us when needed, we may not be able to continue operations. Item 3. CONTROLS AND PROCEDURES 1. Evaluation of disclosure controls and procedures. The Company's chief executive officer and its chief financial officer, after evaluating the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15-d-14(c)) as of September 30, 2004 (the "Evaluation Date") have concluded that as of the Evaluation Date, the Company's disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company would be made known to them by others within those entities, particularly during the period in which this quarterly report was being prepared. 2. Changes in internal controls. There were no significant changes in the Company's internal controls over financial reporting or in other factors that could significantly affect the Company's disclosure controls and procedures subsequent to the Evaluation Date, nor any significant deficiencies or material weaknesses in such disclosure controls and procedures requiring corrective actions. As a result, no corrective actions were taken. 26 PART II Item 1. LEGAL PROCEEDINGS None Item 2. CHANGES IN SECURITIES (c) Recent Sales of Unregistered Securities On July 8, 2004 we issued 54,200 shares of common stock upon conversion of 18.066667 shares of Series C preferred stock. The issuance of the shares was exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933, as securities exchanged by an issuer with its existing security holders where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange. In July 2004 we issued 95,000 shares of common stock to our placement agent, Burnham Hill Partners, a division of Pali Capital, Inc, and its designees for services they rendered in securing $1,900,000 of short term loans for us. The issuance of the shares was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as a transaction by an issuer not involving any public offering. Item 3. DEFAULTS UPON SENIOR SECURITIES None Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None Item 5. OTHER INFORMATION None 27 Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit No. Description ----------- ----------- 3.1 Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.2 of the Company's quarterly report on Form 10-Q for the period ended September 30, 2001, filed with the Commission on November 14, 2001, Commission File No. 0-27368) 3.2 Amendment to Restated Certification of Incorporation (Incorporated by reference to Exhibit 3.2 of the Company's annual report on Form 10-K for the period ended December 31, 2002, filed with the Commission on April 15, 2003, Commission File No. 0-27368) 3.3 Amendment to Certificate of Incorporation adopted June 28, 2002, being a Certificate of Designation of the Relative Rights and Preferences of the Series A convertible preferred stock (Incorporated by reference to Exhibit 3.4 of the Company's quarterly report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 19, 2002, Commission File No. 0-27368) 3.4 Amendment to Certificate of Incorporation filed on August 26, 2002, being an Amended Certificate of Designation of the Relative Rights and Preferences of the Series B convertible preferred stock (Incorporated by reference to Exhibit 3.2 of the Company's annual report on Form 10-K for the period ended December 31, 2002, filed with the Commission on April 15, 2003, Commission File No. 0-27368) 3.5 Amendment to Certificate of Incorporation filed on May 23, 2003, being the Certificate of Designation of the Relative Rights and Preferences of the Series C convertible preferred stock (Incorporated by reference to Exhibit 3.5 of the Company's quarterly report on Form 10-Q for the period ended June 30, 2003, filed with the Commission on August 14, 2003, Commission File No. 0-27368) 3.6 Amendment to Certificate of Incorporation filed on June 10, 2003 (Incorporated by reference to Exhibit 3.6 of the Company's annual report on Form 10-K for the period ended December 31, 2003, filed with the Commission on March 30, 2004, Commission File No. 0-27368) 3.7 Amendment to Certificate of Incorporation filed on August 19, 2003 being the Certificate of Designation of the Relative Rights and Preferences of the Series D convertible preferred stock (Incorporated by reference to Exhibit 3.6 of the Company's quarterly report on Form 10-Q for the period ended September 30, 2003, filed with the Commission on November 14, 2003, Commission File No. 0-27368) 3.8 By-Laws (Incorporated by reference to the Exhibit of the Company's Registration Statement on Form SB-2, or Amendment 1 thereto, filed with the Commission, Commission File No. 33-96090) 31.1 * Rule 13a-14(a) / 15d-14 (a) Certification of Principal Executive Officer 31.2 * Rule 13a-14(a) / 15d-14 (a) Certification of Principal Financial Officer 32.1 * Section 1350 Certification of Principal Executive Officer 32.2 * Section 1350 Certification of Principal Financial Officer
---------- * filed herewith (b) Reports on Form 8-K We did not file any reports on Form 8-K in the third quarter of 2004. 28 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereto duly authorized. Registrant: ORTEC INTERNATIONAL, INC. Date: November 15, 2004 By: /s/ Steven Katz ----------------------------------- Steven Katz, PhD Chairman (Principal Executive Officer) Date: November 15, 2004 By: /s/ Ron Lipstein ----------------------------------- Ron Lipstein Vice Chairman/CEO and Chief Financial Officer (Principal Financial Officer) 29