10-Q 1 acacia_10q-033102.txt ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------- FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002 COMMISSION FILE NUMBER 0-26068 ACACIA RESEARCH CORPORATION --------------------------- (Exact Name of Registrant as Specified in Its Charter) DELAWARE 95-4405754 -------- ---------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 500 NEWPORT CENTER DRIVE, NEWPORT BEACH, CA 92660 ------------------------------------------- ----- (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (949) 480-8300 -------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days. Yes [X] No [ ] At May 10, 2002, the registrant had 19,629,376 shares of common stock, $0.001 par value, issued and outstanding. ================================================================================ ACACIA RESEARCH CORPORATION TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Unaudited Consolidated Balance Sheets as of March 31, 2002 and December 31, 2001........................ 3 Unaudited Consolidated Statements of Operations and Comprehensive Loss for the Three Months Ended March 31, 2002 and 2001..................................... 4 Unaudited Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2002 and 2001.................. 5 Notes to Consolidated Financial Statements.................. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............... 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk.. 25 PART II. OTHER INFORMATION Item 1. Legal Proceedings........................................... 26 Item 2. Changes in Securities....................................... 26 Item 3. Defaults Upon Senior Securities............................. 26 Item 4. Submission of Matters to a Vote of Security Holders......... 27 Item 5. Other Information........................................... 27 Item 6. Exhibits and Reports on Form 8-K............................ 27 SIGNATURES................................................................... 28 2 ACACIA RESEARCH CORPORATION CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 2002 AND DECEMBER 31, 2001 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE INFORMATION) (UNAUDITED)
MARCH 31, DECEMBER 31, 2002 2001 ---------- ---------- ASSETS Current assets: Cash and cash equivalents $ 50,123 $ 59,451 Short-term investments 25,643 25,110 Prepaid expenses, other receivables and other assets 2,795 1,613 ---------- ---------- Total current assets 78,561 86,174 Property and equipment, net of accumulated depreciation 4,610 4,906 Investment in affiliate, at cost 3,000 3,000 Patents, net of accumulated amortization 11,406 11,855 Goodwill, net of accumulated amortization 4,627 4,627 Other assets 444 297 ---------- ---------- $ 102,648 $ 110,859 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable, accrued expenses and other $ 4,424 $ 5,756 Current portion of deferred revenues 7,772 7,088 Current portion of capital lease obligation 955 934 ---------- ---------- Total current liabilities 13,151 13,778 Deferred income taxes 3,754 3,829 Deferred revenues, net of current portion 219 372 Capital lease obligation, net of current portion 1,598 1,845 ---------- ---------- Total liabilities 18,722 19,824 ---------- ---------- Minority interests 31,578 32,303 ---------- ---------- Stockholders' equity: Preferred stock, par value $0.001 per share; 20,000,000 shares authorized; no shares issued or outstanding -- -- Common stock, par value $0.001 per share; 60,000,000 shares authorized; 19,629,376 and 19,592,459 shares issued and outstanding as of March 31, 2002 and December 31, 2001, respectively 20 20 Additional paid-in capital 158,676 158,529 Warrants to purchase common stock 199 199 Comprehensive loss (108) (4) Accumulated deficit (106,439) (100,012) ---------- ---------- Total stockholders' equity 52,348 58,732 ---------- ---------- $ 102,648 $ 110,859 ========== ==========
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 3 ACACIA RESEARCH CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE INFORMATION) (UNAUDITED)
THREE MONTHS ENDED ------------------------------ MARCH 31, 2002 MARCH 31, 2001 -------------- -------------- Revenues: License fee income $ -- $ 2,440 Grant revenue 249 183 ------------- ------------- Total revenues 249 2,623 ------------- ------------- Operating expenses: Research and development expenses (including stock compensation charges of $421 and $2,398 for the three months ended March 31, 2002 and 2001, respectively) 3,089 5,549 Marketing, general and administrative expenses (including stock compensation charges of $1,001 and $6,021 for the three months ended March 31, 2002 and 2001, respectively) 5,073 12,242 Amortization of patents and goodwill 564 633 ------------- ------------- Total operating expenses 8,726 18,424 ------------- ------------- Operating loss (8,477) (15,801) ------------- ------------- Other (expense) income: Interest income 406 1,195 Realized losses on short-term investments (553) -- Unrealized losses on short-term investments (322) -- Interest expense (63) -- Equity in losses of affiliate -- (55) Other income 78 4 ------------- ------------- Total other (expense) income (454) 1,144 ------------- ------------- Loss from operations before income taxes and minority interests (8,931) (14,657) Benefit (provision) for income taxes 69 (13) ------------- ------------- Loss from operations before minority interests (8,862) (14,670) Minority interests 2,435 5,191 ------------- ------------- Net loss (6,427) (9,479) ------------- ------------- Unrealized (losses) gains on short-term investments (95) 39 Unrealized losses on foreign currency translation (9) -- ------------- ------------- Comprehensive loss $ (6,531) $ (9,440) ============= ============= Loss per common share: Basic $ (0.33) $ (0.50) ============= ============= Diluted $ (0.33) $ (0.50) ============= ============= Weighted average number of common and potential common shares outstanding used in computation of loss per share: Basic and diluted 19,610,040 18,985,864 ============= =============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 4 ACACIA RESEARCH CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
THREE MONTHS ENDED --------------------- MARCH 31, MARCH 31, 2002 2001 --------- --------- Cash flows from operating activities: Net loss from continuing operations: $ (6,427) $ (9,479) Adjustments to reconcile net loss from continuing operations to net cash used in operating activities: Depreciation and amortization 933 837 Equity in losses of affiliate -- 55 Minority interests in net loss (2,435) (5,191) Stock-based compensation 1,422 8,419 Deferred tax benefit (75) (39) Net purchases of trading securities (3,358) -- Unrealized losses on short-term investments 322 -- Other 45 182 Changes in assets and liabilities, net of effects of acquisitions: Prepaid expenses, other receivables and other assets (1,322) (1,424) Accounts payable, accrued expenses and other (1,085) 949 Deferred revenue 531 -- --------- --------- Net cash used in operating activities for continuing operations (11,449) (5,691) Net cash used in operating activities for discontinued operations (254) (1,325) --------- --------- Net cash used in operating activities (11,703) (7,016) --------- --------- Cash flows from investing activities: Purchase of additional equity in consolidated subsidiaries -- (100) Purchase of property and equipment (232) (1,517) Purchase of short-term investments (4,540) -- Sale of short-term investments 6,878 5,813 Sale of property and equipment 98 10 Other (101) -- --------- --------- Net cash provided by investing activities from continuing operations 2,103 4,206 Net cash provided by investing activities from discontinued operations -- 111 --------- --------- Net cash provided by investing activities 2,103 4,317 --------- --------- Cash flows from financing activities: Proceeds from the exercise of stock options 214 1,026 Capital contributions from minority shareholders of subsidiaries 300 -- Proceeds from sale of common stock, net of issuance costs -- 18,361 Repayment of capital lease obligation (226) -- Other -- 128 --------- --------- Net cash provided by financing activities 288 19,515 --------- --------- (Decrease) increase in cash and cash equivalents (9,312) 16,816 --------- --------- Cash and cash equivalents, beginning 59,451 35,953 Effect of exchange rate on cash (16) -- --------- --------- Cash and cash equivalents, ending $ 50,123 $ 52,769 ========= =========
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 5 ACACIA RESEARCH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION BASIS OF PRESENTATION. The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnotes required by generally accepted accounting principles in annual financial statements are not included herein. These interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2001 as reported by us in our Annual Report on Form 10-K. The consolidated financial statements of Acacia Research Corporation include all adjustments of a normal recurring nature which, in the opinion of management, are necessary for a fair presentation of our financial position as of March 31, 2002 and results of operations and cash flows for the interim periods presented. The results of operations for the three months ended March 31, 2002 are not necessarily indicative of the results to be expected for the entire year. Acacia Research Corporation ("Acacia" or "we") develops, licenses and provides products for the media technology and life science sectors. Acacia's media technologies business, collectively referred to as "Acacia Media Technologies Group," owns intellectual property related to the telecommunications field, including a television blanking system, also known as the "V-chip," which it licenses to television manufacturers. In addition, Acacia Media Technologies Group owns a worldwide portfolio of pioneering patents relating to audio and video transmission and receiving systems, commonly known as audio-on-demand and video-on-demand, used for distributing content via various methods including computer networks, cable television systems and direct broadcasting satellite systems. Acacia Media Technologies Group is responsible for the development, licensing and protection of its intellectual property and proprietary technologies. Our media technologies group continues to pursue both licensing and strategic business alliances with leading companies in the rapidly growing media technologies industry. Acacia's life sciences business, collectively referred to as "Acacia Life Sciences Group," is comprised of CombiMatrix Corporation ("CombiMatrix") and Advanced Material Sciences, Inc. ("Advanced Material Sciences"). Our core technology opportunity in the life sciences sector has been developed through our majority-owned subsidiary, CombiMatrix. CombiMatrix is a life science technology company with a proprietary system for rapid, cost competitive creation of DNA and other compounds on a programmable semiconductor chip. This proprietary technology has significant applications relating to genomic and proteomic research. Our majority-owned subsidiary, Advanced Material Sciences, holds the exclusive license for CombiMatrix's biological array processor technology in certain fields of material sciences (see also Note 5). We were incorporated on January 25, 1993 under the laws of the State of California. In December 1999, we changed our state of incorporation from California to Delaware. Acacia owns and operates emerging corporations with intellectual property rights, certain of which are involved in developing new or unproven technologies. There is no assurance that any or all such technologies will be successful, and even if successful, that the development of such technologies can be commercialized. 6 2. LOSS PER SHARE Loss per share is presented on both a basic and diluted basis. A reconciliation of the denominator of the basic loss per share computation to the denominator of the diluted loss per share computation is as follows: THREE MONTHS ENDED ------------------------- MARCH 31, MARCH 31, 2002 2001 ----------- ----------- Weighted Average Number of Common Shares Outstanding Used in Computation of Basic EPS 19,610,040 18,985,864 Dilutive Effect of Outstanding Stock Options and Warrants (a) -- -- ----------- ----------- Weighted Average Number of Common and Potential Common Shares Outstanding Used in Computation of Diluted EPS 19,610,040 18,985,864 =========== =========== ------------------------------------------ (a) Potential common shares of 600,271 and 681,374 during the three months ended March 31, 2002 and 2001, respectively, have been excluded from the per share calculation because the effect of their inclusion would be anti-dilutive. 3. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" ("SFAS No. 141"), and SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"). SFAS No. 141 requires that the purchase method be used for all business combinations initiated after June 30, 2001 and that certain intangible assets acquired in a business combination be recognized apart from goodwill. The adoption of SFAS No. 141 did not have a material effect on our consolidated results of operations or financial position. SFAS No. 142 requires goodwill to be tested for impairment under certain circumstances, and written off when determined to be impaired, rather than being amortized as previous standards required. SFAS No. 142 is effective January 1, 2002. As a result of SFAS No. 142, we no longer amortize goodwill. In lieu of amortization, we are required to perform an initial impairment review of our goodwill in 2002 and an annual impairment review thereafter. The impact of the non-amortization of goodwill for the three months ended March 31, 2002 and 2001 is as follows (in thousands): THREE MONTHS ENDED ----------------------------------- MARCH 31, 2002 MARCH 31, 2001 -------------- -------------- Reported net loss $ (6,427) $ (9,479) Add back: goodwill amortization -- 243 -------------- -------------- Adjusted net loss $ (6,427) $ (9,236) ============== ============== Loss per share (basic and diluted): Reported net loss $ (0.33) $ (0.50) Goodwill amortization -- 0.01 -------------- -------------- Adjusted net loss $ (0.33) $ (0.49) ============== ============== We expect to complete our initial review of goodwill during the second quarter of 2002. We currently do not expect to record an impairment charge upon completion of the initial impairment review. However, there can be no assurance that at the time the review is completed a material impairment charge will not be recorded. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"), which addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to 7 Be Disposed Of." SFAS No. 144 also supersedes the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for segments of a business to be disposed of. SFAS No. 144 also amends Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to eliminate the exception to consolidation for a temporarily controlled subsidiary. SFAS No. 144 requires long-lived assets to be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. In conjunction with such tests, it may be necessary to review depreciation estimates and methods as required by Accounting Principles Board ("APB") Opinion No. 20, "Accounting Changes," or the amortization period as required by SFAS No. 142. The adoption of SFAS No. 144 did not have a material effect on our consolidated results of operations or financial position. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections," ("SFAS No. 145") which is effective for transactions occurring after May 15, 2002. SFAS No. 145 rescinds SFAS No. 4 and SFAS No. 64, which addressed the accounting for gains and losses from extinguishment of debt. SFAS No. 44 set forth industry-specific transitional guidance that did not apply to us. SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. SFAS No. 145 also makes technical corrections to certain existing pronouncements that are not substantive in nature. We do not expect the adoption of SFAS No. 145 to have a significant impact on our financial position or results of operations. 4. SEGMENT INFORMATION Acacia has two reportable segments as follows: ACACIA MEDIA TECHNOLOGIES GROUP - Acacia Media Technologies Group owns intellectual property related to the telecommunications field, including a television blanking system, also known as the "V-chip," which it licenses to television manufacturers. In addition, our media technologies group owns a worldwide portfolio of pioneering patents relating to audio and video transmission and receiving systems, commonly known as audio-on-demand and video-on-demand, used for distributing content via various methods including computer networks, cable television systems and direct broadcasting satellite systems. ACACIA LIFE SCIENCES GROUP - Our majority-owned subsidiary, CombiMatrix, is developing a proprietary biochip array processor system that integrates semiconductor technology with new developments in biotechnology and chemistry. Our majority-owned subsidiary, Advanced Material Sciences, holds the exclusive license for CombiMatrix's biological array processor technology in certain fields of material sciences (see also Note 5). We evaluate segment performances based on revenue earned and cost versus earnings potential of future completed products or services. Material intercompany transactions and transfers have been eliminated in consolidation. The accounting policies of the segments are the same as those described in our Annual Report on Form 10-K. Corporate and other includes corporate costs, certain assets and liabilities and other investment activities (including certain intangibles recorded in connection with the acquisition of various ownership interests in our subsidiaries), which are included in our consolidated financial statements but are not allocated to the reportable segments. We use the management approach, which designates the internal organization that is used by management for making operating decisions and assessing performance as the basis of our reportable segments. At December 31, 2001, our reporting segments were adjusted to include Soundview Technologies and Acacia Media Technologies in our Acacia Media Technologies Group segment. In addition, CombiMatrix and Advanced Material Sciences comprise our Acacia Life Sciences Group segment. Segment information has been adjusted for all periods presented. 8 The table below presents information about our reportable segments in continuing operations for the three months ended March 31, 2002 and 2001:
ACACIA MEDIA ACACIA LIFE TECHNOLOGIES SCIENCES CORPORATE THREE MONTHS ENDED MARCH 31, 2002 GROUP GROUP AND OTHER TOTAL --------------------------------- ------------- ------------- ------------- ------------- Revenue $ -- $ 249,000 $ -- $ 249,000 Amortization of patents 20,000 -- 544,000 564,000 Other income -- -- 78,000 78,000 Interest income 8,000 250,000 148,000 406,000 Interest expense -- 60,000 3,000 63,000 Realized losses on investments -- -- 553,000 553,000 Unrealized losses on investments -- -- 322,000 322,000 Loss from continuing operations before income taxes and minority interests 373,000 5,652,000 2,906,000 8,931,000 Non-cash stock compensation charges -- 1,411,000 11,000 1,422,000 Segment assets 10,400,000 35,222,000 53,086,000 98,708,000 Investment in affiliate, at cost -- -- 3,000,000 3,000,000 Purchase of property and equipment -- 178,000 54,000 232,000 ACACIA MEDIA ACACIA LIFE TECHNOLOGIES SCIENCES CORPORATE THREE MONTHS ENDED MARCH 31, 2001 GROUP GROUP AND OTHER TOTAL --------------------------------- ------------- ------------- ------------- ------------- Revenue $ 2,390,000 $ 183,000 $ 50,000 $ 2,623,000 Amortization of patents and goodwill 5,000 -- 628,000 633,000 Other income -- -- 4,000 4,000 Interest income 4,000 733,000 458,000 1,195,000 Equity in losses of affiliate -- -- 55,000 55,000 (Income) loss from continuing operations before income taxes and minority interests (1,066,000) 12,997,000 2,726,000 14,657,000 Non-cash stock compensation charges -- 7,598,000 821,000 8,419,000 Segment assets 1,482,000 47,747,000 56,526,000 105,755,000 Investment in affiliate, at equity -- -- 291,000 291,000 Investment in affiliate, at cost -- -- 3,000,000 3,000,000 Purchase of property and equipment 4,000 1,476,000 37,000 1,517,000
Segment information excludes discontinued operations related to Soundbreak.com as of and for the three months ended March 31, 2002 and 2001. 5. SUBSEQUENT EVENTS On April 25, 2002, our majority-owned subsidiary, CombiMatrix, purchased our interest in Advanced Material Sciences, a development stage company that holds the exclusive license for CombiMatrix's biological array processor technology in certain fields of material science. CombiMatrix issued 180,982 shares of its common stock in exchange for our 58% interest in Advanced Material Sciences. As a result of the sale of our interest in Advanced Material Sciences, CombiMatrix currently owns 87% of Advanced Material Sciences and the remaining interests are owned by unaffiliated entities. On May 7, 2002, we filed a Registration Statement on Form S-4 with the Securities and Exchange Commission in connection with our plan to divide our common stock into two new classes - new "CombiMatrix" stock, that would reflect the performance of our subsidiary CombiMatrix, and new "Acacia Technologies" stock, that would reflect the performance of Acacia's media technology businesses. If the recapitalization plan is approved, Acacia Research Corporation stockholders would receive shares of both of the new classes of stock in exchange for the shares they now hold, and the new shares would be separately traded NASDAQ listed public securities. The Registration Statement also pertains to a proposal pursuant to which we would acquire the minority stockholder interests in our majority-owned subsidiary CombiMatrix. The proposed acquisition would be accomplished through a merger in which the minority stockholders of CombiMatrix would receive shares of our new "CombiMatrix" stock, in exchange for their existing shares of CombiMatrix Corporation. The proposed recapitalization and merger are subject to several conditions, including, but not limited to, receipt of stockholder approval for both companies, receipt of satisfactory tax opinions, approval for listing of both of the new shares on NASDAQ and other customary conditions. Our stockholders will receive a proxy describing the terms of the proposals prior to being asked to vote upon and approve the recapitalization and merger at a special meeting to be held to consider these matters. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENT You should read the following discussion and analysis in conjunction with the consolidated financial statements and related notes thereto contained elsewhere in this report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2001 and our Registration Statement on Form S-4 filed with the Securities and Exchange Commission on May 7, 2002, that discuss our business in greater detail. This report contains forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Reference is made in particular to the description of our plans and objectives for future operations, assumptions underlying such plans and objectives, and other forward-looking statements included in this report. Such statements may be identified by the use of forward-looking terminology such as "may," "will," "expect," "believe," "estimate," "anticipate," "intend," "continue," or similar terms, variations of such terms or the negative of such terms. Such statements are based on management's current expectations and are subject to a number of factors and uncertainties, which could cause actual results to differ materially from those described in the forward-looking statements. Such statements address future events and conditions concerning product development, capital expenditures, earnings, litigation, regulatory matters, markets for products and services, liquidity and capital resources and accounting matters. Actual results in each case could differ materially from those anticipated in such statements by reason of factors such as future economic conditions, changes in consumer demand, legislative, regulatory and competitive developments in markets in which we and our subsidiaries operate, and other circumstances affecting anticipated revenues and costs. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based. Additional factors that could cause such results to differ materially from those described in the forward-looking statements are set forth in connection with the forward-looking statements. OVERVIEW As used in this Form 10-Q, "we," "us," "our," "Acacia" and "Acacia Research" refer to Acacia Research Corporation and its subsidiary companies. Acacia Research Corporation, a Delaware corporation, was originally incorporated in California in January 1993 and reincorporated in Delaware in December 1999. The following discussion is based primarily on our unaudited consolidated balance sheet as of March 31, 2002, and on our unaudited consolidated statement of operations for the period from January 1, 2002 to March 31, 2002. The discussion compares the activities for the three months ended March 31, 2002 to the activities for the three months ended March 31, 2001. This information should be read in conjunction with the accompanying unaudited consolidated financial statements and notes thereto. Acacia Research Corporation develops, licenses and provides products for the media technology and life science sectors. Acacia's media technologies and life sciences businesses are referred to as "Acacia Media Technologies Group" and "Acacia Life Sciences Group," respectively. Acacia licenses its V-chip technology to television manufacturers and owns pioneering technology for digital streaming and audio and video-on-demand. We will continue to pursue both licensing and strategic business alliances with leading companies in the rapidly growing media technologies industry. Acacia's core technology opportunity in the life science sector has been developed through our majority-owned subsidiary, CombiMatrix Corporation ("CombiMatrix"), which is developing a proprietary system for rapid, cost competitive creation of DNA and other compounds on a programmable semiconductor chip. 10 In February 2002, CombiMatrix was awarded a six month $100,000 Phase I National Institutes of Health grant for the development of its protein biochip technology. The title of the grant is "Self-Assembling Protein Microchips." This grant is in addition to a three-year Phase I SBIR grant and a two-year Phase II SBIR grant from the U.S. Department of Defense for the development of multiplexed chip based assays for chemical and biological warfare agent detection. On March 20, 2002, we announced that our board of directors approved a plan to divide our common stock into two new classes of common stock: new "CombiMatrix" common stock, that would reflect the performance of our CombiMatrix subsidiary and all corporate assets, liabilities and related transactions of Acacia Research Corporation attributed to the CombiMatrix business, and new "Acacia Technologies" common stock, that would reflect the performance of our media technology businesses, including Soundview Technologies, Acacia Media Technologies and all corporate assets, liabilities, and related transactions of Acacia Research Corporation attributed to the media technology businesses. The plan is subject to several conditions including shareholder approval. If the recapitalization proposal is approved and the other conditions are satisfied, our stockholders would receive shares of both of the new classes of stock in exchange for existing Acacia Research Corporation shares. The new share classes are intended to be separately listed on the NASDAQ National Market System under the symbols "CBMX" and "ACTG," respectively. We also announced that our board of directors and CombiMatrix's board of directors have approved an agreement for us to acquire the minority stockholder interests in CombiMatrix. The proposed acquisition would be accomplished through a merger in which the minority stockholders of CombiMatrix would receive shares of the new Acacia Research Corporation "CombiMatrix" common stock, in exchange for their existing shares. The proposed transaction will be submitted to our stockholders and the stockholders of CombiMatrix for approval. On May 7, 2002, we filed a registration statement with the Securities and Exchange Commission related to the proposed recapitalization and merger transactions discussed above. In April 2002, CombiMatrix's Japanese subsidiary entered into a technology access and purchase agreement in Japan with the Computational Biology Research Center ("CBRC"), a division of the Japanese National Institute of Advanced Industrial Science and Technology. The CBRC has purchased and installed a CombiMatrix gene chip synthesizer and entered into a multi-year agreement to purchase blank chips that will be used to synthesize custom gene chips. The agreement also gives CBRC access to the CombiMatrix set of informatics tools to help in their efforts to expand biotechnology related businesses in Japan. RESULTS OF OPERATIONS THREE MONTHS ENDED ------------------------------ MARCH 31, 2002 MARCH 31, 2001 -------------- -------------- Net revenues $ 249,000 $ 2,623,000 Research and development expenses (3,089,000) (5,549,000) Marketing, general and administrative expenses (5,073,000) (12,242,000) Amortization of patents and goodwill (564,000) (633,000) Other (expense) income, net (454,000) 1,144,000 Benefit (provision) for income taxes 69,000 (13,000) Minority interests 2,435,000 5,191,000 -------------- -------------- Net loss $ (6,427,000) $ (9,479,000) ============== ============== 11 COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 2002 TO THE THREE MONTHS ENDED MARCH 31, 2001 LICENSE FEE INCOME. During the three months ended March 31, 2002, license fee income was $0 as compared to $2.4 million in license fee income during the three months ended March 31, 2001. The license fee income for the three months ended March 31, 2001 resulted primarily from the settlement of patent infringement litigation brought by Soundview Technologies and includes license fee amounts received from television manufacturers with whom we executed separate settlement and/or license agreements during the first quarter of 2001 and December 2000. Pursuant to the terms of the respective settlement and license agreements with each of the television manufacturers, Soundview Technologies granted to such manufacturers, non-exclusive licenses for its U.S. Patent No. 4,554,584. Soundview Technologies did not execute any license or settlement agreements during the first quarter of 2002. The Acacia Media Technologies Group continues to pursue both licensing and strategic business alliances with other television manufacturers and leading companies in the media technologies industry. Acacia Media Technologies Group's patent on the V-chip technology will expire in July 2003, although the Acacia Media Technologies Group may still collect revenues from the sale of televisions in the United States before that date. The Acacia Media Technologies Group is beginning to license its digital media transmission technology and is developing other technologies and products. The eventual licensing and sale of these technologies is intended to replace the revenue generated by licensing the V-chip technology. If we do not succeed in developing such technologies or are unable to commercially license our existing and future technologies, our financial condition may be adversely impacted. GRANT REVENUE. During the three months ended March 31, 2002 and 2001, grant revenue, all of which related to CombiMatrix, was $0.2 million. Grant revenue during the first quarter of 2002 includes $91,000 in grant revenue from CombiMatrix's continuing performance under its Phase II Small Business Innovative Research Department of Defense contract, $141,000 in one-time contract research and development revenues and $17,000 in revenue related to performance under its Phase I National Institutes of Health grant. Grant revenue for the three months ended March 31, 2001 related to CombiMatrix's continued performance under the Phase II SBIR Department of Defense contract. CombiMatrix was awarded the two-year $0.7 million SBIR Phase II contract in January 2000 and we expect to recognize an additional $91,000 in government grant revenue per quarter over the next two quarters in 2002. In February 2002, CombiMatrix was awarded a six month $100,000 Phase I National Institutes of Health grant for the development of its protein biochip technology, of which $17,000 has been recognized as revenue in the first quarter of 2002, and we expect to recognize the remaining portion of the grant over the next two quarters in 2002. RESEARCH AND DEVELOPMENT EXPENSES. During the three months ended March 31, 2002, research and development expense was $3.1 million, as compared to $5.5 million in the three months ended March 31, 2001. Research and development expenses for both periods relate to CombiMatrix. The decrease in research and development expense for 2002 as compared to the same period in 2001 was primarily due to a decrease in non-cash stock compensation amortization expenses, a reduction in the number of research and development personnel from levels established in the first quarter of 2001, and the recording of approximately $0.3 million in inventory write-offs in the three months ended March 31, 2001. During the three months ended March 31, 2002, research and development expense included non-cash stock compensation charges totaling $0.4 million, as compared to $2.4 million during the three months ended March 31, 2001. The decrease in non-cash stock compensation charges included in research and development expenses is primarily due to the forfeiture and cancellation of certain options in the third and fourth quarters of 2001 and a reduction in scheduled stock compensation amortization related to the accelerated method of amortization utilized by us pursuant to FASB Interpretation No. 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans" ("FIN No. 28"), which results in higher amounts of amortization in the early vesting periods, and lower amounts of amortization in subsequent vesting periods. CombiMatrix's research and development activities during the third and fourth quarters of 2001 and the first quarter of 2002, were focused on efforts to further develop and enhance its microarray technology including increased costs related to significant engineering efforts undertaken to productize its technology. The majority of these efforts were driven by CombiMatrix's obligations under the license and supply agreement with Roche Diagnostics GmbH, executed in July 2001. These projects include development of production microarray synthesis techniques, as well as higher density microarrays. 12 MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. We incurred marketing, general and administrative expenses of $5.1 million ($2.9 million related to CombiMatrix) during the three months ended March 31, 2002, as compared to $12.2 million ($8.3 million related to CombiMatrix) in the three months ended March 31, 2001. The decrease in marketing, general and administrative expenses for 2002 as compared to the same period in 2001 was primarily due to a decrease in non-cash stock compensation expense. Marketing, general and administrative expenses included $1.0 million, (primarily related to CombiMatrix) and $6.0 million ($5.2 million related to CombiMatrix) of non-cash stock compensation charges for the three months ended March 31, 2002 and 2001, respectively. The decrease in non-cash stock compensation charges included in marketing, general and administrative expenses is primarily due to the forfeiture and cancellation of certain options in the third and fourth quarters of 2001 and a reduction in scheduled stock compensation amortization related to the accelerated method of amortization utilized by us pursuant to FIN No. 28. CombiMatrix marketing, general and administrative non-cash stock compensation amortization expense for the three months ended March 31, 2002 are net of $0.7 million in stock compensation expense reversal related to the forfeiture of certain unvested stock options in the first quarter of 2002. The decrease in marketing, general and administrative expenses for 2002 as compared to the same period in 2001 was also due to: a decrease in salaries and benefits costs related to a decrease in headcount at Acacia corporate, resulting from the closure and/or write-off of several of our early stage investments at the end of 2000; a decrease in CombiMatrix's sales and marketing head count and related expenses, recruitment and relocation expenses, administrative head count and legal costs; and a decrease in legal fees incurred related to Soundview Technologies' patent licensing and related infringement settlements. Legal fees related to the license fee agreements executed with television manufacturers are generally incurred on a contingency basis, based on license fee payments received. AMORTIZATION OF PATENTS AND GOODWILL. During the three months ended March 31, 2002 and 2001, amortization expense relating to patents and goodwill was $0.6 million. Amortization expense relating to patents and goodwill for the three months ended March 31, 2002 excludes $0.2 million of amortization expense pursuant to SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"), which requires goodwill to be tested for impairment under certain circumstances, and written off when determined to be impaired, rather than being amortized as previous standards required. The reduction in goodwill amortization in the three months ended March 31, 2002 was offset by an increase in patent amortization related to the increase in our ownership interest in Acacia Media Technologies Corporation (formerly, "Greenwich Information Technologies," a limited liability company) from 33% to 100% through the purchase of the ownership interest of Acacia Media Technologies' other member in November 2001. As a result of the purchase, we will be recording additional patent amortization of $0.2 million on a quarterly basis over the related patents economic useful lives (approximately 10 years) related to the intangibles identified in connection with the application of the purchase method of accounting. OTHER (EXPENSE) INCOME, NET. During the three months ended March 31, 2002, other expense, net (primarily comprised of interest income, realized and unrealized gains and losses on trading securities, equity in losses of affiliate and other) was $0.5 million as compared to $1.1 million in net other income in 2001. INTEREST INCOME. During the three months ended March 31, 2002, interest income was $0.4 million as compared to $1.2 million in the three months ended March 31, 2001. The decrease in interest income during 2002 was primarily due to the impact of a decrease in interest rates on our short-term investments related to sharp interest rate cuts by the Federal Open Market Committee and other external economic factors negatively impacting rates of return on short-term investments occurring during the third and fourth quarters of 2001. REALIZED LOSSES ON SHORT-TERM INVESTMENTS. During the three months ended March 31, 2002, net realized losses on short-term investments was $0.6 million as compared to no realized losses on short-term investments in the three months ended March 31, 2001. The increase in realized losses on short-term investments during 2001 was due to realized losses recorded on our short-term investments classified as trading securities during the three months ended March 31, 2002. We did not invest in trading securities during the three months ended March 31, 2001. UNREALIZED LOSSES ON SHORT-TERM INVESTMENTS. During the three months ended March 31, 2002, net unrealized loses were $0.3 million as compared to no unrealized losses in the same period in 2001. The increase is due to the classification of our investments in equity securities as trading securities during 2002 pursuant to SFAS No. 115. In the first quarter of 2001, all of our short-term investments were classified as available-for-sale and unrealized gains and losses were recorded as a separate component of comprehensive income (loss) in stockholders' equity until realized. EQUITY IN LOSSES OF AFFILIATE. During the three months ended March 31, 2002, equity in losses of affiliate was $0 as compared to $55,000 in the three months ended March 31, 2001. Equity in losses of affiliate during the three months ended March 31, 2001 was comprised of a loss of $55,000 for our 13 equity investment in Acacia Media Technologies. As of December 31, 2001, we no longer account for any of our investments under the equity method as we directly or indirectly own more that 50% of the outstanding voting securities of our subsidiaries and, as a result, account for these investments under the consolidation method of accounting. MINORITY INTERESTS. Minority interests in the losses of consolidated subsidiaries decreased to $2.4 million during the three months ended March 31, 2002 as compared to $5.2 million in the same period in 2001. Minority interests in the losses of consolidated subsidiaries for the three months ended March 31, 2002 were primarily comprised of minority interests in the net losses of CombiMatrix. Minority interests in the losses of consolidated subsidiaries for the three months ended March 31, 2001 were comprised primarily of minority interests in the net losses of CombiMatrix totaling $5.5 million. The decrease is due to a reduction in CombiMatrix's net loss for the three months ended March 31, 2002 as compared to the same period in 2001. NON-CASH STOCK COMPENSATION CHARGES During the year ended December 31, 2000, our majority-owned subsidiary, CombiMatrix, recorded deferred non-cash stock compensation charges aggregating approximately $53.8 million in connection with the granting of stock options. Pursuant to Acacia's policy, the stock options were granted at exercise prices equal to the fair value of the underlying CombiMatrix stock on the date of grant as determined by Acacia. However, such exercise prices were subsequently determined to be below fair value due to a substantial step-up in the fair value of CombiMatrix pursuant to a valuation provided by an investment banker in contemplation of a potential CombiMatrix initial public offering in 2000. In connection with the proposed CombiMatrix initial public offering and pursuant to SEC rules and guidelines, we were required to reassess the value of stock options issued during the one-year period preceding the potential initial public offering and utilize the stepped-up fair value provided by the investment banker for purposes of determining whether such stock option issuances were compensatory, resulting in the calculation of the $53.8 million in deferred non-cash stock compensation charges in 2000. Deferred non-cash stock compensation charges are being amortized by CombiMatrix over the respective option grant vesting periods, which range from one to four years. At March 31, 2002, remaining non-cash deferred stock compensation, net of past amortization, and the impact of previous forfeitures and cancellations totaled $9.8 million. The remaining deferred non-cash stock compensation balance as of March 31, 2002 related to stock options issued by CombiMatrix represents the future non-cash deferred stock compensation expense that will be reflected in our consolidated statements of operations and comprehensive loss as non-cash stock compensation charges over the next eleven quarters from April 1, 2002 through December 31, 2004 as follows: FIRST SECOND THIRD FOURTH YEAR QUARTER QUARTER QUARTER QUARTER TOTAL ---- --------- ----------- ----------- ----------- ----------- 2002 $ -- $2,142,000 $2,003,000 $1,195,000 $5,340,000 2003 958,000 962,000 924,000 494,000 3,338,000 2004 352,000 347,000 317,000 73,000 1,089,000 ----------- $9,767,000 =========== Certain CombiMatrix unvested stock options were forfeited in 2002. Pursuant to the provisions of APB No. 25 and related interpretations, the reversal of previously recognized non-cash stock compensation expense on forfeited unvested stock options, in the amount of $724,000 during the three months ended March 31, 2002, has been reflected in the respective consolidated statements of operations and comprehensive loss as a reduction in non-cash stock compensation expense. Non-cash deferred stock compensation expense scheduled to be recognized in future periods reflected above may be impacted by certain subsequent stock option transactions including modification of terms, cancellations, forfeitures and other activity. INFLATION Inflation has not had a significant impact on Acacia Research Corporation or our subsidiaries. 14 LIQUIDITY AND CAPITAL RESOURCES At March 31, 2002, we had cash and short-term investments of $75.8 million on a consolidated basis, including discontinued operations, of which Acacia Research Corporation, on a stand-alone basis, had $40.7 million. Working capital was $65.4 million on a consolidated basis at March 31, 2002. There were no significant financing activities for the three months ended March 31, 2002. In February 2002, in conjunction with the relocation of our corporate headquarters, we entered into a non-cancelable lease agreement to lease approximately 7,143 square feet of office space in Newport Beach, California through February 2007. Minimum annual rental commitments under this operating lease are $255,000 in 2002; $286,000 in 2003; $295,000 in 2004; $303,000 in 2005; $312,000 in 2006; and $39,000 in 2007. We have no significant commitments for capital expenditures in 2002. Our minimum rental commitments, including CombiMatrix, on operating leases related to continuing operations total $13.4 million through February 2007. We have no committed lines of credit or other significant committed funding. We anticipate that existing working capital reserves will provide sufficient funds for our operating expenses for at least the next twelve months in the absence of making any major new investments. We intend to seek additional financing to fund new or existing businesses. There can be no assurances that we will not encounter unforeseen difficulties that may deplete our capital resources more rapidly than anticipated. Any efforts to seek additional funding could be made through equity, debt or other external financing and there can be no assurance that additional funding will be available on favorable terms, if at all. Such financing transactions may be dilutive to existing investors. If we fail to obtain additional funding when needed, we may not be able to execute our business plans and our business may suffer. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the FASB issued SFAS No. 141, "Business Combinations" ("SFAS No. 141"), and SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"). SFAS No. 141 requires that the purchase method be used for all business combinations initiated after June 30, 2001 and that certain intangible assets acquired in a business combination be recognized apart from goodwill. The adoption of SFAS No. 141 did not have a material effect on our consolidated results of operations or financial position. SFAS No. 142 requires goodwill to be tested for impairment under certain circumstances, and written off when determined to be impaired, rather than being amortized as previous standards required. SFAS No. 142 is effective January 1, 2002. As a result of SFAS No. 142, we will no longer amortize goodwill. In lieu of amortization, we are required to perform an initial impairment review of our goodwill in 2002 and an annual impairment review thereafter. The impact of the non-amortization of goodwill for the three months ended March 31, 2002 and 2001 is as follows (in thousands): THREE MONTHS ENDED ----------------------------------- MARCH 31, 2002 MARCH 31, 2001 -------------- -------------- Reported net loss $ (6,427) $ (9,479) Add back: goodwill amortization -- 243 -------------- -------------- Adjusted net loss $ (6,427) $ (9,236) ============== ============== Loss per share (basic and diluted): Reported net loss $ (0.33) $ (0.50) Goodwill amortization -- 0.01 -------------- -------------- Adjusted net loss $ (0.33) $ (0.49) ============== ============== We expect to complete our initial review of goodwill during the second quarter of 2002. We currently do not expect to record an impairment charge upon completion of the initial impairment review. However, there can be no assurance that at the time the review is completed a material impairment charge will not be recorded. 15 In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"), which addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." SFAS No. 144 also supersedes the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for segments of a business to be disposed of. SFAS No. 144 also amends ARB No. 51, "Consolidated Financial Statements," to eliminate the exception to consolidation for a temporarily controlled subsidiary. SFAS No. 144 requires long-lived assets to be tested for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. In conjunction with such tests, it may be necessary to review depreciation estimates and methods as required by APB Opinion No. 20, "Accounting Changes," or the amortization period as required by SFAS No. 142. The adoption of SFAS No. 144 did not have a material effect on our consolidated results of operations or financial position. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections," ("SFAS No. 145") which is effective for transactions occurring after May 15, 2002. SFAS No. 145 rescinds SFAS No. 4 and SFAS No. 64, which addressed the accounting for gains and losses from extinguishment of debt. SFAS No. 44 set forth industry-specific transitional guidance that did not apply to us. SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. SFAS No. 145 also makes technical corrections to certain existing pronouncements that are not substantive in nature. We do not expect the adoption of SFAS No. 145 to have a significant impact on our financial position or results of operations. RISK FACTORS Set forth below and elsewhere in this Quarterly Report and in the other documents we file with the Securities and Exchange Commission are risks and uncertainties that could cause our actual results to differ materially from the results contemplated by the forward-looking statements contained in this Quarterly Report. BECAUSE OUR BUSINESS OPERATIONS ARE SUBJECT TO MANY INHERENT AND UNCONTROLLABLE RISKS, WE MAY NOT SUCCEED. We have significant economic interests in our subsidiary companies. Our business operations are subject to numerous risks, challenges, expenses and uncertainties inherent in the establishment of new business enterprises. Many of these risks and challenges are subject to outside influences over which we have no control, including: o our subsidiary companies' products and services face uncertain market acceptance; o technological advances may make our subsidiary companies' products and services obsolete or less competitive; o competition; o increases in operating costs, including costs for supplies, personnel and equipment; o the availability and cost of capital; o general economic conditions; and o governmental regulation that excessively restricts our subsidiary companies' businesses. We cannot assure you that our subsidiary companies will be able to market any product or service on a commercial scale, that our subsidiary companies will ever achieve or maintain profitable operations or that they, or we, will be able to remain in business. BECAUSE OF THE RISKS INHERENT IN INVESTING IN EMERGING COMPANIES, INCLUDING THE LACK OF OPERATING HISTORIES AND UNPROVEN TECHNOLOGIES AND PRODUCTS, WE MAY INCUR SUBSTANTIAL LOSSES. Investing in emerging companies carries a high degree of risk, including difficulties in selecting ventures with viable business plans and acceptable likelihoods of success and future profitability. There is a high probability of loss associated with investments in emerging companies. We must also dedicate significant amounts of financial resources, management attention and personnel to identify and develop each new business opportunity without any assurance that these expenditures will prove fruitful. 16 We generally invest in start-up ventures with no operating histories, unproven technologies and products and, in some cases, without experienced management. We may not be successful in developing these start-up ventures. Because of the uncertainties and risks associated with such start-up ventures, we could experience substantial losses associated with failed ventures. In addition, the market for venture capital in the United States is increasingly competitive. As a result, we may lose business opportunities and may need to accept financing and equity investments on less favorable terms. Also, we may be unable to participate in additional ventures because we lack the financial resources to provide them with full funding. We, as well as our subsidiary companies, may need to depend on external financing to provide sufficient capital. WE HAVE A HISTORY OF LOSSES AND EXPECT TO INCUR ADDITIONAL LOSSES IN THE FUTURE. We have sustained substantial losses since our inception resulting in an accumulated deficit of $106.4 million (including a reclassification of accumulated deficit in the amount of $21.7 million to permanent capital representing the fair value of the ten percent (10%) stock dividend paid in 2001) on a consolidated basis, including operating losses of $43.2 million in 2001 and $8.5 million in the first quarter of 2002. We may never become profitable or if we do, we may never be able to sustain profitability. We expect to incur significant research and development, marketing, general and administrative expenses. As a result, we expect to incur significant losses for the foreseeable future. TECHNOLOGY COMPANY STOCK PRICES ARE ESPECIALLY VOLATILE, AND THIS VOLATILITY MAY DEPRESS OUR STOCK PRICE. Our common stock, which is quoted on the NASDAQ National Market System, has experienced significant price and volume fluctuations. Additionally, the stock market generally, and the stock prices of technology companies, specifically, have been very volatile. The market price of our common stock may fluctuate significantly in response to a number of factors beyond our control, including: o changes in financial estimates by securities analysts; o our failure to meet the expectations of securities analysts; o announcements by us, our customers, our subsidiaries or our competitors; o changes in market valuations of similar companies; o changes in accounting rules and regulations; and o future sales of our common stock by our existing stockholders. BECAUSE OUR OPERATING RESULTS HAVE FLUCTUATED SIGNIFICANTLY AND MAY CONTINUE TO DO SO IN THE FUTURE, OUR STOCK PRICE MAY BE VERY VOLATILE. Our operating results may vary significantly from quarter to quarter due to a variety of factors, including: o the operating results of our current and future subsidiary companies; o the nature and timing of our investments in new subsidiary companies; o our decisions to acquire or divest interests in our current and future subsidiaries, which may create changes in losses or income and amortization of goodwill; o changes in our methods of accounting for our current and future subsidiaries, which may cause us to recognize gains or losses under applicable accounting rules; o the timing of the sales of equity interests in our current and future subsidiary companies; o our ability to effectively manage our growth and the growth of our subsidiary companies; o general economic conditions; and o the cost of future acquisitions, which may increase due to intense competition from other potential acquirers of technology-related companies or ideas. We have incurred and expect to continue to incur significant expenses in pursuing and developing new business ventures. To date, we have lacked a consistent source of recurring revenue. Each of the factors we have described may cause our stock to be more volatile than the stock of other companies. BECAUSE OUR SUBSIDIARY COMPANIES MAY NOT GENERATE ANY REVENUES, AND OPERATING RESULTS FROM OUR SUBSIDIARY COMPANIES MAY FLUCTUATE SIGNIFICANTLY, OUR OWN OPERATING RESULTS MAY BE NEGATIVELY AFFECTED. Our operating results may be materially impacted by the operating results of our subsidiary companies. We cannot assure that these companies will be able to meet their anticipated working capital needs to develop their 17 products and services. If they fail to properly develop these products and services, they will be unable to generate meaningful product sales. We anticipate that our operating results are likely to vary significantly as a result of a number of factors, including: o the timing of new product introductions by each subsidiary company; o the stage of development of the business of each subsidiary company; o the technical feasibility of each subsidiary company's technologies and techniques; o the novelty of the technology owned by our subsidiary companies; o the accuracy, effectiveness and reliability of products developed by our subsidiary companies; o the level of product acceptance; o the strength of each subsidiary company's intellectual property rights; o the ability of each subsidiary company to avoid infringing the intellectual property rights of others; o each subsidiary company's ability to exploit and commercialize its technology; o the volume and timing of orders received and product line maturation; o the impact of price competition; and o each subsidiary company's ability to access distribution channels. Many of these factors are beyond our subsidiary companies' control. We cannot provide any assurance that any subsidiary company will experience growth in the future or be profitable on an operating basis in any future period. A LACK OF MARKET ACCEPTANCE OF OUR SUBSIDIARY COMPANIES' PRODUCTS WILL RESULT IN OPERATING LOSSES. Each of our subsidiary companies is developing new technologies and products, as further detailed below. To the extent any of these technologies and products are not accepted by their respective markets, we will incur operating losses. COMBIMATRIX. CombiMatrix is developing a proprietary biochip microarray processor system that integrates semiconductor technology with new developments in biotechnology and chemistry. Although CombiMatrix has been awarded three research grants sponsored by different U.S. governmental agencies, CombiMatrix is a developmental-stage company without any significant current revenues. Its current activities relate almost exclusively to research and development. CombiMatrix must conduct additional testing before any of its products will be ready for sale. Because the technologies critical to the success of this industry are in their infancy, we cannot assure you that CombiMatrix will be able to successfully implement its technologies. If its technologies are successful, CombiMatrix intends to pursue collaborations with pharmaceutical companies for activities such as screening potential drug compounds. We cannot assure you that CombiMatrix, even if successful in developing its technologies, would be able to successfully implement collaborative efforts with pharmaceutical companies and create commercially successful products. Even if CombiMatrix develops commercially viable products, it has no experience manufacturing, marketing, pricing or selling products in the volumes that would be required for commercial success. This inexperience could hinder CombiMatrix's ability to profit from any viable products it may develop. SOUNDVIEW TECHNOLOGIES. Soundview Technologies was formed to commercialize patent rights of a method of video and audio blanking technology, also known as V-chip technology, that screens objectionable television programming and blocks it from the viewer. Although Soundview Technologies has licensed its technology to certain television manufacturers, we cannot assure you that it will continue to be profitable. ACACIA MEDIA TECHNOLOGIES (FORMERLY KNOWN AS GREENWICH INFORMATION TECHNOLOGIES LLC). Acacia Media Technologies owns a worldwide portfolio of pioneering patents relating to audio and video transmission and receiving systems, commonly known as audio-on-demand and video-on-demand, used for distributing content via various methods including computer networks, cable television systems and direct broadcasting satellite systems The market for information-on-demand systems has only recently begun to develop and is rapidly evolving. Demand and market acceptance for information-on-demand systems are subject to substantial uncertainty and risk. We cannot predict whether, or how fast, this market will grow or how long it can be sustained. To date, Acacia Media Technologies has yet to license any of its technology. It is uncertain if and to what extent Acacia Media Technologies will be able to profitably market and license its rights to the information-on-demand technology. THE EXPANSION OF COMBIMATRIX'S PRODUCT LINES MAY SUBJECT IT TO REGULATION BY THE FDA AND FOREIGN REGULATORY AUTHORITIES, WHICH COULD PREVENT OR DELAY THE INTRODUCTION OF NEW PRODUCTS. If CombiMatrix manufactures, markets or sells any products for any regulated clinical or diagnostic applications, those products will be subject to extensive governmental regulation as medical devices in by the FDA and in other 18 countries by corresponding foreign regulatory authorities. The process of obtaining and maintaining required regulatory clearances and approvals is lengthy, expensive and uncertain. Products that CombiMatrix manufactures, markets or sells for research purposes only are not subject to governmental regulations as medical devices or as analyte specific reagents to aid in disease diagnosis. We believe that CombiMatrix's success will depend upon commercial sales of improved versions of products, certain of which cannot be marketed in the United States and other regulated markets unless and until CombiMatrix obtains clearance or approval from the FDA and its foreign counterparts, as the case may be. There can be no assurance that these approvals will be received on a timely basis, or at all, and delays or failures in receiving these approvals may limit our ability to benefit from new CombiMatrix products. ETHICAL, SOCIAL, POLITICAL AND LEGAL ISSUES CONCERNING GENOMIC RESEARCH AND TESTING MAY RESULT IN REGULATIONS RESTRICTING THE USE OF COMBIMATRIX'S TECHNOLOGY OR REDUCE DEMAND FOR ITS PRODUCTS. In the case that CombiMatrix or its customers manufacture, market or sell a regulated diagnostic product, ethical, social and legal concerns about genomic testing and genomic research could result in regulations restricting CombiMatrix's or its customers' activities. For example, the potential availability of testing for genetic predispositions has raised issues regarding the use and confidentiality of information obtained from this testing. Some states in the United States have enacted legislation restricting the use of information derived from genomic testing, and the United States Congress and some foreign governments are considering similar legislation. Restrictions on CombiMatrix or its customers could result in a reduction of sales, if any, and harm our financial results. AS COMBIMATRIX'S OPERATIONS EXPAND, ITS COSTS TO COMPLY WITH ENVIRONMENTAL LAWS AND REGULATIONS WILL INCREASE; FAILURE TO COMPLY WITH THESE LAWS AND REGULATIONS COULD EXPOSE COMBIMATRIX TO SUBSTANTIAL LIABILITIES AND HARM OUR FINANCIAL RESULTS. CombiMatrix's operations involve the use, transportation, storage and disposal of hazardous substances, and as a result, it is subject to environmental and health and safety laws and regulations. As CombiMatrix expands its operations, its use of hazardous substances will increase and lead to additional and more stringent requirements. The cost to comply with these and any future environmental and health and safety regulations could be substantial. In addition, CombiMatrix's failure to comply with laws and regulations, and any releases of hazardous substances by it into the environment, or at disposal sites used by it, could expose CombiMatrix to substantial liability in the form of fines, penalties, remediation costs and other damages, or could lead to a curtailment or shut down of CombiMatrix's operations. These types of events, if they occur, would adversely impact our financial results. COMBIMATRIX MAY BE EXPOSED TO LIABILITY DUE TO PRODUCT DEFECTS. If CombiMatrix commences testing, manufacturing and selling of regulated diagnostic products, it will be exposed to potential product liability claims inherent in such activities. When desirable, CombiMatrix intends to acquire additional insurance for clinical liability risks. CombiMatrix may not be able to obtain such insurance or general product liability insurance on acceptable terms or at reasonable costs. In addition, such insurance may not provide sufficient amounts of coverage for all potential liabilities. A product liability claim or recall could materially and adversely affect CombiMatrix's business, financial condition and results of operations. BECAUSE EACH SUBSIDIARY COMPANY'S SUCCESS GREATLY DEPENDS ON ITS ABILITY TO DEVELOP AND MARKET NEW PRODUCTS AND SERVICES AND TO RESPOND TO THE RAPID CHANGES IN TECHNOLOGY AND DISTRIBUTION CHANNELS, WE CANNOT ASSURE YOU THAT OUR SUBSIDIARY COMPANIES WILL BE SUCCESSFUL IN THE FUTURE. The markets for each subsidiary company's products are marked by extensive competition, rapidly changing technology, frequent product and service improvements and evolving industry standards. We cannot assure you that the existing or future products and services of our subsidiary companies will be successful or profitable. We also cannot assure you that competitors' products, services or technologies will not render our subsidiary companies' products and services non-competitive or obsolete. Our success will depend on our subsidiary companies' ability to adapt to this rapidly evolving marketplace and to develop and market new products and services or enhance existing ones to meet changing customer demands. Our subsidiary companies may be unable to adequately adapt products and services or acquire new products and services that can compete successfully. In addition, our subsidiary companies may be unable to establish and maintain distribution channels. 19 IF WE, OR OUR SUBSIDIARIES, ENCOUNTER UNFORESEEN DIFFICULTIES AND CANNOT OBTAIN ADDITIONAL FUNDING ON FAVORABLE TERMS, OUR BUSINESS MAY SUFFER. As of March 31, 2002, we had cash and short-term investments of $75.8 million on our consolidated financial statements. However, portions of these funds were held by certain of our consolidated subsidiaries and thus are restricted to their individual use. To date, our subsidiary companies have relied primarily upon selling equity securities, including sales to and loans from us, to generate the funds needed to finance implementing their plans of operations. Our subsidiary companies may be required to obtain additional financing through bank borrowings, debt or equity financings or otherwise, which would require us to make additional investments or face a dilution of our equity interests. We cannot assure that we will not encounter unforeseen difficulties that may deplete our capital resources more rapidly than anticipated. Any efforts to seek additional funds could be made through equity, debt or other external financings. However, we cannot assure that additional funding will be available on favorable terms, if at all. If we fail to obtain additional funding when needed for our subsidiary companies and ourselves, we may not be able to execute our business plans and our business may suffer. OUR BUSINESS MAY BE HARMED IF MARKET AND OTHER CONDITIONS ADVERSELY AFFECT OUR ABILITY TO DISPOSE OF CERTAIN ASSETS AT FAVORABLE PRICES. An element of our business plan involves disposing of, in public offerings or private transactions, our subsidiary companies and future partner companies, or portions of assets thereof, to the extent such assets are no longer consistent with our business plan. If we sell any such subsidiary companies or assets, the price we receive will depend upon market and other conditions. Therefore, we may not be able to sell at favorable prices. Market and other conditions beyond our control affect: o our ability to effect these sales; o the timing of these sales; and o the amount of proceeds from these sales. In some instances, we may not be able to sell some or any of these assets due to poor market and other conditions. As a result, we may be adversely affected because we will be unable to dispose of assets or may receive a lesser amount for our assets than we believe is favorable. FAILURE TO EFFECTIVELY MANAGE OUR GROWTH COULD PLACE STRAINS ON OUR MANAGERIAL, OPERATIONAL AND FINANCIAL RESOURCES AND COULD ADVERSELY AFFECT OUR BUSINESS AND OPERATING RESULTS. Our growth has placed, and is expected to continue to place, a significant strain on our managerial, operational and financial resources. Further, as the number of our subsidiary companies and their respective businesses grow, we will be required to manage multiple relationships. Any further growth by us or our subsidiary companies or an increase in the number of our strategic relationships will increase this strain on our managerial, operational and financial resources. This strain may inhibit our ability to achieve the rapid execution necessary to successfully implement our business plan. In addition, our future success depends on our ability to expand our organization to match the growth of our business and our subsidiaries. OUR FUTURE SUCCESS DEPENDS IN PART ON THE CONTINUED SERVICE OF OUR KEY EXECUTIVES, AND THE LOSS OF ANY OF THESE KEY EXECUTIVES COULD ADVERSELY AFFECT OUR BUSINESS AND OPERATING RESULTS. Our success depends in part upon the continued service of our executive officers, particularly Paul R. Ryan, our Chairman and Chief Executive Officer and Robert L. Harris, II, our President. Neither Mr. Ryan nor Mr. Harris has an employment or non-competition agreement with us. The loss of either of these key individuals would be detrimental to our ongoing operations and prospects. 20 OUR FUTURE SUCCESS AND THE SUCCESS OF OUR SUBSIDIARY COMPANIES DEPENDS ON OUR AND THEIR ABILITIES TO ATTRACT AND RETAIN QUALIFIED TECHNICAL PERSONNEL AND QUALIFIED MANAGEMENT AND MARKETING TEAMS. FAILURE TO DO SO WOULD HARM OUR ONGOING OPERATIONS AND BUSINESS PROSPECTS. We believe that our success will depend on continued employment by us and our subsidiary companies of senior management and key technical personnel. Our subsidiary companies will need to attract, retain and motivate qualified management personnel to execute their current business plans and to successfully develop commercially viable products and services. Competition for qualified personnel is intense and we cannot assure you that we will successfully retain our existing key employees or attract and retain any additional personnel we may require. Each of our subsidiary companies has key executives upon whom we significantly depend, and the success of those subsidiary companies depends on their ability to retain and motivate those individuals. OUR SUBSIDIARY COMPANIES FACE INTENSE COMPETITION, OFTEN AGAINST COMPETITORS WITH LONGER HISTORIES, GREATER NAME RECOGNITION AND MORE EXPERIENCE IN RESEARCH AND DEVELOPMENT. OUR FAILURE TO COMPETE EFFECTIVELY COULD HARM OUR BUSINESS. Each of our subsidiary companies faces intense competition. Many of the competitors to our subsidiary companies have greater financial, marketing and other resources. In addition, a number of competitors may have greater brand recognition and longer operating histories than our subsidiary companies. Our subsidiary companies' individual risks are regarding competition further described below. COMBIMATRIX. The pharmaceutical and biotechnology industries are subject to intense competition and rapid and significant technological change. CombiMatrix anticipates that it will face increased competition in the future as new companies enter the market and advanced technologies become available. Many of these competitors have more experience in research and development than CombiMatrix. Technological advances or entirely different approaches developed by one or more of CombiMatrix's competitors could render CombiMatrix's processes obsolete or uneconomical. The existing approaches of CombiMatrix's competitors or new approaches or technology developed by CombiMatrix's competitors may be more effective than those developed by CombiMatrix. SOUNDVIEW TECHNOLOGIES. Other companies may develop competing technologies that offer better or less expensive alternatives to the V-chip offered by Soundview Technologies. Many potential competitors, including television manufacturers, have significantly greater resources. In addition, the outcome of Soundview Technologies' pending litigation against television manufacturers is uncertain. ACACIA MEDIA TECHNOLOGIES. Other companies may develop competing technologies that offer better or less expensive alternatives to the information-on-demand technology offered by Acacia Media Technologies. In the event a competing technology emerges, Acacia Media Technologies would expect substantial competition. WE CANNOT ASSURE THAT WE WILL BE ABLE TO EFFECTIVELY PROTECT OUR SUBSIDIARY COMPANIES' PROPRIETARY TECHNOLOGY, AND WE COULD ALSO BE SUBJECT TO INFRINGEMENT CLAIMS. The success of our subsidiary companies relies, to varying degrees, on proprietary rights and their protection or exclusivity. Although reasonable efforts will be taken to protect their proprietary rights, the complexity of international trade secret, copyright, trademark and patent law, and common law, coupled with limited resources and the demands of quick delivery of products and services to market, create risk that these efforts will prove inadequate. From time to time, we may be subject to third-party claims in the ordinary course of business, including claims of alleged infringement of proprietary rights by us and our subsidiary companies. Any such claims may damage our business by subjecting us and our subsidiary companies to significant liability for damage and invalidating proprietary rights, with or without merit, and could subject our subsidiary companies to costly litigation and the diversion of their technical and management personnel. In the event of any adverse ruling in any intellectual property litigation, we could be required to: o pay substantial damages; o cease the manufacturing, use and sale of certain products; o discontinue the use of certain process technologies; and o obtain a license from a third-party claiming infringement, which might not be available on reasonable terms, if at all. 21 CombiMatrix, Acacia Media Technologies and Soundview Technologies depend largely on the protection of enforceable patent rights. Collectively, they have more than 45 applications pending with the U.S. Patent and Trademark Office and other major foreign country or region (e.g. Europe) patent offices, seeking protection for their core technologies and or related product applications and processes, and have 32 patents or rights to patents that have been issued or granted. We cannot assure you that the pending patent applications will be issued or granted, that third-parties will not infringe, or attempt to invalidate these intellectual property rights or that certain aspects of their intellectual property will not be engineered-around by third-parties without violating the patent rights of CombiMatrix, Acacia Media Technologies or Soundview Technologies. For Acacia Media Technologies and Soundview Technologies, intellectual property constitutes their only significant assets. Existing patents owned by our subsidiary companies and any future issued patents may not be sufficiently broad to prevent others from practicing our subsidiary companies' technologies or developing competitive technologies. In addition, others may oppose or invalidate our subsidiary companies' patents and those patents may fail to provide a competitive advantage. Enforcing our subsidiary companies' intellectual property rights may be difficult, costly and time consuming and ultimately may not be successful. Many of our subsidiary companies also hold licenses from third-parties, and it is possible that they could become subject to infringement actions based upon such licenses. Our subsidiary companies generally obtain representations as to the origin and ownership of such licensed content. However, this may not adequately protect them. Our subsidiary companies also enter into confidentiality agreements with third-parties and generally limit access to information relating to their proprietary rights. Despite these precautions, third-parties may be able to gain access to and use their proprietary rights to develop competing technologies and products with similar or better features and prices. Any substantial unauthorized use of our subsidiary companies' proprietary rights could materially and adversely affect their business and operational results. Since some genetic sequences are patented, CombiMatrix intends to secure indemnification from its customers in the case of any inadvertent synthesis of a patented genetic sequence in preparing its biological array processors. This indemnity will not protect CombiMatrix from being joined or held liable in any litigation involving a claim for misappropriation of unlicensed rights and will not protect CombiMatrix against awards of substantial damages if a customer is unwilling or unable to honor an indemnity obligation. In such an event, CombiMatrix would be required to devote substantial time to defending the litigation and might be required to expend substantial funds defending itself or in the satisfaction of damage awards if our customer refuses or is unable to honor its indemnity obligations. This could materially and adversely affect CombiMatrix's business and operational results. PENDING LAWSUITS INVOLVING SOUNDVIEW TECHNOLOGIES AND COMBIMATRIX COULD ADVERSELY AFFECT THE BUSINESS, RESULTS OF OPERATIONS AND FINANCIAL CONDITIONS OF THOSE SUBSIDIARIES. In 2000, Soundview Technologies filed a federal patent infringement and antitrust lawsuit against certain television manufacturers, the Consumer Electronics Manufacturers Association and the Electronics Industries Alliance d/b/a/ Consumer Electronics Association in the United States District Court for the Eastern District of Virginia, alleging that television sets utilizing certain content blocking technology (commonly known as the "V-chip") and sold in the United States infringe Soundview Technologies' Patent No. 4,554,584. The case is now pending in the U.S. District Court for the District of Connecticut against Sony Corporation of America, Inc., Sony Electronics, Inc., the Electronics Industries Alliance d/b/a/ Consumer Electronics Association, the Consumer Electronics Manufacturers Association, Mitsubishi Digital Electronics America, Inc., Mitsubishi Electronics America, Inc., Toshiba America Consumer Products, Inc. and Sharp Electronics Corporation. However, no assurance can be given that Soundview Technologies will prevail in this action or that the television manufacturers will be required to pay royalties to Soundview Technologies. If Soundview Technologies does not prevail in this litigation, its business, results of operations and financial condition would be materially adversely affected. On November 28, 2000, Nanogen, Inc. ("Nanogen") filed a complaint against CombiMatrix and Donald D. Montgomery, Ph.D., a former employee of Nanogen and an officer and director of CombiMatrix, in the United States District Court for the Southern District of California. Nanogen alleges breach of contract, trade secret misappropriation and that U. S. Patent No. 6,093,302 and other proprietary information belonging to CombiMatrix are instead the property of Nanogen. CombiMatrix and Dr. Montgomery both deny, and intend to vigorously defend against, the claims in the lawsuit. Accordingly, on December 15, 2000, CombiMatrix and Dr. Montgomery filed a motion to dismiss the lawsuit, which was denied in part and granted in part on February 1, 2001. On March 9, 2001, CombiMatrix and Dr. Montgomery filed a counterclaim, alleging breach of express covenants not to sue or otherwise interfere with Dr. Montgomery arising 22 out of a release signed by Nanogen in 1996. On April 4, 2001, Nanogen filed a motion to dismiss the counterclaim, which the court denied in its entirety on July 27, 2001. Fact discovery is ongoing and is scheduled to close on June 3, 2002. CombiMatrix intends to vigorously defend the lawsuit and pursue the counterclaim. Although we believe that Nanogen's claims are without merit, we cannot predict the outcome of the litigation. If Nanogen prevails in its lawsuit against CombiMatrix, CombiMatrix's business, results of operations and financial condition could be materially adversely affected. BECAUSE WE HAVE A LIMITED OPERATING HISTORY, WE CANNOT ASSURE THAT OUR OPERATIONS WILL BE PROFITABLE. We commenced operations in 1993 and, accordingly, have a limited operating history. In addition, many of our subsidiary companies are in the early stages of development and have limited operating histories. You should consider our prospects in light of the risks, expenses and difficulties frequently encountered by companies with such limited operating histories. Since we have a limited operating history, we cannot assure you that our operations will be profitable or that we will generate sufficient revenues to meet our expenditures and support our activities. During the quarter ended March 31, 2002, we had an operating loss of approximately $8.5 million and a net loss of approximately $6.4 million. If we continue to incur operating losses, we may not have enough money to expand our business and our subsidiary companies' businesses in the future. OUR LACK OF CONTROL OVER DECISION-MAKING AND DAY-TO-DAY OPERATIONS AT CERTAIN SUBSIDIARY COMPANIES MEANS THAT WE CANNOT PREVENT THEM FROM TAKING ACTIONS THAT WE BELIEVE MAY RESULT IN ADVERSE CONSEQUENCES. We currently own a 4.9% interest in Advanced Data Exchange and have no board of director representation. Additional rounds of equity financing may further dilute our interest in Advanced Data Exchange. We do not have the ability to control decision-making at Advanced Data Exchange. WE MAY INCUR SIGNIFICANT COSTS TO AVOID INVESTMENT COMPANY STATUS AND MAY SUFFER ADVERSE CONSEQUENCES IF DEEMED TO BE AN INVESTMENT COMPANY. We may incur significant costs to avoid investment company status and may suffer other adverse consequences if deemed to be an investment company under the Investment Company Act. Some of our equity investments may constitute investment securities under the Investment Company Act. A company may be deemed to be an investment company if it owns investment securities with a value exceeding 40% of its total assets, subject to certain exclusions. Investment companies are subject to registration under, and compliance with, the Investment Company Act unless a particular exclusion or regulatory safe harbor applies. If we are deemed an investment company, we would become subject to the requirements of the Investment Company Act. As a consequence, we would be prohibited from engaging in business or issuing securities as we have in the past and might be subject to civil and criminal penalties for noncompliance. In addition, certain of our contracts might be voidable, and a court-appointed receiver could take control of us and liquidate our business. Although we believe our investment securities currently comprise less than 40% of our assets, fluctuations in the value of these securities or of our other assets may cause this limit to be exceeded. This would require us to attempt to reduce our investment securities as a percentage of our total assets. This reduction can be attempted in a number of ways, including the disposition of investment securities and the acquisition of non-investment security assets. If we sell investment securities, we may sell them sooner than we otherwise would. These sales may be at depressed prices and we may never realize anticipated benefits from, or may incur losses on, these investments. Some investments may not be sold due to contractual or legal restrictions or the inability to locate a suitable buyer. Moreover, we may incur tax liabilities when we sell assets. We may also be unable to purchase additional investment securities that may be important to our operating strategy. If we decide to acquire non-investment security assets, we may not be able to identify and acquire suitable assets and businesses. THE AVAILABILITY OF SHARES FOR SALE IN THE FUTURE COULD REDUCE THE MARKET PRICE OF OUR COMMON STOCK. In the future, we may issue securities to raise cash for acquisitions. We may also pay for interests in additional subsidiary companies by using a combination of cash and our common stock or just our common stock. We may also issue securities convertible into our common stock. Any of these events may dilute your ownership interest in us and have an adverse impact on the price of our common stock. In addition, sales of a substantial amount of our common stock in the public market, or the perception that these sales may occur, could reduce the market price of our common stock. This could also impair our ability to raise additional capital through the sale of our securities. 23 BECAUSE SOME OF OUR FACILITIES ARE LOCATED IN CALIFORNIA, WE COULD BE ADVERSELY AFFECTED BY ROLLING BLACKOUTS OR A MAJOR EARTHQUAKE. Our facilities, excluding CombiMatrix, are primarily located in California. California experienced an energy shortage in 2001, and as a result, several cities were subject to rolling blackouts. In the event we experience rolling blackouts or other loss or reduction of electrical power, our operations could be adversely impacted. Additionally, in the event of a major earthquake, our facilities could be significantly damaged or destroyed and result in a material adverse loss to us and some of our subsidiary companies. We have not obtained and do not presently intend to obtain earthquake insurance or business interruption coverage. DELAWARE LAW AND OUR CHARTER DOCUMENTS CONTAIN PROVISIONS THAT COULD DISCOURAGE OR PREVENT A POTENTIAL TAKEOVER OF ACACIA THAT MIGHT OTHERWISE RESULT IN OUR STOCKHOLDERS RECEIVING A PREMIUM OVER THE MARKET PRICE OF THEIR SHARES. Provisions of Delaware law and our certificate of incorporation and bylaws could make more difficult the acquisition of Acacia by means of a tender offer, proxy contest or otherwise, and the removal of incumbent officers and directors. These provisions include: o Section 203 of the Delaware General Corporation Law, which prohibits a merger with a 15%-or-greater stockholder, such as a party that has completed a successful tender offer, until three years after that party became a 15%-or-greater stockholder; o amendment of our bylaws by the stockholders requires a two-thirds approval of the outstanding shares; o the authorization in our certificate of incorporation of undesignated preferred stock, which could be issued without stockholder approval in a manner designed to prevent or discourage a takeover; o provisions in our bylaws eliminating stockholders' rights to call a special meeting of stockholders, which could make it more difficult for stockholders to wage a proxy contest for control of our board of directors or to vote to repeal any of the anti-takeover provisions contained in our certificate of incorporation and bylaws; and o the division of our board of directors into three classes with staggered terms for each class, which could make it more difficult for an outsider to gain control of our board of directors. Such potential obstacles to a takeover could adversely affect the ability of our stockholders to receive a premium price for their stock in the event another company wants to acquire us. WE ARE AT RISK OF SECURITIES CLASS ACTION LITIGATION DUE TO STOCK PRICE VOLATILITY. In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. Due to the potential volatility of our stock price, we may be the target of such litigation in the future. Securities litigation could result in substantial costs and divert management's attention and resources, which could seriously harm our business, financial condition and results of operations. WE INTEND TO DIVIDE OUR COMMON STOCK INTO TWO NEW CLASSES AND TO ACQUIRE THE MINORITY STOCKHOLDER INTERESTS IN COMBIMATRIX. On March 20, 2002, we announced our intention to divide our common stock into two new classes: one that would reflect the performance of our CombiMatrix subsidiary, and another that would reflect the performance of our media technologies business, including Soundview Technologies and Acacia Media Technologies. We also announced our intention to acquire the minority stockholder interests in CombiMatrix. If these proposals are approved by our stockholders, our operating results could be negatively affected by various factors related to the recapitalization and acquisition, including: difficulty obtaining or meeting conditions imposed for any necessary legal, governmental and administrative approvals for the transactions; costs related to the transactions; fluctuating stock market levels that could cause the new stock classes to be less than our current stock value; the failure of the stock market to ascribe value to our new business structure; and the failure of Acacia to realize anticipated benefits of these transactions. 24 WE MAY NOT COMPLETE THE RECAPITALIZATION OF OUR STOCK OR THE ACQUISITION OF THE MINORITY STOCKHOLDER INTERESTS IN COMBIMATRIX. Both the recapitalization of our stock and the acquisition of the remaining minority interests in CombiMatrix are subject to several conditions, including the approval of our stockholders, approval for listing of both of the new share classes on the NASDAQ National Market and other customary conditions. As a result, there cannot be any assurance that the recapitalization of our stock or the acquisition of the minority stockholder interests in CombiMatrix will be completed. If either event does not occur, we expect to continue to operate under our current operating structure. This would prevent us from realizing the possible benefits that the recapitalization and the acquisition would provide to us. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK HIGH-GRADE CORPORATE BONDS, COMMERCIAL PAPER, U.S. GOVERNMENT SECURITIES AND MONEY MARKET ACCOUNTS. Our exposure to market risk includes interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because a significant portion of our investments are in short-term debt securities issued by United States corporations and institutional money market funds. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive without significantly increasing risk. To minimize risk, we maintain a portfolio of cash, cash equivalents and short-term investments in a variety of investment-grade securities and with a variety of issuers, including corporate notes, commercial paper and money market funds. Due to the nature of our short-term investments, we believe that we are not subject to any material market risk exposure. MARKETABLE EQUITY SECURITIES. We conduct a portion of our investing activity through a limited partnership, of which a wholly-owned subsidiary of ours is the general partner. As a result of the significant control that we exercise over the limited partnership, the assets and liabilities and results of operations have been consolidated by us at March 31, 2002. We maintain an investment portfolio of common stock in several publicly held companies. These common stock investments are classified as trading securities and are recorded on the balance sheet at their fair value, with unrealized gains and losses reported in the consolidated statement of operations. We are exposed to equity price risk on our portfolio of marketable equity securities. As of March 31, 2002, our total equity holdings in publicly traded companies were valued at $7.4 million compared to $4.4 million at December 31, 2001. We believe that it is reasonably possible that the fair values of these securities could experience significant fluctuations in the near term. Subsequent to March 31, 2002, we transferred the majority of our investment funds previously held in marketable securities to money market accounts. The actual fair value deterioration of March 31, 2002 marketable equity security positions was approximately 12% or $0.9 million. The following table represents the potential decrease in fair value of our remaining marketable equity securities as of May 10, 2002 that are sensitive to changes in the stock market. Fair value deteriorations of minus 50%, 35% and 15% were selected based on the probability of their occurrence. Potential decrease to the value of securities given X% decrease in each stock's price:
FAIR VALUE AS OF (50%) (35%) (15%) MAY 10, 2002 --------- --------- --------- --------- Marketable equity securities $ 497,000 $ 348,000 $ 149,000 $ 994,000 ========= ========= ========= =========
OTHER We also hold a minority investment in a private company, Advanced Data Exchange. This investment is included in long-term assets and is carried at cost. We monitor our long-term minority investments in private companies for impairment and make appropriate reductions in carrying value when an other-than-temporary decline in fair value is determined to exist. 25 PART II--OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS SOUNDVIEW TECHNOLOGIES On April 5, 2000, Soundview Technologies filed a federal patent infringement and antitrust lawsuit against Sony Corporation of America, Philips Electronics North America Corporation, the Consumer Electronics Manufacturers Association and the Electronics Industries Alliance d/b/a Consumer Electronics Association in the United States District Court for the Eastern District of Virginia, alleging that television sets utilizing certain content blocking technology (commonly known as the "V-chip") and sold in the United States infringe Soundview Technologies' U.S. Patent No. 4,554,584. The case is now pending in the U.S. District Court for the District of Connecticut against Sony Corporation of America, Inc., Sony Electronics, Inc., the Electronics Industries Alliance d/b/a Consumer Electronics Association, the Consumer Electronics Manufacturers Association, Mitsubishi Digital Electronics America, Inc., Mitsubishi Electronics America, Inc., Toshiba America Consumer Products, Inc. and Sharp Electronics Corporation. However, no assurance can be given that Soundview Technologies will prevail in this action or that the television manufacturers will be required to pay royalties to Soundview Technologies. During 2001, Soundview Technologies entered into separate confidential settlement and/or license agreements with Hitachi America Ltd., Pioneer Electronics (USA) Incorporated, Samsung Electronics, LG Electronics, Inc., Daewoo Electronics Corporation of America, Sanyo Manufacturing Corporation, Funai Electric Co., Ltd., JVC Americas Corporation, Thomson Multimedia, Inc., Orion Electric Co., Ltd. and Matsushita Electric Industrial Co., Ltd. whereby Soundview Technologies will receive payments and grant non-exclusive licenses of its V-chip patent. In 2000, Soundview Technologies settled its lawsuit with Philips Electronics North America Corporation. COMBIMATRIX On November 28, 2000, Nanogen, Inc., or Nanogen, filed a complaint in the United States District Court for the Southern District of California against CombiMatrix and Donald D. Montgomery, Ph.D., Senior Vice President, Chief Technology Officer and a director of CombiMatrix. Dr. Montgomery was employed by Nanogen as a senior research scientist between May 1994 and August 1995. The Nanogen complaint alleges, among other things, breach of contract, trade secret misappropriation and that U.S. Patent No. 6,093,302 and other proprietary information belonging to CombiMatrix are instead the property of Nanogen. The complaint seeks, among other things, correction of inventorship on the patent, the assignment of rights in the patent and pending patent applications to Nanogen, an injunction preventing disclosure of trade secrets, damages for trade secret misappropriation and the imposition of a constructive trust. On December 15, 2000, CombiMatrix and Dr. Montgomery filed a motion to dismiss the lawsuit, which was denied in part and granted in part on February 1, 2001. On March 9, 2001, CombiMatrix and Dr. Montgomery filed a counterclaim, alleging breach of express covenants not to sue or otherwise interfere with Dr. Montgomery arising out of a release signed by Nanogen in 1996. On April 4, 2001, Nanogen filed a motion to dismiss the counterclaim, which the court denied in its entirety on July 27, 2001. Fact discovery is ongoing and is scheduled to close on June 3, 2002. CombiMatrix intends to vigorously defend the lawsuit and pursue the counterclaim. Although we believe that Nanogen's claims are without merit, we cannot predict the outcome of the litigation. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. 26 PART II--OTHER INFORMATION -- (CONTINUED) 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 (a) Exhibits. 10.1* First Amendment dated November 30, 2001, to the License and Supply Agreement dated as of July 1, 2001, between CombiMatrix Corporation and Roche Diagnostics GmbH ----------------------------------------- * Confidential treatment for portions of this exhibit has been requested pursuant to the Securities Exchange Act of 1934. (b) Reports on Form 8-K. On March 6, 2002, Acacia filed a Current Report on Form 8-K to report results for the fourth quarter and fiscal year end of 2001. On March 21, 2002, Acacia filed a Current Report on Form 8-K to report that its board of directors approved a plan of recapitalization and merger, subject to several conditions, including stockholder approval. On May 10, 2002, Acacia Filed a Current Report on Form 8-K to report results for the first quarter of 2002. 27 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ACACIA RESEARCH CORPORATION By: /S/ Paul Ryan ---------------------------------------------- Paul Ryan Chief Executive Officer (Authorized Signatory) By: /S/ Clayton J. Haynes ---------------------------------------------- Clayton J. Haynes Chief Financial Officer /Treasurer (Principal Financial Officer) Date: May 15, 2002 28 EXHIBIT INDEX EXHIBIT NUMBER EXHIBIT ------ ------- 10.1* First Amendment dated November 30, 2001, to License and Supply Agreement dated as of July 1, 2001 by and between CombiMatrix Corporation and Roche Diagnostics GmbH --------------- * Confidential treatment for portions of this exhibit has been requested pursuant to the Securities Exchange Act of 1934. 29