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KIPS > SEC Filings for KIPS > Form 10-K on 28-Mar-2013All Recent SEC Filings

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Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis of financial condition and results of operations together with our financial statements and the related notes included elsewhere in this annual report. This discussion and analysis contains forward-looking statements about our business and operations, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. Our actual results may differ materially from those we currently anticipate as a result of many important factors, including the factors we describe under "Risk Factors" and elsewhere in this annual report.


Kips Bay Medical, Inc. ("we", "us", "our" or the "Company") was incorporated in the state of Delaware on May 1, 2007. We are a medical device company focused on manufacturing and commercializing our external saphenous vein support technology, or eSVS Mesh, for use in coronary artery bypass grafting ("CABG") surgery. Our eSVS Mesh is a nitinol mesh sleeve that, when placed on the outside of a saphenous vein graft during CABG surgery, is designed to improve the structural characteristics and long-term performance of the saphenous vein graft. CABG surgery is one of the most commonly performed cardiac surgeries in the United States. In CABG procedures, surgeons harvest blood vessels, including the internal mammary artery from the chest wall and the saphenous vein from the leg, and attach the harvested vessels to the heart in order to bypass, or provide blood flow around, blocked coronary arteries. We believe the use of our eSVS Mesh with saphenous vein grafts in CABG surgery will improve the long-term outcome of CABG procedures, including improved openness, or patency, and improved blood flow characteristics through the saphenous vein graft, resulting in a reduced need for costly and potentially complicated reoperations or revascularization procedures.

We received authorization to apply the CE Mark to our eSVS Mesh in May 2010 and we began marketing and commenced shipments in select international markets in June 2010. Our eSVS Mesh is a novel product and we are not aware of the establishment of any specific or supplemental reimbursements for our eSVS Mesh. Given the budgetary pressures in Europe, our sales to date have been limited.

We are currently conducting a feasibility trial for the U.S Food and Drug Administration ("FDA"). This trial is a multi-center, randomized study of external saphenous vein support using our eSVS Mesh in CABG Surgery and is titled the eMESH I study. The objective of this study is to demonstrate the initial safety and performance of the eSVS Mesh for use as an external saphenous vein graft ("SVG") support device during CABG surgery. The Company expects to enroll up to 120 patients at eight European and four U.S. sites and further expects to use the data from this study as the basis for the filing of a request for an investigational device exemption ("IDE") to perform a larger pivotal study which is required to demonstrate clinical effectiveness and support a request for approval to sell our eSVS Mesh in the United States. Enrollments in this trial commenced in late August 2012 at the Bern University Hospital, Bern, Switzerland and in February 2013 at the Northeast Georgia Medical Center in Gainesville, Georgia. The primary safety endpoint is the 30 day rate of MACE, defined as the rate of the composite of total mortality, myocardial infarction (heart attack), and/or coronary target vessel revascularization (percutaneous coronary intervention or CABG) within 30 days of the procedure. The eSVS Mesh performance will be evaluated based upon the angiographic patency rate of the enrolled grafts, where patency is defined as less than 50% stenosis, or blockage, of the SVG at six months after surgery. We are currently working through the internal review and approval process with a number of leading cardiac centers in Europe and the United States to expand the total number of research sites to 12. As of March 1, 2013, six sites have received ethics committee approval and are actively recruiting patients for this study.

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On November 8, 2012, we announced that the U.S. FDA had approved with conditions our IDE to include four U.S. study sites in the eMESH I clinical feasibility trial of our eSVS Mesh. In its approval, the FDA also indicated that it was allowing a staged enrollment within the United States starting with five patients. In January 2013 the FDA expanded their approval to allow for 15 patients. We are required to provide six-month follow-up angiogram data for five U.S. patients or, alternatively, a combination of 10 patients from inside and outside the United States, for the FDA to review. If the FDA determines that these angiograms are acceptable, we expect to receive the approval from the FDA to enroll the remaining 35 U.S. patients initially requested by us.

On March 7, 2013, in response to additional information we provided to the FDA, the FDA notified us that we had satisfactorily addressed the conditions indicated by the FDA in the their November 8, 2012 approval noted above.

Upon completion of this study, we expect to request an IDE for a pivotal study in the U.S. However, we could be delayed by adverse clinical results or regulatory complications, and we may never receive an IDE for a pivotal study or U.S. marketing approval.

In December 2012, we completed a public offering of 10,000,000 shares of our common stock at a purchase price of $0.65 per share. All shares sold in this offering were newly issued by the Company. Gross proceeds from this offering were $6.5 million. After deducting the underwriting commissions and other expenses, we realized net proceeds of approximately $5.4 million. As additional consideration for this transaction, we issued options to purchase 500,000 shares of our common stock to the underwriter and its designees. These options have a five year term, an exercise price of $0.8125 per share or 125% of the purchase price of shares sold in this public offering, and become exercisable on December 21, 2013, one year after the effective date of this public offering. On January 28, 2013, we issued an additional 475,000 shares to the underwriter at a purchase price of $0.65 per share pursuant to the underwriter's partial exercise of its over-allotment option from this public offering.

As of December 31, 2012, we had an accumulated deficit of $29.9 million. We expect our losses to continue as we pursue commercialization of and further regulatory approvals for our eSVS Mesh. Prior to completing our initial public offering ("IPO") in February 2011, we had financed our operations primarily through the private placement of convertible debt and equity securities.

Successful completion of our development programs and, ultimately, our ability to generate revenues and attain profitable operations are dependent on future trends or events, including:

The availability of adequate reimbursement levels in each jurisdiction. The trend toward managed healthcare in the United States and other countries and legislation intended to reduce the cost of government insurance programs will significantly influence the purchase of healthcare services and products, and could result in lower or no reimbursement for our eSVS Mesh. If we are unable to obtain adequate reimbursement levels in a sufficient number of jurisdictions, our revenues and gross margins will be harmed.

The willingness of qualified distributors to agree to sell our eSVS Mesh in each of the markets in which we are approved. We have identified a number of independent distributors to conduct sales in Europe, and we have entered into agreements for distribution in Switzerland, Italy, Germany, France, Spain, Belgium, the Netherlands, Luxembourg and the United Kingdom. We have also entered into an agreement with an independent distributor to conduct sales in the United Arab Emirates. We may not be able to enter into additional distribution agreements on favorable terms or in a timely manner, which may harm our operating results.

Our ability to negotiate satisfactory pricing with qualified distributors. If we are unable to negotiate satisfactory pricing with qualified distributors in connection with their engagement, our revenues and gross margins may be harmed.

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The pace at which we can train sales representatives of qualified distributors. We believe we have engaged and we intend to further engage distributors that have experienced sales representatives who we expect to be able to train cardiac surgeons on the advantages and features of our eSVS Mesh in a timely manner. In addition, our clinical trial experience has shown that training of cardiac surgeons can occur in a short period of time, normally less than two days, but may take longer. If we are unable to train cardiac surgeons in a timely manner, our operating results may be harmed.

Compliance with regulatory requirements for medical devices. These regulatory requirements are extensive, and we believe they will continue to expand. We expect a substantial amount of our expenses will be used for compliance with these regulatory requirements, including in connection with conducting clinical trials, regulatory submissions and ongoing compliance.

The level of acceptance of our eSVS Mesh in the marketplace. If our eSVS Mesh is unable to achieve market acceptance, our revenues will be limited.

Key Components of Our Results of Operations

Net Sales

We received CE Mark approval in May 2010 and began marketing and commenced shipments of our eSVS Mesh in select European markets in June 2010. We sell our eSVS Mesh to distributors who, in turn, sell to hospitals and clinics. The pricing in all distributor agreements is denominated in U.S. dollars and provides for the transfer of title when we ship our eSVS Mesh to the distributors. We invoice shipping charges to our distributors and include them in net sales. We expense shipping costs at the time we report the related revenue and record them in cost of sales.

Cost of Sales

We fabricate our eSVS Mesh both at our facility and at a contract manufacturer. We conduct final assembly and packaging at our facility. Our cost of sales consists primarily of purchased components, direct labor, allocated manufacturing overhead and royalties payable to Medtronic, Inc. ("Medtronic").

Research and Development Expenses

Since our inception, we have focused our activities on the development of our eSVS Mesh. We expense both internal and external research and development costs as incurred. Research and development costs include the costs to design, develop, test, seek approval for, and enhance our eSVS Mesh and production processes. Expenses related to research and development consist primarily of personnel costs, including salaries, benefits and stock-based compensation, product development, preclinical and clinical trials, professional service fees, materials and supplies and facilities-related costs. We expense amounts paid to obtain patents or acquire licenses, as the ultimate recoverability of the amounts paid is uncertain.

While our research and development expenses to date have been focused on product development and evaluating the feasibility of our eSVS Mesh, we expect that a large percentage of our research and development expenses in the future will be incurred in support of our current and future clinical trials. These expenditures are subject to numerous uncertainties in timing and costs to complete. As we obtain results from clinical trials, we may elect to discontinue or delay clinical trials for certain product applications or programs in order to focus our resources on more promising product applications. Completion of clinical trials may take several years or more, but the length of time generally varies according to the type, complexity, novelty and intended use of a product. The cost of clinical trials may

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vary significantly over the life of the trial as a result of differences arising during the clinical trial, including:

the number of sites included in the clinical trials;

the length of time required to enroll suitable patient subjects;

the number of patients that participate in the clinical trials; and

the duration of patient follow-up.

Our reported expenses related to clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with multiple clinical trial sites and by contract research organizations ("CROs") which provide support to us in the conduct of the clinical trials. The financial terms of these agreements are subject to negotiation and vary from contract to contract and may result in uneven payment flows. Generally, these agreements set forth the scope of work to be performed at a fixed fee or unit price. Payments under the contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. Expenses related to clinical trials generally are accrued based on contracted amounts and the achievement of milestones, such as number of patients enrolled. If timelines or contracts are modified based upon changes to the clinical trial design or scope of work to be performed, we modify our estimates of accrued expenses accordingly.

Selling, General and Administrative Expenses

Our selling, general and administrative expenses consist primarily of salaries and benefits and other costs, including stock-based compensation, for our executive and administrative personnel; legal and other professional fees; travel, sales and marketing costs; insurance and other corporate costs. We have incurred a significant increase in selling general and administrative expenses as a result of becoming a public company in February 2011. These increases have included increased costs for insurance, costs related to quarterly, annual and other periodic filings with the SEC and payments to outside consultants, lawyers and accountants. We have also incurred significant costs to comply with the corporate governance, internal controls and similar requirements applicable to public companies.

Milestone Expense

As consideration for the purchase of the core intellectual property relating to our eSVS Mesh, we have agreed to pay Medtronic an aggregate of up to $15.0 million upon the achievement of certain sales milestones. The milestones and related payments consist of $5.0 million due on the one-year anniversary of the first commercial sale of our eSVS Mesh, $5.0 million due when our cumulative net sales reach $15.0 million and $5.0 million due when our cumulative net sales reach $40.0 million. We recorded our first commercial sale in June 2010 and accrued an expense for the first milestone obligation at that time. This milestone was paid in June 2011.

Interest Income

Interest income consists of interest earned on investments in bank certificates of deposits, money market funds, commercial paper and corporate debt.

Critical Accounting Policies and Estimates

Our management's discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate these estimates and judgments, including those described

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below. We base our estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results and experiences may differ materially from these estimates.

While our significant accounting policies are more fully described in Note 2 to our financial statements, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our reported financial results and affect the more significant judgments and estimates that we use in the preparation of our financial statements.

Revenue Recognition

We sell our eSVS Mesh to international distributors, which subsequently resell it to hospitals and clinics. We recognize revenue in accordance with generally accepted accounting principles as outlined in SEC Staff Accounting Bulletin No. 104, Revenue Recognition, and Accounting Standards Codification ("ASC") 605-10-S99; specifically, when persuasive evidence of an arrangement exists, delivery of goods occurs through the transfer of title and risks and rewards of ownership, the selling price is fixed or determinable and collectability is reasonably assured.

We recognize revenue as products are shipped based on agreements with each of our distributors, which provide that title and risk of loss pass to the distributor upon shipment of the products to the distributor and do not provide the distributors a right of return.

Research and Development Expenses

We expense research and development costs, including clinical trial costs, when incurred, consistent with the guidance of ASC 730, Research and Development. All of our clinical trials are performed at clinical trial sites and certain trials are administered by CROs. We accrue costs for clinical trials based on estimates of work performed under the contracts. Costs of setting up clinical trial sites are accrued immediately. Expenses related to clinical trials generally are accrued based on contracted amounts and the achievement of milestones, such as number of patients enrolled.

All material clinical trial and CRO contracts are terminable by us upon written notice and we are generally only liable for actual effort expended by the CROs and certain non-cancelable expenses incurred at any point of termination.

Stock-Based Compensation

Stock-based incentive awards are accounted for under the provisions of FASB ASC 718, Compensation-Stock Compensation, which requires companies to measure and recognize the cost of employee and non-employee services received in exchange for awards of equity instruments based on the grant date fair value of those awards. Compensation cost is recognized ratably using the straight-line attribution method over the expected vesting period, which is considered to be the requisite service period. In addition, we are required to estimate the amount of expected forfeitures when calculating the compensation costs, instead of accounting for forfeitures as they occur. All of our previously awarded options were classified as equity instruments and continue to maintain their equity classification.

The fair value of options is estimated at the date of grant using the Black-Scholes option pricing model with the assumptions described in the following sentences. Risk free interest rates are based upon U.S. Treasury rates appropriate for the expected term. Expected volatility and forfeiture rates are based on the volatility rates of a set of guideline companies, which consist of public and recently public medical technology companies. The assumed dividend yield is zero, as we do not expect to declare any dividends in the foreseeable future. The expected term is determined using the simplified method

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allowed by SEC Staff Accounting Bulletin No. 110. Prior to the completion of our initial public offering in February 2011, the fair value of our common stock was determined by our Board of Directors at each award grant date based upon a variety of factors, primarily the most recent purchase prices of our common stock issued to third parties in arms-length transactions, but also the progress of our product development, the progress of our preclinical and clinical testing, and the risks associated with our business plan. If we had made different assumptions and estimates, the amount of our recognized and to be recognized stock-based compensation expense could have been materially different. We believe that we have used reasonable methodologies, approaches and assumptions in determining the fair market value of our common stock.

We grant options to employees and non-employees, including members of our Scientific Advisory Board. Option grants to employees have a maximum term of ten years and generally vest over four years at the rate of 25% of the total shares underlying the option each year. Options granted to non-employees have a maximum term of ten years and generally vest over three years with 25% of the total shares underlying the option vesting on the date of grant and 25% of the total shares vesting in each of the next three years.

Option grants to non-employees have been made in conjunction with and as sole consideration for their service as advisors to us. Certain of these advisors have also purchased shares of stock in our private placement offerings, but none beneficially own 5% or more of our outstanding common stock. The fair value of options granted to non-employees is measured at each reporting date until the option, or respective portion of the option, vests and the expense recorded by us is updated accordingly. See Note 9 to our financial statements included elsewhere in this annual report for additional information.

Results of Operations

     Comparison of the Year Ended December 31, 2012 to the Year Ended
     December 31, 2011 (in thousands)

                                                   Year Ended
                                                  December 31,       Percent
                                                 2012       2011      Change
         Net sales                             $    226   $    252      (10.3 )%
         Cost of sales                              (98 )      (91 )      7.7

         Gross profit                               128        161      (20.5 )
         Operating expenses:
         Research and development                 2,483      1,675       48.2
         Selling, general and administrative      3,167      2,755       15.0

         Total operating expenses                 5,650      4,430       27.5
         Other income (expense):
         Interest income                             15         19      (21.1 )

         Net loss before income tax            $ (5,507 ) $ (4,250 )     29.6 %

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Cost of sales, research and development expenses and selling, general and administrative expenses include non-cash stock-based compensation expense as a result of our issuance of stock options and restricted stock grants. We expense the fair value of equity awards over their vesting periods. The terms and vesting schedules for share-based awards vary by type of grant and the employment status of the grantee. The equity awards granted through December 31, 2012 vest upon time-based conditions. We expect to record additional non-cash compensation expense in the future, which may be significant. The following table summarizes the stock-based compensation expense in our statements of comprehensive income for the years ended December 31, 2012 and 2011 (in thousands):

                                                        Year Ended
                                                       December 31,
                                                      2012      2011
               Cost of sales                          $   29    $  46
               Research and development                  150      153
               Selling, general and administrative       409      293

               Total stock-based compensation         $  588    $ 492

Net Sales and Gross Profit

Our net sales decreased to $226,000 in 2012, a decrease of 10.3% from $252,000 in 2011. Our gross profit decreased to $128,000 in 2012, a decrease of 20.5% from $161,000 in 2011. The decrease in net sales and gross profit in 2012 was the result of reduced demand from our distributors in southern Europe which are most affected by national budget problems. We are not aware of any specific or supplemental reimbursement for our eSVS Mesh and we expect sales to continue at modest levels until additional clinical study data is available.

Research and Development

Our research and development ("R&D") expenses increased 48.2% from $1.7 million in the year ended December 31, 2011 to $2.5 million for the year ended December 31, 2012. These increases were driven by increases in clinical study and product development activities related to our eSVS Mesh. In November 2011 we began enrolling patients in post-market studies and in August 2012 began enrolling patients in Europe for a feasibility study for the FDA. During 2012, we also commenced product development efforts intended to support expanding our product labeling to include the use of alternate sealants and to allow physicians to use our eSVS Mesh when performing sequential grafts. We expect that our research and development costs will increase slightly as we conduct our eMESH I clinical feasibility trial for the U.S. FDA.

Selling, General and Administrative

Selling, general and administrative expenses increased 15.0% from $2.8 million in the year ended December 31, 2011 to $3.2 million in the year ended December 31, 2012. These increases were caused by a combination of factors which include: compliance costs associated with becoming a public company in February 2011, costs associated with the expansion of our management team, professional service fees and costs incurred to support our commercial sales activity. The increased costs related to the expansion of our management team and board of directors, both as part of becoming a public company and to support our commercial sales, included approximately $117,000 of increased stock-based compensation expenses for calendar 2012. We expect SG&A expenses to remain relatively stable as we continue to pursue our international sales and marketing efforts.

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     Interest Income

    Interest income decreased from $19,000 in the year ended December 31, 2011
to $15,000 in the year ended December 31, 2012. The decrease resulted from the
reduction in our investable cash as we generated operating losses and negative
cash flows during the year ended December 31, 2012.

     Comparison of the Year Ended December 31, 2011 to the Year Ended
     December 31, 2010 (in thousands)

                                                             Year Ended
                                                            December 31,       Percent
. . .
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