ITEM 1. BUSINESS
This Report contains forward-looking statements made by the Company pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements reflect the Company's current views with respect to such events. Actual results may very materially and adversely from those anticipated, believed, estimated or otherwise indicated. Important factors that could cause actual results to differ materially, include, without limitation, the factors set forth below in "Risk Factors."
OVERVIEW
Ergo Science Corporation ("Ergo" or the "Company") is developing novel treatments for metabolic disorders, including Type II diabetes and obesity, and for cancer. The Company's technology uses orally administered neurotransmitter modulating drugs to address abnormalities of the neuroendocrine system. The Company believes that its approach may provide the platform for a new class of treatments for a variety of glucose and lipid metabolic disorders and cancer. The Company's lead drug candidate, ERGOSET/TM/, is a low-dose, fast-release, oral tablet formulation of bromocriptine, a dopamine agonist previously approved by the U.S. Food and Drug Administration ("FDA") to treat Parkinson's disease and other conditions. The Company recently completed three Phase III clinical trials of ERGOSET for the treatment of Type II diabetes. In two of the Phase III trials, ERGOSET was used as an adjunct to sulfonylurea agents; and in the third trial, ERGOSET was used as monotherapy. Analysis of the Phase III clinical trials indicated that ERGOSET improved control of glycated hemoglobin A\\1c\\ (HbA\\1c\\), glucose, triglycerides, and free fatty acids in Type II diabetics compared to placebo. The Company plans to submit a New Drug Application ("NDA") to FDA for ERGOSET to treat Type II diabetes in mid-1997. Ergo currently retains all marketing rights to its drug candidates.
One of the primary measures of blood glucose levels in diabetics is HbA\\1c\\. In the three Phase III clinical trials of ERGOSET for the treatment of Type II diabetes, known collectively as the TRIAD Study (Time-Regulated Intervention in Adult Diabetes), treatment with ERGOSET reduced HbA\\1c\\ compared to placebo. Analysis of the two adjunctive trials indicates that ERGOSET treatment resulted in an average decrease in HbA\\1c\\ of 1% compared with placebo in the 60 percent of subjects who were classified as pre-defined ERGOSET responders. Compared to baseline, the reduction for responders was 0.6%. In the monotherapy trial, treatment with ERGOSET resulted in a similar decrease of 1% HbA\\1c\\ in the ERGOSET responder group compared to placebo and 0.7% compared to baseline.
Reduction in the level of blood glucose in Type II diabetics reduces the severity and the risk of developing microvascular complications such as kidney failure, blindness and peripheral neuropathy. Reduction in both blood glucose levels and blood lipid levels is also believed to lower the incidence and degree of cardiovascular complications which are the leading cause of death in subjects with Type II diabetes. Treatment with ERGOSET in the Phase III trials resulted in clinically meaningful reductions of triglycerides and free fatty acids compared to placebo. Additionally, the TRIAD study indicated that ERGOSET treatment was safe and generally well-tolerated. See "Business-- Development of ERGOSET and Other Products for Diabetes-- Clinical Trials of ERGOSET for Type II Diabetes" and "Risk Factors-- Forward Looking Statements and Associated Risks."
In 1997 Ergo plans to commence additional Phase II clinical trials of ERGOSET for the treatment of obesity. See "Business-- Development of ERGOSET and Other Products for the Treatment of Obesity." Currently, the Company is continuing to enroll subjects in a small Phase II clinical trial of ERGOSET in combination with another neurotransmitter modulating compound for the treatment of metastatic breast cancer which was begun in late 1995. See "Business-- Development of ERGOSET for the Treatment of Cancer." The Company is also screening for lead clinical candidates for use in photodynamic therapy ("PDT") to treat various cancers and dopamine agonists for Type II diabetes and obesity. See "Business--Development of Photodynamic Therapy (PDT) for the Treatment of Cancer," and "Business--Development of ERGOSET and Other Products for Diabetes--Additional ERGOSET Clinical Trials."
The Company's technology platform is based on over thirty years of research by the Company's founding scientists into the regulation of glucose and lipid metabolism by the neuroendocrine system. In many species, animals become obese and insulin resistant as a means of surviving adverse environmental conditions such as low food availability,
migration or hibernation. These animals then revert to a lean, insulin sensitive condition when environmental conditions become more favorable. Ergo's founding scientists have demonstrated that the shift from the lean to the obese condition in these animals is associated with a shift in the daily patterns of the neuroendocrine system, i.e. a shift in the daily patterns of the levels of neurotransmitters in the brain and hormones throughout the body. Ergo's scientists have further demonstrated that an animal can be switched from an obese state to a lean state by "resetting" the daily neuroendocrine patterns from those associated with obesity to those associated with the lean animal. The Company's research indicates that obese and diabetic humans have daily neuroendocrine patterns that are different from healthy subjects. The Company's strategy for treating Type II diabetes and obesity in humans is to administer neurotransmitter modulating drugs such as ERGOSET on a timed basis to reset the daily neuroendocrine patterns of obese and Type II diabetic patients to more closely resemble the daily neuroendocrine patterns of lean, non-diabetic subjects. See "Business -History and Science of the Company's Technology and Preclinical Research."
The following table illustrates the status of the Company's current product development efforts:
- ----------------------- (1) Dopamine agonists
DEVELOPMENT OF ERGOSET AND OTHER PRODUCTS FOR DIABETES
Diabetes as a Metabolic Disorder. The Company's primary research focus is the treatment of Type II diabetes and obesity. These metabolic disorders involve defects in the complex relationship between glucose and fat metabolism. To sustain life, the human body must convert food into glucose, a simple form of sugar, for use as a source of energy for the body's cells. When glucose is abundant, it is converted into fat (triglycerides) and stored in the adipose tissue for use when food is not available. When glucose is not available from food, triglycerides in the adipose tissue are broken down into free fatty acids that stimulate glucose production by the liver. Insulin, which is secreted by the pancreas, plays an
important role in regulating the level of glucose in the blood stream by stimulating the use of glucose as fuel and by inhibiting the production of glucose in the liver. In a healthy metabolic state, a balance is maintained between the sources and uses of glucose and the sources and uses of fat.
Characteristics of Diabetes. The term diabetes refers to a group of disorders that show a single common feature: abnormally high levels of glucose in the blood. Type I diabetes (juvenile-onset diabetes or insulin dependent diabetes) results from a rapidly progressive dysfunction of the pancreas in producing insulin. Type II diabetes (adult onset or noninsulin dependent diabetes mellitus) is believed to involve a slow insidious process referred to as "insulin resistance." Insulin resistance occurs when insulin-stimulated uptake of glucose into peripheral cells is impaired and the inhibitory effect of insulin on glucose production in the liver is reduced. This condition leads to excessive blood levels of glucose (hyperglycemia). Hyperglycemia in both Type I and Type II diabetics is accompanied by increases in the blood levels of triglycerides, free fatty acids, and other lipids. Type II diabetes is a chronic and incurable disease that accounts for 90% to 95% of all diagnosed cases of diabetes. It is a leading cause of death in the United States.
Many researchers believe that Type II diabetics develop insulin resistance first, then impaired glucose tolerance, and finally diabetes. Due to a combination of environmental and genetic factors, people develop insulin resistance and compensate for modest insulin resistance by secreting more insulin to maintain control of their blood glucose levels. Despite increased insulin production, some people lose their ability to control blood glucose over time as their insulin resistance increases. At this stage, the person develops impaired glucose tolerance, a condition characterized by normal blood glucose levels before eating and hyperglycemia after eating. When a person loses the ability to regulate blood glucose levels and exhibits persistent hyperglycemia, the person is considered to be a Type II diabetic.
When blood glucose levels are not controlled within a narrow range, severe complications can result. Hyperglycemia over an extended period of time is believed to damage the linings of blood vessels, causing the micro- and macrovascular complications characteristic of Type II diabetes such as disorders of the retinal and renal vasculature and loss of circulation in the extremities which may lead to amputation, respectively. In addition, hyperglycemia and the associated high blood levels of triglycerides, free fatty acids, and total cholesterol are believed to lead to cardiovascular disease including coronary artery disease. Approximately 70% to 80% of Type II diabetics are obese, and mortality in most Type II diabetics is caused by cardiovascular disease and stroke, which are commonly associated with hyperlipidemia and obesity.
Need for New Diabetes Treatments. There is no cure for diabetes. After diagnosis, the first course of therapy for Type II diabetics is to try to control hyperglycemia through diet and exercise. If this fails to achieve glycemic control, the subjects typically begin medication. The two leading medications for Type II diabetes have traditionally been insulin and a class of oral drugs called sulfonylureas. Each of these drugs reduces glucose levels by increasing serum insulin levels. Many subjects initially take sulfonylureas, which work by stimulating the production of insulin in the pancreas. The labeling of sulfonylureas includes a special warning on the possible increased risk of cardiovascular mortality from the use of the drugs. Researchers suspect that the increased risk of cardiovascular disease may be the result of above- normal levels of serum insulin, which may stimulate the liver to increase lipid levels in the bloodstream, contributing to atherosclerosis and obesity. Many patients who take sulfonylureas still experience elevated blood glucose and lipid levels. Over time, many Type II diabetics taking sulfonylureas lose their ability to control glucose levels, and may eventually lose their ability to secrete insulin. In either case, the Type II diabetic must then begin daily insulin injections. An estimated 40 percent of Type II diabetics are currently taking insulin according to the American Diabetes Association. For these reasons, there is a need for new diabetes therapies that improve control of blood glucose and the co-morbid conditions associated with the disease.
In recent years the FDA has approved three new drugs for the treatment of Type II diabetes whose mechanisms of action are different than sulfonylureas. Metformin (trade name Glucophage(R)), was approved for monotherapy and adjunctive therapy for patients taking sulfonylureas in March 1995 and is sold by Bristol-Myers Squibb Company. Glucophage is an oral medication that belongs to a class of drugs called biguanides. It is believed to work, at least in part, by reducing glucose output from the liver. Its use carries the risk of lactic acidosis, a rare but possibly fatal side effect. Precose was approved for monotherapy and adjunctive therapy in September 1995 and is sold in the United States under the name Acarbose(R) by Bayer Corporation (previously sold in Europe under the name Glucobay/TM/). Acarbose is an alpha-glucosidase inhibitor which works in the intestine to block the enzymes necessary for the digestion and
absorption of carbohydrates in the intestines. Acarbose reduces blood glucose levels primarily after meals by slowing down the digestion of carbohydrates and lengthening the time it takes for carbohydrates to convert to glucose. It must be taken orally at the start of each meal and causes mild to moderate gastrointestinal side effects in most users. Troglitazone, sold by Warner Lambert Company under the name Rezulin(R), was approved in January 1997. Rezulin has been approved for use in treating diabetics who are taking insulin. It is believed to work in part by increasing the body's sensitivity to insulin. See "Business-- Competition."
Demographics and Market Size. The American Medical Association and the American Diabetes Association ("ADA") estimate that approximately 15 million people suffered from Type II diabetes in the United States in 1996, of whom approximately seven and a half million have been diagnosed with the disease. Another 20 million Americans are estimated to have impaired glucose tolerance. Oral antidiabetic agents are a leading class of pharmaceutical products for the treatment of diabetes with total sales of approximately $1 billion in the United States during 1996. Insulin, used by an estimated 40% of Type II diabetics, is also a leading pharmaceutical product with annual sales of approximately $1 billion in the United States during 1996.
ERGOSET in the treatment of Type II Diabetes. ERGOSET is a low-dose, fast-release, once-daily oral tablet formulation of bromocriptine, a dopamine agonist. ERGOSET tablets are formulated to permit titration of the drug at low doses to minimizes gastrointestinal side effects. The active ingredient in ERGOSET has been approved by FDA for approximately 20 years to treat Parkinson's disease and other conditions. The Company selected bromocriptine for use in treating Type II diabetes primarily because of its ability to increase dopaminergic activity in the hypothalamus area of the brain. In the Phase III clinical trials, ERGOSET was administered each day at approximately 8:00 a.m. This treatment with ERGOSET is believed to help restore a more normal daily pattern of dopaminergic activity in the brain, which is believed to be a central regulator of lipid and glucose metabolism. The Company's research indicates that healthy lean subjects evidence high levels of dopaminergic activity during the daytime and that obese and Type II diabetic patients evidence low levels of dopaminergic activity during that time period.
Clinical Trials of ERGOSET for Type II Diabetes
The primary focus of the Company's clinical trials to date has been to study the effects of ERGOSET on glucose and lipid metabolism for the treatment of Type II diabetes and obesity. The Company began clinical trials of ERGOSET for the treatment of Type II diabetes in 1992 and in 1996 completed its three Phase III clinical trials of ERGOSET as adjunctive and monotherapy for Type II diabetes.
Ergo initiated its three double-blinded, placebo-controlled Phase III clinical trials of ERGOSET treatment in obese, Type II diabetics in January 1995. The Company enrolled over 650 subjects in the three clinical trials, two of which studied ERGOSET as adjunctive therapy and one of which studied ERGOSET as monotherapy. The primary clinical endpoint of each of the Phase III clinical trials was to achieve a clinically and statistically significant reduction in blood levels of HbA\\1c\\, which is considered a reliable indicator of glycemic control in diabetics, and is the primary measure of blood glucose control used by the FDA to determine the efficacy of drug candidates in diabetics. In the Phase III clinical trials of ERGOSET as adjunctive therapy, ERGOSET or placebo was given daily at approximately 8:00 a.m. to nearly 500 Type II diabetics who were on weight-maintaining diets and who were taking sulfonylurea agents. In the monotherapy Phase III clinical trial, ERGOSET or placebo was given daily at approximatley 8:00 a.m. to nearly 160 Type II diabetics who were on a weight- maintaining diet but were not on any other diabetes medication.
In 1996, the Company announced that analysis of the three completed Phase III trials indicated that ERGOSET improved control of HbA\\1c\\, glucose, triglycerides and free fatty acids in Type II diabetics on both a monotherapy and adjunctive therapy basis. The analysis also showed that ERGOSET was generally well-tolerated. The following table summarizes the changes in HbA\\1c\\ levels in the Phase III clinical trials of subjects taking ERGOSET versus subjects taking placebo, the results of which are discussed in further detail below:
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* Intent to treat endpoint analysis includes all subjects who received study drug and had at least one subsequent visit and carries forward to the end their last observation. Intent to treat Week 24 analysis includes values of all subjects who actually completed the study.
The Adjunctive Therapy Trial Results. In the two studies of ERGOSET as adjunctive therapy, all subjects were overt diabetics with average baseline fasting glucose and HbA\\1c\\ levels of 223 mg/dL and 9.4%, respectively. Baseline fasting serum triglycerides and total cholesterol were 248 mg/dL and 212 mg/dL, respectively. Baseline fasting free fatty acids were 847 u eq/L in the one study for which this parameter is available.
On an intent-to-treat basis, the adjunctive therapy trials indicated that ERGOSET improved glycemic control as measured by a reduction in HbA\\1c\\ compared with placebo of 0.6% (p(less than)0.0001). In the pre-defined responder group, ERGOSET resulted in decreases in HbA\\1c\\ of 1% (p(less than)0.0001) compared with placebo, and a decrease of 0.6% (p(less than)0.0001) compared with baseline. The pre-defined responder criterion was designed to identify responders to ERGOSET shortly after the initiation of treatment. Responders were defined as those individuals on ERGOSET who had at least a 0.3% decrease in HbA\\1c\\ from baseline after eight weeks of treatment. According to this pre- established criterion, approximately 60% of all subjects on ERGOSET were classified as responders.
In the two adjunctive Phase III trials, treatment with ERGOSET resulted in reductions in levels of fasting serum triglycerides and fasting free fatty acids compared with placebo. On an intent-to-treat basis, ERGOSET treatment reduced fasting serum triglycerides by 61 mg/dL (p=0.0058), a 24% reduction compared to placebo. In the one study for which free fatty acids results are available, ERGOSET treatment resulted in a reduction of fasting serum free fatty acids of 150 u eq/L (p=.0424) compared to placebo on an intent-to-treat basis.
This analysis also showed that ERGOSET treatment was generally well- tolerated. The most frequently reported side effects were nausea, fatigue, and dizziness which are known to be asociated with the use of bromocriptine. Most side effects reported were mild to moderate in degree and transient in nature. The combined discontinuation rate in the two trials due to side effects was approximately 13% for ERGOSET compared with approximately 2% in the placebo group.
The Monotherapy Trial Results. The Company's Phase III clinical study of ERGOSET as monotherapy treatment for Type II diabetes demonstrated reductions in HbA\\1c\\ consistent with the HbA\\1c\\ results in the Company's two earlier adjunctive therapy trials. Of the 122 subjects who completed the 24 week trial, 60 received ERGOSET and showed a statistically significant 0.6% (p(less than)0.02) reduction compared to placebo in HbA\\1c\\. Sixty-two percent of the subjects receiving ERGOSET and completing the study met the responder group criterion (at least a 0.3% reduction in HbA\\1c\\ from baseline after eight weeks of therapy). This responder group showed a 1% (p(less than)0.0001) reduction compared to
placebo and a 0.7% (p(less than)0.0001) reduction compared to baseline in HbA\\1c\\. Results from the monotherapy trial for ERGOSET also manifested trends in improving lipid profiles. ERGOSET was generally well-tolerated in the monotherapy trial with once a day administration at approximately 8:00 a.m for a 24-week period. The most frequently reported side effects in the monotherapy trial were the nausea, fatigue, nasal congestion and dizziness known to be associated with the use of bromocriptine. Most side effects reported were mild to moderate in degree and transient in nature. The discontinuation rate due to side effects was approximately 13% for ERGOSET versus 5% for placebo.
ERGOSET Clinical Trial Summary. The following table identifies the Phase II and Phase III clinical trials conducted of ERGOSET for the treatment of Type II diabetes and obesity.
FDA Approval Strategy
Based on the results in its three Phase III trials, the Company intends to file an NDA in 1997 for approval of ERGOSET to treat Type II diabetes as a monotherapy and as an adjunctive therapy. However, there can be no assurance that FDA will agree with the Company's assessment of the results of the Phase III clinical trials or that ERGOSET will receive FDA approval as either adjunctive therapy or monotherapy. See "Risk Factors-- Uncertainties Related to Regulatory Approval of ERGOSET for Type II Diabetes" and "Risk Factors-- Government Regulation." The Company is currently conducting extensions to the Phase III clinical trials (for safety) and bioavailability studies of different dosage strengths of ERGOSET, which are expected to be completed during 1997.
Additional ERGOSET Clinical Trials
Ergo is currently conducting preclinical studies in animals using ERGOSET in combination with metformin prior to initiating this drug combination for clinical trials. Ergo also plans to begin clinical trials of ERGOSET as adjunctive therapy with insulin in subjects with Type II diabetes. Insulin is a common treatment for advanced stages of
Type II diabetes, and metformin appears to be gaining market acceptance rapidly as a new therapy. The Company also plans to commence in 1997 another clinical trial to examine the effect of ERGOSET therapy on hyperlipidemia, .i.e., high triglycerides and free fatty acids. The Company is also studying possible second generation product candidates for the treatment of Type II diabetes, including a combination of a dopamine D2 agonist such as ERGOSET with a dopamine D1 agonist, and a therapy involving administration of a dopamine agonist at one time of day in combination with a serotonin agonist at another time of day.
DEVELOPMENT OF ERGOSET AND OTHER PRODUCTS FOR THE TREATMENT OF OBESITY
General. The term obesity is defined as a disorder in which a person's total body weight is more than 30% over the weight that is normal for healthy persons of the same age and height. Obesity is generally characterized by a low lean-to-fat body mass ratio and is often accompanied by high blood lipid levels. While the causes of obesity vary, many researchers believe that insulin resistance contributes to the development of obesity.
Demographics and Market Size. Obesity is a significant health problem in the United States. According to preliminary data from the 1994 National Health and Nutrition Examination Survey, about 60 million Americans, or 45% of the adult population, are overweight and about 35 million, or 26% of the adult population, are obese. Obesity is considered a risk factor for Type II diabetes. Many obese Americans are Type II diabetics, and others are considered to be in pre-diabetic states with varying levels of insulin resistance or impaired glucose tolerance. Obesity is also considered a risk factor for cardiovascular disease, cancer, gall bladder disease and osteoarthritis. Recently, it was reported in the New England Journal of Medicine that obesity itself can affect longevity. When statisticians ruled out the effects of smoking, high-fat diets, lack of exercise and other unhealthy living habits of 115,000 nurses tracked since 1976, they found that 25% of premature deaths in this study were associated with obesity.
In 1996, the FDA approved the sale of REDUX(R) (dexfenfluramine) for the treatment of obesity. Commercial sale of REDUX began in June of 1996. The first six months of sales of REDUX were among the best initial sales for any pharmaceutical product. Also in 1996, the FDA recommended approval of MERIDIA(R) (sibutramine) for the treatment of obesity. Other drugs not indicated for the treatment of obesity are often prescribed for this use (referred to as off-label use).
ERGOSET for the Treatment of Obesity. Ergo's animal studies have demonstrated that bromocriptine and other neurotransmitter modulating drugs are effective in reducing body weight and body fat in seasonal, non-seasonal, and genetic animal models when administered at a specific time daily. Studies presented by Ergo scientists in 1996 indicated that the seasonally insulin resistant, obese Syrian hamsters became insulin sensitive and lean in two weeks through the administration of neurotransmitter modulating drugs at a specific time of day. In other preclinical studies with the leptin-deficient ob/ob mouse, a genetically obese and insulin resistant animal model, Ergo's scientists achieved significant reductions in body fat compared with control animals through the timed administration of neurotransmitter modulating drugs. In one study presented at the June 1996 ADA annual meeting, Ergo's scientists reported that the timed use of two neurotransmitter modulating drugs produced a significant (between 50% and 60%) reduction in food intake and a decrease in body fat of 22% to 32% with no significant decrease in lean body (muscle) mass compared with control animals. See "Business--History and Science of the Company's Technology and Pre-Clinical Research."
Clinical Trials of ERGOSET for the Treatment of Obesity. In one double-blinded, placebo-controlled Phase II clinical trial (Study 93-3), obese subjects were placed on a 25% calorie restriction diet and treated with either ERGOSET or placebo in the morning for an 18-week period. Although the trial population was small, ERGOSET treatment resulted in a statistically significant reduction in percentage of body fat compared to placebo. This trial suggests that ERGOSET treatment may selectively reduce body fat in obese subjects. The Company plans to begin enrolling subjects in a new Phase II clinical trial of ERGOSET to treat obese subjects in the first half of 1997 and plans to pursue additional clinical trials of ERGOSET by itself and in combination with other neurotransmitter modulating drugs to treat obesity.
DEVELOPMENT OF ERGOSET FOR THE TREATMENT OF CANCER
Cancer. Ergo is researching the application of ERGOSET and its neurotransmitter modulating technology to treat breast cancer and other cancers. Preclinical studies conducted by Ergo suggest that temporal neuroendocrine regulation may play an important role in the body's regulation of immune function and its ability to fight cancer. The Company also believes that the presence of tumors may suppress the body's immune response to the tumor, in part by altering the patterns of neurotransmitter activity. In a presentation at the Ninth International Congress of Immunology in 1995, Ergo's scientists demonstrated that the alteration of daily neuroendocrine patterns through the timed administration of neurotransmitter modulating drugs can stimulate the immune system and limit the growth of tumors in mice. In addition to treating cancer, Ergo believes this approach may be useful in treating immune system disorders such as Lupus.
Characteristics and Incidence of Breast Cancer. Breast cancer has the second highest mortality rate from cancer among women in the United States. In 1996, approximately 184,000 women in the United States were diagnosed with breast cancer. Breast cancer is now the leading cause of death for American women aged 40 to 55. Although it was once believed that tumors in the breast appear suddenly and spread slowly from the breast by seeping through the lymphatic system, researchers now believe that breast tumors take years to develop to detectable size and that they metastasize by releasing cancerous cells into the bloodstream, from which the cells lodge and multiply in other parts of the body.
Need for New Cancer Therapies. The primary treatment for breast cancer is surgical removal of the detectable tumor and, in most cases, removal of surrounding tissue and lymphatic systems. Surgery is generally followed by radiation therapy or chemotherapy. All of these treatments harm healthy tissue in addition to the diseased tissue. Radiation therapy kills cells in its target area, inducing breast inflammation and fibroblasts, and may create genetic damage that can lead to other forms of cancer. In addition, radiation therapy has no effect on metastases away from the targeted area. Chemotherapeutic compounds kill cells throughout the body, but often cause fatigue, nausea, hair loss, mouth sores, diarrhea and premature menopause. Chemotherapy is also not believed to destroy all metastasized cancer cells. The surviving cancer cells continue to multiply, which often results in a recurrence of cancer. Accordingly, new therapeutic approaches are needed to eliminate cancer cells more effectively and to reduce damage to healthy tissue.
Clinical Trials of ERGOSET for the Treatment of Breast Cancer. In late 1995, Ergo began a small, open-label Phase II clinical trial of ERGOSET with another neurotransmitter modulating drug in subjects with metastatic breast cancer to evaluate whether the treatment can increase the body's immune activity against the cancer. The Company is continuing to enroll subjects in this study at two sites. Subjects in this trial are dosed using ERGOSET and the other neurotransmitter modulating drug alone or adjunctively with chemotherapy or radiation therapy.
DEVELOPMENT OF PHOTODYNAMIC THERAPY (PDT) FOR THE TREATMENT OF CANCER
Ergo is studying the use of unique photosensitive dyes in PDT for treating cancers. Preclinical studies suggest that these dyes, which are preferentially sequestered within tumor cells, become toxic and result in site- specific, localized destruction of tumor tissue only when irradiated with light supplied by a laser at the proper wavelength. Many cancers that have a poor prognosis and are difficult to treat may respond to this new approach. PDT may be useful in treating cancers of the breast, bladder, brain, spine, pancreas and prostate. Ergo has licensed from The Rowland Institute for Science rights to patents covering the composition and methods of using certain unique photosensitive dyes. Ergo believes its photosensitive dyes may offer advantages over dyes being studied by other companies based on preclinical studies which indicate that Ergo's dyes are not immunosuppressive, sequester preferentially in the tumor and not in surrounding tissue or blood vessels, oxidize with relatively low-intensity photon bombardment, and exit the body relatively quickly. The Company intends to integrate PDT with its understanding of temporal neuroendocrine regulation to try to improve the overall therapeutic effect of PDT. The Company is in the process of identifying a lead photosensitizer for clinical study in its PDT program.
COMMERCIALIZATION STRATEGY
The Company's commercialization strategy includes the formation of marketing alliances with major pharmaceutical companies to market the Company's products. The Company also plans to establish long-term manufacturing agreements for its product supply. The Company currently retains all marketing rights to its drug candidates.
Marketing
The Company intends to form strategic alliances with large pharmaceutical companies to market the Company's product candidates in the United States and internationally. In addition, the Company may build, over time, a direct sales force to market certain products to the managed care and specialist markets in the United States. The Company internally funded the clinical development of ERGOSET for Type II diabetes into advanced clinical trials before seeking collaborative marketing arrangements. The Company is currently seeking a marketing partner for ERGOSET for Type II diabetes. The Company may retain co-promotion and marketing rights to its product candidates in the United States. See "Risk Factors--Limited Sales and Marketing Experience; Dependence on Future Collaborators."
Manufacturing
Ergo does not operate and does not plan to operate manufacturing facilities for the production of either bulk chemicals or the finished pharmaceutical dosage forms for its product candidates. Instead, it plans to establish contracts for the supply of its pharmaceuticals. In 1995 the Company entered into an agreement to buy from Geneva Pharmaceuticals, Inc., and Geneva has agreed to supply, all of the Company's United States requirements for the final dosage form(s) of ERGOSET for the treatment of Type II diabetes and obesity. Geneva has paid the Company various amounts and agreed to pay the Company additional amounts upon the achievement of certain milestones. Geneva may terminate the Geneva Agreement under various circumstances, including if FDA does not accept the Company's first filing of an NDA within 18 months of its submission or approve that NDA within three years of submission or if the Company's requirements for ERGOSET do not exceed certain minimum levels during the two years following FDA approval, if obtained. The Company also has certain rights to terminate the Geneva Agreement. Geneva has a right of first option to be the exclusive supplier of the Company's United States requirements for certain new orally administered drug products on commercially competitive terms.
If Geneva does not perform its obligations under the Geneva Agreement, the Company may not be able to obtain supplies of ERGOSET. Even if the Company is able to obtain ERGOSET from other suppliers, it may not be on the terms or in the quantities that would be acceptable to the Company. The active ingredient in ERGOSET is available from few suppliers in the world, and the manufacturing process for the active ingredient is complex and lengthy. Accordingly, the Company may encounter significant delays if it must obtain supplies of active ingredient or finished tablets from suppliers other than its current suppliers. See "Risk Factors --Manufacturing Uncertainties; Reliance on Third-Party Suppliers."
HISTORY AND SCIENCE OF THE COMPANY'S TECHNOLOGY AND PRECLINICAL RESEARCH
Ergo's founding scientists, Anthony H. Cincotta, Ph.D., formerly of Massachusetts General Hospital and Harvard Medical School, and Albert H. Meier, Ph.D., formerly of Louisiana State University, have conducted extensive research into the way changes in the daily patterns of neuroendocrine activity regulate changes in glucose and lipid metabolism observed in seasonal and non-seasonal animals as well as in the ob/ob mouse, a genetically insulin resistant and obese animal model. Ergo has expanded on this research to focus on how changes in daily patterns of neuroendocrine activities may improve disease conditions in humans.
Overview of Temporal Neuroendocrine Regulation of Metabolism
Many animal species become insulin resistant and obese during one season of the year and insulin sensitive and lean during other seasons. These seasonal increases in lipid production and storage provide an energy source to the animal to endure times of low food availability, provide energy for migration and hibernation, and provide insulation during the winter. Thus, many species of animals have developed this ability to become seasonally insulin resistant and obese in order to survive adverse environmental conditions. Researchers have observed that animals in a seasonally insulin resistant and obese condition display a metabolic profile that is similar to the metabolic profile of insulin resistant and obese humans who have Type II diabetes and its related metabolic disorders.
Ergo's scientists have demonstrated that the seasonally insulin resistant and obese condition in animals is associated with seasonal changes in the daily pattern of neuroendocrine activity. The neuroendocrine system--a complex
physiological system that includes the brain, peripheral nervous system and hormones--is one of the mechanisms that regulates and coordinates many functions of the body. Neurotransmitters in the hypothalamic area of the brain such as dopamine, serotonin and noradrenalin are involved in regulating the production of hormones by the pituitary and other endocrine glands, which in turn help regulate various cellular activities such as the liver's production of lipids.
Ergo's scientists have demonstrated that, when vertebrate animals are in a seasonally insulin resistant, obese condition, they evidence a specific daily pattern of neuroendocrine activity. This pattern is evidenced in part by changes in the serum level of the hormone prolactin at specific times of day. For example, in the Syrian hamster the concentration of the hormone prolactin in the blood of the animal peaks at approximately four hours after sunrise each day when the animal is in its lean insulin sensitive, summer condition. When the animal is in its obese insulin resistant, winter condition, prolactin levels peak at approximately 12 hours after sunrise each day. Further, Ergo's scientists have observed that these changes in daily hormone patterns occur for a number of different hormones and that a pattern exists in the levels of certain hormones in the summer condition of animals that differs from the pattern exhibited during the winter condition. The production of these hormones is regulated by dopamine and other neurotransmitters in the hypothalamus. The following graphs illustrate the differences between the daily pattern of prolactin levels in the Syrian hamster during its lean insulin sensitive condition and the daily pattern during its obese insulin resistant condition.
[Under the heading "Seasonal Neuroendocrine Profile of Syrian Hamster," two line graphs titled "Summer Condition, Insulin Sensitive, Lean" and "Winter Condition, Insulin Resistant, Fat," respectively, with hourly increments of time on the x- axis and plasma prolactin levels on the y-axis, showing prolactin levels in a Syrian hamster peaking at four hours after light onset in an insulin sensitive, lean Syrian hamster and 12 hours after light onset in an insulin resistant, fat Syrian hamster, appear here.]
Moreover, the Company's scientists have demonstrated that the timed administration of certain pharmaceuticals in seasonal animals can alter neurotransmitter activity, which affects daily hormone patterns to produce the desired seasonal metabolic conditions out of season. When neurotransmitter modulating drugs are administered to a seasonally obese insulin resistant animal at specific times designed to shift its neuroendocrine patterns to mimic those of a seasonally lean insulin sensitive animal, the animal's metabolism shifts to a lean insulin sensitive state regardless of the actual season of the year. In studies presented at the June 1996 annual meeting of the American Diabetes Association, Ergo's scientists measured levels of neurotransmitter metabolites in the ventral medial hypothalamus ("VMH") of obese insulin resistant Syrian hamsters. The studies indicated that obese insulin resistant Syrian hamsters became lean and insulin sensitive in two weeks through the administration of neurotransmitter modulating drugs at a specific time of day. The studies also indicated that the altered condition correlated with a change in the levels of neurotransmitter metabolites in the VMH, which evidenced an alteration in the daily neuroendocrine patterns in the animals.
Ergo's scientists have also demonstrated that the timed administration of certain pharmaceuticals in non-seasonal animals with insulin resistance and obesity can alter the animal's daily neuroendocrine pattern and produce a leaner, more insulin sensitive animal. In preclinical studies with the leptin- deficient ob/ob mouse, a genetically obese and insulin resistant animal model, Ergo's scientists achieved significant reductions in body fat compared with control animals through the timed administration of neurotransmitter modulating drugs without injecting leptin. In one study presented at the June 1996 ADA annual meeting, Ergo's scientists reported that the use of two neurotransmitter modulating drugs produced a significant (between 50% and 60%) reduction in food intake and a decrease in body fat of 22% to 32% with no significant decrease in lean body (muscle) mass compared with control animals. The treatment also improved glycemic control, reducing glucose 57% and insulin 50%. The following graph illustrates that body fat, serum insulin levels, and blood glucose levels were reduced in the treated ob/ob mouse compared with control animals.
[Under the heading "Modifying Glucose and Lipid Metabolism in the Ob/Ob Mouse," three bar graphs with both a "control" and "drug" bar on the x-axis and with "fat pad weight," "serum insulin" levels and "blood glucose" levels on the y- axis, respectively, showing that body fat gain, serum insulin levels and blood glucose levels were reduced in the animals on drug compared with the control animals from approximately 3.8g to 1.7g, 9.5 ng/dL to 5.5 ng/dL and 260 mg/dL to 140 mg/dL, respectively, appear here.]
In a second study also presented at the 1996 ADA annual meeting, Ergo's scientists found that the administration of a dopamine agonist and a serotonin agonist at specific but different times of day produced a significant (approximately 30%) reduction in food intake and reduced body fat 30% to 75% and body weight gain 40% to 60% in the treated ob/ob mouse compared with control animals. In that study, lean body mass increased 5% to 17%, indicating that the two-drug treatment reduced weight by selectively reducing body fat. The Company believes the selective reduction in body fat and preservation of lean body mass has significant implications for the treatment of obesity in humans because improvement in the lean-to-fat body mass ratio may reduce cardiovascular risk associated with chronic obesity.
PATENTS, PROPRIETARY RIGHTS AND LICENSES
Ergo's ability to commercialize profitably any product candidates will depend, in part, upon its or its licensors' ability to obtain patents, enforce those patents, preserve trade secrets, and operate without infringing upon the proprietary rights of third parties. The Company has rights to more than 40 issued or pending United States patents and patent applications and to counterparts to many of those patents and patent applications in other countries. The Company's patent portfolio for its current product candidates is based on the timed administration of neurotransmitter modulating drugs to address abnormalities of the neuroendocrine system. The Company has filed a patent application in the United States relating to a fast-release formulation of ERGOSET. LSU has licensed its interest in more than 35 of those patents and patent applications exclusively to the Company. See " Business-- LSU Agreement." The Company is a co-owner of certain of those U.S. patent applications and one U.S. patent. Recently, the Company entered into a license agreement with Massachusetts General Hospital for its interest in certain patent applications covering the treatment of immune dysfunctions and cancer. The Company licenses its PDT technology from The Rowland Institute for Science. The Company's rights in certain patent applications, primarily several of the applications relating to PDT, are not exclusive, but the Company is negotiating with the co-owner of those rights for an exclusive license. See "Risk Factors-- Uncertainty of Protection for Patents and Proprietary Technology."
LSU AGREEMENT
The Company's rights to ERGOSET and its other technologies derive primarily from a license from LSU for certain patents and patent applications. The Company is a co-owner of certain of these patents and patent applications. Under an agreement originally signed in 1990 (as amended, the "LSU Agreement"), LSU granted to Ergo an exclusive license to its rights under certain patents and patent applications. The LSU Agreement will terminate upon expiration of all licensed patents thereunder unless terminated earlier by LSU or the Company in accordance with terms of the LSU Agreement. In the LSU Agreement, the Company agreed to commercialize ERGOSET in all countries where commercialization is reasonably justified economically. The Company is responsible for prosecuting and maintaining the patents and patent applications licensed from LSU and for obtaining governmental approval of any product, process, or method covered thereby in those countries (for example, FDA approval in the United States). The Company's policy is to file foreign counterparts to its licensed patents in countries with significant pharmaceutical markets where such protection is obtainable. The Company has a right of first negotiation for new technologies that LSU develops relating to the licensed technologies. There can be no assurance that the Company will successfully obtain rights to any such new technologies. The LSU Agreement requires the Company to make specified fixed payments to LSU and pay LSU royalties at varying rates on its product sales covered by the licensed patents. The LSU Agreement also requires the Company to maintain customary general liability insurance and customary product liability insurance for all countries in which it sells products licensed under the LSU Agreement. LSU may terminate the LSU Agreement if Ergo breaches the LSU Agreement and fails to cure the breach within 45 days (for breach of payment obligations) or 90 days (for other breaches) after notice of the breach from LSU. If the LSU Agreement is terminated for any reason, the Company would no longer possess the rights necessary to commercialize ERGOSET and certain other technologies relating to the timed administration of neurotransmitter modulating drugs. This would have a material adverse effect on the Company. See "Risk Factors--Uncertainty of Protection for Patents and Proprietary Technology."
MGH AGREEMENT
Recently the Company entered into an exclusive license agreement with Massachusetts General Hospital (the "MGH Agreement") for its interest in certain patent applications covering the treatment of immune dysfunctions and cancer using the timed administration of certain neurotransmitter modulators. The MGH Agreement requires the
Company to pay Massachusetts General Hospital a royalty on product sales and to make specified payments upon the completion of certain milestones. The agreement also sets forth a development schedule for products covered by the licensed patents which requires the Company to commence and complete certain clinical trials within specified time periods. The MGH Agreement requires the Company to maintain insurance and prosecute the licensed patents. Massachusetts General Hospital may terminate the MGH Agreement if the Company breaches its terms and fails to cure the breach within 60 days. If the MGH Agreement is terminated, the Company's rights in many of its patent applications covering the treatment of immune disorders and cancer would be non-exclusive.
COMPETITION
ERGOSET, if it is approved, will compete against existing therapies for Type II diabetes such as insulin and oral antidiabetic agents. Over the past two years, FDA has approved three drugs for the treatment of Type II diabetes that have methods of action that are different from sulfonylureas and are intended to address the hyperglycemia associated with diabetes.
Metformin, under the trade name Glucophage(R), was approved in March 1995 and is sold by Bristol-Myers Squibb Company. Metformin has been used as an adjunct to oral hypoglycemic agents and in monotherapy to improve glycemic control in diabetic subjects without increasing serum insulin levels. It is an oral medication that belongs to a class of drugs called biguanides. It is believed to work, at least in part, by reducing glucose output from the liver. Its use carries the risk of lactic acidosis, a rare but possibly fatal side effect. It appears that Metformin has rapidly gained market acceptance.
Precose, approved for monotherapy and adjunctive therapy by the FDA in September 1995, is sold in the United States by Bayer Corporation under the name Acarbose(R) and was previously sold in Europe under the name Glucobay/TM/. Acarbose is an alpha-glucosidase inhibitor which works in the intestine to block the enzymes necessary for the digestion and absorption of carbohydrates in the intestines. Acarbose reduces blood glucose levels primarily after meals by slowing down the digestion of carbohydrates and lengthening the time it takes for carbohydrates to convert to glucose. It must be taken orally at the start of each meal and causes mild to moderate gastrointestinal side effects.
In January 1997, the FDA approved Troglitazone, sold by Warner Lambert Company under the name Rezulin(R), for use in treating diabetics who are taking insulin. It is believed to work in part by increasing the body's sensitivity to insulin.
The active ingredient in ERGOSET has been approved by FDA for indications other than Type II diabetes. Physicians may choose to prescribe other drugs containing this active ingredient for off-label use to try to achieve the same effects as ERGOSET. Substitution of other forms of the active ingredient may have a material adverse effect on the market for ERGOSET. This risk could be increased if current regulations prohibiting off-label marketing are changed. See "Business--Patents, Proprietary Rights and Licenses" and "Business--Government Regulation." There can be no assurance that the Company's product candidates, if commercialized, will be accepted and prescribed by healthcare professionals.
Ergo competes with biotechnology and established pharmaceutical companies in all of its product development programs. Academic institutions, governmental agencies, and other public and private research organizations also conduct research, seek patent protection, and establish collaborative arrangements with commercial entities for product development and marketing. Products resulting from these activities may compete directly with any that the Company develops. These companies and institutions also compete with the Company in recruiting and retaining highly qualified scientific personnel. Many competitors and potential competitors have substantially greater scientific research and product development capabilities, as well as greater financial, marketing and human resources, than the Company.
Many other entities, including large pharmaceutical companies and institutions, are developing therapeutic products that may compete with Ergo's product candidates in the treatment of Type II diabetes, obesity, and cancer. Several different approaches to treating Type II diabetes are being tested in United States clinical trials, including new oral hypoglycemic agents that stimulate insulin production and new medicines that stimulate glucose uptake in peripheral
tissues. Other drugs are being developed that may limit or delay the damage that diabetes causes to organs such as the eyes and kidneys.
Competition for treatments for Type II diabetes is very intense. The Company expects that competition among products approved for sale will be based on, among other factors, product safety, efficacy, ease of use, effect on co- morbid conditions, availability, price, marketing and distribution. Even if ERGOSET is approved by FDA for sale as a new treatment for Type II diabetes, there can be no assurance that it will be able to compete successfully against other products. See "Business -- Development of ERGOSET and Other Products for Type II Diabetes -- Clinical Trials of ERGOSET for Type II Diabetes," and "Risk Factors -- Uncertainties Related to Regulatory Approval of ERGOSET for Type II Diabetes."
GOVERNMENT REGULATION
Ergo's research and development activities, preclinical studies and clinical trials, and ultimately the manufacturing, marketing and labeling of its products, if approved, are subject to extensive regulation by FDA and other regulatory authorities in the United States. These activities are also regulated in other countries where the Company intends to test and market its products. The United States Federal Food, Drug, and Cosmetic Act and the regulations promulgated thereunder and other federal and state statutes and regulations govern, among other things, the testing, manufacture, safety, efficacy, labeling, storage, record keeping, approval, advertising and promotion of the Company's products. Preclinical study and clinical trial requirements and the regulatory approval process take years and require the expenditure of substantial resources. Additional government regulation may be established that could prevent or delay regulatory approval of the Company's product candidates. Delays or rejections in obtaining regulatory approvals would adversely affect the Company's ability to commercialize any product candidates the Company develops and the Company's ability to receive product revenues or royalties. If regulatory approval of a product candidate is granted, the approval may include significant limitations on the indicated uses for which the product may be marketed.
FDA and other regulatory authorities require that the safety and efficacy of the Company's therapeutic product candidates must be established by at least two adequate and well-controlled Phase III clinical trials. If the results of Phase III clinical trials do not establish the safety and efficacy of the Company's product candidates to the satisfaction of FDA and other regulatory authorities, the Company will not receive the approvals necessary to market its product candidates, which would have a material adverse effect on the Company.
The steps required before a pharmaceutical agent may be marketed in the United States include (a) preclinical laboratory, in vivo, and formulation studies, (b) the submission to FDA of an Investigational New Drug application ("IND"), which must become effective before human clinical trials may commence, (c) adequate and well-controlled human clinical trials to establish the safety and efficacy of the drug, (d) the submission of an NDA to FDA, and (e) FDA approval of the NDA, including approval of all product labeling and advertising.
Preclinical tests include laboratory evaluation of product chemistry, formulation and stability, as well as animal studies to assess the potential safety and efficacy of each product. Preclinical safety tests must be conducted by laboratories that comply with FDA regulations regarding Good Laboratory Practices. The results of the preclinical tests are submitted to FDA as part of an IND and are reviewed by FDA before the commencement of human clinical trials. Unless FDA objects to an IND, the IND will become effective 30 days following its receipt by FDA. There can be no assurance that submission of an IND will result in FDA authorization to commence clinical trials or that the lack of an objection means that FDA will ultimately approve an NDA.
Clinical trials involve the administration of the investigational new drug to humans under the supervision of a qualified principal investigator. Clinical trials must be conducted in accordance with Good Clinical Practices under protocols that detail the objectives of the study, the parameters to be used to monitor safety, and efficacy criteria to be evaluated. Each protocol must be submitted to FDA as a part of the IND. Also, each clinical trial must be approved and conducted under the auspices of an Institutional Review Board, which will consider, among other things, ethical factors, the safety of human subjects, and the possible liability of the institution conducting the clinical trials.
Clinical trials are typically conducted in three sequential phases, but the phases may overlap, as is the case with ERGOSET trials. Phase I clinical trials involve the initial introduction of the drug into healthy human subjects. In Phase I clinical trials, the drug is tested for safety (adverse effects), dosage tolerance, metabolism, distribution, excretion, and pharmacodynamics (clinical pharmacology). Phase II clinical trials are conducted in a limited subject population to gather evidence about the efficacy of the drug for specific, targeted indications; to determine dosage tolerance and optimal dosage; and to identify possible adverse effects and safety risks. When a compound has shown evidence of efficacy and an acceptable safety profile in Phase II evaluations, Phase III clinical trials are undertaken to evaluate clinical efficacy and to test for safety in an expanded subject population at geographically dispersed clinical trial sites. There can be no assurance that any of the Company's clinical trials will be completed successfully or within any specified time period. The Company or FDA may suspend clinical trials at any time.
The Company designed the protocols for its Phase III clinical trials of ERGOSET for Type II diabetes based on its analysis of its research, including various parts of its Phase II clinical trials. Although copies of its Phase III clinical trial protocols were submitted to FDA, there can be no assurance that FDA will not disagree with the design of the Phase III clinical trial protocols. In addition, FDA inspects and reviews clinical trial sites, informed consent forms, data from the clinical trial sites including case report forms and record keeping procedures, and the performance of the protocols by clinical trial personnel to determine compliance with Good Clinical Practice. FDA also seeks to determine whether there was bias in the conduct of clinical trials. The conduct of clinical trials in general and the performance of the Phase III clinical trial protocols is complex and difficult. There can be no assurance that the design or the performance of the Phase III clinical trial protocols will be acceptable to FDA.
The results of preclinical studies and clinical trials, if believed to be successful, are submitted in an NDA to seek FDA approval to market and commercialize the drug product for a specified use. The testing and approval process require substantial time and effort, and there can be no assurance that any approval will be granted for any product or that approval will be granted according to any schedule. FDA may deny an NDA if it believes that applicable regulatory criteria are not satisfied. FDA may also require additional testing for safety and efficacy of the drug. Moreover, if regulatory approval of a drug product is granted, the approval will be limited to specific indications for which FDA believes there is adequate supporting data. There can be no assurance that any of the Company's product candidates will receive regulatory approvals for commercialization. See "Risk Factors--Government Regulation."
Even if regulatory approvals for the Company's product candidates are obtained, the Company, its products, and the facilities manufacturing the Company's products are subject to continual review and periodic inspection. FDA will require post-marketing reporting to monitor the safety of the Company's products. Each United States drug manufacturing establishment must be registered with FDA. Domestic manufacturing establishments are subject to biennial inspections by FDA and must comply with FDA's current Good Manufacturing Practices. To supply drug products for use in the United States, foreign manufacturing establishments must comply with FDA's Good Manufacturing Practices and are subject to periodic inspection by FDA or by regulatory authorities in those countries under reciprocal agreements with FDA. In complying with Good Manufacturing Standards, manufacturers must expend funds, time and effort in the area of production and quality control to ensure full technical compliance. The Company does not have any drug manufacturing capability and must rely on outside firms for this capability. See "Business--Commercialization Strategy-- Manufacturing." FDA stringently applies regulatory standards for manufacturing. Discovery of problems with respect to a product, manufacturer or facility may result in restrictions on the product, manufacturer or facility, including warning letters, suspensions of regulatory approvals, operating restrictions, delays in obtaining new product approvals, withdrawal of the product from the market, product recalls, fines, injunctions, and criminal prosecution.
A bill proposing comprehensive reform of FDA regulations has been introduced in the United States Congress. This bill addresses many facets of FDA regulations, including requirements for NDA approval, requirements for supplemental approvals, and provisions liberalizing off-label information dissemination. It is not certain whether any such legislation will be enacted into law, what form any law will take, or what effect any new law would have on the Company.
Before Ergo's drug products can be marketed outside of the United States, they are subject to regulatory approval similar to FDA requirements in the United States, although the requirements governing the conduct of clinical trials, product licensing, pricing, and reimbursement vary widely from country to country. No action can be taken to market any drug product in a country until an appropriate application has been approved by the regulatory authorities in that
country. FDA approval does not assure approval by other regulatory authorities. The current approval process varies from country to country, and the time spent in gaining approval varies from that required for FDA approval. In some countries, the sale price of a drug product must also be approved. The pricing review period often begins after market approval is granted. Even if a foreign regulatory authority approves any of the Company's product candidates, no assurance can be given that it will approve satisfactory prices for the products.
The active ingredient in ERGOSET has been approved by FDA for use in humans for approximately 20 years for several indications, including treating Parkinson's disease, acromegaly, and hyperprolactinemia. One company marketing bromocriptine in the United States agreed voluntarily to remove the indication of suppressing lactation in postpartum females after FDA initiated action to withdraw the drug's approval for this indication. FDA had noted that the benefit of using the drug for this indication was marginal and did not outweigh the risks in this particular subject population including hypertension, seizures, and cerebrovascular incidents. FDA has not taken action with respect to the other approved indications, and bromocriptine remains on the market for the treatment of Parkinson's disease, acromegaly, and hyperprolactinemia. The Company's clinical trials exclude postpartum females, and the data from the Company's completed Phase II and Phase III clinical trials lead the Company to believe that ERGOSET does not present the same health risks to its proposed subject population.
Ergo's research and development involves the controlled use of hazardous materials, chemicals, viruses, and various radioactive compounds. Although the Company believes that its procedures for handling and disposing of those materials comply with state and federal regulations, the risk of accidental contamination or injury from these materials cannot be eliminated. If such an accident occurs, the Company could be held liable for resulting damages, which could be material to the Company's financial condition and business. The Company will include an environmental assessment in the NDA in accordance with FDA regulations. The Company is also subject to numerous environmental, health and workplace safety laws and regulations, including those governing laboratory procedures, exposure to blood-borne pathogens, and the handling of biohazardous materials. Additional federal, state and local laws and regulations affecting the Company may be adopted in the future. Any violation of, and the cost of compliance with, these laws and regulations could materially and adversely affect the Company.
HUMAN RESOURCES
As of March 28, 1997, the Company had 73 full-time employees, including 14 persons with Ph.D. degrees. Fifty-six of Ergo's employees are engaged in research and development activities. None of the Company's employees is covered by a collective bargaining agreement.
RISK FACTORS
In addition to the other information in this Annual Report on Form 10- K, prospective investors should consider the following factors in evaluating the Company and its business before purchasing any of the Common Stock of the Company.
UNCERTAINTIES RELATED TO REGULATORY APPROVAL OF ERGOSET FOR TYPE II DIABETES
In 1996 the Company announced the statistical analyses of its three Phase III clinical trials of ERGOSET as adjunctive and monotherapy in obese subjects suffering from Type II diabetes. The Company intends to file an NDA with FDA for ERGOSET to treat Type II diabetes in 1997. In order for a drug such as ERGOSET to be approved for commercial sale, FDA and other authorities require that the safety and efficacy of the drug be established by at least two adequate and well-controlled clinical trials. The Company has limited experience in filing and pursuing applications necessary to gain regulatory approvals. Data obtained from preclinical and clinical activities are susceptible to varying interpretations that could delay, limit or prevent FDA regulatory approval. There can be no assurance that FDA and other regulatory authorities will agree with the Company's assessment of the results. If FDA or its advisory panel of experts disagrees with the Company's analysis of the results of the Phase III clinical trials or believes that the results do not establish that ERGOSET is safe and effective in the treatment of Type II diabetes, the Company will not receive the approval necessary to market ERGOSET, which would have a material adverse effect on the Company. In that case, the Company may have to conduct additional Phase III clinical trials in an effort to demonstrate the safety and efficacy of
ERGOSET, which also may not be acceptable to FDA. There can be no assurance that the results of any of the Company's Phase III clinical trials will be satisfactory, that ERGOSET will obtain regulatory approval for commercialization, or that any regulatory approval obtained will not contain material limitations on the indicated uses for which ERGOSET may be marketed. See "Business--Government Regulation." Without regulatory approval, the Company would not be able to commercialize ERGOSET, which would have a material adverse effect on the Company. See "Business-- Development of ERGOSET and Other Products for Diabetes-- Clinical Trials of ERGOSET for Type II Diabetes."
GOVERNMENT REGULATION
The Company's research and development activities, preclinical studies and clinical trials, and ultimately the manufacturing, marketing and labeling of its products, if approved, are subject to extensive regulation by FDA and foreign regulatory authorities. To market product candidates currently under development, the Company must undergo an extensive regulatory approval process. The regulatory process takes many years and requires the expenditure of substantial resources. Although protocols for clinical trials are submitted to FDA prior to commencement of the trials, there can be no assurance that FDA will accept the clinical trials as adequate or well-controlled or accept the results of those trials. In addition, delays or rejections may result from changes in FDA policies about drug approval during the period of product development, from FDA review of NDAs, and from other causes. Similar delays may also be encountered in foreign countries. There can be no assurance that regulatory review will be conducted in a timely manner or that regulatory approval will be obtained for any drugs developed by the Company, including ERGOSET. Moreover, if regulatory approval of a drug is granted, the approval may entail limitations on the indicated uses for which it may be marketed. Further, even if regulatory approval is obtained, a company's marketed drug, its bulk chemical supplier, its manufacturer and its manufacturing facilities are subject to continual review and periodic inspections, and later discovery of problems with a product, supplier, manufacturer or facility may result in restrictions on the product, including a withdrawal of the product from the market. Failure to comply with the applicable regulatory requirements can, among other things, result in fines, suspensions of regulatory approvals, product recalls, operating restrictions and criminal prosecution. Additional government regulation may be enacted or adopted that could prevent or delay regulatory approval of the Company's product candidates.
The Company's business is also subject to regulation under state and federal laws regarding environmental protection and hazardous substances control, including the Occupational Safety and Health Act, the Environmental Protection Act, and the Toxic Substance Control Act. There can be no assurance that statutes or regulations applicable to the Company's business will not be adopted that impose substantial additional costs or otherwise materially adversely affect the Company's operations. See "Business--Government Regulation."
UNCERTAINTIES RELATED TO PRODUCT DEVELOPMENT AND MARKETABILITY
The Company has not yet completed the development of any products and, accordingly, has not begun to market or generate revenues from the commercialization of products. ERGOSET recently completed testing in three Phase III clinical trials as therapy in obese subjects suffering from Type II diabetes. ERGOSET as treatment for obesity or other indications and the Company's other product candidates are at earlier stages of development. There can be no assurance that the Company will successfully develop and market its product candidates, which would have a material adverse effect on the Company.
The results of preclinical studies and initial clinical trials of the Company's product candidates are not necessarily predictive of the results from large-scale clinical trials. The Company must demonstrate through preclinical studies and clinical trials that its product candidates are safe and effective for use in each target indication before the Company can obtain regulatory approvals for the commercial sale of those products. These studies and trials may be very costly and time-consuming. The speed with which the Company is able to enroll subjects in clinical trials is an important factor in determining how quickly clinical trials may be completed. Many factors affect subject enrollment, including the size of the subject population, the proximity of subjects to clinical sites, and the eligibility criteria for the study. Delays in subject enrollment may result in increased costs, trial delays, or both, which could have a material adverse effect on the Company. Even if the Company establishes the safety and efficacy of its product candidates and obtains FDA and other regulatory approvals for its product candidates, physicians may not prescribe the approved product. Also, there can be
no assurance that the Company's product candidates will be accepted by physicians as producing clinically significant benefits.
The administration of any product the Company develops may produce undesirable side effects in humans. The occurrence of side effects could interrupt or delay clinical trials of product candidates and could result in FDA's or other regulatory authorities' denying approval of the Company's product candidates for any or all targeted indications. The Company, FDA or other regulatory authorities may suspend or terminate clinical trials at any time. Even if the Company receives FDA and other regulatory approvals, the Company's product candidates may later exhibit adverse effects that limit or prevent their widespread use or that necessitate their withdrawal from the market.
MANUFACTURING UNCERTAINTIES; RELIANCE ON THIRD-PARTY SUPPLIERS
The Company does not operate and does not plan to operate manufacturing facilities for the production of either bulk chemicals or the pharmaceutical dosage forms for its product candidates. In 1995, the Company entered into a United States supply agreement with Geneva Pharmaceuticals, Inc. ("Geneva") for the finished dosage forms of ERGOSET. If Geneva does not perform its obligations under this agreement or if the agreement is terminated, the Company may not be able to obtain supplies of ERGOSET. Even if the Company is able to obtain ERGOSET from other suppliers, it may not be on the terms or in the quantities acceptable to the Company. Like Geneva, other suppliers would need to meet FDA manufacturing requirements, and there can be no assurance that they would receive FDA approval. The active ingredient in ERGOSET, bromocriptine, is available from few suppliers in the world, and the manufacturing process for the active ingredient is complex and lengthy. Accordingly, the Company will encounter significant delays if it must obtain supplies of active ingredient or finished tablets from other sources or otherwise experiences interruptions in its supplies. See "Business -- Commercialization Strategy-- Manufacturing." If the Company is unable to obtain adequate supplies on favorable terms, its business would be materially adversely affected. The Company and Geneva have recently begun development of additional dosage-strength tablets. This activity is subject to FDA requirements, including demonstration of satisfactory in vitro dissolution, bioavailability, bioequivalence, and manufacturability. There can be no assurance of the outcome of these activities or the times in which they may be completed, if at all.
LIMITED SALES AND MARKETING EXPERIENCE; DEPENDENCE ON FUTURE COLLABORATORS
The Company has limited experience in sales, marketing and distribution. The market for products for Type II diabetes is large. To market a new product for Type II diabetes to primary care and general practice physicians requires significant resources. It is unlikely that the Company would develop such capacity on its own. The Company plans to enter into a marketing agreement with one or more pharmaceutical companies that have established marketing and sales capabilities. There can be no assurance that the Company will enter into a collaborative marketing agreement. To the extent that the Company enters into marketing or distribution arrangements with others, any revenues the Company receives will depend upon the efforts of third parties. While the Company believes that its potential collaborators will have an economic incentive to succeed in performing their obligations under such arrangements, the amount and timing of funds and other resources to be devoted under such arrangements will be controlled by the other parties and will be subject to financial and other difficulties that may befall the other parties. There can be no assurance that any third party will market the Company's products successfully or that any third-party collaboration will be on terms favorable to the Company. If any marketing partner does not market a product successfully, the Company's business would be materially adversely affected. There can be no assurance that the Company will be able to establish sales, marketing and distribution capabilities, that it will be able to enter into a collaborative marketing agreement, or that it or its collaborators will be successful in gaining market acceptance for any products that the Company may develop. The Company's failure to enter into marketing arrangements with third parties would have a material adverse effect on the Company.
NO ASSURANCE OF ADEQUATE THIRD-PARTY REIMBURSEMENT
The Company's ability to commercialize its product candidates successfully, if FDA approval is obtained, will depend in part on the extent to which appropriate reimbursement levels for the cost of the products and related treatment are obtained from government authorities, private health insurers and other organizations, such as health maintenance organizations ("HMOs"). Third- party payors are increasingly challenging pricing of pharmaceutical products. In addition, the trend toward managed healthcare in the United States, the growth of organizations such as HMOs, and legislative
proposals to reform healthcare and government insurance programs could significantly influence the purchase of pharmaceutical products, resulting in lower prices and reducing demand for the Company's product candidates. Such cost containment measures and healthcare reform could affect the Company's ability to sell its product candidates and may have a material adverse effect on the Company.
Significant uncertainty exists about the reimbursement status of newly approved pharmaceutical products. There can be no assurance that reimbursement in the United States or foreign countries will be available for any of the Company's product candidates, that any reimbursement granted will be maintained, or that limits on reimbursement available from third-party payors will not reduce the demand for, or negatively affect the price of, the Company's product candidates. The unavailability or inadequacy of third-party reimbursement for the Company's product candidates would have a material adverse effect on the Company. The Company is unable to forecast what additional legislation or regulation relating to the healthcare industry or third-party coverage and reimbursement may be enacted in the future, or what effect the legislation or regulation would have on the Company's business.
EARLY STAGE OF DEVELOPMENT; HISTORY OF OPERATING LOSSES; ANTICIPATION OF FUTURE LOSSES
The Company is in a development stage. It has generated no revenues from product sales, and it does not expect to generate revenue from product sales for at least the next couple of years, if at all. The Company has been unprofitable since its inception, and as of December 31, 1996, the Company's accumulated deficit was $59,061,288. To date, the Company has dedicated most of its financial resources to ERGOSET research and development, general and administrative expenses, and the prosecution of patents and patent applications. The Company expects to incur significant and increasing expenses for at least the next several years, primarily owing to the expansion of its research and development programs, including preclinical studies and clinical trials. The Company's ability to achieve profitability will depend, among other things, on its successfully completing development of its product candidates, obtaining regulatory approvals, establishing manufacturing, sales and marketing capabilities or collaborative arrangements, and raising sufficient funds to finance its activities. There can be no assurance that the Company will be able to achieve profitability or that profitability, if achieved, can be sustained. See "Selected Consolidated Financial Data," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Business."
FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FUNDING
The Company has experienced negative cash flows from operations since its inception and has funded its activities to date primarily from issuances of equity securities. The Company has expended, and will continue to require, substantial funds to continue research and development, including preclinical studies and clinical trials of its product candidates, and to commence sales and marketing efforts if regulatory approvals are obtained. The Company's capital requirements will depend on many factors, including the problems, delays, expenses and complications frequently encountered by development stage companies; the progress of the Company's research, development and clinical trial programs; the extent and terms of any collaborative research, manufacturing, marketing or other funding arrangements; the costs and timing of seeking regulatory approvals of the Company's product candidates; the Company's ability to obtain regulatory approvals; the success of the Company's sales and marketing programs; costs in filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and changes in economic, regulatory or competitive conditions or the Company's planned business. Estimates about the adequacy of funding for the Company's activities are based on certain assumptions, including the assumption that testing and regulatory procedures relating to the Company's product candidates can be conducted at projected costs. To satisfy its capital requirements, the Company may seek to raise funds in the public or private capital markets. The Company's ability to raise additional funds in the public or private markets will be adversely affected if the results of ongoing or future clinical trials are not favorable or if regulatory approval for any of the Company's product candidates is not obtained or is limited. The Company may seek additional funding through corporate collaborations and other financing vehicles. There can be no assurance that any such funding will be available to the Company, or, if available, that it will be available on acceptable terms. If adequate funds are not available, the Company may be required to curtail significantly one or more of its research or development programs, or it may be required to obtain funds through arrangements with future collaborative partners or others that may require the Company to relinquish rights to some or all of its technologies or product candidates. If the Company is successful in obtaining additional financing, the terms of the financing may have the effect
of diluting or adversely affecting the holdings or the rights of the holders of its common stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations --Liquidity and Capital Resources."
UNCERTAINTY OF PROTECTION FOR PATENTS AND PROPRIETARY TECHNOLOGY
The Company's ability to commercialize any product candidates will depend, in part, upon its or its licensors' ability to obtain patents, enforce those patents, preserve trade secrets, and operate without infringing upon the proprietary rights of third parties. In addition, the Company's patent portfolio for its current product candidates is based on the timed administration of neurotransmitter modulating drugs to address abnormalities of the neuroendocrine system. If similar benefits could be achieved by using such drugs without timed administration, the Company's patents and proprietary technology would not prevent that use, and the use would likely have a material adverse effect on the Company. There can be no assurance that the patent applications licensed to or owned by the Company will result in issued patents, that patent protection will be secured for any particular technology, that any patents that have been or may be issued to the Company or its licensors will be valid or enforceable, or that any patents will provide meaningful protection to the Company. If the Company is unable to obtain and maintain a proprietary position with respect to its clinical candidates it would have a material adverse effect on the Company.
In general, the United States patents and patent applications owned by or licensed to the Company are method-of-use patents that cover the timed use of certain compounds to treat specified conditions. The U.S. patents for bromocriptine, the active ingredient in ERGOSET, have expired, and composition- of-matter protection is not available for the active ingredient. Bromocriptine is currently sold in the United States and other markets for several uses other than the treatment of Type II diabetes or obesity. Even in jurisdictions where the timed use of bromocriptine for Type II diabetes may be covered by the claims of a use patent licensed to the Company, off-label sales might occur, especially if another company markets bromocriptine at a price that is less than the price of ERGOSET, thereby potentially reducing the sales of ERGOSET. See "Business-- Competition" and "Business--Government Regulation."
The patent positions of biotechnology and pharmaceutical companies are highly uncertain and involve complex legal and factual questions. There can be no assurance that patents will issue from the patent applications filed by the Company or its licensors or that the scope of any claims granted in any patent will provide proprietary protection or a competitive advantage to the Company. There can be no assurance that the validity or enforceability of patents issued or licensed to the Company will not be challenged by others or that, if challenged, a court will find the patents to be valid and enforceable. In addition, there can be no assurance that competitors will not be able to circumvent any patents issued or licensed to the Company.
There can be no assurance that the manufacture, use or sale of the Company's product candidates will not infringe patent rights of others. The Company may be unable to avoid infringement of those patents and may have to seek a license, defend an infringement action, or challenge the validity of the patents in court. There can be no assurance that a license will be available to the Company, if at all, upon terms and conditions acceptable to the Company or that the Company will prevail in any patent litigation. Patent litigation is costly and time consuming, and there can be no assurance that the Company will have sufficient resources to pursue such litigation. If the Company does not obtain a license under such patents, is found liable for infringement, or is not able to have such patents declared invalid, the Company may be liable for significant money damages, may encounter significant delays in bringing products to market, or may be precluded from participating in the manufacture, use or sale of products or methods of treatment requiring such licenses. There can be no assurance that the Company has identified United States and foreign patents that pose a risk of infringement.
The Company recently began a small study of two drugs in the treatment of breast cancer. The Company is aware of two issued patents, owned by a third party, some of the claims of which relate to one of the drugs being tested in the breast cancer study. The Company believes that the relevant claims are either invalid or not infringed by the Company's product candidate and method of treatment. If it is determined that any of such relevant claims are infringed by the Company's product candidate and not invalid, the Company may have to seek a license, defend an infringement action, or challenge the validity of such patents in court. There can be no assurance that a license will be available to the Company, that the terms and conditions of any such license would be acceptable to the Company or that the Company
will prevail in any patent litigation. If the Company does not obtain a license, is found liable for infringement, or is not able to have the relevant claims declared invalid, then the Company may be liable for significant money damages, may encounter significant delays, or may be precluded from participating in the manufacture, use or sale of products or methods of treatment covered by such patents.
Ergo also relies on trade secrets and other unpatented proprietary information in its product development activities. To the extent that the Company relies on trade secrets and unpatented know-how to maintain its competitive technological position, there can be no assurance that others may not independently develop the same or similar technologies. The Company seeks to protect trade secrets and proprietary knowledge, in part through confidentiality agreements with its employees, consultants, advisors and collaborators. Nevertheless, these agreements may not effectively prevent disclosure of the Company's confidential information and may not provide the Company with an adequate remedy in the event of unauthorized disclosure of such information. If the Company's employees, scientific consultants or collaborators develop inventions or processes independently that may be applicable to the Company's product candidates, disputes may arise about ownership of proprietary rights to those inventions and processes. Such inventions and processes will not necessarily become the Company's property, but may remain the property of those persons or their employers. Protracted and costly litigation could be necessary to enforce and determine the scope of the Company's proprietary rights. Failure to obtain or maintain patent and trade secret protection, for any reason, would have a material adverse effect on the Company. See "Business--Patents, Proprietary Rights and Licenses."
The Company's rights to ERGOSET and its other technologies derive primarily from a license from Louisiana State University ("LSU") for certain patents and patent applications. The Company is a co-owner of certain of these patents and patent applications. The Company recently entered into a license agreement with Massachusetts General Hospital for its interest in certain patent applications covering the treatment of immune dysfunctions and cancer. The Company has a right of first negotiation for new technologies that LSU develops relating to the licensed technologies. There can be no assurance that the Company will successfully obtain rights to any such new technologies. If the license with LSU is terminated for any reason, the Company would no longer possess the rights necessary to commercialize ERGOSET and certain other technologies relating to the timed administration of neurotransmitter modulating drugs. This would have a material adverse effect on the Company. If the license with Massachusetts General Hospital is terminated for any reason, the Company's rights to certain product candidates and potential candidates would be non- exclusive. See "Business--LSU Agreement" and "Business -- MGH Agreement."
The Company engages in collaborations, sponsored research agreements, and other arrangements, such as the LSU Agreement, with academic researchers and institutions that have received and may receive funding from United States government agencies. As a result of these arrangements, the U.S. government or certain third parties may have rights in certain inventions developed during the course of the performance of such collaborations and agreements as required by law or such agreements.
Several bills affecting patent rights have been introduced in the United States Congress. These bills address various aspects of patent law, including publication, patent term, re-examination, subject matter and enforceability. It is not certain whether any of these bills will be enacted into law or what form new laws may take. Accordingly, the effect of legislative change on the Company's intellectual property estate is uncertain.
COMPETITION AND TECHNOLOGICAL CHANGE
The Company is engaged in pharmaceutical product development characterized by extensive research efforts and rapid technological progress. Although the Company is not aware of any other company attempting to treat Type II diabetes, obesity or other metabolic diseases by altering daily neuroendocrine patterns on a timed basis, many established biotechnology and pharmaceutical companies, universities, and other research institutions with resources significantly greater than the Company's are developing products that directly compete with the Company's products. Those entities may succeed in developing products that are safer, more effective or less costly than the Company's product candidates. Many drugs are commercially available for the treatment of Type II diabetes, including four drugs (Acarbose/(R)/ , Glucophage/(R)/, Amaryl(R) and Rezulin/(R)/) that have recently been approved by FDA. Glucophage has rapidly gained market acceptance as a therapy for Type II diabetes. There can be no assurance that ERGOSET will be able to compete successfully with any of these or other products if ERGOSET receives regulatory approval. In addition, ERGOSET
promotional activities will be limited to the claims on the product label approved by FDA. Other companies may be more successful in marketing their products than the Company because of greater financial resources, stronger sales and marketing efforts, and other factors. If the Company commences significant commercial sales of its products, it or its collaborators will compete in areas in which the Company has little or no experience such as manufacturing and marketing. See "Business--Competition."
The active ingredient in ERGOSET is approved by FDA for indications other than Type II diabetes. Physicians may choose to prescribe other drugs containing this active ingredient for off-label use to try to achieve the same effects as ERGOSET. Substitution of other forms of the active ingredient may have a material adverse effect on the market for ERGOSET. This risk could be increased if current regulations prohibiting off-label marketing are changed. See "Business--Patents, Proprietary Rights and Licenses" and "Business-- Government Regulation." There can be no assurance that the Company's product candidates, if commercialized, will be accepted and prescribed by healthcare professionals. See "Business--Competition."
CONTROL BY EXISTING STOCKHOLDERS
As of March 26, 1997, current directors, executive officers and principal stockholders of the Company, and certain of their affiliates, beneficially own approximately 54% of the outstanding Common Stock on a fully diluted basis. Accordingly, these stockholders, individually and as a group, may be able to influence the outcome of stockholder votes, including votes concerning the election of directors, the adoption or amendment of provisions in the Company's Amended and Restated Certificate of Incorporation (the "Certificate of Incorporation"), and the approval of mergers and other significant corporate transactions. These levels of concentrated ownership by a few persons, along with the factors described in "Risk Factors--Anti-Takeover Provisions," may have the effect of delaying or preventing a change in the management or voting control of the Company.
POTENTIAL PRODUCT LIABILITY; AVAILABILITY OF INSURANCE
The Company risks exposure to product liability claims if the use of its products is alleged to have an adverse effect on patients or subjects. This risk exists for product candidates tested in human clinical trials as well as products that are sold commercially, if any. There can be no assurance that product liability claims, if made, would not result in a recall of the Company's products or a change in the indications for which they may be used. The Company maintains product liability insurance coverage for claims arising from the use of its product candidates in clinical trials. There can be no assurance that this coverage will be adequate to cover claims. Product liability insurance is becoming increasingly expensive, however, and no assurance can be given that the Company will be able to maintain such insurance, obtain additional insurance, or obtain insurance at a reasonable cost or in sufficient amounts to protect the Company against losses that could have a material adverse effect on the Company. Further, there can be no assurance that the Company will be able to obtain product liability insurance for the administration of its product candidates, including ERGOSET, in the future or that such insurance and the resources of the Company would be sufficient to satisfy any liability resulting from product liability claims. In addition, the loss of coverage for the administration of the Company's product candidates would be a breach of the terms of the Company's agreements with its licensors, which could lead to termination of those agreements. See "Business -- LSU Agreement." and "Business -- MGH Agreement."
DEPENDENCE ON KEY PERSONNEL
The success of the Company depends in large part on the Company's ability to attract and retain highly qualified scientific and management personnel. The Company faces competition for such personnel from other companies, research and academic institutions, government entities and other organizations. There can be no assurance that the Company will be successful in hiring or retaining key personnel. See "Business -- Competition" and "Business -- Human Resources."
SHARES ELIGIBLE FOR FUTURE SALE; REGISTRATION RIGHTS
Sales of a substantial number of shares of Common Stock in the public market could adversely affect the market price for the Common Stock. Approximately 5,957,178 shares of Common Stock will be eligible for sale beginning April 18, 1997, subject to compliance with the manner-of-sale, volume and other limitations of Rule 144 (as amended in
February 1997 ). Some investors have the right to require the Company to register the public resale of their shares before that time.
POSSIBLE STOCK PRICE VOLATILITY
The trading price of the Common Stock and the price at which the Company may sell securities in the future could be subject to large fluctuations in response to announcements of research activities, technological innovations or new products by the Company or its competitors, changes in government regulations, developments concerning proprietary rights, formation or termination of corporate alliances, quarterly variations in operating results, litigation, clinical trials of product candidates, approval or denial of NDAs, other FDA action or inaction, general market and economic conditions, the liquidity of the Company and its ability to raise additional funds, and other events. The market prices for securities of emerging biotechnology companies have experienced extreme fluctuations in recent years. These fluctuations have sometimes been unrelated to the operating performance of the affected companies. These market fluctuations as well as general fluctuations in the stock markets may also affect the price of the Common Stock.
ANTI-TAKEOVER PROVISIONS
The Company's Certificate of Incorporation (i) provides for staggered terms of office for directors; (ii) requires certain procedures to be followed and time periods to be met for any stockholder to propose matters to be considered at annual meetings of stockholders, including nominating directors for election at those meetings; (iii) prohibits stockholders from calling special meetings of stockholders; and (iv) authorizes the Board of Directors of the Company to issue up to 10,000,000 shares of preferred stock without stockholder approval and to set the rights, preferences, and other designations, including voting rights, of those shares as the Board of Directors may determine. These provisions, alone or in combination with each other and with the matters described in "Risk Factors--Control by Existing Stockholders," may discourage transactions involving actual or potential changes of control of the Company, including transactions that otherwise could involve payment of a premium over prevailing market prices to holders of Common Stock. The Company also is subject to provisions of the Delaware General Corporation Law that may make some business combinations more difficult.
FORWARD LOOKING STATEMENTS AND ASSOCIATED RISKS
This Annual Report on Form 10-K contains forward-looking statements. The words "anticipate," "believe," "expect," "plan," "intend," "estimate," "project," "will," "could," "may," and other expressions are intended to identify forward-looking statements. Such statements reflect the Company's current views with respect to future events and financial performance and involve risks and uncertainties, including without limitation, the risks described in "Risk Factors." Should one or more of these risks or uncertainties occur, should underlying assumptions prove incorrect, or should other intervening events occur, actual results may vary materially and adversely from those anticipated, believed, estimated or otherwise indicated. The Company does not undertake to update any forward-looking statement that may be made from time to time by or on behalf of the Company.
ITEM 2.

ITEM 2. PROPERTIES
FACILITIES
Ergo leases approximately 36,000 square feet in three buildings in the Charlestown Navy Yard, Charlestown, Massachusetts, of which approximately 26,000 square feet are used for research and development functions and approximately 10,000 square feet are used for administrative functions. The Company's principal offices are leased through June 1999, with a renewal option for one five-year term. Space in a nearby building is leased until August 1997, and space in another building is leased through April 1998, with two five-year renewal options. The Company believes that its facilities are adequate for its current needs. The Company believes it can obtain additional space on commercially reasonable terms.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
LEGAL PROCEEDINGS AND INSURANCE
The Company is not a party to any material legal proceedings. The Company maintains product liability coverage for claims arising from the use of ERGOSET and its technologies in clinical trials. See "Risk Factors--Potential Product Liability; Availability of Insurance."
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
In 1996, Ergo Science Corporation submitted four matters to its stockholders for approval at the 1996 Annual Meeting held on June 25. These matters included (1) the re-election of J. Warren Huff and Stephen A. Duzan as Class I directors of the Company, each to serve until the 2000 Annual Meeting of Stockholders and until their successors are duly elected and qualified or their earlier resignation or removal; (2) an amendment to the Ergo Science Corporation Amended and Restated 1995 Long Term Incentive Plan that increased the number of shares of the Company's common stock available to be issued thereunder from 731,525 shares to 1,431,525; (3) a Stock Option Plan for Non-employee Directors of the Company; and (4) ratification of the Board of Directors' selection of Coopers & Lybrand L.L.P. as independent accountants of the Company for fiscal 1996. Of those shares present at the meeting in person or by proxy, a plurality voted to re-elect Messrs. Huff and Duzan as directors and a majority voted in favor of each of the other three proposals. No other matters were submitted to a vote of the stockholders of Ergo Science Corporation during 1996.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock is quoted on the NASDAQ National Market System under the symbol "ERGO". At March 25, 1997, the number of record holders of the Company's common stock was approximately 298. The following table sets forth the range of high and low bid quotations for the Company's common stock as reported by the NASDAQ National Market System during the period from January 1, 1996 through December 31, 1996.
The Company has not paid cash dividends on its common stock and intends to continue a policy of retaining any earnings for reinvestment in its business.
ITEM 6.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected financial data for the Company as of the dates and for the periods indicated. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and related notes thereto included elsewhere in this Report.
- ------------------------ (1) Includes a noncash charge in 1996 of $1,030,981 related to the resignation of a Company senior executive. See Note 9 of Notes to Consolidated Financial Statements.
(2) Includes a noncash charge in 1995 of $1,747,931 for common stock issued in connection with a renegotiated supply contract. See Note 8 of Notes to Consolidated Financial Statements. (3) See Note 1 of Notes to Consolidated Financial Statements. Does not include 1,664,200 shares of common stock reserved for issuance upon exercise of outstanding options at December 31, 1996 since their inclusion would be antidilutive. See Note 9 of Notes to Consolidated Financial Statements. (4) The Company has never paid cash dividends on its common stock other than distributions made to stockholders when the Company was owned only by individuals and had elected to be an S corporation for U.S. federal income tax purposes. (5) See Note 8 of Notes to Consolidated Financial Statements.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion contains forward-looking statements made by the Company pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements reflect the Company's current views with respect to such future events. Actual results may vary materially and adversely from those anticipated, believed, estimated or otherwise indicated. Important factors that could cause actual results to differ materially include, without limitation, (1) that data obtained from clinical trials are subject to varying interpretations, and there can be no assurance that the FDA (or an FDA panel of experts) will agree with the Company's assessment of clinical trial results; (2) there can be no assurance of FDA approval to market ERGOSET for Type II diabetes or any other indication or that the FDA will not require additional clinical trials of ERGOSET; (3) uncertainty related to the scientific development of a new medical therapy; (4) competition in the anti-diabetic market is intense and other products have been recently approved by the FDA to treat Type II diabetes; (5) the need for additional funding; (6) the uncertainty relating to patent protection in the pharmaceutical and biotechnology industries; and (7) there can be no assurance that the Company will be able to establish corporate alliances to market ERGOSET and assist with the development of product candidates. Further information and additional important factors are set forth in the section entitled "Item 1. Business - Risk Factors". The Company does not undertake to update any forward-looking statement that may be made from time to time by or on behalf of the Company. ERGOSET has not been cleared for marketing by the FDA and is being investigated for use in Type II diabetes pursuant to an Investigational New Drug exemption.
OVERVIEW
Since inception, the Company has been engaged in the discovery and development of novel treatments for metabolic disorders, including Type II diabetes and obesity, and various cancers. The Company's technology, based on the principals of chronobiology, uses the timed administration of oral drugs to modulate the body's neuroendocrine activity. The Company has dedicated most of its financial resources to ERGOSET research and development, general and administrative expenses, and the prosecution of patents and patent applications. To date, the Company has not received any revenues from the sale of products and does not expect to generate such revenues for at least a couple of years, if at all. The Company has been unprofitable since its inception, and the Company's accumulated deficit was $59,061,288 as of December 31, 1996. Although the Company intends to enter into collaborative relationships, it expects to incur substantial and increasing expenses for at least the next several years, due primarily to the expansion of its research and development programs, including preclinical studies and clinical trials. The Company expects that losses will fluctuate from quarter to quarter and that the fluctuations may be substantial.
RESULTS OF OPERATIONS
Years ended December 31, 1995 and 1996
Total revenues increased from $94,348 in 1995 to $1,397,521 in 1996. Revenues were derived primarily from interest income earned on cash, cash equivalents and short-term investments. The increase in interest income is attributable to an increase in the average amounts of cash, cash equivalents and short-term investments during 1996, compared to 1995. The amounts increased as a result of proceeds received from the Company's initial public offering in December 1995 and second public offering in August 1996.
Research and development expenses decreased from $15,663,990 in 1995 to $12,441,228 in 1996. The decrease was due to the reduction of in-process research and development purchases which totaled $7,020,064 and $168,750 in 1995 and 1996, respectively. Excluding the purchases of in-process research and development, expenses increased $3,628,552. The increases were principally the result of greater expenses related to Phase III clinical trials for ERGOSET, continued progress on several earlier stage research programs including those in metastatic breast cancer and photodynamic therapy, and the hiring of additional research personnel.
General and administrative expenses decreased from $6,580,308 in 1995 to $6,139,072 in 1996. The decrease was principally due to a net charge of $1,747,931 in 1995 related to a renegotiated supply agreement. Excluding this nonrecurring, noncash charge, general and administrative expenses increased $1,306,695. The increase in 1996 was due
to a $1,277,980 charge related to the resignation of a Company senior executive, and the hiring of additional administrative personnel. The increase was partially offset by a reduction in legal costs.
Net loss decreased from $22,149,950 in 1995 to $17,182,779 in 1996. The decrease was mainly due to costs associated with the purchase of in-process research and development and the renegotiated supply agreement noted above. Net loss to common stockholders decreased from $31,960,562 to $17,620,111. This decrease was primarily due to a $7,123,536 noncash charge in 1995 related to a preferred stock dividend, in addition to the reduction in costs associated with the purchase of in-process research and development and the renegotiated supply agreement. Net loss per common share decreased from $8.06 to $1.57 in 1995 and 1996, respectively. The decrease was due to the decreased net loss to common stockholders and increased weighted average shares outstanding which totaled 3,966,266 in 1995 and 11,248,315 in 1996.
In the first quarter of 1997, the Company will record a charge of approximately $925,000 for severance payments to be made to the former Chairman of the Board of Directors, officer and employee of the Company. Of the total estimated charge, $450,000 is noncash and the remainder will be paid over a 20 month period.
Years ended December 31, 1994 and 1995
Total revenues declined from $214,916 in 1994 to $94,348 in 1995. Revenues were derived primarily from interest income earned on cash and cash equivalents. The decrease in interest income is attributable to a decrease in the average amounts of cash and cash equivalents during 1995, compared to 1994, as cash was used to fund the Company's operations.
Research and development expenses increased from $4,917,830 in 1994 to $15,663,990 in 1995. The increase was principally the result of greater expenses related to clinical trials of ERGOSET, the purchase of in-process research and development, a license payment to LSU, and preclinical studies.
General and administrative expenses increased from $4,256,934 in 1994 to $6,580,308 in 1995. The increase was principally due to a net charge of $1,747,931 related to a renegotiated supply agreement, non-recurring charges in connection with the termination of a manufacturing agreement, the settlement of litigation, and the hiring of additional administrative personnel.
Net loss increased from $8,959,848 in 1994 to $22,149,950 in 1995. Net loss to common stockholders increased from $9,893,064 to $31,960,562 while net loss per common share increased from $2.56 to $8.06 in 1994 and 1995, respectively.
NET OPERATING LOSS CARRYFORWARD
At December 31, 1996, the Company's reported federal net operating loss carryforwards were approximately $45 million. If not used, the tax loss carryforwards will begin to expire in 2007. The Company's ability to use these carryforwards is subject to limitations resulting from an ownership change as defined in Code sections 382 and 383. See Note 6 of Notes to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company's primary source of cash has been from financing activities which have consisted of private placements of equity securities and two public offerings. Private placements of equity securities through December 31, 1996, provided the Company with aggregate proceeds of $32,999,000. On December 19, 1995, the Company raised $23,030,476 from the sale of stock in an initial public offering, net of commissions and offering costs. Subsequently, on August 14, 1996, the Company raised an additional $32,218,487, net of commissions and offering costs, from the sale of stock in a second public offering. Cash and cash equivalents were $15,896,373 and $18,066,884, while short-term investments were $6,325,502 and $20,550,986, at December 31, 1995 and 1996, respectively. The increases in cash and cash equivalents and short-term investments at December 31, 1996, were due primarily to the proceeds from the second public offering.
The Company's primary use of cash to date has been in operating activities to fund research and development, including preclinical studies and clinical trials, and general and administrative expenses. During 1996, the Company conducted clinical trials of its lead drug candidate, ERGOSET, for the treatment of Type II diabetes, and a two drug
combination for the treatment of breast cancer. On July 18, 1996, the Company announced the results from two Phase III trials of ERGOSET as adjunctive therapy with sulfonylurea agents in the treatment of Type II diabetes. The analysis of the results of these two Phase III trials indicated that ERGOSET improved control of HbA\\1c\\, glucose, triglycerides and free fatty acids in Type II diabetics. The analysis also showed that ERGOSET was generally well-tolerated. On December 20, 1996, the Company announced statistically significant results in its third Phase III trial of ERGOSET as monotherapy treatment of Type II diabetes. This monotherapy study was the final in a group of three double- blinded, placebo-controlled Phase III clinical trials. With the results from the three Phase III clinical trials, the Company conducted a pre-NDA meeting with the FDA on March 20, 1997, and plans to submit an NDA in mid-1997. During this time period, the Company will be actively seeking corporate alliances to market ERGOSET and assist with the development of product candidates. The breast cancer clinical trial currently being conducted by the Company is an open label Phase II study and results from this study are not expected to be released until 1998.
As of December 31, 1996, the Company's net investment in equipment and leasehold improvements was $2,491,866. The Company expects that additional equipment and facilities will be needed as it increases its research and development activities.
The Company believes that its available cash, cash equivalents, short-term investments and expected interest income, will be adequate to fund its current and anticipated levels of operations through mid-1998. Prior to that time, the Company will need to raise additional capital through the sale of securities in the public or private equity markets or by entering into a collaborative arrangement with another company. There can be no assurance, however, that events in the Company's research and development programs or other events affecting the Company's operations will not result in accelerated or unexpected expenditures. The Company is pursuing additional research and development of ERGOSET and other product candidates to treat obesity, breast cancer and other diseases. The Company will require additional financing to expand and complete that research and development. To the extent the Company raises additional capital by issuing equity securities, ownership dilution to existing stockholders will result and future investors may be granted rights superior to those of existing stockholders. There can be no assurance, however, that additional financing will be available from any source or, if available, will be available on acceptable terms.
The terms of the Company's Series D Preferred Stock prohibit the Company from paying dividends on the common stock.
ITEM 8.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Ergo Science Corporation (A Development Stage Enterprise):
We have audited the accompanying consolidated balance sheets of Ergo Science Corporation (the "Company") (a development stage enterprise) as of December 31, 1996 and 1995 and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1996 and the period cumulative from inception (January 23, 1990) to December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ergo Science Corporation as of December 31, 1996 and 1995, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 and the period cumulative from inception (January 23, 1990) to December 31, 1996, in conformity with generally accepted accounting principles.
COOPERS & LYBRAND L.L.P.
Boston, Massachusetts February 28, 1997
ERGO SCIENCE CORPORATION (A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of the consolidated financial statements
ERGO SCIENCE CORPORATION (A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of the consolidated financial statements
ERGO SCIENCE CORPORATION (A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of the consolidated financial statements
ERGO SCIENCE CORPORATION (A DEVELOPMENT STAGE ENTERPRISE)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
The accompanying notes are an integral part of the consolidated financial statements
ERGO SCIENCE CORPORATION (A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES
Organization
Ergo Science Development Corporation ("Ergo") was incorporated on January 23, 1990. Ergo operated as an S Corporation from inception to September 30, 1992, when it converted to a C Corporation. In April 1995, Ergo went through a recapitalization whereby all the stock of Ergo was exchanged on a one- for-one basis for an equal amount of stock in Ergo Science Holdings, Incorporated, previously a wholly-owned subsidiary of Ergo. Subsequent to the recapitalization, Ergo Science Holdings, Incorporated changed its name to Ergo Science Corporation (the "Company"). The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. All intercompany accounts and transactions are eliminated upon consolidation.
The Company is a development stage enterprise as defined in Statement of Financial Accounting Standards No. 7, and is devoting substantially all of its efforts to conducting research and development and raising capital to fund operations. The ultimate success of the Company is dependent upon the development and marketing of its products and its ability to secure adequate financing until the Company is operating profitably.
Research and Development Costs
Research and development costs are expensed as incurred.
Cash Equivalents and Investments
The Company considers all highly liquid investments with a maturity of 90 days or less at the date of purchase to be cash equivalents.
Debt securities are classified as held-to-maturity when the Company has positive intent and ability to hold the securities to maturity. Held-to- maturity securities are stated at amortized cost.
At December 31, 1996 and 1995 cash equivalents were composed primarily of investments in money market funds and held-to-maturity securities with original maturities of 90 days or less. Due to the nature of these securities, there were no unrealized gains or losses at the balance sheet dates. These investments consisted of United States Government obligations and high grade commercial paper and asset backed securities that mature within 90 days of purchase.
Concentration of Credit Risk
The Company has not realized any losses on its investments. The Company has invested the net proceeds of its public offerings in short-term, interest-bearing, investment-grade securities, including U.S. Treasury and agency securities and high-grade corporate notes.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that effect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statement and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates.
Uncertainties
The Company is subject to risks common to companies in the Pharmaceutical Industry including, but not limited to, development by the Company or its competitors of new technological innovations, dependence on key personnel, protection of proprietary technology, and compliance with FDA governmental regulations.
Net Loss Per Common Share
Net loss per common share is computed based upon the weighted average number of common shares and common equivalent shares (using the treasury stock method) outstanding after certain adjustments described below. Common equivalent shares are not included in the per share calculations where the effect of their inclusion would be anti-dilutive, except that, in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 83, all common and common equivalent shares issued during the twelve-month period prior to the filing of the initial public offering, even when antidilutive, have been included in the calculation as if they were outstanding for all periods through September 30, 1995, using the treasury stock method. In the computation of net loss per common share, accretion of preferred stock to the redemption amount is included as an increase to net loss available to common stockholders.
Fully diluted net loss per common share is the same as primary net loss per common share.
Equipment and Leasehold Improvements
Equipment and leasehold improvements are stated at cost. Depreciation is calculated using straight-line basis over a 2 to 7 year estimated useful life. Leasehold improvements are amortized over the shorter of the life of the leases or the estimated useful life of the related assets. Repairs and maintenance costs are charged to expense as incurred. Upon retirement or sale, the cost of the assets disposed of and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in the determination of net income.
Capital Leases
Assets and liabilities relating to capital leases are recorded at the present value of the future minimum rental payments using interest rates appropriate at the inception of the lease. Capital lease amortization is included with depreciation and amortization expense.
Organization Costs
Certain costs associated with organizing the Company had been capitalized and were being amortized on a straight-line basis over a period of five years. All capitalized organization costs were fully amortized as of December 31, 1995.
Income Taxes
Deferred tax liabilities and assets are recognized based on temporary differences between the financial statement basis and tax basis of assets and liabilities using current statutory tax rates. A valuation allowance against net deferred tax assets is established if, based on the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. See Note 6.
Recent Accounting Pronouncements
In 1997, the Financial Accounting Standards Board ("FASB") released the Statement of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings per Share". SFAS 128 simplifies the standards for computing earnings per share ("EPS") and makes them comparable to international EPS standards. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basis and diluted EPS on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. SFAS 128 is effective for financial statements issued for periods ending after December 15, 1997, including interim periods. SFAS 128 requires restatement of all prior- period EPS data presented. Management has not yet determined the impact of SFAS 128 on the Company's financial statements.
2. SHORT-TERM INVESTMENTS
The following is a summary of held-to-maturity securities not classified as cash and cash equivalents as of December 31:
Since held-to-maturity securities are short-term in nature, changes in market interest rates would not have a significant impact on fair value of these securities. These securities are carried at amortized cost which approximates fair value. All short-term investments mature within 83 days of December 31, 1996.
3. EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Equipment and leasehold improvements consist of the following at December 31:
Depreciation expense for the years ended December 31, 1996, 1995 and 1994 was $1,094,748, $802,275, and $522,920, respectively.
In July 1996, the Company entered into a sale lease-back agreement which included $549,718 in furniture and office and lab equipment. Assets under capital leases, net of accumulated amortization at December 31, 1996 and 1995 were $598,786 and $127,280, respectively.
4. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consist of the following at December 31,
5. LEASES
The Company leases office and research space and office equipment under operating lease arrangements which expire on various dates through the year 2000. Certain operating lease arrangements include options to renew for additional periods or payment terms that are subject to increases due to taxes and other operating costs of the lessor. In addition, the Company leases certain equipment under lease arrangements which have been accounted for as capital leases. Future minimum commitments, by year and in the aggregate, under these long-term noncancelable leases consist of the following at December 31, 1996:
Rent expense for the years December 31, 1996, 1995 and 1994 amounted to $657,574, $251,637, and $247,930, respectively.
Cash paid for interest on capital leases was $51,206, $13,908, and $2,023 in 1996, 1995 and 1994, respectively.
6. INCOME TAXES
Significant components of the Company's deferred tax assets and liabilities as of December 31 are as follows:
The change in the total valuation allowance for the years ended December 31, 1996 and 1995 were increases of $6,547,000 and $6,092,000, respectively.
As of December 31, 1996, the Company had net operating loss carryforwards for income tax purposes of approximately $45 million which expire through 2010. The Company's ability to use the carryforwards is subject to limitations resulting from an ownership change as defined in Internal Revenue Code Sections 382 and 383.
7. CAPITAL STOCK
In October 1995, the Board of Directors increased the number of authorized shares of common stock to 50,000,000 and the authorized number of shares of preferred stock to 10,000,000. The Board of Directors may establish, without stockholder approval, one or more classes or series of preferred stock having the number of shares, designations, relative voting rights, dividend rates, liquidation and other rights, preferences and limitations that the Board of Directors may designate. Also in October 1995, the Company effected a 25-for-1 stock split and converted all shares of the Company's Class A Common Stock and Class B Common Stock into one class of common stock. Accordingly, all share and per share amounts reflect the stock splits and the Class A/Class B conversion as though they had occurred at the beginning of the initial period presented.
On September 10, 1992, the Company issued $3,500,000 principal amount of Series A 6% convertible notes for cash at face value. On October 12, 1993, the Company converted the $3,500,000 of Series A 6% convertible notes into 8,826 shares of Voting Series A 6% Redeemable Convertible Preferred Stock, $.01 par value, with a stated value of $3,730,750. In connection therewith, the Company recognized a charge to expense of $48,458 representing the remaining unamortized balance of the deferred issuance costs.
On October 12, 1993, the Company sold 20,940 shares of Voting Series B 6% Redeemable Convertible Preferred Stock, $.01 par value, for an aggregate amount of $10,041,986.
On July 15, 1994, the Company sold 6,255 shares of Voting Series C 6% Redeemable Convertible Preferred Stock, $.01 par value, for an aggregate amount of $2,999,605.
Each share of Series A, Series B, and Series C Redeemable Convertible Preferred Stock (the "Preferred Stock") was convertible, at the option of the stockholder, into common stock by dividing the stated value for each share adjusted
for unpaid and undeclared dividends (in effect at the time) by the conversion price (in effect at the time). The conversion price of the Preferred Stock was subject to adjustment under certain conditions identified in the agreement, and automatically converted upon the closing of the public offering into shares of common stock of the Company, at the conversion price in effect at the time.
The holders of Preferred Stock were also entitled to voting rights equal to the number of common shares into which the preferred shares would have been converted into at the time. The holders of Series A and Series C Preferred Stock each had the right to elect one member to the Board of Directors. The holders of Series B Preferred Stock had the right to elect two members to the Board of Directors. Such voting power terminated upon the public offering.
The holders of Preferred Stock were entitled to receive quarterly cash dividends at a rate of 6% per annum, compounded semi-annually, on the stated value thereof, commencing November 1, 1993, for Series A and Series B Preferred Stock and August 1, 1994 for Series C Preferred Stock. Accumulated and unpaid dividends were accreted and charged to cumulative dividends on redeemable preferred stock. Such dividends were cumulative, commencing on the date of original issue, and payable to holders of record when and as declared by the Board of Directors. The dividend value of the Preferred Stock was $31.64, $35.83 and $13.22 per share for Series A, Series B and Series C Preferred Stock, respectively, at December 31, 1994. Unpaid and undeclared dividends to holders of Preferred Stock amounting to $509,525, $750,373 and $82,675 for Series A, Series B and Series C, respectively, had been accreted in cumulative dividends on redeemable preferred stock at December 31, 1994.
In the event of liquidation, the holders of Preferred Stock were entitled to be paid a liquidation amount equal to the greater of the conversion amount per share at the time or the stated value per share at the time. As of December 31, 1994, the aggregate liquidation values, of the Series A, Series B and Series C Preferred Stock were $4,009,525, $10,792,359 and $3,082,325, respectively.
On April 27, 1995, in connection with a revised license and royalty agreement negotiated with Louisiana State University (LSU), the Company issued 125,000 shares of common stock to certain inventors, including two members of the Company's Board of Directors. The shares were issued in exchange for the inventors' share of the royalty obligation the Company has under the royalty agreement with LSU. Accordingly, the Company recorded a $2,000,000 charge for the purchase of in-process research and development.
On May 30, 1995, the Company sold 10,426 shares of Series C Redeemable Convertible Preferred Stock, par value $.01, for $4,999,892.
On September 1, 1995, the Series A, Series B and Series C Redeemable Convertible Preferred Stock designations were amended. The effect of this amendment was to cancel the accretion of dividends on the Series A Preferred Stock since its issuance on October 13, 1993, and the accretion on Series B and Series C Preferred Stocks since their issuance and to reset the stated value at September 1, 1995 to the original stated value of each series. The Company re- commenced accreting dividends on September 1, 1995. In connection with these amendments, the Company recorded a preferred stock dividend in the amount of $7,123,536 which reflects the difference between the $9 per share fair market value of the Company's common stock on the date of amendments and the $6.41 per share amended weighted average conversion price of the Series A, B and C Preferred Stock, multiplied by the number of additional shares of common stock those preferred stockholders received upon conversion.
In September 1995, the Company obtained a loan commitment from the holders of the Series A, B and C Redeemable Convertible Preferred Stock for an amount up to $6,000,000. The Company received an initial advance against this commitment of $1,000,000 and had the option to draw further advances in installments of $1,000,000. Outstanding amounts bore interest at 10% and would mature at the earlier of the closing of a private placement, the closing of an initial public offering (IPO), or January 31, 1996. Upon the maturity of the outstanding amounts which resulted from the closing of the IPO the Company issued the investors 451,767 shares of common stock of the Company equal to the outstanding amount, $4,065,949 divided by $9.00 per share in full satisfaction of amounts under the loan.
On December 19, 1995, the Company completed its IPO and sold an aggregate of 2,875,000 shares of common stock at $9.00 per share resulting in net proceeds, after deducting underwriting discounts and offering costs, of
$23,030,476. In addition, upon the closing of the IPO, the Series A, B and C Preferred Stock including all applicable dividends accreted in cumulative dividends on redeemable preferred stock since September 1, 1995, were automatically converted into shares of common stock in accordance with the underlying agreements.
On August 14, 1996, the Company completed a second public offering and sold an aggregate of 2,842,706 shares of common stock at $12.25 per share resulting in net proceeds, after deducting underwriting discounts and offering costs, of $32,218,487.
See Note 8 for a description of Series D Preferred Stock.
8. LICENSE AGREEMENTS AND SUPPLIER CONTRACTS
In the fall of 1991, the Company entered into an exclusive licensing arrangement with an investment group organized in New England (the New England Group). Under the terms of this arrangement, a partnership (The New England Venture) organized by the investment group acquired an exclusive license arrangement to commercialize the Company's products and medical protocols in the six New England States. In the spring of 1992, the Company, the New England Group, and a group of investors in Florida organized a partnership (the Florida Venture) to commercialize the Company's products and medical protocols in the state of Florida. The Company entered into a license arrangement with the Florida Venture to commercialize the products and medical protocols in Florida.
In the fall of 1992, the Company organized a partnership to commercialize the Company's products and medical protocols in the state of Louisiana (the Louisiana Venture). The Company entered into a license arrangement with the Louisiana Venture to commercialize the products and medical protocols in Louisiana.
During 1991 and 1993, the Company received fees from two suppliers for the exclusive right to supply the Company with certain drug products. In exchange, the Company agreed to purchase all of its drug requirements from the suppliers at agreed upon prices.
$1,950,000 of the license fees and $1,750,000 of the supplier contracts fees received by the Company were characterized as nonrefundable in the respective agreements. Through December 31, 1992, such nonrefundable fees were recognized as revenue over the period from receipt of funds to the estimated date of FDA approval because of the Company's obligations to perform research and sponsor clinical trials prior to that approval. However, during 1993 the Company began discussions with the sublicensees about exchanging their sublicense rights for the Company's common stock. The Company also began discussions with suppliers to renegotiate the supply contracts to fit more closely the redesigned plan for commercialization of its products. Therefore, no additional deferred revenue from sublicensing fees and from supplier contracts had been recognized in 1994 and 1993.
Effective January 1, 1995, the Company renegotiated the contract with one of its drug suppliers. In recognition of the supplier's initial contribution of its supply agreement fee to fund the Company's drug development efforts, the Company issued 156,400 shares of common stock, par value $.01. The Company assigned a value of $16 per share; the value assigned in excess of the unamortized deferred revenue from the fees previously received resulted in a net charge to operations of $1,089,356 in January 1995. The Company subsequently issued an additional 73,175 shares of common stock to the supplier under antidilution provisions of the renegotiated agreement, which resulted in a net charge to operations of $658,575 in November 1995.
In September 1995, the Company terminated its manufacturing agreement with the other drug supplier and recorded a charge of $215,385 for a cash payment to that supplier.
In April 1995, the Company went through a recapitalization whereby all the stock of the Company was exchanged on a one-for-one basis for an equal amount of stock in Ergo Science Holdings, Incorporated, previously a wholly-owned subsidiary of the Company. Subsequent to the recapitalization, Ergo Science Holdings, Inc. changed its name to Ergo Science Corporation.
As a result of the redesigned plan for commercialization of the Company's products, territorial sublicenses were no longer commercially feasible for the partnerships. Accordingly, on April 27, 1995, the Company effectively canceled the partnership sublicenses by acquiring all the partners' interests in the New England Venture, the Florida Venture and the Louisiana Venture. Rather than return the sublicense fees, including both the refundable and unamortized nonrefundable portions originally contributed by the partnerships, the Company issued 278,875 shares of common stock and 5,618 shares of Series D Exchangeable Preferred Stock (the "Series D Preferred Stock"), par value $.01. The Company ascribed a value of $16 per share to the common stock issued and $584 per share of Series D Preferred Stock. The excess of fair value of the stock issued over the related unamortized deferred revenue resulted in a net charge to operations of $3,520,000 for the purchase of in-process research and development.
The holders of Series D Preferred Stock are also entitled to receive quarterly cash dividends at a rate of 6% per annum compounded semiannually on the stated value. Such dividends shall be cumulative, commencing on the date of original issue, and shall be payable to holders of record, when and as declared, by the Board of Directors. The Company will have the option to convert the Series D Preferred Stock into common stock during the 90 days after the Company receives FDA approval to market its first product, if it receives that approval. If the Company does not exercise its option to convert the Series D Preferred Stock into common stock within the 90 days, the Series D Preferred Stock will automatically be exchanged for subordinated debt securities at the end of the 90 days. The Company currently intends to exercise its option to convert the Series D Preferred Stock to common stock if it receives FDA approval, and, accordingly, the Series D Preferred Stock was recharacterized as Preferred Stock upon closing of the IPO. The Series D Preferred Stock is carried at face value plus accrued unpaid dividends. The terms of the Company's Series D Preferred Stock prohibit the Company from paying dividends on the common stock.
On April 27, 1995, in conjunction with the recapitalization, the Company also sold 1,285 shares of the Series D Preferred Stock, par value $.01 and 33,400 shares of common stock, par value $.01, for $1,285,000.
In November 1995, the Company declared a dividend of 224,307 common shares to the holders of Series D Preferred Stock and, accordingly, recorded a charge in the fourth quarter of $2,018,763 to net loss to common stockholders.
On December 19, 1995, upon completion of the Company's IPO, the Series D Preferred Stock was no longer redeemable at the holder's option.
On December 19, 1996, the one year anniversary of the IPO, the Company issued 18,750 common shares to LSU in conjunction with a novative license and royalty agreement and, accordingly, recorded a charge of $168,750. See Note 10 for a description of the novative license and royalty agreement.
9. STOCK OPTIONS AND INCENTIVE PLAN
The Company has granted options to purchase shares of common stock to key employees and directors. The options vest over periods of up to four years and expire at various dates through December 27, 2006.
Statement of Financial Accounting Standards No. 123, "Accounting for Stock- Based Compensation" ("SFAS 123") requires that companies either recognize compensation expense for grants of stock, stock options, and other equity instruments based on fair value, or provide pro forma disclosure of net income or loss and earnings or loss per share in the notes to the financial statements. The Company has adopted the disclosure provisions of SFAS 123 in 1996 and has applied APB Opinion 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option plans. The effects of applying SFAS 123 in this pro forma disclosure are not likely to be representative of the effects on reported income or loss for future years. SFAS 123 does not apply to awards prior
to 1995 and additional awards in future years are anticipated. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates as calculated in accordance with SFAS 123, the Company's net loss and loss per share for the years ended December 31, 1996 and 1995 would have been increased to the pro forma amounts indicated below:
The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: an expected life of 5 years, expected volatility of 44%, a dividend yield of 0% and a weighted average risk-free interest rate of 6.56% for 1996 and 5.85% for 1995. The fair value of options granted in 1996 and 1995 was $3,695,732 and $2,518,965, respectively.
In October 1995, the Company granted to various employees options to purchase 621,625 shares of common stock at $6.71 per share. Deferred compensation of $1,423,521 related to those option grants is being amortized to operations over the four-year vesting period of the options.
In December 1995, the Company issued to its financial advisor, at the closing of the IPO, an option exercisable for three years to acquire 20,000 shares of common stock with an exercise price per share equal to the IPO price per share.
In December 1995, the Company granted one of its medical advisors an option to purchase 10,000 shares of common stock at an exercise price equal to the IPO price per share. One quarter of these shares vested on the grant date and the balance will vest over three years.
During 1996, the Company granted to various employees options to purchase 711,395 shares of common stock at exercise prices ranging from $6.71 to $23.50 per share. Of the total number of options issued in 1996, 433,550 were issued at prices equal to the market prices on the grant dates. The remaining 277,845 options were granted at prices below market. Of those options granted at prices below market, 220,000 were issued in conjunction with the resignation of a Company senior executive. In connection with the issuance of these options, the Company recorded compensation expense of $1,030,981.
Information related to stock option activity for the period from inception to December 31, 1996 is as follows:
The following table summarizes information about stock options outstanding at December 31, 1996:
At December 31, 1996 there were 1,664,200 options at an average price of $6.59 outstanding of which 725,895 options were exercisable. In connection with the issuance of stock options at exercise prices below fair market value, as determined by the Company's Board of Directors, the Company recorded compensation expense of $2,015,251, $490,961 and $253,492 in 1996, 1995 and 1994, respectively. In 1996, fair market value was based on market price. The $1,172,374 remaining deferred compensation at December 31, 1996 will be amortized over the vesting periods of the underlying options.
Effective as of November 1, 1994, the Board of Directors adopted the Ergo Science Development Corporation Long-Term Incentive Plan (the "Incentive Plan") pursuant to which certain officers, directors, and key employees may be granted awards with respect to shares of the Company's common stock. The awards which may be granted under the Incentive Plan include incentive stock options, nonstatutory options, stock appreciation rights (SARs) and restricted stock awards. At December 31, 1996 and 1995, the aggregate number of shares of the Company's common stock which may be issued pursuant to incentive awards under the Incentive Plan were 1,431,525 and 731,525 shares, respectively (for
which common shares have been reserved). Awards of options to provide 661,395, 631,625 and 7,500 shares at exercise prices of $6.71-$23.50, $6.71-$9.00 and $0.80 per share, respectively, were granted under the Incentive Plan in 1996, 1995 and 1994, respectively. These amounts are included in the tables above.
On May 15, 1996, the Board of Directors approved, subject to stockholder approval, a proposal to adopt a Stock Option Plan for Non-Employee Directors of the Company (the "Director Stock Plan"). The Director Stock Plan provides for an initial grant of an option to purchase 10,000 shares of common stock to each eligible non-employee director upon first being elected or appointed to serve on the Board of Directors. Those eligible directors already serving at the time the Director Stock Plan approved by the stockholders of the Company were each granted a stock option to purchase 10,000 shares of common stock with a deemed date of grant of May 15, 1996. If a director remains eligible to receive stock options under the Director Stock Plan on the second anniversary of the date that a director is first granted a stock option under the Director Stock Plan, that director will be granted a second stock option to purchase 10,000 shares of common stock. Stock options granted under the Director Stock Plan will vest and become exercisable in equal increments on the first and second anniversary of their date of grant, but no stock options may be exercised more than ten years after the date of its grant. The Director Stock Plan was approved by the stockholders at the Company's 1996 Annual Meeting which took place on June 25, 1996. In conjunction with the approval of the Director Stock Plan, options were granted to purchase 20,000 shares of common stock at an exercise price of $21.13. In addition, options to purchase 10,000 shares were issued to each of the three newly appointed Directors in the second half of 1996. Exercise prices range from $12.75 to $13.75 per share. These amounts are included in the tables above.
10. COMMITMENTS AND CONTINGENCIES
The Company has a royalty agreement with LSU under which the Company pays LSU a royalty based upon gross sales. The Company also has a commitment to make payments of an agreed percentage of net cash flow to LSU once the Company generates positive net cash flow, as defined. LSU is obligated to expend substantially all of such net cash flow payments from the Company on research supervised by one of the Company's consultants (or the Company's designee), and the Company has the option of licensing any patents that arise from such research.
On May 1, 1995, Ergo Research Corporation, a wholly-owned subsidiary of the Company, entered into a novative license and royalty agreement with LSU that replaces the royalty agreement with LSU described in the prior paragraph. In conjunction with the new agreement an initial fee of $200,000 was paid to LSU upon execution, $500,000 was paid upon the initial public offering of the common stock of the Company in December 1995 and 18,750 common shares with a fair value of $168,750 were issued one year after that offering in December 1996. These costs were charged to operations in the periods indicated as the purchase of in-process research and development. The agreement also requires additional fees of $350,000 for the first and $500,000 for all subsequent administrative approvals of licensed pharmaceutical products. The Company must pay LSU a royalty based upon gross sales with minimum royalties due.
11. NONCASH INVESTING AND FINANCING ACTIVITIES
Certain capital lease obligations are considered noncash items and, accordingly, are not reflected in the consolidated statements of cash flows. Noncash capital lease obligations of $58,290 and $123,502 were incurred in 1995 and 1994, respectively, when the Company entered into leases for lab and office equipment. In 1996, the Company entered into a sale lease-back agreement which resulted in the receipt of $549,718 in cash proceeds. See Note 3.
12. SUBSEQUENT EVENTS
Effective February 1, 1997, the Company implemented a deferred compensation plan under Section 401(k) of the Internal Revenue Code (the "401k Plan"). Under the 401k Plan, eligible employees are permitted to contribute, subject to certain limitations, up to 20% of their gross salary. The Company makes a matching contribution which currently totals 50% of the employee's contribution, up to a maximum amount equal to the lesser of $2,500 or 6% of the employees gross salary.
13. EVENTS SUBSEQUENT TO THE DATE OF THE ACCOUNTANT'S REPORT (UNAUDITED)
In the first quarter of 1997, the Company will record a charge of approximately $925,000 for severance payments to be made to the former Chairman of the Board of Directors, officer and employee of the Company. Of the total estimated charge, $450,000 is noncash and the remainder will be paid over a 20 month period.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES.
None
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth under the heading "Directors and Executive Officers" contained in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A in connection with the Company's 1997 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
The information set forth under the heading "Management Compensation", "Performance Graph" and "Compensation Committee Report on Executive Compensation" contained in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A in connection with the Company's 1997 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the heading "Security Ownership of Certain Beneficial Owners and Management" contained in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A in connection with the Company's 1997 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the heading "Certain Relationships and Related Transactions" contained in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A in connection with the Company's 1997 Annual Meeting of Stockholders is incorporated herein by reference.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Charlestown and State of Massachusetts on March 31, 1997.
ERGO SCIENCE CORPORATION
By: /s/ Alan T. Barber ------------------------------- Alan T. Barber
Vice President, Finance and Administration and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated.
INDEX TO EXHIBITS