K2M Group Holdings, Inc.
K2M GROUP HOLDINGS, INC. (Form: 424B4, Received: 05/09/2014 11:01:05)
Table of Contents

Filed Pursuant to Rule 424(b)(4)
Registration No. 333-194550

 

 

8,825,000 Shares

 

K2M GROUP HOLDINGS, INC.

 

Common Stock

 

$15.00 per share

  LOGO

 

 

 

•       K2M Group Holdings, Inc. is offering 8,825,000 shares.

 

•       This is our initial public offering and no public market currently exists for our shares.

•       The initial public offering price is $15.00 per share.

 

•       Our common stock has been approved for listing on the NASDAQ Global Select Market, or NASDAQ under the trading symbol “KTWO.”

 

 

After the completion of this offering, Welsh, Carson, Anderson & Stowe XI, L.P. and its affiliates will continue to own a majority of the shares eligible to vote in the election of our directors. As a result, we will be a “controlled company.” See “Management—Director Independence.”

This investment involves risks. See “ Risk Factors ” beginning on page 13.

We are an “emerging growth company” as defined by the Jumpstart Our Business Startups Act of 2012 and, as such, we have elected to comply with certain reduced public company reporting requirements for this prospectus and future filings.

 

 

 

     Per Share      Total  

Initial public offering price

   $ 15.00       $ 132,375,000   

Underwriting discounts (1)

   $ 1.05       $ 9,266,250   

Proceeds, before expenses, to K2M Group Holdings, Inc.

   $ 13.95       $ 123,108,750   

 

 

 

(1)  

See “Underwriting” for additional information regarding underwriting compensation.

The underwriters have a 30-day option to purchase up to 1,323,750 additional shares of common stock from the selling stockholders identified in this prospectus to cover over-allotments, if any. We will not receive any proceeds from the sale of shares of common stock by the selling stockholders.

Neither the Securities and Exchange Commission nor any state securities commission has approved of anyone’s investment in these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

Piper Jaffray      Barclays        Wells Fargo Securities   

 

 

 

William Blair

Cowen and Company

The date of this prospectus is May 7, 2014.


Table of Contents

LOGO


Table of Contents

TABLE OF CONTENTS

 

Summary

     1   

Risk Factors

     13   

Forward-Looking Statements

     57   

Trademarks and Service Marks

     57   

Industry and Market Data

     57   

Use of Proceeds

     58   

Dividend Policy

     59   

Capitalization

     60   

Dilution

     62   

Selected Historical Consolidated Financial Data

     64   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     66   

Business

     88   

Management

     117   

Executive Compensation

     122   

Principal and Selling Stockholders

     135   

Certain Relationships and Related Party Transactions

     138   

Description of Capital Stock

     142   

Shares Eligible for Future Sale

     150   

Material United States Federal Income and Estate Tax Consequences to  Non-U.S. Holders

     152   

Underwriting

     155   

Legal Matters

     163   

Experts

     163   

Where You Can Find More Information

     163   

Index to Consolidated Financial Statements

     F-1   

 

 

Unless indicated otherwise, the information included in this prospectus (1) assumes no exercise by the underwriters of the option to purchase up to an additional 1,323,750 shares of common stock from the selling stockholders, (2) reflects the automatic conversion of all of our Series A redeemable convertible preferred stock, $0.001 par value, or our Series A Preferred, and our Series B redeemable convertible preferred stock, $0.001 par value, or our Series B Preferred, into our common stock immediately prior to consummation of this offering and (3) reflects the 2.43 -for- 1.00 reverse stock split effectuated on May 7, 2014.

 

 

We have not authorized anyone to provide any information or to make any representations other than those contained in this prospectus or in any free writing prospectuses we have prepared. We take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. This prospectus is an offer to sell only the shares offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus is current only as of its date.

 

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SUMMARY

This summary highlights information contained elsewhere in this prospectus and does not contain all of the information you should consider before investing in shares of our common stock. You should read this entire prospectus carefully, including the sections entitled “Risk Factors,” “Selected Historical Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the financial statements and the related notes included elsewhere in this prospectus, before you decide to invest in shares of our common stock.

Except where the context requires otherwise, references in this prospectus to “K2M,” “the Company,” “we,” “us” and “our” refer to K2M Group Holdings, Inc., together with its consolidated subsidiaries. Welsh, Carson, Anderson & Stowe XI, L.P. and certain of its affiliated funds, our current majority owners, are referred to herein as “WCAS” or “our Sponsor,” and WCAS, together with the other owners of K2M Group Holdings, Inc. prior to this offering, are collectively referred to as our “existing owners.”

Overview

We are a global medical device company focused on designing, developing and commercializing innovative and proprietary complex spine technologies and techniques. Our complex spine products are used by spine surgeons to treat some of the most difficult and challenging spinal pathologies, such as deformity (primarily scoliosis), trauma and tumor. We believe these procedures typically receive a higher rate of positive insurance coverage and often generate more revenue per procedure as compared to traditional degenerative spine surgery procedures. We have applied our product development expertise in innovating complex spine technologies and techniques to the design, development and commercialization of an expanding number of minimally invasive surgery, or MIS, products. These proprietary MIS products are designed to allow for less invasive access to the spine and faster patient recovery times as compared to traditional open access surgical approaches. We have also leveraged these core competencies in the design, development and commercialization of an increasing number of products for patients suffering from degenerative spinal conditions.

Our products consist of implants, disposables and instruments which are marketed and sold primarily to hospitals for use by spine surgeons. During our 10 year history, we have commercialized 57 product lines that are used in complex spine surgery, MIS and degenerative procedures, enabling us to favorably compete in the $10.0 billion global spinal surgery market. Of our 57 commercialized product lines, our MESA technology or products that incorporate MESA have accounted for approximately 39%, 37% and 35% of our revenue for the years ended December 31, 2011, 2012 and 2013, respectively. While the quality, safety and efficacy of our marketed products are not yet supported by long-term clinical data, we believe many of our products provide several benefits, including:

 

   

simplified surgical techniques;

 

   

less invasive access to implant sites;

 

   

enhanced capabilities to manipulate and correct the spinal column;

 

   

lower profile spinal implant technology; and

 

   

improved clinical outcomes.

In addition to our current product portfolio, we continue to invest in the design, development and commercialization of new solutions for unmet clinical needs in the complex spine and MIS markets by leveraging our highly efficient product development process. We have introduced 34 new product lines since the beginning of 2011 demonstrating our ability to leverage this product development process to rapidly innovate new products.

 

 

 

 

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Our focus on our core competences of complex spine and MIS is highlighted by the fact that, for the years ended December 31, 2011, 2012 and 2013, 59%, 60% and 58%, respectively, of our revenue in the United States was derived from the use of our products in complex spine and MIS surgeries. We believe this represents a greater proportion of total revenue devoted to these markets as compared to our competitors. We further believe the proportion of our international revenue derived from complex spine and MIS is even higher than in the United States.

We have grown our revenue to $157.6 million in 2013 from $60.4 million in 2008, representing a five-year compound annual growth rate, or CAGR, of 21%. For the years ended December 31, 2011, 2012 and 2013, our net income (loss) was $13.3 million, $(32.7) million and $(37.9) million and our Adjusted EBITDA was $(7.4) million, $(1.8) million and $(5.3) million, respectively. For information about how we calculate Adjusted EBITDA, please see “—Summary Historical Consolidated Financial Data.” We expect to continue to incur additional losses in the near term as we invest in the global expansion of our business. As of December 31, 2013, our accumulated deficit was $70.6 million.

We currently market and sell our products in the United States and 28 other countries. For the year ended December 31, 2013, international sales represented approximately 29% of our revenue. We have made significant investments in building a hybrid sales organization consisting of direct sales employees, independent sales agencies and distributor partners. As of December 31, 2013, our U.S. sales force consisted of 114 direct sales employees and 48 independent sales agencies and our international distribution network consisted of 37 direct sales employees, five independent sales agencies and 15 independent distributorships. We expect to continue to invest in our global hybrid sales organization by increasing the number of our direct sales employees and broadening our relationships with independent sales agencies and distributor partners. We believe the continuing expansion of our global sales force will provide us with significant opportunities for future growth as we increase our penetration of existing geographic markets and enter new ones. We do not sell our products through or participate in physician owned distributorships, or PODs, and no surgeons own any shares of our common stock.

Market Opportunity

According to iData Research, Inc., or iData, the global spine surgery market was valued at approximately $10.0 billion in 2012 and is expected to grow to $14.9 billion by 2019. We believe this market will continue to grow as a result of the following growth drivers:

 

   

Complex Spine : We believe the $1.2 billion global complex spine market has been underserved and underdeveloped by major spine market competitors, which generally focus on the larger degenerative spine market. As a result, we believe the complex spine patient population has and will continue to benefit from innovative technologies and techniques that simplify surgical procedures, enable MIS approaches and allow for surgical treatment earlier in the continuum of care.

 

   

MIS : We believe the overall improvement to the standard of care resulting from the introduction of new MIS products will increase demand and drive growth in the $1.4 billion MIS market. We believe the vast majority of surgeons and patients, when given the option, will utilize MIS procedures rather than traditional open procedures due to the advantages of MIS approaches, which often include less soft tissue disruption, reduced frequency of surgical morbidity, faster operating times, improved scarring-related aesthetics and, as a consequence of these advantages, shorter patient recovery times.

 

   

Degenerative Spine : We believe that several factors will continue to influence the growth in the $6.0 billion global degenerative spine market, including aging patient demographics,

 

 

 

 

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increased life expectancies, the desire for maintaining and/or improving lifestyles and demand from patients and surgeons for innovative technologies and techniques that enable simplified surgical procedures, faster procedure times and improved clinical outcomes.

 

   

Biomaterials : The $1.5 billion biomaterials market includes products that are used by spine surgeons during the surgical treatment of certain complex spine and degenerative pathologies to augment spinal implants and to promote fusion by accelerating, augmenting or substituting for the normal regenerative capacity of bone. Biomaterials are used in the treatment of certain complex and degenerative pathologies and, as such, we expect them to demonstrate similar growth trends.

Our Competitive Strengths

Our executive management team is highly experienced in the spinal surgery industry. We believe this experience and the following competitive strengths have been instrumental to our success and position us well to grow our revenue and market share.

 

   

Focus in Complex Spine and MIS.  Our strategic focus and core competencies are the design, development and commercialization of innovative complex spine and MIS technologies and techniques supported by our strong relationships with key opinion leaders and spine societies focused on the complex spine and MIS markets.  

 

   

Comprehensive Portfolio of Innovative Proprietary Technologies . We have developed a comprehensive portfolio of products that address a broad array of spinal pathologies, anatomies and surgical approaches in the complex spine and MIS markets, and this broad product portfolio provides us with an opportunity to cross-sell our product offerings in the degenerative market. We have developed and maintain an expanding intellectual property portfolio which includes 163 issued patents globally and 175 pending patent applications globally.

 

   

Highly Efficient Product Development Process.  Our integrated approach to product development leverages our access to key opinion leaders, engineers, product managers and clinical and regulatory personnel to conceptualize, design and develop new products.

 

   

Broad Global Distribution Network.  We have made significant investments in our global distribution network, which, as of December 31, 2013, included 151 direct sales employees and contractual relationships with 53 independent sales agencies and 15 distributor partners. We have also broadened our operational capabilities by increasing inventory levels and opened offices in strategic markets worldwide.

 

   

Demonstrated Track Record of Innovation and Execution. Our executive management team has the vision, experience and network of relationships to continue our successful growth.

Our Strategies

Our goal is to drive sustainable growth by servicing the needs of patients, surgeons and hospitals through product innovation and differentiation in the complex spine and MIS markets and continuing to leverage these core competencies in the degenerative spinal surgery market. To achieve this goal, we intend to:

 

   

Capitalize on our highly efficient product development process to innovate new technologies and techniques ;

 

   

Leverage our investments in infrastructure to further penetrate the global spine market ;

 

   

Expand our global distribution footprint; and

 

   

Selectively pursue opportunities to enhance our product offerings .

 

 

 

 

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Our Products

We have developed a comprehensive portfolio of products that address a broad array of spinal pathologies, anatomies and surgical approaches in the complex spine, MIS and degenerative markets. Some of our key proprietary technologies and their associated benefits include the following:

 

   

MESA: a low-profile spinal screw technology, used primarily during deformity correction, featuring our proprietary locking mechanism that eliminates the need for a secondary locking feature and reduces rotational force on the spine during implantation, which has been used to treat more than 30,000 patients;

 

   

Rail 4D: an innovative “beam-like” implant, utilized with our proprietary MESA spinal screws, that aids in the restoration of spinal balance while providing enhanced rigidity and significantly greater strength as compared to existing titanium and cobalt chrome rod offerings;

 

   

Deformity Cricket: spinal correction instrumentation, utilized with our proprietary MESA spinal screws, that provides surgeons with an innovative approach to more easily capture, manipulate and align a deformed spine as compared to traditional deformity correction instrumentation such as threaded rod reducers and rod forks;

 

   

SERENGETI: minimally invasive retractor systems featuring one-step placement of screws and retractors, thereby reducing the number of surgical steps, while allowing for direct visualization and improved access to the spine;

 

   

RAVINE: minimally invasive retractor systems that represent an innovative design departure from standard tubular retractors, facilitating retractor placement, positioning and fixation to the patient’s anatomy through a lateral access approach;

 

   

EVEREST: a spinal screw technology that we believe, based on internal testing, provides for improved insertion speed, industry-leading pull-out strength and the ability to accommodate a variety of titanium and cobalt chrome rods of two different diameters; and

 

   

tifix : a locking technology integrated into a number of our interbody and plate implants providing surgeons with the flexibility to insert screws at various angles and lock them to an implant with a one-step locking mechanism that eliminates the need for a secondary locking feature.

Recent Developments

For the fiscal quarter ended March 31, 2014, we estimate that our revenue will range from $41.5 million to $42.5 million, an increase of 19.7% assuming the midpoint of the range when compared with $35.1 million in the fiscal quarter ended March 31, 2013. Approximately 55% of the estimated increase in revenue is due to greater sales volume in the United States due to continued expansion of our customer base and changes in product mix. The remaining increase in revenue is due to growth in our direct markets outside of the United States, such as the United Kingdom and Ireland and our distributor markets in Australia and Scandinavia. We estimate that our net loss will be between $14.6 million and $15.4 million for the fiscal quarter ended March 31, 2014, compared with a loss of $10.9 million in the fiscal quarter ended March 31, 2013. The increase in net loss is primarily due to higher cost of revenue driven by changes in the mix of U.S. and international revenue, higher selling expenses driven by increased sales volume and increased compensation costs related to the expansion of our global sales force, and a reduced benefit from income taxes due to higher valuation allowance requirements on deferred tax assets.

The financial data presented above is preliminary, based upon our estimates and is subject to revision based upon our financial closing procedures and the completion of our financial statements. Our actual

 

 

 

 

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results may be materially different from our estimate. In addition, these estimated results are not necessarily indicative of our results for the full fiscal year or any future period. The preliminary financial data included above has been prepared by, and is the responsibility of, management. Ernst & Young LLP has not audited, reviewed, compiled or performed any procedures with respect to the above preliminary financial data. Accordingly, Ernst & Young LLP does not express an opinion or any other form of assurance with respect thereto.

Risks Related to Our Business and this Offering

An investment in shares of our common stock involves substantial risks and uncertainties that may adversely affect our business, financial condition, results of operations and cash flows. Some of the more significant challenges and risks relating to an investment in our company include:

 

   

We have incurred losses in the past and may not be able to achieve or sustain profitability in the future;

 

   

We must continue to successfully demonstrate to spine surgeons the merits of our technologies and techniques compared to those of our competitors;

 

   

Pricing pressure from our competitors, hospitals and changes in third-party coverage and reimbursement may impact our ability to sell our products at prices necessary to support our current business strategies;

 

   

We operate in a highly competitive market and we must continue to develop and commercialize new products or our revenue may decline. If our competitors develop and commercialize products that are safer, more effective, less costly or otherwise more attractive than our products, our ability to generate revenue may be reduced or eliminated;

 

   

Many of our competitors have greater resources than we have;

 

   

If hospitals and other healthcare providers are unable to obtain adequate coverage and reimbursement for procedures performed using our products, it is unlikely that our products will gain widespread acceptance;

 

   

The safety and efficacy of our products are not yet supported by long-term clinical data, which could limit sales, and our products might therefore prove to be less safe and effective than initially thought;

 

   

If we are unable to maintain and expand our network of direct sales employees, independent sales agencies and international distributors, we may not be able to generate anticipated sales;

 

   

If we do not enhance our product offerings through our research and development efforts, we may be unable to effectively compete;

 

   

Our products and operations are subject to extensive governmental regulation both in the United States and abroad, and our failure to comply with applicable requirements could cause our business to suffer;

 

   

If we are unable to protect our intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights;

 

   

Our international operations subject us to certain operating risks, which could adversely impact our net sales, results of operations and financial condition;

 

   

Our Sponsor, who will beneficially own approximately 62.4% of our common stock (or 59.4% if the underwriters exercise in full their option to purchase additional shares from the

 

 

 

 

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selling stockholders) following this offering, controls us, and its interests may conflict with ours or yours in the future; and

 

   

Upon the listing of our shares on NASDAQ, we will be a “controlled company” within the meaning of NASDAQ rules and, as a result, will qualify for, and may rely on, exemptions from certain corporate governance requirements.

See “Risk Factors” for a discussion of these and other factors you should consider before making an investment in shares of our common stock.

Implications of Being an Emerging Growth Company

We qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. As a result, we are permitted to, and intend to, rely on exemptions from certain disclosure requirements that are applicable to other companies that are not emerging growth companies. Accordingly, we have included compensation information for only our three most highly compensated executive officers and have not included a compensation discussion and analysis of our executive compensation programs in this prospectus. In addition, for so long as we are an emerging growth company, we will not be required to:

 

   

engage an independent registered public accounting firm to report on our internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act;

 

   

adopt new or revised financial accounting standards applicable to public companies until such standards are also applicable to private companies;

 

   

comply with any requirement that may be adopted by the Public Company Accounting Oversight Board, or the PCAOB, regarding mandatory audit firm rotation or a supplement to the independent registered public accounting firm’s report providing additional information about the audit and the financial statements (i.e., an auditor discussion and analysis);

 

   

submit certain executive compensation matters to shareholder advisory votes, such as “say-on-pay,” “say-on-frequency” and “say-on-golden parachutes;” or

 

   

disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the chief executive officer’s compensation to median employee compensation.

We will remain an emerging growth company until the earliest to occur of:

 

   

our reporting of $1.0 billion or more in annual gross revenues;

 

   

our issuance, in any three year period, of more than $1.0 billion in non-convertible debt;

 

   

the end of the fiscal year in which the market value of our common stock held by non-affiliates exceeds $700.0 million on the last business day of our second fiscal quarter; and

 

   

the end of fiscal 2019.

Corporate History and Information

K2M Group Holdings, Inc. was incorporated in Delaware in June 2010. Our principal executive offices are located at 751 Miller Drive SE, Leesburg, Virginia 20175 and our telephone number is (703) 777-3155. Our website address is www.k2m.com. The information on, or accessible through, our website is deemed not to be incorporated in this prospectus or to be part of this prospectus.

 

 

 

 

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THE OFFERING

 

Issuer

K2M Group Holdings, Inc.

 

Common stock offered by K2M Group Holdings, Inc.

8,825,000 shares.

 

Common stock to be outstanding immediately after this offering

37,085,906 shares.

 

Option to purchase additional shares of common stock from the selling stockholders

The selling stockholders have granted the underwriters a 30-day option from the date of this prospectus to purchase up to 1,323,750 additional shares of our common stock at the initial public offering price, less underwriting discounts.

 

Use of proceeds

Our net proceeds from the sale of 8,825,000 shares of our common stock in this offering will be approximately $120.0 million, after deducting the underwriting discount and estimated offering expenses payable by us. We intend to use the net proceeds received by us from this offering (1) to retire all $39.2 million of the indebtedness outstanding under the notes held by certain of our shareholders, or the Shareholder Notes, (2) to pay all $18.5 million of accumulated and unpaid dividends on our Series A Preferred and Series B Preferred, (3) to repay all of the outstanding borrowings of $23.5 million under our existing $30.0 million asset-based revolving credit facility maturing October 2014, or our revolving credit facility, and (4) for working capital and general corporate purposes. Our use of proceeds from this offering for working capital and general corporate purposes is currently expected to include approximately $6.0 million to expand our global distribution network by hiring qualified sales employees and purchasing inventory to support their sales efforts and approximately $10.5 million in connection with our relocation to a new leased headquarters facility in 2015. See “Use of Proceeds.”

 

  As a result of the payment of all indebtedness outstanding under the Shareholder Notes and the payment of all accumulated and unpaid dividends on the Series A Preferred and the Series B Preferred, approximately $56.3 million of the net proceeds from this offering will ultimately be received by affiliates of the Company, assuming the offering was completed on March 31, 2014. See “Certain Relationships and Related Party Transactions.”

 

  We will not receive any proceeds from the sale of any shares of our common stock by the selling stockholders, if any, pursuant to the underwriters’ option to purchase additional shares.

 

 

 

 

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Directed share program

At our request, the underwriters have reserved up to 441,250 shares of common stock, or approximately 5.0% of the shares being offered by us pursuant to this prospectus, for sale at the initial public offering price to our directors, officers and employees and certain other persons associated with us, as designated by us. The number of shares available for sale to the general public will be reduced to the extent that these individuals purchase all or a portion of the reserved shares. Any reserved shares not so purchased will be offered by the underwriters to the general public on the same basis as the other shares offered by this prospectus. For further information regarding our directed share program, please see “Underwriting.”

 

Dividend policy

We have no current plans to pay dividends on our common stock. Any decision to declare and pay dividends in the future will be made at the sole discretion of our Board of Directors and will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions and other factors that our Board of Directors may deem relevant. See “Dividend Policy.”

 

Risk factors

See “Risk Factors” for a discussion of risks you should carefully consider before deciding to invest in our common stock.

 

NASDAQ trading symbol

“KTWO.”

The number of shares of our common stock to be outstanding immediately after the consummation of this offering is based on 27,998,536 shares of common stock outstanding as of December 31, 2013 and does not reflect:

 

   

1,650,289 shares of common stock reserved for future issuance under our new Omnibus Incentive Plan, or the 2014 Omnibus Incentive Plan;

 

   

411,523 shares of common stock reserved for future issuance under our new 2014 Employee Stock Purchase Program, or the ESPP;

 

   

4,179,119 shares of common stock issuable upon exercise of outstanding options issued under our existing equity incentive plans at a weighted exercise price of $8.16 per share; or

 

   

576,132 shares of common stock issuable upon vesting of outstanding restricted stock units.

Unless otherwise indicated, this prospectus reflects and assumes the following:

 

   

the automatic conversion of all of our Series A Preferred to 2,983,903 shares of our common stock upon the consummation of this offering;

 

   

the automatic conversion of all of our Series B Preferred to 2,593,123 shares of our common stock upon the consummation of this offering;

 

   

the 2.43 -for- 1.00 reverse stock split effectuated on May 7, 2014; and

 

   

no exercise by the underwriters of their option to purchase additional shares from the selling stockholders.

 

 

 

 

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SUMMARY HISTORICAL CONSOLIDATED FINANCIAL DATA

The following table sets forth our summary historical consolidated financial data for the periods indicated. We derived the summary historical consolidated financial data presented below as of December 31, 2012 and 2013, and for each of the three years in the period ended December 31, 2013, from our audited consolidated financial statements included elsewhere in this prospectus. We derived the summary historical consolidated balance sheet data presented below as of December 31, 2011 from our audited consolidated financial statements that are not included in this prospectus. Our historical results are not necessarily indicative of the results expected for any future period. The summary historical consolidated financial data reflects the 2.43 -for- 1.00 reverse stock split effectuated on May 7, 2014 prior to this offering.

The pro forma balance sheet data as of December 31, 2013 and the pro forma basic and diluted weighted average shares and pro forma basic and diluted net loss per common share data for the year ended December 31, 2013 presented below are unaudited and give effect to the automatic conversion of all outstanding shares of our Series A Preferred to 2,983,903 shares of our common stock and the automatic conversion of all outstanding shares of our Series B Preferred to 2,593,123 shares of our common stock.

The pro forma as adjusted balance sheet data as of December 31, 2013 and the pro forma as adjusted basic and diluted weighted average shares and basic and diluted net loss per share data for the year ended December 31, 2013 are unaudited and give effect to (1) the automatic conversion of all outstanding shares of our Series A Preferred to 2,983,903 shares of our common stock and the automatic conversion of all outstanding shares of our Series B Preferred to 2,593,123 shares of our common stock, (2) the sale of 8,825,000 shares of our common stock in this offering at the initial public offering price of $15.00 per share, (3) the application of our net proceeds from this offering to retire all outstanding indebtedness under the Shareholder Notes, (4) the application of our net proceeds from this offering to repay all indebtedness outstanding under our revolving credit facility and (5) the application of our net proceeds from this offering to pay all accumulated dividends on our Series A Preferred and our Series B Preferred, as if each had occurred as of December 31, 2013 in the case of the pro forma as adjusted balance sheet data, and on January 1, 2013, in the case of the pro forma as adjusted basic and diluted net loss per share data. The pro forma as adjusted consolidated summary financial data is not necessarily indicative of what our financial position or results of operations would have been if this offering had been completed as of the date indicated, nor is such data necessarily indicative of our financial position or results of operations for any future date or period.

 

 

 

 

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You should read the summary historical financial data below, together with the consolidated financial statements and related notes thereto appearing elsewhere in this prospectus, as well as “Selected Historical Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the other financial information included elsewhere in this prospectus.

 

     Year Ended December 31,  
     2011     2012     2013  
     (in thousands, except per share data)  

Statement of Operations Data:

      

Revenue

   $ 118,005      $ 135,145      $ 157,584   

Cost of revenue

     47,984        43,962        50,162   
  

 

 

   

 

 

   

 

 

 

Gross profit

     70,021        91,183        107,422   

Operating expenses:

      

Research, development and engineering

     11,930        9,031        12,402   

Sales and marketing

     63,176        70,163        80,183   

General and administrative

     49,431        57,821        59,758   

Contingent consideration

     (50,436     (324     —     
  

 

 

   

 

 

   

 

 

 

Total operating expenses

     74,101        136,691        152,343   
  

 

 

   

 

 

   

 

 

 

Loss from operations

     (4,080     (45,508     (44,921

Other income (expense):

      

Foreign currency transaction gain(loss)

     (560     1,034        1,477   

Interest expense

     (236     (1,222     (2,810
  

 

 

   

 

 

   

 

 

 

Total other expense, net

     (796     (188     (1,333
  

 

 

   

 

 

   

 

 

 

Loss before benefit from income taxes

     (4,876     (45,696     (46,254

Benefit from income taxes

     (18,221     (13,041     (8,341
  

 

 

   

 

 

   

 

 

 

Net income (loss)

     13,345        (32,655     (37,913

Accretion or write-up of preferred stock

     (13,773     (9,954     (19,439
  

 

 

   

 

 

   

 

 

 

Net loss allocable to common stockholders

   $ (428   $ (42,609   $ (57,352
  

 

 

   

 

 

   

 

 

 

Per Share Data:

      

Net loss per common share—basic and diluted

   $ (0.02   $ (1.94   $ (2.58)   

Pro forma net loss per common share—basic and diluted (unaudited)

       $ (1.37)   

Pro forma as adjusted net loss per common share— basic and diluted (unaudited)

       $ (0.97)   

Weighted-average number of shares used in per share amounts:

      

Basic and diluted

     21,774        21,921        22,239   

Pro forma basic and diluted

         27,703   

Pro forma as adjusted basic and diluted

         36,528   

 

 

 

 

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     As of December 31,  
     2011      2012      2013  
     Actual      Actual      Actual      Pro Forma      Pro Forma
As Adjusted
 
                          (Unaudited)  
     (in thousands)  

Balance Sheet Data:

              

Cash and cash equivalents

   $ 12,226       $ 7,011       $ 7,419       $ 7,419       $ 69,058   

Working capital

     44,588         47,369         32,549         16,849         117,688   

Total assets

     329,659         299,617         296,936         296,936         358,575   

Total long-term debt, net of discount

     13,000         26,668         19,650         19,650         —     

Total liabilities

     73,354         71,517         93,670         109,370         50,520   

Total redeemable convertible preferred stock

     65,719         78,068         109,081         —           —     

Total stockholders’ equity

     190,586         150,032         94,185         187,566         308,055   

 

     Year Ended December 31,  
     2011     2012     2013  
     (in thousands)  

Other Financial Data:

      

Depreciation and amortization

   $ 34,831      $ 41,824      $ 36,776   

Adjusted EBITDA (1)

     (7,353     (1,765     (5,266

 

(1)  

Adjusted EBITDA represents net income (loss) plus interest expense, income tax expense (income tax benefit), depreciation and amortization, stock-based compensation expense and foreign currency transaction loss (foreign currency transaction gain), plus or minus, as applicable, adjustments related to our purchase by the Sponsor.

 

   We present Adjusted EBITDA because we believe it is a useful indicator of our operating performance. Our management uses Adjusted EBITDA principally as a measure of our operating performance and believes that Adjusted EBITDA is useful to investors because it is frequently used by analysts, investors and other interested parties to evaluate companies in our industry. We also believe Adjusted EBITDA is useful to our management and investors as a measure of comparative operating performance from period to period.

 

   Adjusted EBITDA is a non-GAAP financial measure and should not be considered as an alternative to net income (loss) as a measure of financial performance or cash flows from operations as a measure of liquidity, or any other performance measure derived in accordance with GAAP and it should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. In addition, Adjusted EBITDA is not intended to be a measure of free cash flow for management’s discretionary use, as it does not reflect certain cash requirements such as tax payments, debt service requirements, capital expenditures and certain other cash costs that may recur in the future. Adjusted EBITDA contains certain other limitations, including the failure to reflect our cash expenditures, cash requirements for working capital needs and cash costs to replace assets being depreciated and amortized. In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in this presentation. Our presentation of Adjusted EBITDA should not be construed to imply that our future results will be unaffected by any such adjustments. Management compensates for these limitations by primarily relying on our GAAP results in addition to using Adjusted EBITDA supplementally. Our definition of Adjusted EBITDA is not necessarily comparable to other similarly titled captions of other companies due to different methods of calculation.

 

 

 

 

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   A reconciliation of net income (loss) to Adjusted EBITDA is set forth below:

 

     Year Ended December 31,  
     2011     2012     2013  
     (in thousands)  

Net income (loss)

   $ 13,345      $ (32,655   $ (37,913

Interest expense

     236        1,222        2,810   

Income tax benefit

     (18,221     (13,041     (8,341

Depreciation and amortization

     34,831        41,824        36,776   

Stock-based compensation expense

     3,272        2,243        2,879   

Foreign currency transaction (gain) loss

     560        (1,034     (1,477

Adjustments related to our purchase by the Sponsor (a)

     (41,376     (324     —     
  

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

   $ (7,353   $ (1,765   $ (5,266

 

  (a)  

Adjustments related to our purchase by the Sponsor were comprised of the reversal of the contingent consideration liability of $50.4 million offset by the recognition in cost of revenue of a $9.1 million write-up of inventory to fair market value for the year ended December 31, 2011 and the reversal of the contingent consideration liability of $0.3 million for the year ended December 31, 2012.

 

 

 

 

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RISK FACTORS

Investing in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below and the other information contained in this prospectus, including our consolidated financial statements and the related notes, before you decide whether to purchase our common stock.

Risks Related to Our Business and Our Industry

We have incurred losses in the past and may not be able to achieve or sustain profitability in the future.

We have incurred losses in most fiscal years since inception. We incurred net losses of $32.7 million and $37.9 million in 2012 and 2013, respectively. As a result of ongoing losses, we had an accumulated deficit of $70.6 million at December 31, 2013. We expect to continue to incur significant product development, clinical and regulatory, sales and marketing and other expenses. In addition, following this offering, our general and administrative expenses will increase due to the additional costs associated with being a public company. We will need to generate significant additional revenue to achieve and maintain profitability, and even if we achieve profitability, we cannot be sure that we will remain profitable for any substantial period of time. Our failure to achieve or maintain profitability could negatively impact the value of our common stock.

We must continue to successfully demonstrate to spine surgeons the merits of our technologies and techniques compared to those of our competitors.

Spine surgeons play a significant role in determining the course of treatment and, ultimately, the type of product that will be used to treat a patient. As a result, our success depends, in large part, on effectively marketing to them. In order for us to sell our products, we must continue to successfully demonstrate to spine surgeons the merits of our technologies and techniques compared to those of our competitors for use in treating patients with spinal pathologies. Acceptance of our products depends on educating spine surgeons as to the distinctive characteristics, perceived benefits, safety, ease of use and cost-effectiveness of our products as compared to our competitors’ products, and on training spine surgeons in the proper application of our products. If we are not successful in convincing spine surgeons of the merits of our products or educating them on the use of our products, they may not use our products and we may be unable to increase our sales, sustain our growth or achieve profitability.

Furthermore, we believe many spine surgeons may be hesitant to adopt certain products unless they determine, based on experience, clinical data and published peer-reviewed journal articles, that our complex spine products, MIS technologies and techniques and degenerative products provide benefits or are an attractive alternative to existing treatments of spine disorders. Surgeons may be hesitant to change their medical treatment practices for the following reasons, among others:

 

   

lack of experience with our technologies;

 

   

existing relationships with competitors and sales representatives that sell competitive products;

 

   

lack or perceived lack of evidence supporting additional patient benefits;

 

   

perceived liability risks generally associated with the use of new products and procedures;

 

   

less attractive availability of coverage and reimbursement within healthcare payment systems compared to other products and techniques;

 

   

costs associated with the purchase of new products and equipment; and

 

   

the time commitment that may be required for training.

 

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In addition, we believe recommendations and support of our products by influential spine surgeons are essential for market acceptance and adoption. If we do not receive support from such surgeons or long-term data does not show the benefits of using our products, surgeons may not use our products. In such circumstances, we may not achieve expected sales or profitability.

Pricing pressure from our competitors, hospitals and changes in third-party coverage and reimbursement may impact our ability to sell our products at prices necessary to support our current business strategies.

Competition in the spinal surgery industry has increased as a result of new market entrants, new technologies and as more established companies have intensified competitive pricing pressure. As a result of these competitive forces, we believe there will be increased pricing pressure in the future. Because our products are generally purchased by hospitals that typically bill various third-party payors, changes in the purchasing behavior of such hospitals or the amount such payors are willing to reimburse our customers for procedures using our products, including as a result of healthcare reform initiatives, could create additional pricing pressure on us. In addition to these competitive forces, we continue to see pricing pressure as hospitals introduce new pricing structures into their contracts and agreements, including fixed price formulas, capitated pricing and construct pricing intended to contain healthcare costs. If we see such trends continue to drive down the prices we are able to charge for our products, our profit margins will shrink, which may adversely affect our ability to invest in and grow our business.

We operate in a highly competitive market and we must continue to develop and commercialize new products or our revenues may decline. If our competitors develop and commercialize products that are safer, more effective, less costly or otherwise more attractive than our products, our ability to generate revenue may be reduced or eliminated.

Our currently marketed products are, and any future products we develop and commercialize will be, subject to intense competition. The spinal surgery industry is intensely competitive, subject to rapid change and highly sensitive to the introduction of new products or other market activities of industry participants. Our ability to compete successfully will depend on our ability to develop products that reach the market in a timely manner, receive adequate coverage and reimbursement from third-party payors, and are safer, less invasive and more effective than competing products and treatments. Because of the size of the potential market, we anticipate that companies will dedicate significant resources to developing competing products.

We are aware of several companies that compete or are developing technologies in our current and future product areas. As a result, we expect competition to remain intense. We believe that our principal competitors include Medtronic Spine and Biologics, DePuy Synthes, Stryker, Globus Medical and NuVasive, which together represent a significant portion of the spinal surgery market. We also compete with smaller spinal surgery market participants such as Alphatec Spine, Biomet, LDR Holding Corporation, Orthofix and Zimmer, whose products generally have a smaller market share than the principal competitors listed above. At any time, these and other potential market entrants may develop new devices or treatment alternatives that may render our products obsolete or uncompetitive. In addition, they may gain a market advantage by developing and patenting competitive products or processes earlier than we can or by obtaining regulatory clearances or market registrations more rapidly than we can. Many of our current and potential competitors have substantially greater sales and financial resources than we do. In addition, these companies may have more established distribution networks, entrenched relationships with surgeons and greater experience in launching, marketing, distributing and selling products.

In addition, new market participants continue to enter the spinal surgery industry. Many of these new competitors specialize in a specific product or focus on a particular market sector, making it more difficult for us to increase our overall market position. The frequent introduction by competitors of products that are or claim to be superior to our products or that are alternatives to our existing or planned products may also create market confusion that may make it difficult to differentiate the benefits

 

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of our products over competing products. In addition, the entry of multiple new products and competitors may lead some of our competitors to employ pricing strategies that could adversely affect the pricing of our products and pricing in the spinal surgery market generally.

Spine surgeons often contribute to the decisions as to whether hospitals purchase our products, and we believe that many spine surgeons are highly sensitive to technological change and to the commercial reputation of spinal product companies. Accordingly, we believe that many spine surgeons actively seek new technologies and devote special attention to companies they perceive to have novel and innovative solutions to surgical challenges. As a result, we believe that we must continue to develop and commercialize innovative new products or our existing customers may decrease their purchases from us and instead purchase products from companies perceived by them to be more innovative. In order to develop innovative products, we must attract and retain talented and experienced engineers and management personnel, have productive dialogues with practicing spine surgeons and hospital purchasing administrations and have adequate capital to fund research and development efforts. If we fail to deliver innovative products to the market, our future revenue may be reduced and our stock price may decline.

In addition, we face a particular challenge overcoming the long-standing practices by some spine surgeons of using the products of our larger, more established competitors. Spine surgeons who have completed many successful, complex surgeries using the products made by these competitors may be disinclined to try new products from a source with which they are less familiar. If these spine surgeons do not try our products, then our revenue growth may slow or decline and our stock price may decline.

Our competitors may also develop and patent processes or products earlier than we can or obtain regulatory clearance, approval or CE Certificates of Conformity for competing products more rapidly than we can, which could impair our ability to develop and commercialize similar processes or products. We also compete with our competitors in establishing clinical trial sites and patient enrollment in clinical trials, as well as in acquiring technologies and technology licenses complementary to our products or advantageous to our business. In addition, we compete with our competitors to engage the services of sales agencies and independent distributors, both those presently working with us and those with whom we hope to work as we expand.

Many of our competitors have greater resources than we have.

Many of our current and potential competitors are major medical device companies that have substantially greater financial, technical and marketing resources than we do. Many of these current and potential competitors are publicly traded or are divisions of publicly-traded companies, which enjoy several competitive advantages, including:

 

   

greater financial and human resources for product development, sales and marketing and patent litigation;

 

   

significantly greater name recognition;

 

   

established relationships with spine surgeons, hospitals and third-party payors;

 

   

more expansive portfolios of intellectual property rights;

 

   

broader product range and ability to cross-sell their products or offer rebates or bundle products to incentivize hospitals or surgeons to use their products;

 

   

products supported by long-term clinical data;

 

   

large and established sales and marketing and distribution networks; and

 

   

greater experience in conducting research and development, manufacturing, clinical trials, preparing regulatory submissions and obtaining regulatory clearance, approval or CE Certificates of Conformity for products and marketing approved products.

 

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Aggregation of hospital purchasing from collaboration and consolidation may lead to demands for price concessions or to the exclusion of some suppliers from certain market opportunities, which could have an adverse effect on our business, results of operations or financial condition.

Because healthcare costs have risen significantly over the past decade, numerous initiatives and reforms initiated by legislators, regulators and third-party payors to curb these costs have resulted in a consolidation trend in the healthcare industry to aggregate purchasing power. As the healthcare industry consolidates, competition to provide products and services to industry participants has become more intense and may intensify. This in turn has resulted and will likely continue to result in greater pricing pressures or the exclusion of certain suppliers from certain market opportunities as group purchasing organizations, independent delivery networks and large single accounts continue to use their market power to consolidate purchasing decisions. In addition, such consolidation may lead these organizations to limit their number of suppliers. We expect that market demand, government regulation, third-party coverage and reimbursement policies and societal pressures will continue to impact the healthcare industry, resulting in further business consolidations and alliances among our customers, which may exert further downward pressure on the prices of our products and may adversely impact our business, results of operations or financial condition.

If hospitals and other healthcare providers are unable to obtain adequate coverage and reimbursement for procedures performed using our products, it is unlikely that our products will gain widespread acceptance.

Maintaining and growing sales of our products depends on the availability of adequate coverage and reimbursement from third-party payors, including government programs, such as Medicare and Medicaid, private insurance plans and managed care programs. Hospitals and other healthcare providers that purchase products, such as the ones that we manufacture, generally rely on third-party payors to pay for all or part of the costs and fees associated with the procedures performed with these products. The existence of adequate coverage and reimbursement for the procedures performed with our products by government and private insurance plans is central to the acceptance of our current and future products. We may be unable to sell our products on a profitable basis if third-party payors deny coverage or reduce their current levels of payment, or if our costs increase faster than increases in reimbursement levels. In the United States, many private payors use coverage decisions and payment amounts determined by the Centers for Medicare and Medicaid Services, or CMS, which administers the Medicare program, as guidelines in setting their coverage and reimbursement policies. Future action by CMS or other government agencies may diminish payments to physicians, outpatient centers and/or hospitals. Those private payors that do not follow the Medicare guidelines may adopt different coverage and reimbursement policies for procedures performed with our products. For some governmental programs, such as Medicaid, coverage and reimbursement differ from state to state, and some state Medicaid programs may not pay an adequate amount for the procedures performed with our products, if any payment is made at all. As the portion of the U.S. population over the age of 65 and eligible for Medicare continues to grow, we may be more vulnerable to coverage and reimbursement limitations imposed by CMS. Furthermore, the healthcare industry in the United States has experienced a trend toward cost containment as government and private insurers seek to control healthcare costs by imposing lower payment rates and negotiating reduced contract rates with service providers. Therefore, we cannot be certain that the procedures performed with our products will be reimbursed at a cost-effective level. Accordingly, even if our products and procedures using our products are currently covered and reimbursed by third-party payors, adverse changes in payors’ coverage and reimbursement policies that affect our products would harm our ability to market and sell our products and adversely impact our business, results of operations or financial condition.

Moreover, we are unable to predict what changes will be made to the reimbursement methodologies used by third-party payors. We cannot be certain that under current and future payment systems, in which healthcare providers may be reimbursed a set amount based on the type of procedure performed, such as those utilized by Medicare and in many privately managed care systems, the cost of our products will be properly reflected and incorporated into the overall cost of the procedure.

 

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In addition, as we continue to expand into international markets, market acceptance may depend, in part, upon the availability of coverage and reimbursement within prevailing healthcare payment systems. Reimbursement and healthcare payment systems in international markets such as in the European Economic Area, or the EEA, which is comprised of the 28 Member States of the European Union, or the EU, Iceland, Liechtenstein and Norway, vary significantly by country, and include both government-sponsored healthcare and private insurance. We may not obtain international coverage and reimbursement approvals in a timely manner, if at all. Our failure to receive such approvals, and any adverse changes in coverage and the reimbursement policies of foreign third-party payors, would negatively impact market acceptance of our products in such international markets.

The safety and efficacy of our products is not yet supported by long-term clinical data, which could limit sales, and our products might therefore prove to be less safe and effective than initially thought.

We have obtained 510(k) clearances to manufacture, market and sell the products we market in the United States, unless exempt from premarket review by the U.S. Food and Drug Administration, or the FDA, and the right to affix the CE mark to the products we market in the EEA. In the 510(k) clearance process, the FDA must determine that a proposed device is “substantially equivalent” to a legally marketed device, known as a “predicate” device, with respect to intended use, technology and safety and effectiveness, which sometimes requires the submission of clinical data. In the EEA, as a general rule, compliance with the Essential Requirements laid down in Annex I to the Council Directive 93/42/EEC of 14 June 1993 concerning medical devices, or the Medical Devices Directive, must be based on clinical data, though such clinical data can originate from the literature if equivalence to the device to which the literature relates can be demonstrated. For implantable devices and devices classified as Class III in the EEA, the provisions of Annex I to the Medical Devices Directive require manufacturers to conduct clinical investigations to generate the required clinical data, unless it is justifiable to rely on the existing clinical data related to similar devices. While clinical data generated during a clinical investigation is sometimes required to support a 510(k) clearance, CE mark or product registration in other countries, we have not yet generated our own clinical data in support of our currently marketed products. As a result, we currently lack the breadth of published long-term clinical data supporting the quality, safety and efficacy of our products that might have been generated in connection with more costly and rigorous premarket approval, or PMA, processes, and that some of our competitors who have been in business longer may have collected.

To address this issue, we are currently collecting and plan to continue collecting long-term clinical data regarding the quality, safety and effectiveness of our marketed products. For example, we are currently launching voluntary postmarket studies with respect to the degenerative disc disease market in relation to our MESA, EVEREST and RAVINE medical devices. The clinical data collected and generated as part of these studies will enable us to further strengthen our clinical evaluation concerning safety and performance of these important products. We believe that this additional data will help with the marketing of our MESA, EVEREST and RAVINE medical devices by providing our customers with additional confidence in the long-term safety and efficacy of these products. However, as we conduct clinical trials designed to generate long-term data on our products, the data we generate may not be consistent with our existing data and may demonstrate less favorable safety or efficacy. These results could reduce demand for our products and significantly reduce our ability to achieve expected revenue. We do not expect to undertake such studies for all of our products and will only do so in the future where we anticipate the benefits will outweigh the costs. In addition, in the degenerative disease market, we may determine from postmarket experience that certain patient characteristics, such as age or preexisting medical conditions, may affect fusion rates, which could lead to misleading or contradictory data on the efficacy of our degenerative disease products. For these reasons, spine surgeons may be less likely to purchase our products than competing products with longer-term clinical data. Also, we may not choose or be able to generate the comparative data that some of our competitors have or are generating and we may be subject to greater regulatory and product liability risks. Moreover, if future

 

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results and experience indicate that our products cause unexpected or serious complications or other unforeseen negative effects, we could be subject to mandatory product recalls or withdrawals, suspension or withdrawal of FDA or other government clearances or approvals or CE Certificates of Conformity, significant legal and regulatory liability and harm to our business reputation.

We are dependent on a limited number of third-party suppliers for most of our products and components, and the loss of any of these suppliers, or their inability to provide us with an adequate supply of quality materials, could harm our business.

We rely on third-party suppliers to supply substantially all of our products as well as the raw materials for the limited number of products we manufacture in-house. For us to be successful, our suppliers must be able to provide us with products and components in substantial quantities, in compliance with regulatory requirements, in accordance with agreed upon specifications, at acceptable costs and on a timely basis. Our anticipated growth could strain the ability of our suppliers to deliver an increasingly large supply of products, materials and components. Suppliers often experience difficulties in scaling up production, including problems with production yields and quality control and assurance, especially with biomaterials products such as allograft, which is processed human tissue. If we are unable to obtain sufficient quantities of high quality components to meet demand on a timely basis, we may not be able to produce sufficient quantities of our products to meet market demand and, as a result, could lose customers, our reputation may be harmed and our business could suffer.

Our dependence on a limited number of suppliers exposes us to risks, including limited control over pricing, availability and delivery schedules. If any one or more of our suppliers cease to provide us with sufficient quantities of manufactured products or raw materials in a timely manner or on terms acceptable to us, or cease to manufacture components of acceptable quality, we would have to seek alternative sources of supply. Because of the nature of our internal quality control requirements, regulatory requirements and the proprietary nature of the parts, we cannot quickly engage additional or replacement suppliers for many of our critical components. Failure of any of our third-party suppliers to deliver products or raw materials at the level our business requires would limit our ability to meet our sales commitments to our customers and could have a material adverse effect on our business. We may also have difficulty obtaining similar components from other suppliers that are acceptable to the FDA, the competent authorities or notified bodies of the countries of the EEA, each a Notified Body, or other foreign regulatory authorities, and the failure of our suppliers to comply with strictly enforced regulatory requirements could expose us to regulatory action including warning letters, product recalls and withdrawals, suspension or withdrawal of our regulatory clearances or CE Certificates of Conformity, termination of distribution, product seizures or civil, administrative or criminal penalties. We could incur delays while we locate and engage qualified alternative suppliers, and we may be unable to engage alternative suppliers on favorable terms or at all. Any such disruption or increased expenses could harm our business, results of operations or financial condition.

If we are unable to maintain and expand our network of direct sales employees, independent sales agencies and international distributors, we may not be able to generate anticipated sales.

In the United States we maintain a hybrid sales organization consisting of 114 direct sales employees and 48 independent agency partners. We currently generate revenue from 28 countries internationally, in addition to the United States. Our international sales organization includes 37 direct sales employees, primarily located in the United Kingdom and Germany. In addition, we directly manage five independent sales agencies across Italy and Canada. We sell to 15 distributors in certain other international markets. Our results of operations are directly dependent upon the sales and marketing efforts of not only our employees, but also our independent sales agencies and distributors. We expect our direct sales employees, independent sales agencies and distributors to develop long-lasting relationships with the surgeons and hospitals they serve. If our direct sales employees, independent sales agencies or distributors fail to adequately promote, market and sell our products, our sales could significantly decrease. During

 

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the year ended December 31, 2013, on a net basis, we added 55 direct sales employees and three independent sales agencies. If revenue generated by our newly hired direct sales employees and independent sales agencies fails to increase over time in line with our expectations, our business, results of operations and financial condition could be materially adversely affected.

We face significant challenges and risks in managing our geographically dispersed distribution network and retaining the individuals who make up that network. If any of our direct sales employees, independent sales agencies or distributors were to reduce their efforts to promote our products or cease to do business with us, our sales could be adversely affected. In such a situation, we may need to seek alternative direct sales employees, independent sales agencies or distributors or increase our reliance on our existing direct sales employees, which we may be unable to do in a timely and efficient manner, if at all. In addition, our competitors may require that members of our sales force cease doing business with us. We may not be able to rely on our sales force to distribute new products that we introduce that compete with products of our competitors that they also represent. If a direct sales employee, independent sales agency or distributor were to depart and be retained exclusively by one of our competitors, we may be unable to prevent them from helping competitors solicit business from our existing customers, which could further adversely affect our sales. Because of the intense competition for their services, we may be unable to recruit or retain additional qualified independent sales agencies or distributors or to hire additional direct sales employees. We also may not be able to enter into agreements with them on favorable or commercially reasonable terms, if at all. Failure to hire or retain qualified direct sales employees or independent sales agencies or distributors would adversely impact our ability to generate sales and expand our business.

As we launch new products and increase our marketing efforts with respect to existing products, we will need to expand the reach of our marketing and sales networks. Our future success will depend largely on our ability to continue to hire or contract with, train, retain and motivate skilled sales managers, direct sales employees, independent sales agencies and distributors with significant technical knowledge in various areas, such as spinal care practices, spine injuries and disease and spinal health. New hires and new independent sales agencies and distributors require training and take time to achieve full productivity. If we fail to hire quality personnel, fail to provide adequate training or experience high turnover in our sales force, the new members of our sales force may not be as productive as is necessary to maintain or increase our sales.

The proliferation of physician-owned distributorships could result in increased pricing pressure on our products or harm our ability to sell our products to physicians who own or are affiliated with those distributorships.

Physician-owned distributorships, or PODs, are product distributors that are owned, directly or indirectly, by physicians. These physicians derive a proportion of their revenue from selling or arranging for the sale of products for use in procedures they perform on their own patients at hospitals that agree to purchase from or through the POD, or that otherwise furnish ordering physicians with income that is based directly or indirectly on those orders of products.

We do not sell or distribute any of our products through PODs. The number of PODs in the spinal surgery industry may continue to grow as economic pressures increase throughout the industry, hospitals, insurers and physicians search for ways to reduce costs and, in the case of the physicians, search for ways to increase their incomes. PODs and the physicians who own, or partially own, them have significant market knowledge and access to the surgeons who use our products and the hospitals that purchase our products and thus the growth of PODs may reduce our ability to compete effectively for business from surgeons who own such distributorships.

 

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A large percentage of our revenue is derived from the sale of our MESA, DENALI and EVEREST spinal systems or products that incorporate these technologies, and therefore, a decline in the sales of these products could have a material impact on our business, results of operations and financial condition.

Revenue from our MESA spinal systems and other products that incorporate our MESA technology represented approximately 39%, 37% and 35% of our revenue for the years ended December 31, 2011, 2012 and 2013, respectively, revenue from our DENALI spinal systems and other products that incorporate our DENALI technology represented approximately 29%, 22% and 19% of our revenue for the years ended December 31, 2011, 2012 and 2013, respectively, and revenue from our EVEREST spinal systems and other products that incorporate our EVEREST technology represented approximately 3%, 9% and 12% of our revenue for the years ended December 31, 2011, 2012 and 2013. Competition is intense among companies selling devices for spinal surgery, and sales of MESA, DENALI or EVEREST could decline as a result of a number of factors, such as the introduction by a competitor of products which our customers prefer. Sales of MESA, DENALI or EVEREST could also be disrupted by allegations of intellectual property infringement which, even if meritless, could result in temporary injunctions against sales of these products and damage to relationships with agencies, distributors and customers. A decline in sales of MESA, DENALI or EVEREST for any reason could have a material adverse impact on our business, results of operations and financial condition.

Our business could suffer if we lose the services of key members of our senior management, consultants or personnel.

We are dependent upon the continued services of key members of our senior management and a limited number of consultants and personnel. In particular, we are highly dependent on the skills and leadership of our Chief Executive Officer, Eric D. Major, and our Chief Medical Officer, John P. Kostuik, M.D. The loss of either of these individuals could disrupt our operations or our strategic plans. In addition, our future success will depend on, among other things, our ability to continue to hire or contract with, and retain, the necessary qualified scientific, technical and managerial personnel, for whom we compete with numerous other companies, academic institutions and organizations. The loss of members of our management team, consultants or personnel, or our inability to attract or retain other qualified personnel or consultants could have a material adverse effect on our business, results of operations and financial condition.

If we do not enhance our product offerings through our research and development efforts, we may be unable to effectively compete.

In order to increase our market share in the spinal surgery industry, we must enhance and broaden our product offerings in response to changing customer demands and competitive pressures and technologies. We might not be able to successfully develop, obtain regulatory clearances, approvals, or CE Certificates of Conformity for or market new products, and our future products might not be accepted by the surgeons or the third-party payors who reimburse for many of the procedures performed with our products. The success of any new product offering or enhancement to an existing product will depend on numerous factors, including our ability to:

 

   

properly identify and anticipate surgeon and patient needs;

 

   

develop and introduce new products or product enhancements in a timely manner;

 

   

adequately protect our intellectual property and avoid infringing upon the intellectual property rights of third parties;

 

   

demonstrate the quality, safety and efficacy of new products; and

 

   

obtain the necessary regulatory clearances, approvals or CE Certificates of Conformity for new products or product enhancements.

 

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If we do not develop and obtain regulatory clearance, approval or CE Certificate of Conformity for new products or product enhancements in time to meet market demand, or if there is insufficient demand for these products or enhancements, our results of operations will suffer. Our research and development efforts may require a substantial investment of time and resources before we are adequately able to determine the commercial viability of a new product, technology, material or other innovation. Such efforts may not result in the development of a viable product. In addition, even if we are able to successfully develop enhancements or new generations of our products, these enhancements or new generations of products may not produce sales in excess of the costs of development and they may be quickly rendered obsolete by changing customer preferences or the introduction by our competitors of products embodying new technologies or features.

If we fail to properly manage our anticipated growth, our business could suffer.

Our rapid growth has placed, and will continue to place, a significant strain on our management and on our operational and financial resources and systems. Failure to manage our growth effectively could cause us to over-invest or under-invest in infrastructure, and result in losses or weaknesses in our infrastructure, which could materially adversely affect our business. Any failure by us to manage our growth effectively could have an adverse effect on our ability to achieve our development and commercialization goals.

We may seek to grow our business through acquisitions of or investments in new or complementary businesses, products or technologies, through the licensing of products or technologies from third parties or other strategic alliances, and the failure to manage acquisitions, investments, licenses or other strategic alliances, or the failure to integrate them with our existing business, could have a material adverse effect on us.

Our success depends on our ability to continually enhance and broaden our product offerings in response to changing customer demands, competitive pressures, technologies and market pressures. Accordingly, from time to time we may consider opportunities to acquire, make investments in or license other technologies, products and businesses that may enhance our capabilities, complement our current products or expand the breadth of our markets or customer base. Potential and completed acquisitions, strategic investments, licenses and other alliances involve numerous risks, including:

 

   

problems assimilating the purchased or licensed technologies, products or business operations;

 

   

issues maintaining uniform standards, procedures, controls and policies;

 

   

unanticipated costs associated with acquisitions or strategic alliances;

 

   

diversion of management’s attention from our core business;

 

   

adverse effects on existing business relationships with suppliers and customers;

 

   

risks associated with entering new markets in which we have limited or no experience;

 

   

potential loss of key employees of acquired businesses; and

 

   

increased legal and accounting compliance costs.

We do not know if we will be able to identify acquisitions or strategic relationships we deem suitable, whether we will be able to successfully complete any such transactions on favorable terms or at all or whether we will be able to successfully integrate any acquired business, product or technology into our business or retain any key personnel, suppliers or distributors. Our ability to successfully grow through strategic transactions depends upon our ability to identify, negotiate, complete and integrate suitable target businesses, technologies or products and to obtain any necessary financing. These efforts could be

 

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expensive and time-consuming and may disrupt our ongoing business and prevent management from focusing on our operations. If we are unable to integrate any acquired businesses, products or technologies effectively, our business, results of operations and financial condition could be materially adversely affected.

If we are unable to train surgeons on the safe and appropriate use of our products, we may be unable to achieve our expected growth.

An important part of our sales process includes the ability to train surgeons on the safe and appropriate use of our products. If we become unable to attract potential new surgeon customers to our training programs, or if we are unable to attract existing customers to training programs for future products, we may be unable to achieve our expected growth.

There is a learning process involved for spine surgeons to become proficient in the use of our products. This training process may take longer than expected and may therefore affect our ability to increase sales. Following completion of training, we rely on the trained surgeons to advocate the clinical benefits of our products in the broader marketplace. Convincing surgeons to dedicate the time and energy necessary for adequate training is challenging, and we cannot assure you we will be successful in these efforts. If surgeons are not properly trained, they may misuse or ineffectively use our products. This may also result in unsatisfactory patient outcomes, patient injury, negative publicity or lawsuits against us, any of which could have an adverse effect on our business.

Although we believe our training methods for surgeons are conducted in compliance with applicable FDA and foreign regulatory requirements, if the FDA or any other regulatory authority determines that our training constitutes promotion of an unapproved use, they could request that we modify our training or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty.

We are required to maintain high levels of inventory, which could consume a significant amount of our resources, reduce our cash flows and lead to inventory impairment charges.

As a result of the need to maintain substantial levels of inventory, we are subject to the risk of inventory obsolescence. Many of our products come in sets, which feature components in a variety of sizes so that the appropriate spinal implant may be selected by the surgeon based on the patient’s needs. In order to market our products effectively, we often must maintain and provide hospitals with consigned sets which typically consist of spinal implants and instruments, including products to ensure redundancy and products of different sizes. In a typical surgery, fewer than all of the components of the set are used, and therefore certain portions of the set may become obsolete before they can be used. In the event that a substantial portion of our inventory becomes obsolete, it could have a material adverse effect on our earnings and cash flows due to the resulting costs associated with the inventory impairment charges and costs required to replace such inventory.

Our total assets include substantial amounts of goodwill and intangible assets and an impairment of our goodwill or intangible assets could adversely affect our results of operations.

Goodwill and intangible assets represented approximately 62.7% of our total assets as of December 31, 2013. We evaluate our goodwill for impairment on an annual basis or at other times during the year if events or circumstances indicate that it is more likely than not that the fair value is below the carrying value. We evaluate intangible assets for impairment when facts or circumstances suggest that the carrying value of these assets may not be recoverable. Our evaluation of impairment requires us to make certain estimates and assumptions including projections of future results. Such estimates and assumptions may not prove to be accurate in the future. After performing our evaluation for impairment, including an analysis to determine the recoverability of intangible assets, we will record a noncash impairment loss

 

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when the carrying value of the underlying asset, asset group or reporting unit exceeds its fair value. If these impairment losses are significant, our results of operations could be adversely affected.

If we experience significant disruptions in our information technology systems, our business, results of operations and financial condition could be adversely affected.

The efficient operation of our business depends on our information technology systems. We rely on our information technology systems to effectively manage:

 

   

sales and marketing, accounting and financial, and legal and compliance functions;

 

   

inventory management;

 

   

engineering and product development tasks; and

 

   

our research and development data.

Our information technology systems are vulnerable to damage or interruption from:

 

   

earthquakes, fires, floods and other natural disasters;

 

   

terrorist attacks and attacks by computer viruses or hackers;

 

   

power losses; and

 

   

computer systems, or Internet, telecommunications or data network failures.

The failure of our information technology systems to perform as we anticipate or our failure to effectively implement new systems could disrupt our entire operation and could result in decreased sales, increased overhead costs, excess inventory and product shortages and a loss of important information, all of which could have a material adverse effect on our reputation, business, results of operations and financial condition.

Most of our operations are at a single location. Any disruption in this facility or any inability to ship a sufficient number of our products to meet demand could adversely affect our business and results of operations.

Most of our operations are at a single location in Leesburg, Virginia. We also maintain a facility in Malvern, Pennsylvania. Either of these facilities may be affected by man-made or natural disasters, such as a tornado or hurricane. While we currently rely on third parties to manufacture, assemble, package, label and sterilize most of our products and components, we might also be forced to rely on third parties to inspect, warehouse or ship our products and components in the event our facilities are affected by a disaster. Our Leesburg facility, if damaged or destroyed, could be difficult to replace and any efforts to repair or replace could require substantial lead-time. In addition, if we obtain an FDA PMA for any of our future devices, we might be required to obtain prior FDA approval of an alternate facility, which could delay or prevent our marketing of the affected products until this supplemental approval is obtained. Our Notified Body in the EEA or other international regulatory authorities may also need to audit our alternate facility to ensure that we continue to comply with applicable quality systems requirements. In addition, our products are expensive to make and are valuable to hospitals and surgeons worldwide. If a theft of our inventory occurred at our Leesburg facility or elsewhere, it could be a significant loss to us. Although we believe we possess adequate insurance for damage to our property and the disruption of our business from casualties, this insurance may not be sufficient to cover all of our potential losses and may not continue to be available to us on acceptable terms, or at all.

We may not be able to strengthen our brand.

We believe that establishing and strengthening the K2M brand and the brands associated with our individual product lines is critical to achieving widespread acceptance of our products, particularly

 

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because of the rapidly developing nature of the market for our products. Promoting and positioning our brand will depend largely on the success of our marketing efforts and our ability to provide surgeons with a reliable product for successful treatment of spine diseases and disorders. Historically, our efforts to build our brand have involved significant expense, and it is likely that our future marketing efforts will require us to incur significant additional expenses. These brand promotion activities may not yield increased sales and, even if they do, any sales increases may not offset the expenses we incur to promote our brand. If we fail to successfully promote and maintain our brand, or if we incur substantial expenses in an unsuccessful attempt to promote and maintain our brand, our products may not be accepted by spine surgeons, which would cause our sales to decrease and would adversely affect our business, results of operations and financial condition.

Fluctuations in insurance cost and availability could adversely affect our profitability or our risk management profile.

We hold a number of insurance policies, including product liability insurance, directors’ and officers’ liability insurance, general liability insurance, property insurance and workers’ compensation insurance. If the costs of maintaining adequate insurance coverage increase significantly in the future, our results of operations could be materially adversely affected. Likewise, if any of our current insurance coverage should become unavailable to us or become economically impractical, we would be required to operate our business without indemnity from commercial insurance providers. If we operate our business without insurance, we could be responsible for paying claims or judgments against us that would have otherwise been covered by insurance, which could materially adversely affect our business, results of operations and financial condition. In addition, the financial health of our insurers may deteriorate and they may not be able to respond if we should have claims reaching their policies.

Our business may be interrupted and adversely affected if we are unable to secure and prepare new space for our corporate headquarters prior to the expiration of our lease.

Our lease for our headquarters in Leesburg, Virginia will expire in May 2015. There can be no assurance that we will be successful in locating, securing and preparing new space on or before such date. We are currently in negotiations to relocate our corporate headquarters and enter into a new lease for such location when our existing lease expires in 2015. We intend to use a portion of the proceeds from this offering in connection with such relocation, including the build-out of the new facility. See “Use of Proceeds.” This new lease is expected to result in an increase of approximately $2.0 million to $2.5 million in our annual rent for our headquarters. If we are unable to enter into a definitive agreement for new space prior to the date our current lease expires, we may have to enter into a lease for new space on terms which may be substantially less favorable than the terms of our existing lease. In addition, even if we do enter into a definitive agreement for the lease of new space prior to the expiration of our current lease, we may need to expend substantial amounts of time and money in order to prepare the space to meet our business needs and requirements, which could result in significant expenses to us and may delay our ability to relocate to the new location.

Furthermore, if we fail to enter into a definitive agreement for our new headquarters facility as expected or are unable to locate, secure and prepare new space on or before the expiration of our current lease and/or move out of our existing headquarters before such time, we may incur penalties from our existing landlord, additional expenses and fees associated with temporary space and related moving costs. All of the foregoing could result in substantial costs to us and could result in material interruption to our business and operations.

 

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Risks Related to our Legal and Regulatory Environment

Our products and operations are subject to extensive governmental regulation in the United States, and our failure to comply with applicable requirements could cause our business to suffer.

The medical device industry is regulated extensively by governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies and authorities. The FDA and other U.S. and foreign governmental agencies and authorities regulate and oversee, among other things, with respect to medical devices:

 

   

design, development and manufacturing;

 

   

testing, labeling, content and language of instructions for use and storage;

 

   

clinical trials;

 

   

product safety;

 

   

marketing, sales and distribution;

 

   

pre-market clearance and approval;

 

   

conformity assessment procedures;

 

   

record-keeping procedures;

 

   

advertising and promotion;

 

   

recalls and other field safety corrective actions;

 

   

post-market surveillance, including reporting of deaths or serious injuries and malfunctions that, if they were to recur, could lead to death or serious injury;

 

   

post-market studies; and

 

   

product import and export.

The regulations to which we are subject are complex and have tended to become more stringent over time. Regulatory changes could result in restrictions on our ability to carry on or expand our operations, higher than anticipated costs or lower than anticipated sales.

Our failure to comply with U.S. federal and state regulations could lead to the issuance of warning letters or untitled letters, the imposition of injunctions, suspensions or loss of regulatory clearance or approvals, product recalls, termination of distribution, product seizures or civil penalties. In the most extreme cases, criminal sanctions or closure of our manufacturing facilities are possible.

Our products and operations also are subject to extensive governmental regulation in foreign jurisdictions, such as Europe, and our failure to comply with applicable requirements could cause our business to suffer.

In the EEA, our medical devices must comply with the Essential Requirements laid down in Annex I to the Medical Devices Directive. Compliance with these requirements is a prerequisite to be able to affix the CE mark to our medical devices, without which they cannot be marketed or sold in the EEA. To demonstrate compliance with the Essential Requirements and obtain the right to affix the CE mark to our medical devices, we must undergo a conformity assessment procedure, which varies according to the type of medical device and its classification. Except for low risk medical devices (Class I with no measuring function and which are not sterile), where the manufacturer can issue an EC Declaration of Conformity based on a self-assessment of the conformity of its products with the Essential Requirements, a conformity assessment procedure requires the intervention of a Notified Body, which is an organization designated by a competent authority of an EEA country to conduct conformity assessments. Depending

 

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on the relevant conformity assessment procedure, the Notified Body would audit and examine the Technical File and the quality system for the manufacture, design and final inspection of our devices. The Notified Body issues a CE Certificate of Conformity following successful completion of a conformity assessment procedure conducted in relation to the medical device and its manufacturer and their conformity with the Essential Requirements. This Certificate entitles the manufacturer to affix the CE mark to its medical devices after having prepared and signed a related EC Declaration of Conformity.

As a general rule, demonstration of conformity of medical devices and their manufacturers with the Essential Requirements must be based, among other things, on the evaluation of clinical data supporting the safety and performance of the products during normal conditions of use. Specifically, a manufacturer must demonstrate the device achieves its intended performance during normal conditions of use and that the known and foreseeable risks, and that any adverse events, are minimized and acceptable when weighed against the benefits of its intended performance, and that any claims made about the performance and safety of the device (e.g., product labeling and instructions for use) are supported by suitable evidence. This assessment must be based on clinical data, which can be obtained from (1) clinical studies conducted on the devices being assessed, (2) scientific literature from similar devices whose equivalence with the assessed device can be demonstrated or (3) both clinical studies and scientific literature. With respect to implantable medical devices or Class III devices, the manufacturer must conduct clinical studies to obtain the required clinical data, unless reliance on existing clinical data from

equivalent devices can be justified. The conduct of clinical studies in the EEA is governed by detailed regulatory obligations. These may include the requirement of prior authorization by the competent authorities of the country in which the study takes place and the requirement to obtain a positive opinion from a competent Ethics Committee. This process can be expensive and time-consuming.

Our failure to comply with applicable foreign regulatory requirements, including those administered by the competent authorities of the EEA countries, could result in enforcement actions against us, including refusal, suspension or withdrawal of our CE Certificates of Conformity by our Notified Body, which could hurt our ability to market products in the EEA in the future.

If we fail to maintain regulatory approvals and clearances, or are unable to obtain, or experience significant delays in obtaining, FDA clearances or approvals for our future products or product enhancements, our ability to commercially distribute and market these products could suffer.

Before we can commercially distribute a new medical device product or a significant modification to an existing product in the United States, we must obtain either clearance under Section 510(k) of the Federal Food, Drug and Cosmetics Act, or the FDCA, or approval of a PMA application from the FDA, unless an exemption from premarket review applies. In the 510(k) clearance process, the FDA must determine that a proposed device is “substantially equivalent” to a legally marketed device, known as a “predicate” device, with respect to intended use, technology and safety and effectiveness, in order to clear the proposed device for marketing. Clinical data is sometimes required to support substantial equivalence. The PMA pathway requires an applicant to demonstrate the safety and effectiveness of the device based, in part, on extensive data, including, but not limited to, technical, preclinical, clinical trial, manufacturing and labeling data. The PMA process is typically required for devices that are deemed to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices. Products that are approved through a PMA application generally need FDA approval before they can be modified. Similarly, some modifications made to products cleared through a 510(k) may require a new 510(k). Both the 510(k) and PMA processes can be expensive and lengthy and require the payment of significant fees, unless exempt. The FDA’s 510(k) clearance process usually takes from three to 12 months, but may last longer. The process of obtaining a PMA is much more costly and uncertain than the 510(k) clearance process and generally takes from one to three years, or even longer, from the time the application is submitted to the FDA until an approval is obtained. The process of obtaining regulatory clearances or approvals to market a medical device can be costly and time-consuming, and we may not be able to obtain these clearances or approvals on a timely basis, if at all.

 

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Our currently commercialized products have either received premarket clearance under Section 510(k) of the FDCA or are exempt from premarket review. If the FDA requires us to go through a lengthier, more rigorous examination for future products or modifications to existing products than we had expected, our product introductions or modifications could be delayed or canceled, which could cause our sales to decline. Should the FDA disagree with our position that certain of our products are appropriately considered exempt from premarket review and require us to submit a 510(k) or PMA in order to market our devices, it could limit our ability to market these products. In addition, the FDA may determine that future products will require the more costly, lengthy and uncertain PMA process. Although we do not currently market any devices under a PMA, the FDA may demand that we obtain a PMA prior to marketing certain of our future products or modifications to existing products. In addition, if the FDA disagrees with our determination that a product we currently market is subject to an exemption from premarket review, the FDA may require us to submit a 510(k) or PMA in order to continue marketing the product. Further, even with respect to those future products where a PMA is not required, we cannot assure you that we will be able to obtain 510(k) clearance with respect to those products.

The FDA can delay, limit or deny clearance or approval of a device for many reasons, including:

 

   

we may not be able to demonstrate to the FDA’s satisfaction that our products are safe and effective for their intended users;

 

   

the data from pre-clinical studies and clinical trials may be insufficient to support clearance or approval, where required; and

 

   

the manufacturing process or facilities we use may not meet applicable requirements.

Obtaining clearances and approvals can be a time consuming process, and delays in obtaining required future clearances or approvals would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would harm our future growth.

Modifications to our products may require new 510(k) clearances, premarket approvals or new or amended CE Certificates of Conformity, and may require us to cease marketing or recall the modified products until clearances, approvals or the relevant CE Certificates of Conformity are obtained.

Any modification to a 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, design, or manufacture, requires a new 510(k) clearance or, possibly, a PMA. The FDA requires every manufacturer to make this determination in the first instance, but the FDA may review such determinations. The FDA may not agree with our decisions regarding whether new clearances or approvals are necessary. We have modified some of our 510(k)- cleared products, and have determined based on our review of the applicable FDA guidance that in certain instances new 510(k) clearances or PMAs are not required. If the FDA disagrees with our determination and requires us to submit new 510(k)s or PMAs for modifications to our previously cleared products for which we have concluded that new clearances or approvals are unnecessary, we may be required to cease marketing or to recall the modified products until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties.

Furthermore, the FDA’s ongoing review of the 510(k) program may make it more difficult for us to make modifications to our previously cleared products, either by imposing more strict requirements on when a new 510(k) for a modification to a previously cleared product must be submitted, or applying more onerous review criteria to such submissions. In July and December 2011, respectively, the FDA issued draft guidance documents addressing when to submit a new 510(k) due to modifications to 510(k)-cleared products and the criteria for evaluating substantial equivalence.

The July 2011 draft guidance document was ultimately withdrawn as the result of the FDASIA, and as a result, the FDA’s original guidance document regarding 510(k) modifications, which dates back to 1997,

 

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remains in place. It is uncertain when the FDA will seek to issue new guidance on product modifications. Any efforts to do so could result in a more rigorous review process and make it more difficult to obtain clearance for device modifications.

In the EEA, we must inform the Notified Body that carried out the conformity assessment of the medical devices we market or sell in the EEA of any planned substantial changes to our quality system or changes to our medical devices which could affect compliance with the Essential Requirements laid down in Annex I to the Medical Devices Directive or the devices’ intended use. The Notified Body will then assess the planned changes and verify whether they affect the products’ conformity with the Medical Devices Directive. If the assessment is favorable, the Notified Body will issue a new CE Certificate of Conformity or an addendum to the existing certificate attesting compliance with the Essential Requirements and quality system requirements laid down in the Annexes to the Medical Devices Directive.

We may fail to obtain or maintain foreign regulatory approvals to market our products in other countries.

We currently market our products internationally and intend to expand our international marketing. International jurisdictions require separate regulatory approvals and compliance with numerous and varying regulatory requirements. For example, we intend to seek regulatory clearance to market our primary products in Brazil, China and other key markets. The approval procedures vary among countries and may involve requirements for additional testing, and the time required to obtain approval may differ from country to country and from that required to obtain FDA clearance or approval, or a CE Certificate of Conformity in the EEA.

In certain of our international markets, our product registrations are in the name of our distributors and if we end our relationships with such distributors, we may experience difficulties in getting such product registrations back in our name or obtaining new registrations from the appropriate regulatory authorities.

Clearance or approval by the FDA, or the CE marking of our products in the EEA, does not ensure approval or certification by regulatory authorities in other countries or jurisdictions, and approval or certification by one foreign regulatory authority does not ensure approval or certification by regulatory authorities in other foreign countries, the EEA or by the FDA. The foreign regulatory approval or certification process may include all of the risks associated with obtaining FDA clearance or approval, or a CE Certificate of Conformity. We may not obtain foreign regulatory approvals on a timely basis, if at all. We may not be able to file for regulatory approvals or certifications and may not receive necessary approvals to commercialize our products in any market. If we fail to receive necessary approvals or certifications to commercialize our products in foreign jurisdictions on a timely basis, or at all, our business, results of operations and financial condition could be adversely affected.

Even after clearance or approval for our products is obtained, we are subject to extensive post-market regulation by the FDA. Our failure to meet strict regulatory requirements could require us to pay fines, incur other costs or even close our facilities.

Even after we have obtained the proper regulatory clearance or approval to market a product, the FDA has the power to require us to conduct post-market studies. These studies can be very expensive and time-consuming to conduct. Failure to complete such studies in a timely manner could result in the revocation of clearance or approval and the recall or withdrawal of the product, which could prevent us from generating sales from that product in the United States. The FDA has broad enforcement powers, and any regulatory enforcement actions or inquiries, or other increased scrutiny on us, could dissuade some surgeons from using our products and adversely affect our reputation and the perceived safety and efficacy of our products.

 

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We are also required to comply with the FDA’s Quality System Regulation, or QSR, which covers the methods used in, and the facilities and controls used for, the design, manufacture, quality assurance, labeling, packaging, sterilization, storage, shipping, installation and servicing of our marketed products. The FDA enforces the QSR through periodic announced and unannounced inspections of manufacturing facilities. In addition, in the future, regulatory authorities and/or customers may require specific packaging of sterile products, which could increase our costs and the price of our products.

Later discovery of previously unknown problems with our products, including unanticipated adverse events or adverse events of unanticipated severity or frequency, manufacturing problems, or failure to comply with regulatory requirements such as QSR, may result in changes to labeling, restrictions on such products or manufacturing processes, withdrawal of the products from the market, voluntary or mandatory recalls, a requirement to repair, replace or refund the cost of any medical device we manufacture or distribute, fines, suspension of regulatory approvals, product seizures, injunctions or the imposition of civil or criminal penalties which would adversely affect our business, operating results and prospects.

If our products, or malfunction of our products, cause or contribute to a death or a serious injury, we will be subject to medical device reporting regulations, which can result in voluntary corrective actions or agency enforcement actions.

Under the FDA’s medical device reporting, or MDR, regulations, we are required to report to the FDA any incident in which our product may have caused or contributed to a death or serious injury or in which our product malfunctioned and, if the malfunction were to recur, would likely cause or contribute to death or serious injury. Repeated product malfunctions may result in a voluntary or involuntary product recall, which could divert managerial and financial resources, impair our ability to manufacture our products in a cost-effective and timely manner, and have an adverse effect on our reputation, results of operations and financial condition. We are also required to follow detailed recordkeeping requirements for all firm-initiated medical device corrections and removals, and to report such corrective and removal actions to the FDA if they are carried out in response to a risk to health and have not otherwise been reported under the MDR regulations. In addition, in December of 2012, the FDA issued a draft guidance intended to assist the FDA and the industry in distinguishing medical device recalls from product enhancements. Per the guidance, if any change or group of changes to a device addresses a violation of the FDCA, that change would generally constitute a medical device recall and require submission of a recall report to the FDA.

All manufacturers bringing medical devices to market in the EEA are legally bound to report any incident that led or might have led to the death or serious deterioration in the state of health of a patient, user or other person, and which the manufacturer’s device is suspected to have caused, to the competent authority in whose jurisdiction the incident occurred. In such case, the manufacturer must file an initial report with the relevant competent authority, which would be followed by further evaluation or investigation of the incident and a final report indicating whether further action is required.

Any adverse event involving our products could result in future voluntary corrective actions, such as recalls or customer notifications, or agency action, such as inspection or enforcement action. Adverse events involving our products have been reported to us in the past, and we cannot guarantee that they will not occur in the future. Any corrective action, whether voluntary or involuntary, will require the dedication of our time and capital, distract management from operating our business and may harm our reputation and financial results.

 

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A recall of our products, either voluntarily or at the direction of the FDA or another governmental authority, or the discovery of serious safety issues with our products, could have a significant adverse impact on us.

The FDA and similar foreign governmental authorities such as the competent authorities of the EEA countries have the authority to require the recall of commercialized products in the event of material deficiencies or defects in design or manufacture or in the event that a product poses an unacceptable risk to health. Manufacturers may, under their own initiative, recall a product if any material deficiency in a device is found. A government-mandated or voluntary recall by us or one of our distributors could occur as a result of an unacceptable risk to health, component failures, manufacturing errors, design or labeling defects or other deficiencies and issues. Recalls of any of our products would divert managerial and financial resources and have an adverse effect on our reputation, results of operations and financial condition, which could impair our ability to produce our products in a cost-effective and timely manner in order to meet our customers’ demands. We may also be required to bear other costs or take other actions that may have a negative impact on our future sales and our ability to generate profits.

Further, under the FDA’s MDR regulations, we are required to report to the FDA any incident in which our product may have caused or contributed to a death or serious injury or in which our product malfunctioned and, if the malfunction were to recur, would likely cause or contribute to death or serious injury.

In the EEA we must comply with the EU Medical Device Vigilance System. Under this system, incidents must be reported to the relevant authorities of the EEA countries, and manufacturers are required to take Field Safety Corrective Actions, or FSCAs, to reduce a risk of death or serious deterioration in the state of health associated with the use of a medical device that is already placed on the market. An incident is defined as any malfunction or deterioration in the characteristics and/or performance of a device, as well as any inadequacy in the labeling or instructions for use or an unanticipated adverse reaction or side effect which, directly or indirectly, might lead to or might have led to the death of a patient, user or other person or to a serious deterioration in their state of health. An FSCA may include the recall, modification, exchange, destruction or retrofitting of the device. FSCAs must be communicated by the manufacturer or its legal representative to its customers and/or to the end users of the device through Field Safety Notices.

Repeated product malfunctions may result in a voluntary or involuntary product recall, which could divert managerial and financial resources, impair our ability to manufacture our products in a cost-effective and timely manner and have an adverse effect on our reputation, results of operations and financial condition.

If we or our suppliers fail to comply with ongoing regulatory requirements, or if we experience unanticipated problems with our products, our products could be subject to restrictions or withdrawal from the market.

Any product for which we obtain clearance or approval, and the manufacturing processes, reporting requirements, post-approval clinical data and promotional activities for such product, will be subject to continued regulatory review, oversight and periodic inspection by the FDA and other domestic and foreign regulatory bodies. In particular, we and our third-party suppliers are required to comply with the QSR. In the EEA countries, compliance with harmonized standards is also recommended as this is interpreted as a presumption of conformity with the relevant Essential Requirements laid down in Annex I to the Medical Devices Directive. These FDA regulations and EU standards cover the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging, sterilization, storage and shipping of our products. Compliance with the QSR is subject to continual review and is monitored rigorously through periodic inspections by the FDA. Compliance with harmonized standards in the EEA is also subject to regular review through audits by Notified Bodies or

 

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other certification bodies. If we, or our manufacturers, fail to adhere to QSR requirements in the United States or other harmonized standards in the EEA, this could delay production of our products and lead to fines, difficulties in obtaining regulatory clearances and CE Certificate of Conformity, recalls, enforcement actions, including injunctive relief or consent decrees, or other consequences, which could, in turn, have a material adverse effect on our financial condition or results of operations.

The FDA has inspected our Leesburg facility on three separate occasions: August 2006, October 2007 and January 2011. We received a Form FDA-483 list of inspectional observations on each occasion all of which have been closed by the FDA.

Any future failure by us or one of our suppliers to comply with applicable statutes and regulations administered by the FDA, or the failure to timely and adequately respond to any adverse inspectional observations or product safety issues, could result in any of the following enforcement actions:

 

   

untitled letters, warning letters, fines, injunctions, consent decrees and civil penalties;

 

   

unanticipated expenditures to address or defend such actions;

 

   

customer notifications or repair, replacement, refund, recall, detention or seizure of our products;

 

   

operating restrictions or partial suspension or total shutdown of production;

 

   

refusing or delaying our requests for 510(k) clearance or PMA approval of new products or modified products;

 

   

withdrawing 510(k) clearances that have already been granted;

 

   

refusal to grant export approval for our products; or

 

   

criminal prosecution.

Any of these sanctions could have a material adverse effect on our reputation, business, results of operations and financial condition. Furthermore, our key component suppliers may not currently be or may not continue to be in compliance with all applicable regulatory requirements, which could result in our failure to produce our products on a timely basis and in the required quantities, if at all.

Outside the EEA and the United States, our products and operations are also often required to comply with standards set by foreign regulatory bodies, and those standards, types of evaluation and scope of review differ among foreign regulatory bodies. We intend to comply with the standards enforced by such foreign regulatory bodies as needed to commercialize our products. If we fail to comply with any of these standards adequately, a foreign regulatory body may take adverse actions similar to those within the power of an EEA Notified Body or competent authority or the FDA. Any such action may harm our reputation and business, and could have an adverse effect on our business, results of operations and financial condition.

We may be subject to enforcement action if we engage in improper marketing or promotion of our products.

Our promotional materials and training methods must comply with FDA and other applicable laws and regulations, including the prohibition of the promotion of unapproved, or off-label, use. Surgeons may use our products off-label, as the FDA does not restrict or regulate a surgeon’s choice of treatment within the practice of medicine. However, if the FDA determines that our promotional materials or training constitutes promotion of an off-label use, it could request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil fine or criminal penalties. It is also possible that other federal,

 

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state or foreign enforcement authorities might take action if they consider our promotional or training materials to constitute promotion of an off-label use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement. In that event, our reputation could be damaged and adoption of the products could be impaired. Although our policy is to refrain from statements that could be considered off-label promotion of our products, the FDA or another regulatory agency could disagree and conclude that we have engaged in off-label promotion. In addition, the off-label use of our products may increase the risk of injury to patients and, in turn, the risk of product liability claims. Product liability claims are expensive to defend and could divert our management’s attention, result in substantial damage awards against us, and harm our reputation.

Further, the advertising and promotion of our products is subject to the Medical Devices Directive, Directive 2006/114/EC concerning misleading and comparative advertising, Directive 2005/29/EC on unfair commercial practices, and other EEA countries’ legislation governing the advertising and promotion of medical devices. In addition, we are subject to EU and national Codes of Conduct. These laws and Codes of Conduct may limit or restrict the advertising and promotion of our products to the general public and may impose limitations on our promotional activities with healthcare professionals.

The misuse or off-label use of our products may harm our image in the marketplace or result in injuries that lead to product liability suits, which could be costly to our business.

The FDA and the competent authorities of the EEA countries do not prevent a physician from using our products off-label, as the FDA and the laws of the EEA countries generally do not restrict or regulate a physician’s choice of treatment within the practice of medicine. The use of our products for indications other than those indications for which our products have been cleared by the FDA, or CE marked in the EEA, may not effectively treat such conditions or may increase the risk of injury to patients, which could harm our reputation in the marketplace among physicians and patients. Physicians may also misuse our products or use improper techniques if they are not adequately trained, potentially leading to injury and an increased risk of product liability. If our products are misused or used with improper technique, we may become subject to costly litigation by our customers or their patients. Product liability claims could divert management’s attention from our core business, be expensive to defend and result in sizable damage awards against us that may not be covered by insurance. Any of these events could harm our business and results of operations and cause our stock price to decline.

Clinical trials necessary to support a PMA application are expensive and require the enrollment of large numbers of patients, and suitable patients may be difficult to identify and recruit . Delays or failures in any future clinical trials will prevent us from commercializing any modified or new products associated with such trials and could adversely affect our business, results of operations and financial condition.

Certain of our future products may require the approval of a PMA. Initiating and completing clinical trials necessary to support a PMA application, and additional safety and efficacy data beyond that typically required for a 510(k) clearance, can be time consuming and expensive and the outcome uncertain. Moreover, the results of early clinical trials are not necessarily predictive of future results, and any product we advance into clinical trials may not have favorable results in later clinical trials.

Conducting successful clinical studies requires the enrollment of large numbers of patients, and suitable patients may be difficult to identify and recruit. Patient enrollment in clinical trials and completion of patient participation and follow-up depends on many factors, including the size of the patient population, the nature of the trial protocol, the attractiveness of, or the discomforts and risks associated with, the treatments received by enrolled subjects, the availability of appropriate clinical trial investigators and support staff, proximity of patients to clinical sites, patient ability to meet the eligibility and exclusion criteria for participation in the clinical trial and patient compliance. For example, patients may be discouraged from enrolling in our clinical trials if the trial protocol requires them to undergo extensive post-treatment procedures or follow-up to assess the safety and effectiveness of our products or

 

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if they determine that the treatments received under the trial protocols are not attractive or involve unacceptable risks or discomforts. Patients may also not participate in our clinical trials if they choose to participate in contemporaneous clinical trials of competitive products. In addition, patients participating in clinical trials may die before completion of the trial or suffer adverse medical events unrelated to investigational products.

Sufficient and appropriate clinical protocols to demonstrate safety and efficacy are required and we may not adequately develop such protocols to support clearance and approval. Further, the FDA may require us to submit data on a greater number of patients than we originally anticipated and/or for a longer follow-up period or change the data collection requirements or data analysis applicable to our clinical trials. Delays in patient enrollment or failure of patients to continue to participate in a clinical trial may cause an increase in costs and delays in the approval and attempted commercialization of our products or result in the failure of the clinical trial. In addition, despite considerable time and expense invested in our clinical trials, the FDA may not consider our data adequate to demonstrate safety and efficacy. Such increased costs and delays or failures could adversely affect our business, results of operations and prospects.

If the third parties on which we rely to conduct our clinical trials and to assist us with pre-clinical development do not perform as contractually required or expected, we may not be able to obtain regulatory approval for or commercialize our products.

We do not have the ability to independently conduct pre-clinical or clinical trials for our products and, if we need to conduct such trials in the future, we would need to rely on third parties, such as contract research organizations, medical institutions, clinical investigators and contract laboratories to conduct such trials. If these third parties do not successfully carry out their contractual duties or regulatory obligations or meet expected deadlines, if these third parties need to be replaced, or if the quality or accuracy of the data they obtain is compromised due to the failure to adhere to our clinical protocols or regulatory requirements or for other reasons, our pre-clinical development activities or clinical trials may be extended, delayed, suspended or terminated, and we may not be able to obtain regulatory approval for, or successfully commercialize, our products on a timely basis, if at all, and our business, results of operations and prospects may be adversely affected. Furthermore, our third-party clinical trial investigators may be delayed in conducting our clinical trials for reasons outside of their control.

The results of clinical trials may not support future product candidates or claims or may result in the discovery of adverse side effects.

In the future, we may need to conduct clinical trials to support approval of new products, and any future clinical trial activities that we undertake will be subject to extensive regulation and review by numerous governmental authorities both in the United States and abroad. Clinical studies intended to support a 510(k) or PMA must be conducted in compliance with the FDA’s Good Clinical Practice regulations and similar requirements in foreign jurisdictions. Even if our clinical trials are completed as planned, we cannot be certain that their results will support our product candidate claims or that the FDA or foreign authorities and Notified Bodies will agree with our conclusions regarding them. Success in pre-clinical studies and early clinical trials does not ensure that later clinical trials will be successful, and we cannot be sure that the later trials will replicate the results of prior trials and pre-clinical studies. The clinical trial process may fail to demonstrate that our product candidates are safe and effective for the proposed indicated uses, which could cause us to abandon a product candidate and may delay development of others. Any delay or termination of our clinical trials will delay the filing of associated product submissions and, ultimately, our ability to commercialize products requiring submission of clinical data. It is also possible that patients enrolled in a clinical trial will experience adverse side effects that are not currently part of the product candidate’s safety profile, which could cause us to delay or abandon development of such product.

 

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Governmental regulation and limited sources and suppliers could restrict our procurement and use of allograft bone tissue.

In the United States, the procurement and transplantation of allograft bone tissue is subject to federal law pursuant to the National Organ Transplant Act, or NOTA, a criminal statute which prohibits the purchase and sale of human organs used in human transplantation, including bone and related tissue, for “valuable consideration.” NOTA permits reasonable payments associated with the removal, transportation, processing, preservation, quality control, implantation and storage of human bone tissue. We provide processing fees to certain of our suppliers, which are registered tissue banks, for their services related to recovering allograft bone tissue. If NOTA is interpreted or enforced in a manner that prevents us from making these processing fees to our tissue bank suppliers for the services they render for us, our business could be materially adversely affected. The FDA periodically inspects tissue processors to determine compliance with these requirements. Violations of applicable regulations noted by the FDA during facility inspections could adversely affect the continued marketing of our products. We believe we comply with all aspects of the FDA’s Current Good Tissue Practice regulations, although there can be no assurance that we will comply, or will comply on a timely basis, in the future. The entity that provides us with allograft bone tissue is responsible for performing donor recovery, donor screening and donor testing and our compliance with those aspects of the Current Good Tissue Practice regulations that regulate those functions are dependent upon the actions of this independent entity.

Two third-party suppliers currently supply all of our needs for biomaterials products, which incorporate allograft bone tissue. The processing of allograft bone tissue into our biomaterials products is very labor-intensive and it is therefore difficult to maintain a steady supply stream. In addition, due to seasonal changes in mortality rates, some scarce tissues used in our biomaterials products may be, at times, in particularly short supply. We cannot be certain that our current supply of biomaterials products from our suppliers, plus any additional sources that we identify in the future, will be sufficient to meet our needs. Our dependence on a limited number of third-party suppliers and the challenges we may face in obtaining adequate supplies of allograft bone tissue involve several risks, including limited control over pricing, availability, quality and delivery schedules. In addition, any supply interruption in a sole-sourced human tissue component, could materially harm our and our third-party suppliers’ ability to manufacture our biomaterials products until a new source of supply, if any, could be found. We may be unable to find a sufficient alternative supply channel in a reasonable time period or on commercially reasonable terms, if at all, which would have a material adverse effect on our business, results of operations and financial condition.

Negative publicity concerning methods of tissue recovery and screening of donor tissue in our industry could reduce demand for our biomaterials products and impact the supply of available donor tissue.

Media reports or other negative publicity concerning both alleged improper methods of tissue recovery from donors and disease transmission from donated tissue could limit widespread acceptance of some of our biomaterials products. Unfavorable reports of improper or illegal tissue recovery practices, both in the United States and internationally, as well as incidents of improperly processed tissue leading to the transmission of disease, may broadly affect the rate of future tissue donation and market acceptance of technologies incorporating human tissue. In addition, such negative publicity could cause the families of potential donors to become reluctant to agree to donate tissue to for-profit tissue processors. For example, the media has reported examples of alleged illegal harvesting of body parts from cadavers and resulting recalls conducted by certain companies selling human tissue based products affected by the alleged illegal harvesting. These reports and others could have a negative effect on our biomaterials business.

 

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We are subject to environmental laws and regulations that can impose significant costs and expose us to potential financial liabilities.

The manufacture of certain of our products, including our biomaterials products, and the handling of materials used in the product testing process, including in our cadaveric laboratory, involve the controlled use of biological and/or hazardous materials and wastes. Our business and facilities and those of our suppliers are subject to foreign, federal, state and local laws and regulations relating to the protection of human health and the environment, including those governing the use, manufacture, storage, handling and disposal of, and exposure to, such materials and wastes. In addition, under some environmental laws and regulations, we could be held responsible for costs relating to any contamination at our present facilities and at third-party waste disposal sites even if such contamination was not caused by us. A failure to comply with current or future environmental laws and regulations could result in severe fines or penalties. Any such expenses or liability could have a significant negative impact on our business, results of operations and financial condition.

We or our suppliers may be the subject of claims for non-compliance with FDA regulations in connection with the processing, manufacturing or distribution of our proposed allograft bone tissue or other biomaterials products.

Allegations may be made against us or against donor recovery groups or tissue banks, including those with which we have a contractual supplier relationship, claiming that the acquisition or processing of biomaterials products does not comply with applicable FDA regulations or other relevant statutes and regulations. Allegations like these could cause regulators or other authorities to take investigative or other action against us or our suppliers, or could cause negative publicity for us or our industry generally. These actions or any negative publicity could cause us to incur substantial costs, divert the attention of our management from our business and harm our reputation.

If we or our sales representatives fail to comply with fraud and abuse laws, we could be subject to civil and criminal penalties, which could adversely impact our reputation and business operations.

There are numerous U.S. federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws and physician self-referral laws. Our relationships with surgeons, hospitals, group purchasing organizations and our international distributors are subject to scrutiny under these laws. Violations of these laws are punishable by criminal and civil sanctions, including significant monetary penalties and, in some instances, imprisonment and exclusion from participation in federal and state healthcare programs, including the Medicare, Medicaid and Veterans Administration health programs.

Healthcare fraud and abuse regulations are complex, and even minor irregularities can potentially give rise to claims that a statute or prohibition has been violated. The laws that may affect our ability to operate include:

 

   

the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, receiving, offering or paying remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the purchase, order or recommendation of, any good or service for which payment may be made under federal healthcare programs such as Medicare and Medicaid;

 

   

the federal False Claims Act, which prohibits, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid or other third-party payors that are false or fraudulent;

 

   

the federal Health Insurance Portability and Accountability Act of 1996, as amended, which created federal criminal laws that prohibit executing a scheme to defraud any healthcare benefit program and making false statements relating to healthcare matters;

 

   

the Federal Trade Commission Act and similar laws regulating advertisement and consumer protections;

 

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the federal Foreign Corrupt Practices Act of 1977, or the FCPA, which prohibits corrupt payments, gifts or transfers of value to foreign officials; and

 

   

foreign and/or U.S. state law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers.

Further, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010, or, collectively, the PPACA, among other things, amends the intent requirements of the federal Anti-Kickback Statute and the criminal statute governing healthcare fraud. A person or entity can now be found guilty of violating the federal Anti-Kickback Statute and the federal criminal healthcare fraud statute without actual knowledge of the statute or specific intent to violate it. In addition, the PPACA provides that the government may assert that a claim including items or services resulting from a violation of the federal Anti-Kickback Statute constitutes a false or fraudulent claim for purposes of the federal False Claims Act or federal civil money penalties statute. Possible sanctions for violation of laws include monetary fines, civil and criminal penalties, exclusion from Medicare and Medicaid programs and forfeiture of amounts collected in violation of such prohibitions. Moreover, while we do not submit claims and our customers make the ultimate decision on how to submit claims, from time-to-time, we may provide reimbursement guidance to our customers. If a government authority were to conclude that we provided improper advice to our customers and/or encouraged the submission of false claims for reimbursement, we could face action against us by government authorities. Any violations of these laws, or any action against us for violation of these laws, even if we successfully defend against it, could result in a material adverse effect on our reputation, business, results of operations and financial condition.

Because of the breadth of these laws and the narrowness of the statutory exceptions and safe harbors available under the federal Anti-Kickback Statute, it is possible that some of our business activities, including our relationship with surgeons, hospitals, group purchasing organizations and our independent sales agencies and distributors, could be subject to challenge under one or more of such laws.

We have entered into certain agreements, including consulting agreements and royalty agreements, with surgeons, including some who order and use our products in procedures they perform. While these transactions were structured to comply with all applicable laws, including state and federal anti-kickback laws, to the extent applicable, regulatory agencies may view these transactions as prohibited arrangements that must be restructured, or discontinued, or for which we could be subject to other significant penalties, including debarment. Although compliance programs can mitigate the risk of investigation and prosecution for violations of these laws, the risks cannot be entirely eliminated. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. We could also be adversely affected if regulatory agencies interpret our financial relationships with spine surgeons who order our products to be in violation of applicable laws. This could subject us to civil and criminal penalties for non-compliance, the cost of which could be substantial.

To enforce compliance with the federal laws, the U.S. Department of Justice, or DOJ, has recently increased its scrutiny of interactions between healthcare companies and healthcare providers, which has led to a number of investigations, prosecutions, convictions and settlements in the healthcare industry. Dealing with investigations can be time and resource consuming and can divert management’s attention from the business. In addition, settlements with the DOJ or other law enforcement agencies have forced healthcare providers to agree to additional compliance and reporting requirements as part of a consent decree or corporate integrity agreement. Any such investigation or settlement could increase our costs or otherwise have an adverse effect on our business.

In addition, there has been a recent trend of increased federal and state regulation of payments made to physicians. The PPACA imposed new reporting requirements on device manufacturers for payments

 

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made by them and in some cases, their distributors, to physicians and teaching hospitals, as well as ownership and investment interests held by physicians (commonly known as the Physician Payment Sunshine Act). Failure to submit required information may result in civil monetary penalties of up to an aggregate of $150,000 per year (or up to an aggregate of $1 million per year for “knowing failures”), for all payments, transfers of value or ownership or investment interests that are not timely, accurately and completely reported in an annual submission. The period between August 1, 2013 and December 31, 2013 was the first reporting period, and manufacturers were required to report aggregate payment data by March 31, 2014, and will be required to report detailed payment data and submit legal attestation to the accuracy of such data during Phase 2 of the program (which begins in May 2014 and extends for at least 30 days). Thereafter, manufacturers must submit reports by the 90th day of each subsequent calendar year. Due to the difficulty in complying with the Physician Payment Sunshine Act and the use of independent sales agencies as part of our U.S. sales force, we cannot assure you that we will successfully report all transfers of value by us and our independent sales agencies, and any failure to comply could result in significant fines and penalties.

Certain states mandate implementation of commercial compliance programs, impose restrictions on device manufacturer marketing practices and tracking and/or require the reporting of gifts, compensation and other remuneration to physicians. A similar trend is observed in foreign jurisdictions such as France. In France, a recently adopted law and a decree require companies working in the health sector to publicly disclose direct or indirect benefits granted to, and agreements entered into with, physicians and other healthcare professionals. The shifting commercial compliance environment and the need to build and maintain robust and expandable systems to comply with different compliance and/or reporting requirements in multiple jurisdictions increase the possibility that a healthcare company may violate one or more of the requirements.

Most of these laws apply to not only the actions taken by us, but also actions taken by our independent sales agencies and distributors. We have limited knowledge and control over the business practices of our independent sales agencies and distributors, and we may face regulatory action against us as a result of their actions which could have a material adverse effect on our reputation, business, results of operations and financial condition.

In addition, the scope and enforcement of these laws is uncertain and subject to rapid change in the current environment of healthcare reform, especially in light of the lack of applicable precedent and regulations. Federal or state regulatory authorities might challenge our current or future activities under these laws. Any such challenge could have a material adverse effect on our reputation, business, results of operations and financial condition. Any state or federal regulatory review of us, regardless of the outcome, would be costly and time-consuming. In addition, we cannot predict the impact of any changes in these laws, whether or not retroactive.

U.S. legislative or FDA regulatory reforms may make it more difficult and costly for us to obtain regulatory approval of our product candidates and to manufacture, market and distribute our products after approval is obtained.

From time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the regulatory approval, manufacture and marketing of regulated products or the reimbursement thereof. In addition, FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business and our products. Any new regulations or revisions or reinterpretations of existing regulations may impose additional costs or lengthen review times of future products. In addition, FDA regulations and guidance are often revised or reinterpreted by the agency in ways that may significantly affect our business and our products. It is impossible to predict whether legislative changes will be enacted or FDA regulations, guidance or interpretations changed, and what the impact of such changes, if any, may be.

For example, the FDA may change its clearance and approval policies, adopt additional regulations or revise existing regulations, or take other actions which may prevent or delay approval or clearance of our products under development or impact our ability to modify our currently cleared products on a timely

 

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basis. For example, in 2011, the FDA initiated a review of the premarket clearance process in response to internal and external concerns regarding the 510(k) program, announcing 25 action items designed to make the process more rigorous and transparent. In addition, as part of the Food and Drug Administration Safety and Innovation Act of 2012, or the FDASIA, Congress enacted several reforms entitled the Medical Device Regulatory Improvements and additional miscellaneous provisions which will further affect medical device regulation both pre- and post-approval. The FDA has implemented, and continues to implement, these reforms, which could impose additional regulatory requirements upon us and delay our ability to obtain new 510(k) clearances, increase the costs of compliance or restrict our ability to maintain our current clearances. For example, the FDA recently issued guidance documents intended to explain the procedures and criteria the FDA will use in assessing whether a 510(k) submission meets a minimum threshold of acceptability and should be accepted for review. Under the “Refuse to Accept” guidance, the FDA conducts an early review against specific acceptance criteria to inform 510(k) submitters if the submission is administratively complete, or if not, to identify the missing element(s). Submitters are given the opportunity to provide the FDA with the identified information, but if the information is not provided within a defined time, the submission will not be accepted for FDA review. Any change in the laws or regulations that govern the clearance and approval processes relating to our current and future products could make it more difficult and costly to obtain clearance or approval for new products, or to produce, market and distribute existing products. Significant delays in receiving clearance or approval, or the failure to receive clearance or approval for our new products would have an adverse effect on our ability to expand our business.

U.S. legislative or regulatory healthcare reforms may make it more difficult and costly for us to market and distribute our products after clearance or approval is obtained.

Recent political, economic and regulatory influences are subjecting the healthcare industry to fundamental changes. The sales of our products depend in part on the availability of coverage and reimbursement from third-party payors such as government health programs, private health insurers, health maintenance organizations and other healthcare-related organizations. Both the federal and state governments in the United States and foreign governments continue to propose and pass new legislation and regulations designed to contain or reduce the cost of healthcare. Such legislation and regulations may result in decreased reimbursement for medical devices and/or the procedures in which they are used, which may further exacerbate industry-wide pressure to reduce the prices charged for medical devices. This could harm our ability to market our products and generate sales.

Federal and state governments in the United States have recently enacted legislation to overhaul the nation’s healthcare system. While the goal of healthcare reform is to expand coverage to more individuals, it also involves increased government price controls, additional regulatory mandates and other measures designed to constrain medical costs. The PPACA significantly impacts the medical device industry. Among other things, the PPACA:

 

   

imposes an annual excise tax of 2.3% on any entity that manufactures or imports medical devices offered for sale in the United States, which began on January 1, 2013 (described in more detail below);

 

   

establishes a new Patient-Centered Outcomes Research Institute to oversee and identify priorities in comparative clinical effectiveness research in an effort to coordinate and develop such research;

 

   

implements payment system reforms including a national pilot program on payment bundling to encourage hospitals, physicians and other providers to improve the coordination, quality and efficiency of certain healthcare services through bundled payment models; and

 

   

creates an independent payment advisory board that will submit recommendations to reduce Medicare spending if projected Medicare spending exceeds a specified growth rate.

 

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In addition, other legislative changes have been proposed and adopted since the PPACA was enacted. On August 2, 2011, the President signed into law the Budget Control Act of 2011, which, among other things, created the Joint Select Committee on Deficit Reduction to recommend to Congress proposals in spending reductions. The Joint Select Committee did not achieve a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, triggering the legislation’s automatic reduction to several government programs. This includes reductions to Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013. On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012, or the ATRA, which, among other things, further reduced Medicare payments to several providers, including hospitals, imaging centers and cancer treatment centers and increased the statute of limitations period for the government to recover overpayments to providers from three to five years. We expect that additional state and federal healthcare reform measures will be adopted in the future, any of which could limit the amounts that federal and state governments will pay for healthcare products and services, which could result in reduced demand for our products or additional pricing pressure.

Our financial performance may be adversely affected by medical device tax provisions in the healthcare reform laws.

The PPACA imposes, among other things, an excise tax of 2.3% on any entity that manufactures or imports medical devices offered for sale in the United States, which began on January 1, 2013. Under these provisions, the Congressional Research Service predicts that the total cost to the medical device industry may be up to $20 billion over the next decade. The Internal Revenue Service issued final regulations implementing the tax in December of 2012 which requires, among other things, bi-monthly payments and quarterly reporting. We anticipate that primarily all of our sales of medical devices in the United States will be subject to this 2.3% excise tax. During the year ended December 31, 2013, we recognized $2.0 million in tax expense associated with the medical device tax in the United States, which is included in cost of revenue.

Risks Related to our Financial Results and Need for Financing

We will need to generate significant sales to become profitable.

We intend to increase our operating expenses substantially as we add sales representatives, independent sales agencies and distributors to increase our geographic sales coverage, increase our marketing capabilities, conduct clinical trials and increase our general and administrative functions to support our growing operations. We will need to generate significant sales to achieve profitability and we might not be able to do so. Even if we do generate significant sales, we might not be able to achieve profitability on a quarterly or annual basis in the future. If our sales grow more slowly than we anticipate or if our operating expenses exceed our expectations, our financial performance will likely be adversely affected.

Our sales volumes and our results of operations may fluctuate over the course of the year.

We have experienced and continue to experience meaningful variability in our sales and gross profit among quarters, as well as within each quarter, as a result of a number of factors, including, among other things:

 

   

the number of products sold in the quarter;

 

   

the unpredictability of sales of full sets of spinal implants and instruments to our international distributors;

 

   

the demand for, and pricing of, our products and the products of our competitors;

 

   

the timing of or failure to obtain regulatory clearances or approvals for products;

 

   

costs, benefits and timing of new product introductions;

 

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increased competition;

 

   

the availability and cost of components and materials;

 

   

the number of selling days in the quarter;

 

   

fluctuation and foreign currency exchange rates; and

 

   

impairment and other special charges.

Our business is not generally seasonal in nature but our sales may be influenced by summer vacation and winter holiday periods, as we have experienced a higher incidence of adolescent surgeries during these periods which may lead to higher sales of our products in the second and fourth quarters of our fiscal year.

Our future capital needs are uncertain and we may need to raise additional funds in the future, and such funds may not be available on acceptable terms or at all.

We believe that our current cash and cash equivalents, including the proceeds from this offering together with our expected cash from operations will be sufficient to meet our projected operating requirements for the foreseeable future. However, continued expansion of our business will be expensive and we may seek additional funds from public and private stock offerings, borrowings under our existing or new credit facilities or other sources which we may not be able to maintain or obtain on acceptable or commercially reasonable terms, if at all. Our capital requirements will depend on many factors, including:

 

   

market acceptance of our products;

 

   

the revenue generated by sales of our products;

 

   

the costs associated with expanding our sales and marketing efforts;

 

   

the expenses we incur in manufacturing and selling our products;

 

   

the costs of developing and commercializing new products or technologies;

 

   

the scope, rate of progress and cost of our clinical trials;

 

   

the cost of obtaining and maintaining regulatory approval or clearance of our products and products in development;

 

   

the costs associated with complying with state, federal and international transparency laws;

 

   

the cost of filing and prosecuting patent applications and defending and enforcing our patent and other intellectual property rights;

 

   

the cost of defending, in litigation or otherwise, any claims that we infringe third-party patent or other intellectual property rights;

 

   

the cost of enforcing or defending against non-competition claims;

 

   

the number and timing of acquisitions and other strategic transactions;

 

   

the costs associated with our planned international expansion;

 

   

the costs associated with increased capital expenditures, including fixed asset purchases of instrument sets which we loan to hospitals to support surgeries; and

 

   

unanticipated general and administrative expenses.

 

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As a result of these factors, we may seek to raise additional capital to:

 

   

maintain appropriate product inventory levels;

 

   

fund our operations and clinical trials;

 

   

continue our research and development;

 

   

defend, in litigation or otherwise, any claims that we infringe third-party patents or other intellectual property rights;

 

   

address FDA or other governmental, legal/enforcement actions and remediate underlying problems;

 

   

commercialize our new products, if any such products receive regulatory clearance or approval for sale; and

 

   

acquire companies and license products or intellectual property.

Such capital may not be available on favorable terms, or at all. Furthermore, if we issue equity or debt securities to raise additional capital, our existing stockholders may experience dilution, and the new equity or debt securities may have rights, preferences and privileges senior to those of our existing stockholders. In addition, if we raise additional capital through collaboration, licensing or other similar arrangements, it may be necessary to relinquish valuable rights to our products, potential products or proprietary technologies, or grant licenses on terms that are not favorable to us. If we cannot raise capital on acceptable terms, we may not be able to develop or enhance our products, execute our business plan, take advantage of future opportunities, or respond to competitive pressures, changes in our supplier relationships, or unanticipated customer requirements. Any of these events could adversely affect our ability to achieve our development and commercialization goals, which could have a material adverse effect on our business, results of operations and financial condition.

Our revolving credit facility expires on October 29, 2014, and if we are unable to extend the maturity date or obtain a new credit facility, it would have a material adverse effect on our operations and liquidity.

Our revolving credit facility expires on October 29, 2014 and all outstanding borrowings will become due and payable. We expect to seek an extension of the term of this facility or a new credit facility in the near future. If, however, we are not able to extend the revolving credit facility or obtain a new credit facility, we will be required to seek alternative financing or sell equity or debt to continue our operations. No assurance can be given that any extension, refinancing, additional borrowing or sale of debt will be available when needed or that we will be able to negotiate acceptable terms.

Our revolving credit facility contains restrictive covenants that may limit our operating flexibility.

Our revolving credit facility contains certain restrictive covenants that limit, among other things, our ability to dispose of assets, merge with other companies or consummate certain changes of control, pay dividends, incur additional indebtedness and liens, make investments, enter into transactions with affiliates, enter new businesses or prepay subordinated indebtedness. We therefore may not be able to engage in any of the foregoing transactions unless we obtain the consent of the lenders or terminate the revolving credit facility. There is no guarantee that we will be able to generate sufficient cash flow or sales to meet the financial covenants or pay the principal and interest on such debt. Furthermore, there is no guarantee that future working capital, borrowings or equity financing will be available to repay or refinance any such debt.

 

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Continuing worldwide economic instability could adversely affect our revenue, collectability of our accounts receivable, financial condition or results of operations and those of our suppliers, counterparties and consumers, which could harm our financial position.

Since fiscal year 2008, the global economy has been impacted by the sequential effects of an ongoing global financial crisis. This global financial crisis has caused extreme disruption in the financial markets, including severely diminished liquidity and credit availability. There can be no assurance that there will not be further deterioration in the global economy. Our customers and suppliers may experience financial difficulties or be unable to borrow money to fund their operations, which may adversely impact their ability to purchase our products, pay for our products on a timely basis, if at all, or supply us with our products. As with our customers and suppliers, these economic conditions make it more difficult for us to accurately forecast and plan our future business activities. In light of the current economic state of many countries in which we do business, we continue to monitor their creditworthiness. Failure to receive payment of all or a significant portion of these receivables could adversely affect our results of operations.

Risks Related to our Intellectual Property and Potential Litigation

If we are unable to protect our intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights.

Our success depends significantly on our ability to protect our proprietary rights to the technologies and inventions used in, or embodied by, our products. We rely on patent protection, as well as a combination of copyright, trade secret and trademark laws, and nondisclosure, confidentiality and other contractual restrictions to protect our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage.

Patent Rights

As of December 31, 2013, we owned 103 issued U.S. patents, 60 issued foreign patents, 105 pending U.S. patent applications and 70 pending foreign patent applications. It is our practice to file continuation and divisional applications as warranted which may provide additional intellectual property protection if those continuation and divisional applications issue as U.S. patents. Our issued patents expire between 2015 and 2033, subject to payment of required maintenance fees, annuities and other charges.

We have applied for patent protection relating to certain existing and proposed products and processes. While we generally apply for patents in those countries that represent major markets where we intend to make, have made, use or sell key patented products, we may not accurately predict all of the countries where patent protection will ultimately be desirable. If we fail to timely file a patent application in any such country, we may be precluded from doing so at a later date.

Furthermore, the process of applying for patent protection itself is time consuming and expensive and we cannot assure you that any of our patent applications will issue as patents. The rights granted to us under our patents, including prospective rights sought in our pending patent applications, may not be meaningful or provide us with any commercial advantage and they could be opposed, contested or circumvented by our competitors or be declared invalid or unenforceable in judicial or administrative proceedings. In addition, our pending patent applications include claims to material aspects of our products and procedures that are not currently protected by issued patents. In addition, the patents we own may not be of sufficient scope or strength to provide us with any meaningful protection or commercial advantage, and competitors may be able to design around our patents or develop products that provide outcomes comparable to ours without infringing on our intellectual property rights.

 

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Moreover, the United States Patent and Trademark Office, or USPTO, and various foreign governmental patent agencies require compliance with a number of procedural, documentary, fee payment and other similar provisions during the patent application process. In addition, periodic maintenance fees on issued patents often must be paid to the USPTO and foreign patent agencies over the lifetime of the patent. While an unintentional lapse can in many cases be cured by payment of a late fee or by other means in accordance with the applicable rules, there are situations in which noncompliance can result in abandonment or lapse of the patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. Non-compliance events that could result in abandonment or lapse of a patent or patent application include, but are not limited to, failure to respond to official actions within prescribed time limits, non-payment of fees and failure to properly legalize and submit formal documents. If we fail to maintain the patents and patent applications covering our products or procedures, we may not be able to stop a competitor from marketing products that are the same as or similar to our products, which would have a material adverse effect on our business.

Due to differences between foreign and U.S. patent laws, our patented intellectual property rights may not receive the same degree of protection in foreign countries as they would in the United States. Even if patents are granted outside the United States, effective enforcement in those countries may not be available, and the scope of protection may vary significantly from country to country. In some cases, we have filed patent applications outside the United States in the EEA, Canada, Australia and Japan and we therefore lack any patent protection in all other countries. In countries where we do not have significant patent protection, we may not be able to stop a competitor from marketing products in such countries that are the same as or similar to our products.

Trademarks

We rely on our trademarks as one means to distinguish our products from the products of our competitors, and have registered or applied to register many of these trademarks. As of December 31, 2013, we had 27 U.S. trademark registrations, 62 foreign trademark registrations, five pending U.S. applications to register trademarks and 28 foreign applications to register trademarks. However, our trademark applications may not be approved. Third parties may oppose our trademark applications, or otherwise challenge our use of the trademarks. In the event that our trademarks are successfully challenged, we could be forced to rebrand our products, which could result in loss of brand recognition and could require us to devote resources to advertising and marketing new brands. Our competitors may infringe our trademarks and we may not have adequate resources to enforce our trademarks.

Confidentiality Agreements and Intellectual Property Assignments

Furthermore, although we have taken steps to protect our intellectual property and proprietary technology, including entering into confidentiality agreements and intellectual property assignment agreements with our employees, consultants and scientific advisors, such agreements may not be enforceable or may not provide meaningful protection for our proprietary information or technology in the event of unauthorized use or disclosure or other breaches of such agreements.

Intellectual Property Litigation

In the event a competitor infringes upon our patents, trademarks or other intellectual property rights, enforcing those patents, trademarks and other rights may be costly, difficult, time consuming or unsuccessful. Even if successful, litigation to enforce our intellectual property rights or to defend our patents against challenge could be expensive and time consuming and could divert our management’s attention from managing our business. Litigation to defend our patents and trademarks against challenges or enforce our intellectual property rights could provoke significant retaliatory litigation, which could be costly, result in the diversion of management’s time and efforts, require us to pay damages and other amounts or prevent us from marketing our existing or future products. Moreover, we may not have sufficient resources or desire to enforce our intellectual property rights or to defend our patents or trademarks against a challenge.

 

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We rely heavily on patent rights that we either license from others or have obtained through assignments which may be subject to assignment back to the original assignor. In both cases, if we fail to make payments, or under certain other circumstances, the other party may terminate the license or require re-assignment of the patent rights, as applicable. If we are unable to maintain our licenses to or ownership of such patent rights, as applicable, or obtain additional licenses and assignments that we may need, our ability to compete will be harmed.

We rely heavily on intellectual property that we license from others, including patented technology that is integral to our devices. We are particularly dependent on our licensing arrangements relating to our MESA technology. We also rely on our licensing arrangement relating to our angle-stable fixation systems and our licensing arrangement relating to our interbody fusion implants. Any of these licensors or other third-party licensors may terminate our license or, in some cases, terminate the limited exclusivity we enjoy under a license, in the event that we fail to make required payments or for other causes. In addition, we may not have the right to enforce licensed patents against third-party infringers, and we thus may be unable to derive full competitive advantage from the licensed patents. Approximately 54%, 54% and 53% of our revenue were derived from sales of products that incorporate licensed technologies for the years ended December 31, 2011, 2012 and 2013, respectively. Furthermore, a number of the patents and patent applications we own were acquired pursuant to assignments which are subject to assignment back to the original licensor if we fail to make required payments or for other causes. If we are unable to maintain our licenses to or ownership of certain patent rights, our ability to compete in the market for spinal surgery devices will be harmed.

In addition, as we enhance our current product offerings and develop new ones, we may find it advisable or necessary to seek additional licenses or assignments from third parties that hold patents covering technology or methods used in our products. If we cannot obtain these additional licenses or assignments, we could be forced to design around those patents at additional cost or abandon the product altogether. As a result, our ability to grow our business and compete in the market for spinal surgery devices may be harmed.

The medical device industry is characterized by patent litigation and we could become subject to litigation that could be costly, result in the diversion of management’s time and efforts, require us to pay damages or prevent us from marketing our existing or future products.

Our commercial success will depend in part on not infringing the patents or violating the other proprietary rights of others. Significant litigation regarding patent rights occurs in our industry. Our competitors in both the United States and abroad, many of which have substantially greater resources and have made substantial investments in patent portfolios and competing technologies, may have applied for or obtained or may in the future apply for and obtain, patents that will prevent, limit or otherwise interfere with our ability to make, use and sell our products. Generally, we do not conduct independent reviews of patents issued to third parties. In addition, patent applications in the United States and elsewhere can be pending for many years before issuance, so there may be applications of others now pending of which we are unaware that may later result in issued patents that will prevent, limit or otherwise interfere with our ability to make, use or sell our products. The large number of patents, the rapid rate of new patent applications and issuances, the complexities of the technology involved and the uncertainty of litigation increase the risk of business assets and management’s attention being diverted to patent litigation. In the future, we may receive communications from various industry participants alleging our infringement of their patents, trade secrets or other intellectual property rights and/or offering licenses to such intellectual property. Any lawsuits resulting from such allegations could subject us to significant liability for damages and invalidate our proprietary rights. Any potential intellectual property litigation also could force us to do one or more of the following:

 

   

stop making, selling or using products or technologies that allegedly infringe the asserted intellectual property rights;

 

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lose the opportunity to license our technology to others or to collect royalty payments based upon successful protection and assertion of our intellectual property rights against others;

 

   

incur significant legal expenses;

 

   

pay substantial damages or royalties to the party whose intellectual property rights we may be found to be infringing;

 

   

pay the attorney fees and costs of litigation to the party whose intellectual property rights we may be found to be infringing;

 

   

redesign those products that contain the allegedly infringing intellectual property, which could be costly, disruptive and/or infeasible; or

 

   

attempt to obtain a license to the relevant intellectual property from third parties, which may not be available on reasonable terms or at all.

Any litigation or claim against us, even those without merit, may cause us to incur substantial costs, and could place a significant strain on our financial resources, divert the attention of management from our core business and harm our reputation. Further, as the number of participants in the spinal surgery industry grows, the possibility of intellectual property infringement claims against us increases. If we are found to infringe the intellectual property rights of third parties, we could be required to pay substantial damages (which may be increased up to three times of awarded damages if we are found to have willfully infringed such intellectual property rights) and/or substantial royalties and could be prevented from selling our products unless we obtain a license or are able to redesign our products to avoid infringement. Any such license may not be available on reasonable terms, if at all, and there can be no assurance that we would be able to redesign our products in a way that would not infringe the intellectual property rights of others. If we fail to obtain any required licenses or make any necessary changes to our products or technologies, we may have to withdraw existing products from the market or may be unable to commercialize one or more of our products, all of which could have a material adverse effect on our business, results of operations and financial condition.

In addition, we generally indemnify our customers, independent sales agencies and international distributors with respect to infringement by our products of the proprietary rights of third parties. Third parties may assert infringement claims against our customers, independent sales agencies or distributors. These claims may require us to initiate or defend protracted and costly litigation on behalf of our customers, independent sales agencies or distributors, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of our customers, independent sales agencies or distributors or may be required to obtain licenses for the products they use. If we cannot obtain all necessary licenses on commercially reasonable terms, our customers may be forced to stop using our products.

We may be subject to damages resulting from claims that we, our employees, our independent sales agencies or our distributors have wrongfully used or disclosed alleged trade secrets of our competitors or are in breach of non-competition or non-solicitation agreements with our competitors.

Many of our employees were previously employed at other medical device companies, including our competitors or potential competitors, in some cases until recently. Many of our independent sales agencies and distributors sell, or in the past have sold, products of our competitors. We may be subject to claims that we, our employees or our independent sales agencies and distributors have inadvertently or otherwise used or disclosed alleged trade secrets or other proprietary information of these former employers or competitors. In addition, we have been and may in the future be subject to claims that we caused an employee to breach the terms of his or her non-competition or non-solicitation agreement. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and could be a distraction to management. If our

 

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defense to those claims fails, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. Any litigation or the threat thereof may adversely affect our ability to hire employees or contract with independent sales agencies and distributors and their representatives. A loss of key personnel or their work product could have an adverse effect on our business, results of operations and financial condition.

If product liability lawsuits are brought against us, our business may be harmed, and we may be required to pay damages that exceed our insurance coverage.

Our business exposes us to potential product liability claims that are inherent in the testing, manufacture and sale of medical devices for spine surgery procedures. Spine surgery involves significant risk of serious complications, including bleeding, nerve injury, paralysis and even death. Furthermore, if spine surgeons are not sufficiently trained in the use of our products, they may misuse or ineffectively use our products, which may result in unsatisfactory patient outcomes or patient injury. We could become the subject of product liability lawsuits alleging that component failures, malfunctions, manufacturing flaws, design defects or inadequate disclosure of product-related risks or product-related information resulted in an unsafe condition or injury to patients.

We have had, and continue to have, a small number of product liability claims relating to our products, none of which either individually, or in the aggregate, have resulted, or we believe will result, in a material negative impact on our business. In the future, we may be subject to additional product liability claims, some of which may have a negative impact on our business.

Regardless of the merit or eventual outcome, product liability claims may result in:

 

   

decreased demand for our products;

 

   

injury to our reputation;

 

   

significant litigation costs;

 

   

substantial monetary awards to or costly settlements with patients;

 

   

product recalls;

 

   

loss of revenue;

 

   

the inability to commercialize new products or product candidates; and

 

   

diversion of management attention from pursuing our business strategy and may be costly to defend.

Although we have product and other liability insurance that we believe is appropriate for our current level of operations, this insurance is subject to deductibles and coverage limitations. Our current product liability insurance may not continue to be available to us on acceptable terms, if at all, and, if it is available, the coverage may not be adequate to protect us against any future product liability claims. If we are unable to obtain insurance at acceptable cost or on acceptable terms with adequate coverage or otherwise protect against potential product liability claims, we could be exposed to significant financial and other liabilities, which may harm our business. If a product liability claim or series of claims is brought against us for uninsured liabilities or for amounts in excess of insured liabilities, it could have a material adverse effect on our business, results of operations and prospects. Any product liability claim brought against us, with or without merit, could result in the increase of our product liability insurance rates or the inability to secure coverage in the future. In addition, a recall of some of our products, whether or not the result of a product liability claim, could result in significant costs and loss of customers.

 

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In addition, medical malpractice carriers are withdrawing coverage in certain regions or substantially increasing premiums. In the event we become a defendant in a product liability suit in which the treating surgeon or hospital does not have adequate malpractice insurance, the likelihood of liability being imposed on us could increase.

Defending a suit, regardless of merit, could be costly, could divert management’s attention from our business and might result in adverse publicity, which could result in the withdrawal of, or inability to recruit, clinical trial patient participants or result in reduced acceptance of our products in the market. As a result, any product liability claims against us, regardless of their merit, could severely harm our financial condition, strain our management and other resources and adversely affect or eliminate the prospects for commercialization or sales of a product or product candidate that is the subject of any such claim.

Because allograft bone tissue used in our biomaterials program may entail a risk of communicable diseases to human recipients, we may be the subject of product liability claims regarding our allograft bone tissue.

The development and use of allograft bone tissue and biomaterials products may entail particular risk of transmitting diseases to human recipients. Any such transmission could result in the assertion of substantial product liability claims against us. In addition, successful product liability claims made against one of our competitors could cause claims to be made against us or expose us to a perception that we are vulnerable to similar claims. Claims against us arising out of our biomaterials program, regardless of their merit or potential outcome, may also hurt our reputation and ability to sell our products.

Risks Related to Our International Operations

Our international operations subject us to certain operating risks, which could adversely impact our net sales, results of operations and financial condition.

We began selling our products internationally in 2008. We currently generate revenue from 28 countries internationally, in addition to the United States, including the United Kingdom, Germany, Spain, Italy, Canada, Australia and Japan. International sales of our products represented 25%, 26% and 29% of our revenue for the years ended December 31, 2011, 2012 and 2013, respectively. The sale and shipment of our products across international borders, as well as any purchase of components and products from international sources, subject us to extensive U.S. and foreign governmental trade, import and export and customs regulations and laws. Compliance with these regulations is costly and exposes us to penalties for non-compliance. Other laws and regulations that can significantly impact us include various anti-bribery laws, including the FCPA and anti-boycott laws. Any failure to comply with applicable legal and regulatory obligations could impact us in a variety of ways that include, but are not limited to, suspension or withdrawal of our CE Certificates of Conformity, significant criminal, civil and administrative penalties, including imprisonment of individuals, fines and penalties, denial of export privileges, seizure of shipments, product recalls and withdrawals, restrictions on certain business activities, and exclusion or debarment from government contracting. Also, the failure to comply with applicable legal and regulatory obligations could result in the disruption of our shipping and sales activities.

In addition, many of the countries in which we sell our products are, to some degree, subject to political, economic or social instability. Our international operations expose us and our distributors to risks inherent in operating in foreign jurisdictions. These risks include, but are not limited to:

 

   

differing existing or future regulatory and certification requirements;

 

   

the imposition of additional U.S. and foreign governmental controls or regulations;

 

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the imposition of costly and lengthy new export licensing requirements;

 

   

pricing pressure that we may experience internationally, which could result from, among other causes, the fact that many foreign governments subject their constituent surgical device companies to a materially less costly regulatory regime than that imposed upon U.S. surgical device companies by the United States government;

 

   

difficulties and costs of staffing and managing foreign operations;

 

   

changes in third-party reimbursement policies that may require some of the patients who receive our products to directly absorb medical costs or that may necessitate the reduction of the selling prices of our products;

 

   

changes in duties and tariffs, license obligations and other non-tariff barriers to trade;

 

   

the imposition of new trade restrictions;

 

   

the imposition of restrictions on the activities of foreign agents, representatives and distributors;

 

   

scrutiny of foreign tax authorities which could result in significant fines, penalties and additional taxes being imposed on us;

 

   

potentially adverse U.S. tax consequences, including regulatory requirements regarding our ability to repatriate profits to the United States;

 

   

the imposition of U.S. or international sanctions against a country, company, person or entity with whom we do business that would restrict or prohibit continued business with the sanctioned country, company, person or entity;

 

   

laws and business practices favoring local companies;

 

   

greater difficulty in collecting accounts receivable and longer collection periods;

 

   

management communication and integration problems related to entering new markets with different languages, cultures and political systems;

 

   

difficulties in maintaining consistency with our internal guidelines in new markets;

 

   

difficulties in enforcing agreements through certain foreign legal systems;

 

   

the uncertainty of protection for intellectual property rights in some countries and difficulties in enforcing or defending intellectual property rights internationally; and

 

   

political and economic instability and terrorism.

In addition, our international operations expose us to risks of fluctuations in foreign currency exchange rates. Because our financial statements are denominated in U.S. dollars, a decline in foreign currencies in which we make sales would negatively impact our overall revenue as reflected in our financial statements. To date, we have not used risk management techniques to hedge the risks associated with these fluctuations. Even if we were to implement hedging strategies, not every exposure can be hedged and, where hedges are put in place based on expected foreign currency exchange exposure, they are based on forecasts that may vary or that may later prove to have been inaccurate. As a result, fluctuations in foreign currency exchange rates or our failure to successfully hedge against these fluctuations could have a material adverse effect on our results of operations and financial condition. We also may encounter difficulties in converting our earnings from international operations to U.S. dollars for use in the United States. These obstacles may include problems moving funds out of the countries in which the funds were earned and difficulties in collecting accounts receivable in foreign countries where the usual accounts receivable payment cycle is longer.

 

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Any of these factors may adversely impact our operations. All of our international sales with independent distributor partners to date have been denominated in U.S. dollars. In the EEA, healthcare regulation and reimbursement for medical devices varies significantly from country-to-country. This changing environment could adversely affect our ability to sell our products in some EEA countries, which could negatively affect our results of operations.

Failure to comply with the FCPA and similar laws associated with our activities outside the United States could subject us to penalties and other adverse consequences.

We are subject to the FCPA and other anti-bribery legislation around the world. The FCPA generally prohibits covered entities and their intermediaries from engaging in bribery or making other prohibited payments, offers or promises to foreign officials for the purpose of obtaining or retaining business or other advantages. In addition, the FCPA imposes recordkeeping and internal controls requirements on publicly traded corporations and their foreign affiliates, which are intended to, among other things, prevent the diversion of corporate funds to the payment of bribes and other improper payments, and to prevent the establishment of “off books” slush funds from which such improper payments can be made. As a substantial portion of our revenue is, and we expect will continue to be, from jurisdictions outside of the United States, we face significant risks if we fail to comply with the FCPA and other laws that prohibit improper payments, offers or promises of payment to foreign governments and their officials and political parties by us and other business entities for the purpose of obtaining or retaining business or other advantages. In many foreign countries, particularly in countries with developing economies, some of which represent significant markets for us, it may be a local custom that businesses operating in such countries engage in business practices that are prohibited by the FCPA or other laws and regulations. Although we have implemented a company policy requiring our employees and consultants to comply with the FCPA and similar laws, such policy may not be effective at preventing all potential FCPA or other violations. Although our agreements with our international distributors clearly state our expectations for our distributors’ compliance with U.S. laws, including the FCPA, and provide us with various remedies upon any non-compliance, including the ability to terminate the agreement, we also cannot guarantee our distributors’ compliance with U.S. laws, including the FCPA. Therefore there can be no assurance that none of our employees and agents, or those companies to which we outsource certain of our business operations, have not and will not take actions that violate our policies or applicable laws, for which we may be ultimately held responsible. Any violation of the FCPA and related policies could result in severe criminal or civil sanctions, which could have a material and adverse effect on our reputation, business, results of operations and financial condition.

Furthermore, we are subject to the export controls and economic embargo rules and regulations of the United States, including, but not limited to, the Export Administration Regulations and trade sanctions against embargoed countries, which are administered by the Office of Foreign Assets Control within the Department of the Treasury, as well as the laws and regulations administered by the Department of Commerce. These regulations limit our ability to market, sell, distribute or otherwise transfer our products or technology to prohibited countries or persons. A determination that we have failed to comply, whether knowingly or inadvertently, may result in substantial penalties, including fines and enforcement actions and civil and/or criminal sanctions, the disgorgement of profits and the imposition of a court-appointed monitor, as well as the denial of export privileges, and may have an adverse effect on our reputation.

Risks Related to this Offering and Ownership of Our Common Stock

Our Sponsor controls us, and its interests may conflict with ours or yours in the future.

Immediately following this offering, our Sponsor will beneficially own approximately 62.4% of our common stock, or 59.4% if the underwriters exercise in full their option to purchase additional shares from the selling stockholders. Even when our Sponsor and its affiliates cease to own shares of our stock representing a majority of the total voting power, for so long as our Sponsor continues to own a

 

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significant percentage of our stock our Sponsor will still be able to significantly influence the composition of our Board of Directors and the approval of actions requiring stockholder approval. Accordingly, for such period of time, our Sponsor will have significant influence with respect to our management, business plans and policies, including the appointment and removal of our officers. In particular, for so long as our Sponsor continues to own a significant percentage of our stock, our Sponsor will be able to cause or prevent a change of control of our company or a change in the composition of our Board of Directors and could preclude any unsolicited acquisition of our company. The concentration of ownership could deprive you of an opportunity to receive a premium for your shares of common stock as part of a sale of our company and ultimately might affect the market price of our common stock.

Our Sponsor and its affiliates engage in a broad spectrum of activities, including investments in the medical device industry generally. In the ordinary course of their business activities, our Sponsor and its affiliates may engage in activities where their interests conflict with our interests or those of our stockholders. Our amended and restated certificate of incorporation will provide that none of our Sponsor, any of its affiliates or any director who is not employed by us (including any non-employee director who serves as one of our officers in both his director and officer capacities) or his or her affiliates will have any duty to refrain from engaging, directly or indirectly, in the same business activities or similar business activities or lines of business in which we operate. Our Sponsor also may pursue acquisition opportunities that may be complementary to our business, and, as a result, those acquisition opportunities may not be available to us. In addition, our Sponsor may have an interest in pursuing acquisitions, divestitures and other transactions that, in its judgment, could enhance its investment, even though such transactions might involve risks to you.

Upon the listing of our shares on NASDAQ, we will be a “controlled company” within the meaning of NASDAQ rules and, as a result, will qualify for, and may rely on, exemptions from certain corporate governance requirements. You will not have the same protections afforded to stockholders of companies that are subject to such requirements.

After completion of this offering, our Sponsor will continue to control a majority of the voting power of our common stock entitled to vote generally in the election of directors. As a result, we will be a “controlled company” within the meaning of the corporate governance standards of NASDAQ. Under these rules, a company of which more than 50% of the voting power in the election of directors is held by an individual, group or another company is a “controlled company” and may elect not to comply with certain corporate governance requirements. For example, controlled companies, within one year of the date of the listing of their common stock:

 

   

are not required to have a board that is composed of a majority of “independent directors,” as defined under the rules of such exchange;

 

   

are not required to have a compensation committee that is composed entirely of independent directors; and

 

   

are not required to have a nominating and corporate governance committee that is composed entirely of independent directors.

Accordingly, you may not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of NASDAQ.

 

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We will incur increased costs and become subject to additional regulations and requirements as a result of becoming a public company, which could lower our profits or make it more difficult to run our business.

As a public company, we will incur significant legal, accounting and other expenses that we have not incurred as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC and NASDAQ. The expenses incurred by public companies generally for reporting and corporate governance purposes have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. These laws and regulations also could make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our Board of Directors, our board committees or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our common stock, fines, sanctions and other regulatory action and potentially civil litigation.

If we are unable to implement and maintain effective internal control over financial reporting in the future, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our common stock may be negatively affected.

We are not currently required to comply with the rules of the SEC implementing Section 404 of the Sarbanes-Oxley Act and are therefore not required to make a formal assessment of the effectiveness of our internal control over financial reporting for the purpose. Upon becoming a public company, we will be required to maintain internal controls over financial reporting and to report any material weaknesses in such internal controls. In addition, beginning with our second annual report on Form 10-K, we will be required to furnish a report by management on the effectiveness of our internal control over financial reporting, pursuant to Section 404 of the Sarbanes-Oxley Act. However, as an emerging growth company, our independent registered public accounting firm will not be required to express an opinion as to the effectiveness of our internal control over financial reporting pursuant to Section 404 until the later of the year following our first annual report on Form 10-K or the date we are no longer an emerging growth company. At such time, our independent registered public accounting firm may issue a report that is adverse in the event it is not satisfied with the level at which our controls are documented, designed or operating. The process of designing, implementing, and testing the internal control over financial reporting required to comply with this obligation is time consuming, costly, and complicated. If we identify material weaknesses in our internal control over financial reporting, if we are unable to comply with the requirements of Section 404 of the Sarbanes-Oxley Act in a timely manner or to assert that our internal control over financial reporting is effective or if our independent registered public accounting firm, when required, is unable to express an opinion as to the effectiveness of our internal control over financial reporting, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our common stock could be negatively affected, and we could become subject to investigations by the stock exchange on which our securities are listed, the SEC or other regulatory authorities, which could require additional financial and management resources.

There may not be an active trading market for shares of our common stock, which may cause shares of our common stock to trade at a discount from the initial offering price and make it difficult to sell the shares of common stock you purchase.

Prior to this offering, there has not been a public trading market for shares of our common stock. It is possible that after this offering an active trading market will not develop or continue or, if developed,

 

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that any market will be sustained which would make it difficult for you to sell your shares of common stock at an attractive price or at all. The initial public offering price per share of common stock will be determined by agreement among us and the representatives of the underwriters, and may not be indicative of the price at which shares of our common stock will trade in the public market after this offering.

The market price of shares of our common stock may be volatile, which could cause the value of your investment to decline.

Even if a trading market develops, the market price of our common stock may be highly volatile and could be subject to wide fluctuations. Securities markets worldwide experience significant price and volume fluctuations. This market volatility, as well as general economic, market or political conditions, could reduce the market price of shares of our common stock in spite of our operating performance. In addition, our results of operations could be below the expectations of public market analysts and investors due to a number of potential factors, including variations in our quarterly results of operations, additions or departures of key management personnel, failure to meet analysts’ earnings estimates, publication of research reports about our industry, litigation and government investigations, changes or proposed changes in laws or regulations or differing interpretations or enforcement thereof affecting our business, adverse market reaction to any indebtedness we may incur or securities we may issue in the future, changes in market valuations of similar companies or speculation in the press or investment community, announcements by our competitors of significant contracts, acquisitions, dispositions, strategic partnerships, joint ventures or capital commitments, adverse publicity about the industries we participate in or individual scandals, and in response the market price of shares of our common stock could decrease significantly. You may be unable to resell your shares of common stock at or above the initial public offering price.

In the past few years, stock markets have experienced extreme price and volume fluctuations. In the past, following periods of volatility in the overall market and the market price of a company’s securities, securities class action litigation has often been instituted against these companies. This litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources.

Because we have no current plans to pay cash dividends on our common stock, you may not receive any return on investment unless you sell your common stock for a price greater than that which you paid for it.

We intend to use a portion of the net proceeds from this offering to pay all accumulated and unpaid dividends on our Series A Preferred and Series B Preferred. However, we have no current plans to pay dividends on our common stock. The declaration, amount and payment of any future dividends on shares of common stock will be at the sole discretion of our Board of Directors. Our Board of Directors may take into account general and economic conditions, our financial condition and results of operations, our available cash and current and anticipated cash needs, capital requirements, contractual, legal, tax and regulatory restrictions and implications on the payment of dividends by us to our stockholders or by our subsidiaries to us and such other factors as our Board of Directors may deem relevant. In addition, our ability to pay dividends will be limited by our revolving credit facility and may be limited by covenants of other indebtedness we or our subsidiaries incur in the future. As a result, you may not receive any return on an investment in our common stock unless you sell our common stock for a price greater than that which you paid for it.

Investors in this offering will suffer immediate and substantial dilution.

The initial public offering price per share of common stock will be substantially higher than our pro forma net tangible book value per share immediately after this offering. As a result, you will pay a price per share of common stock that substantially exceeds the per share book value of our tangible assets

 

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after subtracting our liabilities. In addition, you will pay more for your shares of common stock than the amounts paid by our existing owners. You will incur immediate and substantial dilution in an amount of $11.79 per share of common stock. See “Dilution.”

You may be diluted by the future issuance of additional common stock in connection with our incentive plans, acquisitions or otherwise.

After this offering we will have approximately 712.9 million shares of common stock authorized but unissued. Our amended and restated certificate of incorporation to become effective immediately prior to the consummation of this offering authorizes us to issue these shares of common stock and options, rights, warrants and appreciation rights relating to common stock for the consideration and on the terms and conditions established by our Board of Directors in its sole discretion, whether in connection with acquisitions or otherwise. We have reserved 1,650,289 shares for issuance under our 2014 Omnibus Incentive Plan. See “Executive Compensation—Equity Compensation and Stock Purchase Plan.” In addition, we have reserved 411,523 shares of common stock for future issuance under our ESPP. See “Executive Compensation—Equity Compensation and Stock Purchase Plan.” Any common stock that we issue, including under our 2014 Omnibus Incentive Plan, our ESPP or other equity incentive plans that we may adopt in the future, would dilute the percentage ownership held by the investors who purchase common stock in this offering.

If we or our existing investors sell additional shares of our common stock after this offering, the market price of our common stock could decline.

The sale of substantial amounts of shares of our common stock in the public market, or the perception that such sales could occur, could harm the prevailing market price of shares of our common stock. These sales, or the possibility that these sales may occur, also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Upon completion of this offering we will have a total of 37,085,906 shares of our common stock outstanding. Of the outstanding shares, the 8,825,000 shares sold in this offering (or 10,148,750 shares if the underwriters exercise their option to purchase additional shares) will be freely tradable without restriction or further registration under the Securities Act, except that any shares sold pursuant to the directed share program will be subject to lock-up agreements and any shares held by our affiliates, as that term is defined under Rule 144 of the Securities Act, may be sold only in compliance with the limitations described in “Shares Eligible for Future Sale.”

The remaining outstanding 28,260,906 shares of common stock held by our existing owners after this offering (or 26,937,156 shares if the underwriters exercise their option to purchase additional shares in full) will be subject to certain restrictions on resale. We, our executive officers, directors and all significant equity holders, including the selling stockholders and each participant in the directed share program, will sign lock-up agreements with the underwriters that will, subject to certain customary exceptions, restrict the sale of the shares of our common stock held by them for 180 days (or 60 days in the case of participants in the directed share program) following the date of this prospectus. The representatives of the underwriters may, in their sole discretion and without notice, release all or any portion of the shares of common stock subject to lock-up agreements. See “Underwriting” for a description of these lock-up agreements.

Upon the expiration of the lock-up agreements described above, all of such 28,260,906 shares (or 26,937,156 shares if the underwriters exercise their option to purchase additional shares in full) will be eligible for resale in a public market, subject, in the case of shares held by our affiliates, to volume, manner of sale and other limitations under Rule 144. We expect that our Sponsor will be considered an affiliate 180 days after this offering based on their expected share ownership (consisting of 23,113,149 shares, or 22,025,369 shares if the underwriters exercise their option to purchase additional shares in full). Certain other of our stockholders may also be considered affiliates at that time. In addition, pursuant to a registration rights agreement entered into in connection with our purchase by the Sponsor, we granted our Sponsor the right, subject to certain conditions, to require us to register the sale of their

 

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shares of our common stock under the Securities Act. By exercising their registration rights and selling a large number of shares, our Sponsor could cause the prevailing market price of our common stock to decline. Following completion of this offering, the shares covered by registration rights would represent approximately 75% of our outstanding common stock (or 71% if the underwriters exercise in full their option to purchase additional shares). Registration of any of these outstanding shares of common stock would result in such shares becoming freely tradable without compliance with Rule 144 upon effectiveness of the registration statement. See “Shares Eligible for Future Sale.”

We intend to file one or more registration statements on Form S-8 under the Securities Act to register shares of our common stock or securities convertible into or exchangeable for shares of our common stock issued pursuant to our 2014 Omnibus Incentive Plan, our ESPP and our existing equity incentive plans. Any such Form S-8 registration statements will automatically become effective upon filing. Accordingly, shares registered under such registration statements will be available for sale in the open market. We expect that the initial registration statement on Form S-8 will cover 5,908,967 shares of our common stock.

As restrictions on resale end or if our Sponsor exercises its registration rights, the market price of our shares of common stock could drop significantly if the holders of these restricted shares sell them or are perceived by the market as intending to sell them. These factors could also make it more difficult for us to raise additional funds through future offerings of our shares of common stock or other securities.

Anti-takeover provisions in our organizational documents and Delaware law might discourage or delay acquisition attempts for us that you might consider favorable.

Our amended and restated certificate of incorporation and amended and restated bylaws to become effective immediately prior to the consummation of this offering will contain provisions that may make the merger or acquisition of our company more difficult without the approval of our Board of Directors. Among other things:

 

   

although we do not have a stockholder rights plan, these provisions would allow us to authorize the issuance of undesignated preferred stock in connection with a stockholder rights plan or otherwise, the terms of which may be established and the shares of which may be issued without stockholder approval, and which may include super voting, special approval, dividend, or other rights or preferences superior to the rights of the holders of common stock;

 

   

these provisions provide for a classified Board of Directors with staggered three-year terms;

 

   

these provisions prohibit stockholder action by written consent from and after the date on which our Sponsor and its affiliates beneficially own, in the aggregate, less than 50% in voting power of the stock of the Company entitled to vote generally in the election of directors unless such action is recommended by all directors then in office;

 

   

these provisions provide that the Board of Directors is expressly authorized to make, alter, or repeal our bylaws and that for as long as our Sponsor and its affiliates beneficially own, in the aggregate, at least 50% in voting power of the stock of the Company entitled to vote generally in the election of directors, any amendment, alteration, recission or repeal of our bylaws by our stockholders will require the affirmative vote of a majority in voting power of the outstanding shares of our stock. At any time when our Sponsor and its affiliates beneficially own, in the aggregate, less than 50% in voting power of all outstanding shares of the stock of the Company entitled to vote generally in the election of directors, any amendment, alteration, recission or repeal of our bylaws by our stockholders will require the affirmative vote of the holders of at least 66  2 / 3 % in voting power of all the then-outstanding shares of stock of the Company entitled to vote thereon, voting together as a single class; and

 

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these provisions establish advance notice requirements for nominations for elections to our board or for proposing matters that can be acted upon by stockholders at stockholder meetings.

Further, as a Delaware corporation, we are also subject to provisions of Delaware law, which may impair a takeover attempt that our stockholders may find beneficial. These anti-takeover provisions and other provisions under Delaware law could discourage, delay or prevent a transaction involving a change in control of our company, including actions that our stockholders may deem advantageous, or negatively affect the trading price of our common stock. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and to cause us to take other corporate actions you desire.

We are an “emerging growth company” and we cannot be certain if the reduced disclosure requirements applicable to “emerging growth companies” will make our common stock less attractive to investors.

We are an “emerging growth company,” as defined in the JOBS Act, and we may take advantage of certain exemptions and relief from various reporting requirements that are applicable to other public companies that are not “emerging growth companies.” In particular, while we are an “emerging growth company” (1) we will not be required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, (2) we will be exempt from any rules that may be adopted by the PCAOB requiring mandatory audit firm rotations or a supplement to the auditor’s report on financial statements, (3) we will be subject to reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and (4) we will not be required to hold nonbinding advisory votes on executive compensation or stockholder approval of any golden parachute payments not previously approved.

In addition, we are electing to delay the adoption of new or revised accounting standards applicable to public companies until those standards apply to private companies, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result of this election, our financial statements may not be comparable to the financial statements of other public companies.

We also currently intend to take advantage of the reduced disclosure requirements regarding executive compensation. If we remain an “emerging growth company” after fiscal 2014, we may take advantage of other exemptions, including the exemptions from the advisory vote requirements and executive compensation disclosures under the Dodd-Frank Wall Street Reform and Customer Protection Act, or the Dodd-Frank Act, and the exemption from the provisions of Section 404(b) of the Sarbanes-Oxley Act. We may remain an “emerging growth company” until as late as December 31, 2019 (the fiscal year-end following the fifth anniversary of the completion of this initial public offering), though we may cease to be an “emerging growth company” earlier under certain circumstances, including (1) if the market value of our common stock that is held by nonaffiliates exceeds $700.0 million as of any June 30, in which case we would cease to be an “emerging growth company” as of the following December 31, (2) if our gross revenue exceeds $1.0 billion in any fiscal year or (3) if we issue more than $1.0 billion in non-convertible notes in any three year period.

The exact implications of the JOBS Act are still subject to interpretations and guidance by the SEC and other regulatory agencies, and we cannot assure you that we will be able to take advantage of all of the benefits of the JOBS Act. In addition, investors may find our common stock less attractive if we rely on the exemptions and relief granted by the JOBS Act. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may decline and/or become more volatile.

 

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Our Board of Directors is authorized to issue and designate shares of our preferred stock in additional series without stockholder approval.

Our amended and restated certificate of incorporation authorizes our Board of Directors, without the approval of our stockholders, to issue 100 million shares of our preferred stock, subject to limitations prescribed by applicable law, rules and regulations and the provisions of our amended and restated certificate of incorporation, as shares of preferred stock in series, and to establish from time to time the number of shares to be included in each such series, and to fix the designation, powers, preferences and rights of the shares of each such series and the qualifications, limitations or restrictions thereof. The powers, preferences and rights of these additional series of preferred stock may be senior to or on parity with our common stock, which may reduce its value.

Our ability to use our net operating loss carryforwards may be subject to limitation.

As of December 31, 2013, we had federal net operating loss carryforwards, or NOLs, to offset future taxable income. A lack of future taxable income would adversely affect our ability to use these NOLs and, as a result of this and other factors, we have taken a valuation allowance against the NOLs. In addition, under Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, a corporation that undergoes an “ownership change” is subject to limitations on its ability to use its NOLs to offset future taxable income. We underwent such an ownership change in 2010, and, as a result, we are limited in our ability to use the portion of our NOLs that existed as of the time of such ownership change. Because of this limitation and other factors, we have taken a valuation allowance against that portion of our NOLs. Future changes in our stock ownership, including those that result from this or future offerings, could result in an ownership change under Section 382 of the Code. If such an ownership change occurred, our ability to use our NOLs to offset future taxable income, if any, could be limited.

 

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FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that reflect our current views with respect to, among other things, our operations and financial performance. Forward-looking statements include all statements that are not historical facts. In some cases, you can identify these forward-looking statements by the use of words such as “outlook,” “believes,” “expects,” “potential,” “continues,” “may,” “will,” “should,” “could,” “seeks,” “predicts,” “intends,” “plans,” “estimates,” “anticipates” or the negative version of these words or other comparable words. Such forward-looking statements are subject to various risks and uncertainties. Accordingly, there are or will be important factors that could cause actual outcomes or results to differ materially from those indicated in these statements. We believe these factors include but are not limited to those described under “Risk Factors.” These factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this prospectus.

We operate in a very competitive and challenging environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this prospectus. We cannot assure you that the results, events and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results events, or circumstances could differ materially from those described in the forward-looking statements.

The forward-looking statements made in this prospectus relate only to events as of the date on which the statements are made. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures, investments or other strategic transactions we may make.

TRADEMARKS AND SERVICE MARKS

MESA, Deformity Cricket, Rail 4D Technology, RAVINE, SERENGETI, EVEREST and tifix (licensed by D. Wolter) and other trademarks, trade names and service marks of K2M and our brands appearing in this prospectus are the property of K2M and our affiliates.

Solely for convenience, the trademarks, service marks and trade names may be referred to in this prospectus without the ® and ™ symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the rights of the applicable licensors to these trademarks, service marks and trade names. All trademarks, service marks and trade names appearing in this prospectus are the property of their respective owners.

INDUSTRY AND MARKET DATA

Within this prospectus, we reference information and statistics regarding the medical device and spinal surgery industries. We have obtained this information and statistics from various independent third-party sources, including independent industry publications, reports by market research firms and other independent sources. iData Research, Inc., the primary source for third-party market data and industry statistics and forecasts included in this prospectus, was contracted by us to compile this information. iData does not guarantee the performance of any company about which it collects and provides data. Nothing in the iData data should be construed as advice. Some data and other information are also based on the good faith estimates of management, which are derived from our review of internal surveys and independent sources. We believe that these external sources and estimates are reliable, but have not independently verified them.

 

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USE OF PROCEEDS

We estimate that our net proceeds from this offering will be approximately $120.0 million, after deducting the underwriting discounts and estimated offering expenses payable by us.

We intend to use the net proceeds received by us from this offering (1) to retire all $39.2 million of the indebtedness outstanding under the Shareholder Notes, (2) to pay all $18.5 million of accumulated and unpaid dividends on our Series A Preferred and our Series B Preferred, (3) to repay all $23.5 million of the outstanding borrowings under our revolving credit facility and (4) for working capital and general corporate purposes. Our use of proceeds from this offering for working capital and general corporate purposes is currently expected to include approximately $6.0 million to expand our global distribution network by hiring qualified sales employees and purchasing inventory to support their sales efforts and approximately $10.5 million in connection with our expected relocation to a new leased headquarters facility in 2015.

As of March 31, 2014, we had indebtedness with an aggregate principal value at maturity of $39.2 million outstanding under the Shareholder Notes. The Shareholders Notes accrue interest at a rate of 10.0% per annum, if paid in cash, or 13.0% per annum, if paid-in-kind, and mature on June 21, 2022. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Indebtedness—Shareholder Notes.” We used the proceeds from our Shareholder Notes to fund working capital and make investments in our business. Certain of the Shareholder Notes are held by affiliates of the Company and such affiliates will receive a portion of the proceeds from this offering. See “Certain Relationships and Related Party Transactions.”

As of March 31, 2014, we had $23.5 million of borrowings outstanding under our revolving credit facility. Our revolving credit facility is scheduled to mature on October 29, 2014. As of March 31, 2014, the average interest rate on the borrowings under our revolving credit facility was 4.25% per annum. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Indebtedness—Revolving Credit Facility.” We used the borrowings under our revolving credit facility to fund working capital and make investments in our business.

As of March 31, 2014, we had $17.6 million of accumulated and unpaid dividends on our Series A Preferred and our Series B Preferred. Certain of our Series A Preferred and our Series B Preferred are held by affiliates of the Company and, in connection with the payment of all accumulated and unpaid dividends on our Series A Preferred and our Series B Preferred described above, such affiliates will receive a portion of the proceeds from this offering. See “Certain Relationships and Related Party Transactions.”

We will not receive any proceeds from the sale of shares of our common stock by the selling stockholders, if any, pursuant to the underwriters’ option to purchase additional shares. For more information about the selling stockholders, see “Principal and Selling Stockholders.”

 

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DIVIDEND POLICY

We intend to use a portion of the net proceeds from this offering to pay all accumulated and unpaid dividends on our Series A Preferred and our Series B Preferred. See “Use of Proceeds.” However, we have no current plans to pay dividends on our common stock. Any decision to declare and pay dividends in the future will be made at the sole discretion of our Board of Directors and will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions and other factors that our Board of Directors may deem relevant. In addition, the credit agreement governing our revolving credit facility restricts our ability to pay dividends on our common stock. We expect that any future credit agreements will contain similar restrictions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Indebtedness—Revolving Credit Facility.”

We did not declare or pay any dividends on our common stock in 2011, 2012 or 2013.

 

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CAPITALIZATION

The following table sets forth our capitalization as of December 31, 2013, on:

 

   

an actual basis;

 

   

a pro forma basis to give effect to the following, as if each had occurred on December 31, 2013: (i) the automatic conversion of all shares of our Series A Preferred to 2,983,903 shares of our common stock, (ii) the automatic conversion of all shares of our Series B Preferred to 2,593,123 shares of our common stock and (iii) the 2.43 -for- 1.00 reverse stock split effectuated on May 7, 2014; and

 

   

a pro forma as adjusted basis to give effect to the following, as if each had occurred on December 31, 2013: (i) the automatic conversion of all shares of our Series A Preferred to 2,983,903 shares of our common stock, (ii) the automatic conversion of all shares of our Series B Preferred to 2,593,123 shares of our common stock, (iii) the 2.43 -for- 1.00 reverse stock split effectuated on May 7, 2014, (iv) the sale of 8,825,000 shares of common stock by us at an offering price of $15.00 per share in this offering and (v) the application of the net proceeds of this offering (1) to retire all $22.3 million of the indebtedness outstanding under the Shareholder Notes, (2) to pay all $15.7 million of accumulated and unpaid dividends on our Series A Preferred and Series B Preferred, (3) to repay all of the outstanding borrowings of $23.5 million under our revolving credit facility and (4) for working capital and general corporate purposes.

The information below is illustrative only, and our capitalization following this offering will be adjusted based on the actual initial public offering price and other terms of this offering determined at pricing, including the amount by which actual offering expenses are higher or lower than estimated. You should read this table together with the information contained in this prospectus, including “Use of Proceeds,” “Selected Historical Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and related notes included elsewhere in this prospectus.

 

    As of December 31, 2013  
    Actual     Pro Forma     Pro Forma
As Adjusted
 
          (Unaudited)  
    (amounts in thousands, except share data)  

Total debt and obligations:

     

Borrowings under our revolving credit facility (1)

  $ 23,500      $ 23,500      $ —     

Shareholder Notes, net of unamortized discount

    19,650       19,650        —     
 

 

 

   

 

 

   

 

 

 

Total debt

    43,150        43,150        —     

Series A redeemable convertible preferred stock, $0.001 par value, 7,300,000 shares authorized, 7,250,885 shares issued and outstanding, actual; and no shares authorized, issued and outstanding, pro forma and pro forma as adjusted

    56,667        —          —     

Series B redeemable convertible preferred stock, $0.001 par value, 6,500,000 shares authorized, 6,301,290 shares issued and outstanding, actual; and no shares authorized, issued and outstanding, pro forma and pro forma as adjusted

    52,414        —          —     

Preferred stock, par value $0.001 per share, no shares authorized, issued or outstanding, actual; no shares authorized, issued or outstanding, pro forma; and 100,000,000 shares authorized, no shares issued or outstanding, pro forma as adjusted

    —          —          —     

Common stock, par value $0.001 per share, 100,000,000 shares authorized and 22,421,509 shares issued and outstanding, actual; 750,000,000 shares authorized and 27,998,536 shares issued and outstanding, pro forma; and 750,000,000 shares authorized and 36,823,536 shares issued and outstanding, pro forma as adjusted

    22        28        37   

Additional paid-in capital

    165,651        259,026        382,126   

Accumulated other comprehensive loss

    (920     (920     (920

Accumulated deficit

    (70,568     (70,568     (73,188
 

 

 

   

 

 

   

 

 

 

Total stockholders’ equity

    94,185        187,566        308,055   
 

 

 

   

 

 

   

 

 

 

Total capitalization

  $ 246,416      $ 230,716      $ 308,055   
 

 

 

   

 

 

   

 

 

 

footnotes on following page

 

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(1)

Our revolving credit facility consists of a $30.0 million asset-based revolving credit facility maturing in October 2014. As of December 31, 2013, we had $23.5 million of borrowings outstanding and approximately $4.7 million in additional borrowing capacity thereunder. Our borrowing capacity depends, in part, on inventory, accounts receivable and other assets that fluctuate from time to time and may further depend on the lenders’ discretionary ability to impose reserves and availability blocks and to recharacterize assets that might otherwise incrementally increase borrowing availability.

The foregoing table and calculations do not reflect:

 

   

1,650,289 shares of common stock reserved for future issuance under our 2014 Omnibus Incentive Plan;

 

   

411,523 shares of common stock reserved for future issuance under our ESPP;

 

   

4,179,119 shares of common stock issuable upon exercise of outstanding options issued under our existing equity incentive plans at a weighted exercise price of $8.16 per share; or

 

   

576,132 shares of common stock issuable upon vesting of outstanding restricted stock units.

 

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DILUTION

If you invest in our common stock in this offering, your ownership interest will be diluted to the extent of the difference between the initial public offering price per share and the pro forma net tangible book value per share as adjusted to give effect to this offering and the use of proceeds therefrom. Dilution results from the fact that the per share offering price of the common stock is substantially in excess of the book value per share attributable to the shares of common stock held by existing stockholders.

Our net tangible book deficit as of December 31, 2013 was approximately $92.1 million, or a deficit of $4.11 per share of our common stock. We calculate net tangible book deficit per share by taking the amount of our total tangible assets, reduced by the amount of our total liabilities, and then dividing that amount by the total number of shares of common stock outstanding.

After giving effect to (1) our sale of the shares in this offering at the initial public offering price of $15.00 per share, after deducting the underwriting discount and estimated offering expenses payable by us and (2) the use of proceeds therefrom, as set forth under “Use of Proceeds,” as if each had occurred on December 31, 2013, our pro forma net tangible book value as of December 31, 2013 would have been $118.2 million, or $3.21 per share. This amount represents an immediate increase in net tangible book value (or a decrease in net tangible book deficit) of $7.32 per share to existing stockholders and an immediate and substantial dilution in net tangible book value of $11.79 per share to new investors purchasing shares in this offering at the initial public offering price.

The following table illustrates this dilution on a per share basis:

 

Assumed Initial public offering price per share

     $ 15.00   

Net tangible book deficit per share as of December 31, 2013

   $ (4.11  

Increase in net tangible book value per share attributable to new investors purchasing shares in this offering and use of proceeds therefrom

     7.32     
  

 

 

   

Pro forma net tangible book value per share of common stock, as adjusted to give effect to this offering

       3.21   
    

 

 

 

Dilution per share to new investors in this offering

     $ 11.79   
    

 

 

 

Dilution is determined by subtracting pro forma net tangible book value per share of common stock, as adjusted to give effect to this offering, from the initial public offering price per share of common stock.

If the underwriters exercise in full their option to purchase additional shares of our common stock from the selling stockholders, there would be no change in the as adjusted negative net tangible book value per share or the dilution to new investors in this offering, because we would not receive any proceeds from the sale of such shares.

 

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The following table summarizes, as of December 31, 2013, the differences between the number of shares purchased from us, the total consideration paid to us, and the average price per share paid by existing stockholders and by new investors. As the table shows, new investors purchasing shares in this offering will pay an average price per share substantially higher than our existing stockholders paid. The table below is based on 36,823,536 shares of common stock outstanding immediately after the consummation of this offering and does not give effect to shares of common stock reserved for future issuance under the 2014 Omnibus Incentive Plan, the ESPP or our existing incentive plans. The table below gives effect to the sale of new shares of common stock in this offering at the initial public offering price of $15.00 per share and excludes the underwriting discount and estimated offering expenses payable by us:

 

     Shares Purchased     Total Consideration     Average
Price Per
Share
 
     Number      Percent     Amount      Percent    
                  (in thousands, other than
shares and percentages)
       

Existing stockholders

     27,998,536         76.0 %   $ 237,665         64.2 %   $ 8.49   

New investors (1)

     8,825,000         24.0        132,375         35.8        15.00   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Total

     36,823,536         100.0 %   $ 370,040         100.0 %   $ 10.05   

 

(1)  

Does not reflect any shares that may be purchased by new investors from the selling stockholders pursuant to the underwriters’ option to purchase additional shares.

If the underwriters were to fully exercise their option to purchase 1,323,750 additional shares of our common stock from the selling stockholders, the percentage of shares of our common stock held by existing stockholders who are directors, officers or affiliated persons as of December 31, 2013 would be 72.4% and the percentage of shares of our common stock held by new investors would be 27.6%.

The tables and calculations above assume no exercise of outstanding options. As of December 31, 2013, there were 4,179,119 shares of common stock issuable upon exercise of outstanding options at a weighted average exercise price of approximately $8.16 per share. To the extent that the outstanding options are exercised, there will be further dilution to new investors purchasing common stock in the offering. See “Description of Capital Stock.”

 

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S ELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA

The following tables set forth our selected historical consolidated financial and operating data for the periods indicated. The selected financial data as of December 31, 2012 and 2013 and for each of the three years in the period ended December 31, 2013, have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The selected historical consolidated balance sheet data presented below as of December 31, 2011 has been derived from our audited consolidated financial statements that are not included in this prospectus. Our historical results are not necessarily indicative of the results expected for any future period. The selected historical consolidated financial data reflects the 2.43 -for- 1.00 reverse stock split effectuated on May 7, 2014.

The pro forma basic and diluted weighted average shares and pro forma basic and diluted net loss per common share data for the year ended December 31, 2013 presented below are unaudited and give effect to the automatic conversion of all outstanding shares of our Series A Preferred to 2,983,903 shares of our common stock and the automatic conversion of all outstanding shares of our Series B Preferred to 2,593,123 shares of our common stock immediately prior to the consummation of this offering.

The pro forma as adjusted basic and diluted weighted average shares and basic and diluted net loss per share data for the year ended December 31, 2013 are unaudited and give effect to (1) the automatic conversion of all outstanding shares of our Series A Preferred to 2,983,903 shares of our common stock and the automatic conversion of all outstanding shares of our Series B Preferred to 2,593,123 shares of our common stock, (2) the sale of 8,825,000 shares of our common stock in this offering at the initial public offering price of $15.00 per share, (3) the application of our net proceeds from this offering to retire all outstanding indebtedness under the Shareholder Notes, (4) the application of our net proceeds from this offering to repay all indebtedness outstanding under our revolving credit facility and (5) the application of our net proceeds from this offering to pay all accumulated and unpaid dividends on our Series A Preferred and our Series B Preferred, as if each had occurred on January 1, 2013. The pro forma as adjusted consolidated summary financial data is not necessarily indicative of what our financial position or results of operations would have been if this offering had been completed as of the date indicated, nor is such data necessarily indicative of our financial position or results of operations for any future date or period.

You should read the selected historical consolidated financial data below, together with the consolidated financial statements and related notes thereto appearing elsewhere in this prospectus, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the other financial information included elsewhere in this prospectus. Our historical results of operations are not necessarily indicative of future results of operations.

 

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     Year Ended December 31,  
     2011     2012     2013  
     (in thousands, except per share data)  

Statement of Operations Data:

      

Revenue

   $ 118,005      $ 135,145      $ 157,584   

Cost of revenue

     47,984        43,962        50,162   
  

 

 

   

 

 

   

 

 

 

Gross profit

     70,021        91,183        107,422   

Operating expenses:

      

Research, development and engineering

     11,930        9,031        12,402   

Sales and marketing

     63,176        70,163        80,183   

General and administrative

     49,431        57,821        59,758   

Contingent consideration

     (50,436     (324     —     
  

 

 

   

 

 

   

 

 

 

Total operating expenses

     74,101        136,691        152,343   
  

 

 

   

 

 

   

 

 

 

Loss from operations

     (4,080     (45,508     (44,921

Other income (expense):

      

Foreign currency transaction gain(loss)

     (560     1,034        1,477   

Interest expense

     (236     (1,222     (2,810
  

 

 

   

 

 

   

 

 

 

Total other expense, net

     (796     (188     (1,333
  

 

 

   

 

 

   

 

 

 

Loss before benefit from income taxes

     (4,876     (45,696     (46,254

Benefit from income taxes

     (18,221     (13,041     (8,341
  

 

 

   

 

 

   

 

 

 

Net income (loss)

     13,345        (32,655     (37,913

Accretion or write-up of preferred stock

     (13,773     (9,954     (19,439
  

 

 

   

 

 

   

 

 

 

Net loss allocable to common stockholders

   $ (428   $ (42,609   $ (57,352
  

 

 

   

 

 

   

 

 

 

Per Share Data:

      

Net loss per common share—basic and diluted

   $ (0.02   $ (1.94   $ (2.58

Pro forma net loss per common share—basic and diluted (unaudited)

       $ (1.37

Pro forma as adjusted net loss per common share— basic and diluted (unaudited)

       $ (0.97

Weighted-average number of shares used in per share amounts:

      

Basic and diluted

     21,774        21,921        22,239   

Pro forma basic and diluted

        
27,703
  

Pro forma as adjusted basic and diluted

         36,528   

 

     As of December 31,  
     2011      2012      2013  
     (in thousands)  

Balance Sheet Data:

        

Cash and cash equivalents

   $ 12,226       $ 7,011       $ 7,419   

Working capital

     44,588         47,369         32,549   

Total assets

     329,659         299,617         296,936   

Total long-term debt, net of discount

     13,000         26,668         19,650   

Total liabilities

     73,354         71,517         93,670   

Total redeemable convertible preferred stock

     65,719         78,068         109,081   

Total stockholders’ equity

     190,586         150,032         94,185   

 

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MAN AGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with “Summary—Summary Historical Consolidated Financial Data,” “Risk Factors,” “Selected Historical Consolidated Financial Data” and our consolidated financial statements and related notes thereto included elsewhere in this prospectus. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those contained in or implied by the forward-looking statements. All references to years, unless otherwise noted, refer to our fiscal years, which end on December 31.

Overview

We are a global medical device company focused on designing, developing and commercializing innovative and proprietary complex spine technologies and techniques. Our complex spine products are used by spine surgeons to treat some of the most difficult and challenging spinal pathologies, such as deformity (primarily scoliosis), trauma and tumor. We believe these procedures typically receive a higher rate of positive insurance coverage and often generate more revenue per procedure as compared to other spine surgery procedures. We have applied our product development expertise in innovating complex spine technologies and techniques to the design, development and commercialization of an expanding number of proprietary MIS products. These proprietary MIS products are designed to allow for less invasive access to the spine and faster patient recovery times compared to traditional open access surgical approaches. We have also leveraged these core competencies in the design, development and commercialization of an increasing number of products for patients suffering from degenerative spinal conditions.

We categorize our revenue in the United States amongst revenue generated from treatment of complex spine pathologies, treatment using MIS approaches and the treatment of degenerative spinal conditions. We define our complex spine procedures as those that involve the treatment of the most difficult and challenging spinal pathologies, such as deformity (primarily scoliosis), trauma and tumor. We consider MIS procedures as those involving products designed to allow for less invasive access to the spine and faster patient recovery times as compared to traditional open access surgical approaches. We categorize degenerative procedures as those involving products treating degenerative spinal conditions such as traditional spinal fusions. We report revenue related to the sale of biomaterials as part of our complex spine, MIS and degenerative spine revenue categories. We expect our revenue to continue to be driven by aggregate sales growth in all categories. Our revenue classifications may evolve as we grow our business, continue to commercialize new products, adapt to surgeon preferences and surgical techniques and expand our sales globally.

The primary market for our products has been the United States, where we sell our products through a hybrid sales organization consisting of direct sales employees and independent sales agencies. As of December 31, 2013, our U.S. sales force consisted of 114 direct sales employees and 48 independent sales agencies, who distribute our products and are compensated through a combination of base salaries, individual and company-based performance bonuses, commissions and stock options. We do not sell our products through or participate in PODs and no surgeons own any shares of our common stock.

We also market and sell our products internationally in 28 countries. We sell our products directly in certain markets such as the United Kingdom and Germany and use independent distributors in other markets such as Australia, Japan and Spain. For the year ended December 31, 2013, international sales accounted for approximately 29% of our revenue. As of December 31, 2013, our international sales force consisted of 37 direct sales employees, five independent agencies and 15 independent distributors.

 

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Our independent distributors manage the billing relationship with each hospital in their respective territories and are responsible for servicing the product needs of their surgeon customers. We believe there are significant opportunities for us to increase our presence through the expansion of our sales force and the commercialization of additional products.

Components of our Results of Operations

We manage our business globally within one reportable segment, which is consistent with how our management reviews our business, prioritizes investment and resource allocation decisions and assesses operating performance.

Revenue

We market and sell spinal implants, disposables and instruments, primarily to hospitals, for use by surgeons to treat patients with spinal pathologies. In the United States and international markets where we have direct employee sales locations, which include the United Kingdom, Ireland, Germany, Austria and Switzerland, we manage and maintain the sales relationships with our hospital customers. In those international markets where we utilize independent distributorships, we do not manage or maintain the sales relationships with the hospital customers. We do, however, support our distributor partners by providing product training, medical education, and engineering expertise to surgeons practicing in these markets.

In markets where we have a direct presence, we generally assign our surgical sets to our direct sales employees. A surgical set typically contains the instruments, including any disposables, and spinal implants necessary to complete a successful surgery. With our support, the direct sales employee maintains the surgical sets and places them with our hospital customers for use by surgeons. We recognize revenue upon receipt of a delivered order confirming that our products have been used in a surgical procedure.

In our international markets where we utilize independent distributorships, we generally sell our surgical sets and the related spinal implant replenishments to our distributors on pre-agreed business terms. We recognize revenue when the title to the goods and the risk of loss related to those goods are transferred. All such sales to distributors are not subject to contingencies and are, therefore, final.

We generated approximately 25%, 26% and 29% of international revenue for the years ended December 31, 2011, 2012 and 2013, respectively. We anticipate that sales in international markets will grow faster than sales in the United States in the near term.

In addition, we generated approximately 59%, 60% and 58% of our U.S. revenue from the sale of our complex spine and MIS products for the years ended December 31, 2011, 2012 and 2013, respectively, and we expect that these core product categories will continue to be a significant contributor to our revenue growth in the future.

While we believe the proportion of our international revenue from complex spine and MIS is even higher than in the United States, a significant portion of our international revenue is derived from our distributor partners who do not report their product usage at the surgeon or hospital level, which prevents us from providing a specific breakdown for our international revenue among our three product categories.

Cost of Revenue

Except for certain specialty products that we manufacture in-house, our instruments, spinal implants and related offerings are manufactured to our specifications by third-party suppliers who meet our manufacturer qualification standards. Our third-party manufacturers meet FDA, ISO and other country-

 

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specific quality standards supported by our internal specifications and procedures. Substantially all of our suppliers manufacture our products in the United States. Our cost of revenue consists primarily of costs of products purchased from our third-party suppliers, amortization of surgical instruments, inventory reserves, royalties, shipping, inspection and related costs incurred in making our products available for sale or use. Cost of revenue also includes related personnel and consultants’ compensation and stock-based compensation expense. In 2011, cost of revenue reflected the amortization of stepped up inventory value resulting from our purchase by the Sponsor. Beginning in 2013, our cost of revenue included the effect of a 2.3% excise tax on the sale of medical devices sold in the United States. We expect our cost of revenue to increase in absolute terms due primarily to increased sales volume and changes in the geographic mix of our sales as our international operations tend to have a higher cost of revenue as a percentage of sales.

Research, Development and Engineering

Our research, development and engineering expenses primarily consist of research and development, engineering, product development, clinical expenses, regulatory expenses, consulting services, third-party prototyping services, outside research activities, materials production and other costs associated with development of our products. Research, development and engineering expenses also include related personnel and consultants’ compensation and stock-based compensation expense. We expense research, development and engineering costs as they are incurred. We expect to incur additional research, development and engineering costs as we continue to design and commercialize new products. While our research, development and engineering expenses fluctuate from period to period based on the timing of specific research, development and testing initiatives, we generally expect these costs will increase in absolute terms over time as we continue to expand our product portfolio and add related personnel.

Sales and Marketing

Sales and marketing expenses primarily consist of commissions to our independent distributors, as well as compensation, commissions, benefits and other related costs, including stock-based compensation, for personnel employed in our sales, marketing and clinical sales support departments. Sales and marketing also includes the costs of medical education, training and corporate communications activities. We expect our sales and marketing expenses will increase in absolute terms due to increased sales volume, the continued expansion of our sales force and the continued design and commercialization of new products.

General and Administrative

General and administrative expenses include compensation, benefits and other related costs, including stock-based compensation for personnel employed in our executive management, finance, regulatory, information technology and human resource departments, as well as facility costs and costs associated with consulting and other finance, legal, information technology and human resource services provided by third-parties. We include legal and litigation expenses as well as costs related to the development and protection of our IP portfolio in general and administrative expenses. We expect our general and administrative expenses to continue to increase in absolute dollars as we hire additional personnel to support the growth of our business. In addition, we expect to incur increased expenses as a result of being a public company. General and administrative expenses also include amortization expense of our intangible assets. However, the amortization of intangible assets is expected to decline over the next several years as described in Note 6 to the audited consolidated financial statements which are included elsewhere in this prospectus as the intangibles become fully amortized based on their estimated useful lives.

 

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Income Tax Provision

We are taxed at the rates applicable within each jurisdiction in which we operate and/or generate revenue. The composite income tax rate, tax provisions, deferred tax assets and deferred tax liabilities will vary according to the jurisdiction in which profits arise. Tax laws are complex and subject to different interpretations by management and the respective governmental taxing authorities, and require us to exercise judgment in determining our income tax provision, our deferred tax assets and liabilities and the valuation allowance recorded against our net deferred tax assets. Deferred tax assets and liabilities are determined using the enacted tax rates in effect for the years in which those tax assets are expected to be realized. A valuation allowance is established when it is more likely than not that the future realization of all or some of the deferred tax assets will not be achieved.

Material Trends and Uncertainties

The global spinal surgery industry has been growing as a result of:

 

   

the increased accessibility of healthcare to more people worldwide;

 

   

advances in technologies for treating conditions of the spine, which have increased the addressable market of patients; and

 

   

overall population growth, aging patient demographics and an increase in life expectancies around the world.

Nonetheless, we face a number of challenges and uncertainties, including:

 

   

ongoing requirements from our hospital partners related to pricing and operating procedures;

 

   

continued market acceptance of our new product innovations;

 

   

the unpredictability of government regulation over healthcare in the worldwide markets; and

 

   

competitive threats in the future displacing current surgical treatment protocols.

 

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Results of Operations

The following table sets forth, for the periods indicated, our results of operations expressed as dollar amounts:

 

     Year Ended December 31,  
     2011     2012     2013  
     (in thousands)  

Revenue

   $ 118,005      $ 135,145      $ 157,584   

Cost of revenue

     47,984        43,962        50,162   
  

 

 

   

 

 

   

 

 

 

Gross profit

     70,021        91,183        107,422   

Operating expenses:

      

Research, development and engineering

     11,930        9,031        12,402   

Sales and marketing

     63,176        70,163        80,183   

General and administrative

     49,431        57,821        59,758   

Contingent consideration

     (50,436     (324     —     
  

 

 

   

 

 

   

 

 

 

Total operating expenses

     74,101        136,691        152,343   
  

 

 

   

 

 

   

 

 

 

Loss from operations

     (4,080     (45,508     (44,921

Other income (expense):

      

Foreign currency translation gain (loss)

     (560     1,034        1,477   

Interest expense

     (236     (1,222     (2,810
  

 

 

   

 

 

   

 

 

 

Total other expense, net

     (796     (188     (1,333
  

 

 

   

 

 

   

 

 

 

Loss before benefit from income taxes

     (4,876     (45,696     (46,254

Benefit from income taxes

     (18,221     (13,041     (8,341
  

 

 

   

 

 

   

 

 

 

Net income (loss)

     13,345        (32,655     (37,913

Accretion or write-up of preferred stock

     (13,773     (9,954     (19,439
  

 

 

   

 

 

   

 

 

 

Net loss attributable to common stockholders

   $ (428   $ (42,609   $ (57,352
  

 

 

   

 

 

   

 

 

 

Year Ended December 31, 2013 Compared to the Year Ended December 31, 2012

Revenue

The following table sets forth, for the periods indicated, our revenue by geography expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and as percentages:

 

     Year Ended
December 31,
     Increase/Decrease  
     2012      2013      $ change      % change  
     (dollars in thousands)  

United States

   $ 99,845       $ 111,772       $ 11,927         11.9

International

     35,300         45,812         10,512         29.8
  

 

 

    

 

 

    

 

 

    

Total revenue

   $ 135,145       $ 157,584       $ 22,439         16.6
  

 

 

    

 

 

    

 

 

    

Total revenue increased $22.5 million, or 16.6%, from $135.1 million for the year ended December 31, 2012 to $157.6 million for the year ended December 31, 2013. The increase in revenue was driven by $12.8 million in greater sales volume in the United States due to continued expansion of our customer base, a $5.8 million increase due to changes in our product mix in the United States, $5.3 million in growth in our direct international markets, primarily Italy and the United Kingdom, and $5.4 million in growth in our international distributor markets, primarily Australia, Spain and Scandinavia. The increases in the United States were offset by decreases in sales to our existing customer base of $6.7 million.

 

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U.S. Revenue

The following table sets forth, for the periods indicated, our U.S. revenue by product category expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and as percentages:

 

     Year Ended
December 31,
     Increase/Decrease  
     2012      2013      $ Change      % Change  

Complex spine

   $ 37,792       $ 40,505       $ 2,713         7.2

Minimally invasive

     21,671         24,340         2,669         12.3

Degenerative

     40,382         46,927         6,545         16.2
  

 

 

    

 

 

    

 

 

    

Total U.S. revenue

   $ 99,845       $ 111,772       $ 11,927         11.9
  

 

 

    

 

 

    

 

 

    

U.S. revenue increased $12.0 million, or 11.9%, from $99.8 million for the year ended December 31, 2012 to $111.8 million for the year ended December 31, 2013. Sales in our complex spine, MIS and degenerative categories represented 38%, 22% and 40% of U.S. revenue, respectively, for the year ended December 31, 2012, compared to 36%, 22% and 42% of U.S. revenue, respectively, for the year ended December 31, 2013. The overall U.S. revenue growth was driven by increased surgical activity from new surgeon users representing $12.8 million of revenue and changes in our product mix representing $5.8 million of revenue, offset by a decrease in revenue of $6.7 million from existing customer usage. The degenerative category growth of $6.5 million primarily reflects increased surgeon usage of our EVEREST product line of $7.2 million, offset, in part, by declines in sales of other degenerative products. The MIS category growth of $2.7 million primarily reflects increased surgeon usage of our percutaneous SERENGETI system of $1.4 million. The complex spine category growth of $2.7 million reflects increased surgeon usage of our MESA Rail 4D product, which was released in 2012, of $1.1 million. For the year ended December 31, 2013, 24% of our MIS sales were attributable to complex spine procedures while 76% were attributable to degenerative procedures, as compared to 23% and 77%, respectively, for the year ended December 31, 2012.

International Revenue

International revenue increased $10.5 million, or 29.8%, from $35.3 million for the year ended December 31, 2012 to $45.8 million for the year ended December 31, 2013. International revenue increased as a result of expanded customer usage of $5.3 million in our Italian, United Kingdom and German direct markets. The revenue growth from these direct markets includes a $0.1 million decrease in revenue resulting from foreign currency fluctuations, primarily due to a weakening of the Pound Sterling and the Euro as compared to the U.S. Dollar. Sales of our MESA deformity spinal system were the primary product driver of this revenue growth. International revenue also reflects growth of $5.4 million from our international distributor partners, primarily in Australia, Spain and Scandinavia.

Cost of Revenue

Cost of revenue increased $6.2 million, or 14.1%, from $44.0 million for the year ended December 31, 2012 to $50.2 million for the year ended December 31, 2013. The increase was primarily due to increased sales volume, changes in the mix of U.S. and international revenue and a $2.0 million increase due to the medical device excise tax in the United States that came into effect on January 1, 2013. Amortization expense, a component of cost of revenue, decreased $5.0 million, or 49.4%, from $10.2 million in the year ended December 31, 2012 to $5.2 million for the year ended December 31, 2013, as we began amortizing our surgical sets over a five year period, versus our historical practice of amortizing our instrument sets over a three year period. The impact of the change reduced expenses by $6.7 million for the year ended December 31, 2013.

 

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Gross Margin

Gross margin increased as a percentage of revenue to 68.2% for the year ended December 31, 2013, from 67.5% for the year ended December 31, 2012. The increase in gross margin as a percentage of revenue is primarily due to the change in useful life for our surgical instruments. We began amortizing our surgical sets over a five year period, versus our historical practice of amortizing our sets over a three year period, resulting in a $6.7 million decrease in cost of revenue, or a 4.3% improvement in gross margin for the year ended December 31, 2013. The increase in gross margin was offset by the $2.0 million impact from a medical device excise tax in the United States that came into effect on January 1, 2013, as well as changes in the mix of sales between the United States and international markets. International revenue reimbursements from insurers vary widely in each international region and are typically lower than revenue reimbursements from insurers in the United States.

Research, Development and Engineering

Research, development and engineering expenses increased $3.4 million, or 37.3%, from $9.0 million for the year ended December 31, 2012 to $12.4 million for the year ended December 31, 2013. The increase was primarily due to increased development of products in our pipeline and engineering support for the launch of new product lines.

Sales and Marketing

Sales and marketing expenses increased $10.0 million, or 14.3%, from $70.2 million for the year ended December 31, 2012 to $80.2 million for the year ended December 31, 2013. The increase was primarily due to an increase in sales commissions as a result of the increase in sales volume and increased employee compensation costs associated with the hiring of 55 direct sales employees on a net basis, and increased costs for training and marketing related expenses.

General and Administrative

General and administrative expenses increased $2.0 million, or 3.3%, from $57.8 million for the year ended December 31, 2012 to $59.8 million for the year ended December 31, 2013. The increase was primarily due to increased employee compensation and benefit costs associated with the increase in personnel to support the expansion of our business, partially offset by a decrease in third-party legal and other consulting expenses. General and administrative expenses included amortization of intangible assets of $30.1 million in each of the years ended December 31, 2012 and 2013.

Other Income (Expense)

Other expenses increased $1.1 million from $0.2 million for the year ended December 31, 2012 to $1.3 million for the year ended December 31, 2013. The increase was driven by increased interest expense related to higher average debt balances, including under the Shareholder Notes.

Benefit from Income Taxes

Benefit from income taxes decreased $4.7 million, or 36.0%, from $13.0 million for the year ended December 31, 2012 to $8.3 million for the year ended December 31, 2013. Our effective tax rate calculated as a percentage of loss before income tax benefit was 28.5% for the year ended December 31, 2012 and 18.0% for the year ended December 31, 2013. The change in the effective tax rate was due to the effect of an increase in the valuation allowance on our deferred tax assets as of December 31, 2013.

 

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Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011

Revenue

The following table sets forth, for the periods indicated, our revenue by geography expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and as percentages:

 

     Year Ended
December 31,
     Increase/Decrease  
     2011      2012      $ change      % change  
     (dollars in thousands)  

U.S.

   $ 88,820       $ 99,845       $ 11,025         12.4

International

     29,185         35,300         6,115         21.0
  

 

 

    

 

 

    

 

 

    

Total revenue

   $ 118,005       $ 135,145         17,140         14.5
  

 

 

    

 

 

    

 

 

    

Revenue increased $17.1 million, or 14.5%, from $118.0 million for the year ended December 31, 2011 to $135.1 million for the year ended December 31, 2012. The increase in revenue resulted primarily from an increase in surgical activity resulting from new surgeon customers and additional procedure volume from existing customers. In the United States, new surgeon customer volume represented an increase of $9.5 million. The degenerative category of product lines represented the greatest growth reflecting an $8.7 million increase in EVEREST product sales in both new and existing customer accounts. In our international markets, we experienced revenue growth of $1.3 million in our direct markets, including the United Kingdom and Germany, and another $4.0 million of growth in our independent distributor markets, including Australia, Spain and Japan.

U.S. Revenue

The following table sets forth, for the periods indicated, our U.S. revenue by product category expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and as percentages:

 

     Year Ended
December 31,
     Increase/Decrease  
     2011      2012      $ change      % change  
     (dollars in thousands)  

Complex spine

   $ 36,198       $ 37,792       $ 1,594         4.4

MIS

     16,420         21,671         5,251         32.0

Degenerative spine

     36,202         40,382         4,180         11.5
  

 

 

    

 

 

    

 

 

    

Total U.S. revenue

   $ 88,820       $ 99,845       $ 11,025         12.4
  

 

 

    

 

 

    

 

 

    

U.S. revenue increased $11.0 million, or 12.4%, from $88.8 million for the year ended December 31, 2011 to $99.8 million for the year ended December 31, 2012. Sales in our complex spine, MIS and degenerative categories represented approximately 41%, 18% and 41% of U.S. revenue, respectively, for the year ended December 31, 2011, compared to approximately 38%, 22% and 40% of U.S. revenue, respectively, for the year ended December 31, 2012. The overall U.S. revenue growth was driven by new surgeon users representing an increase of $9.5 million offset, in part, by a decrease in revenue of $2.9 million from existing customer usage and product mix changes. The degenerative category growth of $4.2 million primarily reflects increased surgeon usage of our EVEREST product line of $8.7 million, offset, in part, by a $6.0 million decline in sales of our DENALI degenerative system. The EVEREST system was introduced in 2011 as an enhancement to the DENALI degenerative system. The MIS category growth of $5.3 million primarily reflects increased surgeon usage of our lateral access RAVINE

 

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product line of $1.9 million and increased surgeon usage of our percutaneous SERENGETI system of $0.9 million. The complex spine category growth of $1.6 million primarily reflects increased surgeon usage of our MESA spinal deformity system. For the year ended December 31, 2012, 23% of our MIS sales were attributable to complex spine procedures while 77% were attributable to degenerative procedures, as compared to 16% and 84%, respectively, for the year ended December 31, 2011.

International Revenue

International revenue increased $6.1 million, or 21.0%, from $29.2 million for the year ended December 31, 2011 to $35.3 million for the year ended December 31, 2012. International revenue increased as a result of expanded customer usage in our United Kingdom and German direct markets of $1.3 million and includes a $0.2 million decrease in revenue resulting from foreign currency fluctuations, primarily due to a weakening of the Pound Sterling and the Euro as compared to the U.S. Dollar. The MESA spinal deformity system represents the primary driver of product growth in these direct markets. Growth from our independent distributors represented $4.0 million of international revenue growth, primarily reflecting strength in Spain and Australia.

Cost of Revenue

Cost of revenue decreased $4.0 million, or 8.4%, from $48.0 million for the year ended December 31, 2011 to $44.0 million for the year ended December 31, 2012. The decrease was primarily due to a $9.0 million reduction in amortization on inventory that was written up to fair value in 2011 in connection with our purchase by our Sponsor. This decrease was partially offset by an increase of $5.6 million related to increased product sales volume. Additionally, cost of revenue included $7.3 million and $10.2 million of instrument amortization expense for the years ended December 31, 2011 and December 31, 2012, respectively.

Gross Margin

Gross margin increased as a percentage of revenue from 59.3% for the year ended December 31, 2011 to 67.5% for the year ended December 31, 2012. The increase in gross margin as a percentage of revenue was primarily driven by $9.0 million in amortization on inventory that was written up to fair value in 2011 in connection with our purchase by our Sponsor and sold during 2011. The improvement in gross margin was offset by changes in the mix of sales between the United States and international markets.

Research, Development and Engineering

Research, development and engineering expense decreased $2.9 million, or 24.3%, from $11.9 million for the year ended December 31, 2011 to $9.0 million for the year ended December 31, 2012. The decrease was primarily due to a reduction of development and testing expenses of $1.8 million resulting from the timing of new product introductions and a decrease in outside service expenses of $0.7 million resulting from differences in the timing of research activities.

Sales and Marketing

Sales and marketing expense increased $7.0 million, or 11.1%, from $63.2 million for the year ended December 31, 2011 to $70.2 million for the year ended December 31, 2012. The increase was primarily the result of increased employee compensation costs and benefits associated with investments in our direct sales organization, offset, in part, by a reduction in marketing expenses.

General and Administrative

General and administrative expense increased $8.4 million, or 17.0%, from $49.4 million for the year ended December 31, 2011 to $57.8 million for the year ended December 31, 2012. General and administrative expenses include amortization of intangible assets, which increased $3.9 million, or 14.9%, from $26.2 million for the year ended December 31, 2011 to $30.1 million for the year ended

 

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December 31, 2012. The remaining increase of $4.5 million was primarily attributable to increased employee compensation and benefit expenses associated with additional personnel, as well as increases in expenses for third-party consulting, finance and legal activities.

Contingent Consideration

Contingent consideration decreased $50.1 million from $50.4 million for the year ended December 31, 2011 to $0.3 million for the year ended December 31, 2012. In 2011, we reduced our liability for contingent purchase price consideration related to our purchase by the Sponsor following an assessment of the criteria necessary to achieve such consideration and its determination that such criteria would not be met.

Other Income (Expense)

Other expenses decreased $0.6 million, or 76.4%, from $0.8 million for the year ended December 31, 2011 to $0.2 million for the year ended December 31, 2012. The decrease was driven by a foreign currency transaction gains of $1.0 million for 2012 as compared to a foreign currency transaction losses of $0.6 million for 2011, partially offset by a $1.0 million increase in interest expense relating to the higher average debt balances.

Benefit from Income Taxes

Benefit from income taxes decreased $5.2 million, or 28.4%, from $18.2 million for the year ended December 31, 2011 to $13.0 million for the year ended December 31, 2012. Our effective tax rate calculated as a percentage of loss before benefit from income taxes was 373.7% for 2011 and 28.5% for 2012. The change in the effective tax rate was mostly due to the effect of the permanent difference related to the change in fair value of contingent consideration recorded in 2011.

Liquidity and Capital Resources

Since our inception in 2004, we have incurred significant operating losses and anticipate that our losses will continue in the near term. We expect our operating expenses will continue to grow as we expand our product portfolio and penetrate further into new and existing markets. We will need to generate significant revenue to achieve profitability. To date we have funded our operations primarily with proceeds from the sales of preferred and common stock, borrowings under the Shareholder Notes and our revolving credit facility and cash flow from operations. Gross proceeds from the sales of preferred stock, common stock and Shareholder Notes since our purchase by the Sponsor were $54.0 million.

As of December 31, 2013, our cash and cash equivalents were $7.4 million compared to cash and cash equivalents as of December 31, 2012 of $7.0 million. As of December 31, 2013, we had outstanding indebtedness of $19.7 million under the Shareholder Notes, net of unamortized discount of $2.6 million, and outstanding borrowings of $23.5 million under our revolving credit facility. As of December 31, 2013, we had working capital of $32.5 million, compared to $47.4 million as of December 31, 2012. As of December 31, 2013, as adjusted to give effect to this offering, our cash and cash equivalents and indebtedness would have been $69.1 million and zero, respectively, assuming the net proceeds of this offering are used as set forth in “Use of Proceeds.”

Our principal long-term liquidity need is working capital to support the continued growth of our business through the hiring of direct sales employees and independent agencies to expand our global sales force, purchases of additional inventory to support future sales activities and development and commercialization of new products through our research and development function. We are currently in negotiations to relocate our corporate headquarters and enter into a new lease for such location when our existing lease expires in 2015. We intend to use a portion of the proceeds from this offering in

 

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connection with such relocation, including the build-out of the new facility. See “Use of Proceeds.” This new lease is expected to result in an increase of approximately $2.0 million to $2.5 million in our annual rent for our headquarters. We expect to fund our long-term capital needs with the net proceeds from this offering, the availability under our revolving credit facility (which may vary due to changes in our borrowing base) and cash flow from operations. To the extent additional funds are necessary to meet our long-term liquidity needs as we continue to execute our business strategy, we anticipate that they will be obtained through the incurrence of additional indebtedness, additional equity financings or a combination of these potential sources of funds.

Although we believe that these sources will provide sufficient liquidity for us to meet our long-term capital needs, our liquidity and our ability to fund these needs will depend to a significant extent on our future financial performance, which will be subject in part to general economic, competitive financial, regulatory and other factors that are beyond our control. In addition to these general economic and industry factors, the principal factors determining whether our cash flows will be sufficient to meet our long-term liquidity requirements will be our ability to provide attractive products to our customers, changes in our customers’ ability to obtain third-party coverage and reimbursement for procedures that use our products, increased pricing pressures resulting from intensifying competition and cost increases and slower product development cycles resulting from a changing regulatory environment. If those factors change significantly or other unexpected factors adversely affect us, our business may not generate sufficient cash flow from operations and future financings may not be available on terms acceptable to us or at all to meet our liquidity needs.

In assessing our liquidity, management reviews and analyzes our current cash on-hand, the average number of days our accounts receivable are outstanding, payment terms that we have established with our vendors, inventory turns, foreign exchange rates, capital expenditure commitments and income tax rates.

Cash Flows

The following table shows our cash flows from operating, investing and financing activities for the years ended December 31, 2011, 2012 and 2013:

 

     Year Ended December 31,  
     2011     2012     2013  
     (dollars in thousands)  

Net cash (used in) operating activities

   $ (18,244   $ (16,447   $ (19,090

Net cash (used in) investing activities

     (11,324     (5,036     (9,934

Net cash provided by financing activities

     22,579        16,246        29,380   

Effect of exchange rate on cash

     4        22        52   
  

 

 

   

 

 

   

 

 

 

Net change in cash and cash equivalents

   $ (6,985   $ (5,215   $ 408   
  

 

 

   

 

 

   

 

 

 

Cash Used in Operating Activities

Net cash used in operating activities increased $2.7 million from $16.4 million for the year ended December 31, 2012 to $19.1 million for the year ended December 31, 2013. The increase in net cash used in operations was due to an increase of $15.7 million in inventory to support future sales activities and a $5.8 million increase in accounts receivable due to increased sales of $22.4 million, or a 16.6% increase in revenue from the year ended December 31, 2012 to the year ended December 31, 2013, driven by the continued expansion of our global distribution network through the hiring of additional direct sales employees and independent sales agencies.

Net cash used in operating activities decreased $1.8 million from $18.2 million for the year ended December 31, 2011 to $16.4 million for the year ended December 31, 2012. The decrease in net cash

 

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used in operating activities was primarily attributable to revenue growth of $17.1 million, or 14.5%, from 2011 to 2012, reductions in research and development spending and a decrease in sales and marketing expenses as a percentage of revenue.

Cash Used in Investing Activities

Net cash used in investing activities increased $4.9 million from $5.0 million for the year ended December 31, 2012 to $9.9 million for the year ended December 31, 2013. The increase in net cash used in investing activities was primarily attributable to increased purchases of surgical instruments for use within our global distribution network.

Net cash used in investing activities decreased $6.3 million from $11.3 million for the year ended December 31, 2011 to $5.0 million for the year ended December 31, 2012. The decrease in net cash used in investing activities was primarily attributable to fewer purchases of long-lived assets for use within our global distribution network.

Cash Provided by Financing Activities

Net cash provided by financing activities increased $13.2 million from $16.2 million for the year ended December 31, 2012 to $29.4 million for the year ended December 31, 2013. The increase was primarily attributable to proceeds from the issuance of additional shares of Series B Preferred and the Shareholder Notes.

Net cash provided by financing activities decreased $6.4 million from $22.6 million for the year ended December 31, 2011 to $16.2 million for the year ended December 31, 2012. The decrease was primarily attributable to reduced liquidity requirements due to less cash used in operating and investing activities year over year, which resulted in reduced borrowings in the year ended December 31, 2012.

Capital Expenditures

Our capital expenditures of $10.8 million for the year ended December 31, 2011, $4.8 million for the year ended December 31, 2012 and $9.8 million for the year ended December 31, 2013 consisted primarily of consigned instrumentation to support surgical sales and the expansion of our global distribution network, purchases of software and software development activities, facilities hardware and computer hardware and related software licenses for our internal systems.

We expect capital expenditures to increase as we continue to further expand our global distribution network through the purchase of additional inventory. We intend to use a portion of the net proceeds from this offering, cash flows from our operations and funding available from our revolving credit facility to fund our additional future capital expenditures.

Indebtedness

Revolving Credit Facility

On October 29, 2012, we entered into a senior secured asset-based revolving credit facility with Silicon Valley Bank and Comerica Bank, or the Lenders, that provides credit facilities in an aggregate amount of $30.0 million consisting of a revolving credit facility and a sub-facility for letters of credit in the aggregate availability amount of $1.0 million, a swing line sub-facility in the aggregate availability amount of $5.0 million and an Export-Import Bank of the United States, or the Export-Import Bank, sub-facility in the aggregate availability amount of $10.0 million. In addition, we may be eligible to receive a one-time increase of $5.0 million in aggregate credit availability subject to our compliance with the credit agreement governing the revolving credit facility, as well as additional commitments from the Lenders. At any time, the aggregate obligations shall not exceed the lesser of the total revolving commitment, of which the initial amount is $30.0 million, and the borrowing base, which is calculated as

 

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80% of our accounts receivable plus up to the lesser of 35% of the eligible inventory or $5.0 million. At any time, the aggregate credit availability on the Export-Import Bank credit facility is limited to the lesser of Export-Import Bank commitments of the Lenders, initially established at $10.0 million, or the borrowing base, which is calculated as a certain percentage of qualifying assets. Our revolving credit facility matures in October 2014.

Interest is charged monthly at prime rate plus 1.0%. Various fees, including commitment fees, equivalent to the product of 0.25% and the average unused portion of the revolving line of credit, annual administrative agent fees, Export-Import Bank line of credit fees and letter of credit fees, are due to the Lenders over the term of the revolving credit facility.

Borrowings under the revolving credit facility are secured by a first priority lien on all of our personal property assets, including intellectual property. The revolving credit facility contains financial covenants which require us to generate Consolidated Adjusted EBITDA (as defined in the credit agreement governing the revolving credit facility) of at least $6.0 million in each trailing-four quarter period and to maintain Liquidity (as defined in the credit agreement governing the revolving credit facility) of at least $3.0 million at all times. The revolving credit facility also contains other restrictive covenants with which we must comply, including restrictive covenants which limit transfer of cash to foreign subsidiaries, limitations on our ability to pay dividends on our common stock and make other payments to stockholders. Outstanding borrowings on the revolving credit facility were $23.5 million at December 31, 2013 and accrued interest at a rate of 4.25% at December 31, 2013. As of December 31, 2013, we had $4.7 million of unused borrowing availability under our revolving credit facility.

In addition, as long as we maintain unrestricted cash at a specific Lender’s bank, plus unused borrowing availability of at least $7.5 million, we may maintain a static loan balance and therefore, collections may be transferred to our operating cash account. In the event cash and unused borrowing availability drop below $7.5 million, cash collections are applied to reduce the outstanding revolver balance. The credit agreement governing our revolving credit facility contains an early termination fee of 1.0% to 2.0% of the aggregate amount of the revolving credit facility, should we decide to terminate the revolving credit facility before October 29, 2014. We expect to repay outstanding borrowings under our revolving credit facility with a portion of the proceeds from this offering. See “Use of Proceeds.”

In May 2013, we entered into a waiver and amendment to the revolving credit facility in which (1) we acknowledged that we were in default under the credit agreement governing our revolving credit facility as a result of our failure to comply with the minimum Consolidated Adjusted EBITDA financial covenant set forth in such credit agreement and the related cross-default under the agreement governing our Export-Import Bank credit facility, (2) the Lenders agreed to waive such defaults and (3) we and the Lenders agreed to amend certain definitions set forth in the credit agreement governing our revolving credit facility.

During February 2014, we entered into an amendment to the revolving credit facility in which (i) we and the Lenders agreed that an event of default had occurred as a result of the borrowers making investments in certain of their subsidiaries in the amount of approximately $4.3 million during the year ended December 31, 2013 which amount was in excess of the $2.0 million limit and (ii) the Lenders agreed to waive such event of default for fiscal 2013. Following this amendment, we were in compliance with all covenants under the revolving credit facility as of December 31, 2013.

As part of our anticipated transition to a public company, we are in discussions with the Lenders to modify the revolving credit facility. We recently agreed upon a non-binding term sheet with the Lenders providing for an increase in commitments from $30.0 million to $40.0 million, an extension of the maturity date from October 2014 to October 2015 and a modification of our financial covenants. On April 30, 2014, in anticipation of the consummation of this offering, we entered into an amendment to

 

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the revolving credit facility to implement some of the changes agreed to in the term sheet, which included certain modifications to the credit agreement to (1) allow for the repayment of our outstanding Shareholder Notes with the proceeds from this offering, (2) replace the existing minimum Consolidated Adjusted EBITDA financial covenant with a maximum loss financial covenant which requires that consolidated net loss of K2M, Inc. and K2M UK, Ltd., our primary operating companies, shall not exceed (i) $(11) million for the three-month period ended March 31, 2014 and (ii) $(16) million for the six-month period ending June 30, 2014 and (3) permit the Lenders to add additional financial covenants to the extent that this offering is not consummated on or prior to June 30, 2014. Based on preliminary financial data disclosed under “Summary—Recent Developments,” we are in compliance with the maximum loss financial covenant for the three-month period ended March 31, 2014, as the consolidated net loss of our operating companies excludes interest and amortization expense related to intangible assets recorded by K2M Group Holdings, Inc. and K2M Holdings, Inc. We anticipate entering into an amendment effecting the remainder of the changes contemplated by the term sheet, including the increase in commitments to $40.0 million and the extension of the maturity date to October 2015, shortly after the completion of this offering.

Shareholder Notes

In June 2012, we executed a securities purchase agreement and a note agreement with two existing shareholders. Pursuant to the securities purchase agreement, the existing shareholders agreed to purchase 66,244 shares of our common stock from us at $9.82 per share, resulting in cash proceeds of $0.7 million. Pursuant to the note agreement, we issued notes to such stockholders an aggregate principal amount of $5.3 million at a discount for cash consideration of $4.7 million.

In May and June 2013, we executed securities purchase agreements and note agreements with certain existing stockholders. Pursuant to such securities purchase agreements, such existing shareholders agreed to purchase 126,235 shares of our common stock from us at $10.74 per share, resulting in cash proceeds of $1.4 million. Pursuant to the note agreements, we issued notes to such stockholders in an aggregate principal amount of $11.2 million at a discount for cash consideration of $9.9 million.

In November and December 2013, we executed securities purchase agreements and note agreements with certain existing stockholders. Pursuant to such securities purchase agreements, such existing shareholders agreed to purchase 57,448 shares of our common stock from us at $12.73 per share, resulting in cash proceeds of $0.7 million. Pursuant to the note agreements, we issued notes to such stockholders in an aggregate principal amount of $5.7 million at a discount for cash consideration of $5.0 million.

In January and March 2014, we executed securities purchase agreements and note agreements with certain existing stockholders. Pursuant to such securities purchase agreements, such existing stockholders agreed to purchase 121,111 shares of our common stock from us at $19.05 per share, resulting in cash proceeds of $2.3 million. Pursuant to the note agreements, we issued notes to such stockholders in an aggregate principal amount of $16.9 million at a discount for cash consideration of $14.6 million.

Each of the Shareholder Notes bear interest at 10.0% per annum, if paid in cash, or 13.0% per annum, if paid in kind, payable semi-annually in arrears on June 30 and December 31 of each year. For each of the Shareholder Notes, the principal balance and any unpaid interest thereon are due on June 21, 2022.

The Shareholder Notes are subordinate in ranking to the revolving credit facility described above. On the fifth anniversary of the issuance date, and annually thereafter, we may be required to prepay a portion of the outstanding Shareholder Notes to maintain compliance with the securities purchase agreements. We may elect to prepay the principal balance of the Shareholder Notes and any accrued interest without penalty. We plan to prepay the principal balance of the Shareholder Notes and any accrued interest, upon the completion of this offering using the net proceeds therefrom, as required by the terms of the note agreements.

 

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Contractual Obligations

The following table summarizes our outstanding contractual obligations as of December 31, 2013:

 

     Total      < 1 Year      1-3 Years      4-5 Years      After
5 Years
 
(dollars in thousands)                                   

Revolving credit facility (1)

   $ 23,500       $ 23,500       $ —         $ —         $ —     

Shareholder Notes (2)

     22,270         —           —           —           22,270   

Operating Lease Obligations

     3,529         2,103         1,417         9         —     

Purchase Obligations

     704         704         —           —           —     

Minimum IP Obligations (3)

     6,863         1,470         2,938         855         1,600   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 56,866       $ 27,777       $ 4,355       $ 864       $ 23,870   

 

(1)  

Indebtedness outstanding under our revolving credit facility is expected to be repaid as part of the use of proceeds from this offering.

(2)  

The Shareholder Notes are expected to be retired as part of the use of proceeds from this offering.

(3)  

The above table does not include certain contractual obligations payable in connection with various intellectual property agreements, including (1) contingent obligations payable upon the achievement of certain regulatory and sales milestones and (2) royalties payable on net sales of products developed from the applicable intellectual property. However, the table includes all contractual obligations payable in connection with such intellectual property agreements that are fixed and determinable and not subject to cancellation provisions.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements requires us to make assumptions, estimates and judgments that affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. We use historical experience and other assumptions as the basis for our judgments and making these estimates. Because future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Any changes in those estimates will be reflected in our consolidated financial statements as they occur. While our significant accounting policies are more fully described in Note 1 to our consolidated financial statements included elsewhere in this prospectus, we believe that the critical accounting policies addressed below reflect our most significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or service has been rendered, the price to the buyer is fixed or determinable and collectability is reasonably assured.

Revenue in our direct markets is generated by making our products available to hospitals that purchase specific products for use in surgery on a case-by-case basis. Revenue from sales generated by use of products is recognized upon receipt of a delivered order confirming that our products have been used in a surgical procedure.

In our international markets where we utilize independent distributors who then resell the products to their hospital customers, we recognize revenue upon shipment of our products to the international distributors, who accept title at point of shipment.

 

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Excess and Obsolete Inventory

We state inventory at the lower of cost or market using a weighted-average cost method. The majority of our inventory is finished goods, because we utilize third-party suppliers to source most of our products. We evaluate the carrying value of our inventory in relation to the estimated forecast of product demand, which takes into consideration the estimated life cycle of product releases. A significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand, which could lead to additional reserves for excess and obsolete inventory.

The need to maintain substantial levels of inventory impacts the risk of obsolescence. We maintain numerous different products in our inventory portfolio. Each product system is designed to include implantable parts that come in different sizes and shapes to accommodate a surgeon’s needs in the operating theatre. A product set is the specific configuration of implants, disposables and instrumentation provided for use in a surgical procedure. Typically a small number of a set’s components are used in each surgical procedure and, therefore, certain components within the set may become obsolete before other components based on usage patterns. Our excess and obsolete reserves reflect the usage patterns of the components within each product set.

In addition, we continue to introduce new products and product innovations, which we believe will increase our revenue and enhance our relationships with surgeons and hospitals. As a result, we may be required to take charges for excess and/or obsolete inventory, which may have a significant impact on the value of our inventory and our results of operations. Charges incurred for excess and obsolete inventory and other inventory reserves which are included in cost of revenue, totaled $4.6 million, $2.9 million and $2.3 million in the years ended December 31, 2011, 2012 and 2013, respectively.

Goodwill and Intangible Assets

Goodwill represents the excess of the consideration transferred over the estimated fair value of assets acquired and liabilities assumed in connection with our purchase by the Sponsor. Goodwill is tested for impairment at least on an annual basis. Goodwill is tested for impairment at the reporting unit level by comparing the reporting unit’s fair value to its carrying value. Under recent guidance, prior to performing the annual two-step goodwill impairment test, a company is first permitted to perform a qualitative assessment to determine if the two-step quantitative test must be completed. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance, as well as company and specific reporting unit specifications. If after performing this assessment, the company concludes it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then it is required to perform a two-step quantitative test. Otherwise, the two-step test is not required. In the first step of the quantitative test, the company is required to determine the fair value of each reporting unit and compare it to the carrying amount of the reporting unit. Fair value of the reporting unit is determined using an income and discounted cash flow approach.

The impairment evaluation related to goodwill requires the use of considerable management judgment to determine discounted future cash flows including estimates and assumptions regarding the amount and timing of cash flows, cost of capital and growth rates. Cash flow assumptions used in the assessment are estimated using assumptions in our annual operating budget, as well as our long-term strategic plan. Our budget and strategic plan contain revenue assumptions that are based on existing product technologies, new technologies that are in the process of being developed along with their expected launch dates and life cycle expectations. In addition, management considers relevant market information, peer company data and historical financial information.

If the carrying amount of the reporting unit exceeds the fair value of the reporting unit, the company performs the second step of the impairment test, as this is an indication that the reporting unit goodwill may be impaired. In the second step of the impairment test, the company determines the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its

 

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implied fair value, then an impairment of goodwill has occurred and the company must recognize an impairment loss for the difference between the carrying amount and the implied fair value of goodwill.

The Company used a quantitative assessment for its goodwill impairment testing during 2011 and 2012 and a qualitative assessment for its goodwill during 2013. Our evaluation of goodwill completed during the years ended December 31, 2011, 2012 and 2013 resulted in no impairment losses.

Intangible assets are amortized over their estimated period of benefit using the straight line method and estimated useful lives ranging from four to seven years. Intangible assets are also reviewed for impairment when facts or circumstances suggest that the carrying value of these assets may not be recoverable.

Income Taxes

We recognize deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We measure deferred tax assets and liabilities using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. We recognize the effect on deferred tax assets and liabilities of a change in tax rates in the period that includes the enactment date.

We establish valuation allowances when necessary to reduce net deferred tax assets to the amount expected to be realized if, based on available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

While we believe that our tax positions are fully supportable, there is a risk that certain positions could be challenged. In these instances, we would evaluate whether a reserve is necessary. If we determine that it is more likely than not that a tax position will be sustained upon audit, based solely on the technical merits of the position, we recognize the benefit. We measure the benefit by determining the amount that is more likely than not to be sustained by a taxing authority with full knowledge of all relevant information. We monitor our tax positions, tax assets and liabilities regularly. We reevaluate the technical positions of our tax positions and recognize an uncertain tax benefit or reverse a previously recorded tax benefit when (1) a tax audit is completed, (2) applicable tax law, including tax case or legislative guidance, changes or (3) the statute of limitations expires. Significant judgment is required in accounting for tax reserves.

Stock-Based Compensation

We apply the fair value recognition provisions of Financial Accounting Standards Board Accounting Standards Codification Topic 718, Compensation-Stock Compensation , which we refer to as ASC 718. Determining the amount of stock-based compensation to be recorded requires us to develop estimates of the fair value of stock options as of their grant date. Stock-based compensation expense is recognized ratably over the requisite service period, which in most cases is the vesting period of the award. The estimated fair value of stock-based awards for employee and non-employee director services are expensed over the requisite service period. We have issued option awards, exercisable into 333,648 shares of common stock to non-employees, excluding non-employee directors. These awards are initially recorded at their estimated fair value as determined in accordance with authoritative guidance, are periodically revalued as the options vest and are recognized as expense over the related service period. As a result, the charge to operations for non-employee awards with vesting conditions is affected each reporting period by changes in the fair value of our common stock.

Most of the stock options we granted from our purchase by the Sponsor in the year ended December 31, 2010 through the year ended December 31, 2011 are time and performance based and include two vesting components. 50% of the option is subject to a four-year time-based schedule, and 50% of the option is subject to performance-based criteria, which also includes the requirement that the four-year time-based vesting must be satisfied. The performance-based vesting criteria is based on our performance

 

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at the Performance Target Measurement Event (as defined in the Non-Qualified Stock Option Award Agreement under the 2010 Equity Award Plan) which includes a deemed liquidation, initial public offering or sale of our outstanding stock, as measured by the internal rate of return performance criteria on that date as defined in the Non-Qualified Stock Option Award Agreement under the 2010 Equity Award Plan. The Performance Target Measurement Event must occur prior to the contractual term of the options in order for the options to be subject to vesting. The sale of our common stock upon the effectiveness of this registration statement would be deemed a Performance Target Measurement Event under the 2010 Equity Award Plan, however, we do not expect the internal rate of return performance criteria to be met by this date because this rate is based on the return on investment our Sponsor has realized on their investments (common stock and preferred stock) and loans made to the Company. Following the completion of this offering, our Sponsor will continue to hold shares of our common stock, including conversion of their holdings of Series A Preferred and Series B Preferred. Until our Sponsor’s present investment position is liquidated or distributed, we will be unable to evaluate definitively the internal rate of return performance criteria.

As of December 31, 2013, there was approximately $3.5 million of total unrecognized compensation expense related to the performance-based vesting component of unvested employee stock options outstanding under our stock compensation plan which will be recognized when we meet the performance target measurement as discussed above, and the time-based vesting component is satisfied. As of December 31, 2013, the weighted average contractual term of the options, subject to the performance-based vesting, is 0.25 years. All stock options granted subsequent to 2011 solely vest based on a time-based vesting schedule and do not contain any performance-based vesting criteria.

Calculating the fair value of stock-based awards requires that we make highly subjective assumptions. We use the Black-Scholes option pricing model to value our stock option awards. Use of this valuation methodology requires that we make assumptions as to the volatility of our common stock, the expected term of our stock options, and the risk free rate of return for a period that approximates the expected term of our stock options and our expected dividend yield. Because we are a privately-held company with a limited operating history, we utilize the historical stock price volatility from a representative group of public companies to estimate expected stock price volatility. We selected companies from the medical device industry, specifically those who are focused on the design, development and commercialization of products for the treatment of spine disorders, including those who have similar characteristics to us, such as stage of life cycle and size as well as pro forma equity/debt capitalization. We intend to continue to utilize the historical volatility of the same or similar public companies to estimate expected volatility until a sufficient amount of historical information regarding the price of our publically traded stock becomes available.

We use the simplified method as prescribed by SEC Staff Accounting Bulletin No. 107, Share-based Payment , to calculate the expected term of stock option grants to employees as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term of stock options granted to employees. We utilize a dividend yield of zero because we have never paid cash dividends on our common stock and have no current intention to pay cash dividends. The risk-free rate of return used for each grant is based on the U.S. Treasury yield curve in effect at the time of grant for instruments with a similar expected life. We estimated the fair value of options granted to employees using a Black-Scholes option pricing model with the following assumptions:

 

     December 31,  
     2011      2012      2013  

Expected dividend yield

     0%         0%         0%   

Expected volatility

     31.33-33.04%         32.85-34.38%         35.42-40.00%   

Risk-free interest rate

     1.35-2.82%         0.92-1.04%         1.25-2.00%   

Expected average life of options

     6-7 years         6-7 years         7 years   

Forfeiture rate

     3.1%         3.1%         3.1%   

 

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To the extent that further evidence regarding the assumptions in the table above become available and provide estimates that we believe are more indicative of actual trends, we may refine or change our approach to deriving these assumptions. Any such changes could materially affect the stock-based compensation expense we record in the future.

Under the terms of our stock option awards, we permit employees to use vested shares to satisfy minimum income tax withholding requirements. In February 2013, we modified certain employee awards underlying options to purchase 377,312 shares of our common stock to permit the grantee to use vested shares to satisfy tax withholding in excess of the minimum requirements when the option is exercised. This modification resulted in the reclassification of the carrying value of these options to a liability and the subsequent change in the fair value of the liability at each reporting period to be recorded as an expense. These outstanding stock options are remeasured at each reporting date and will continue to be remeasured until the earlier of their exercise or expiration. Any changes in valuation are recorded as stock option compensation expense for the period. In connection with this modification, we recorded a liability of $1.9 million on our consolidated balance sheet, and, during the year ended December 31, 2013, we recorded stock-based compensation expense of $1.3 million related to changes in the fair value of the liability. All options subject to this modification expire on or before April 1, 2014.

Over the most recent three years, stock-based compensation expense associated with the stock options we granted totaled:

 

Year ended December 31, 2011

   $ 3.3 million   

Year ended December 31, 2012

   $ 2.2 million   

Year ended December 31, 2013

   $ 2.9 million   

As of December 31, 2013, we had $1.8 million of total unrecognized stock-based compensation expense (exclusive of compensation expense related to the performance-based vesting components of certain stock option awards) related to nonvested employee stock options, which we expect to recognize over a weighted-average remaining vesting period of approximately 2.54 years.

We expect stock-based compensation to grow in future periods due to the potential increases in the value of our common stock and headcount.

The following table sets forth information with respect to stock options granted to employees, directors and non-employees from January 1, 2013 through December 31, 2013:

 

Grant Date

   Options
Granted
     Exercise
Price
     Fair Value
per Share of
Common
Stock
     Average
Intrinsic
Value
 

January 22, 2013

     21,605       $ 9.26       $ 9.26       $ 3.60   

May 2013

     133,539       $ 10.74       $ 10.74       $ 4.25   

June 2013

     9,671       $ 10.74       $ 10.74       $ 4.33   

July 2013

     4,733       $ 10.74       $ 10.74       $ 4.40   

October 23, 2013

     93,827       $ 11.64       $ 11.64       $ 5.15   

The intrinsic value of all outstanding vested and unvested options as of December 31, 2013 is $31.4 million based on an estimated per share price of $15.70 for our common stock, based on 4,179,119 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2013 with a weighted average exercise price of $8.16 per share.

Significant Factors, Assumptions and Methodologies Used in Determining Fair Value of Common Stock

Historically, the compensation committee of our board of directors has determined the fair value of the common stock underlying our stock options with assistance from management and based upon information available at the time of grant. The intention has been that all options granted have a price

 

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per share exercise price not less than the per share fair value of our common stock underlying those options on the date of grant. Estimating the fair value of our common stock required our board of directors to make complex and subjective judgments. We considered a combination of valuation methodologies, including discounted cash flows, market and transaction approaches. The most significant factors considered by our board of directors when determining the fair value of our common stock were as follows:

 

   

External market and economic conditions affecting the medical device industry such as:

 

   

Insurer scrutiny regarding the medical necessity of degenerative procedures;

 

   

FDA and insurer approval of new motion preservation products; and

 

   

Impact of market dynamics on the trading value of our peer group;

 

   

Our historical operating performance and anticipated future operating performance;

 

   

Our need for future financing to fund commercial operations;

 

   

Comparable valuations of medical device peer companies in merger activities and in the public markets in conjunction with the likelihood of achieving a liquidity event such as a sale of our company or an initial public offering;

 

   

Third-party valuations utilizing a discounted cash flow methodology for both the preferred and common stock;

 

   

Significant assumptions embedded in this approach considered expected annual revenue growth of 15% to 25% and gross profit margins of approximately 65% to 70% based on expected product sales and sales penetration plans. The discount rate used in these analyses ranged from 14% to 16%, while termination values ranged from 2% to 4%; and

 

   

Distribution of enterprise value among the classes of our common and preferred stock and expected conversion date of the preferred stock;

 

   

All other estimates and analysis provided by third parties such as lenders and other financial advisors supporting the valuation of our company; and

 

   

A comparison of these factors against the same factors at the time of our purchase by the Sponsor. The most significant of these being:

 

   

the trading multiples of the public company peer group—equity values to revenue;

 

   

the industry average revenue growth rates and the specific growth rates of peer companies with characteristics similar to the Company; and

 

   

transaction multiples of successfully completed merger or acquisitions of peer group companies.

We have historically obtained annual third-party valuations in addition to the analyses described above to assist our board of directors in determining the fair value of our common stock at each year end. Such valuations of our common stock were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation.

A discussion of the determination of the fair value of our common stock on our option grant dates from January 2013 to October 23, 2013, our most recent option issuance, is provided below:

January 22, 2013

Our board of directors granted options to purchase 21,399 shares of common stock with an exercise price per share of $9.26 on January 22, 2013, which equaled our determination of the per share fair value of our common stock on the date of grant. To set the exercise price and to determine the per share

 

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fair value of the grant, the board of directors along with management evaluated the materials as described above and concluded that the per share fair value on the date of grant was $9.26.

May—July 2013

Our board of directors granted options to purchase 133,539 shares of common stock from May 21 – May 31, 2013 and options to purchase an aggregate of 14,403 shares of common stock from June 3 – June 11, 2012 and during July 2013. Each of these grants were made with a per share exercise price of $10.74 which equaled our determination of the per share fair value of our common stock on the date of grant. The determination of fair value was based on the same types of materials as used in the January grant and as described above as updated for information as of a more recent date.

October 2013

Our board of directors granted options to purchase 93,416 shares of common stock with an exercise price per share of $11.64 in October 2013, which equaled our determination of the per share fair value of our common stock on the date of grant. To set the exercise price and to determine the per share fair value of the grant, the board of directors along with management evaluated the materials as described above and concluded that the per share fair value on the date of grant was $11.64.

Factors contributing to the increase in the per share fair value of $9.26 from the January 2013 grant to the $11.64 fair value of these grants included:

 

   

Improved operating performance, trading values and multiples of other medical device companies, which resulted in a higher projected enterprise value for the Company;

 

   

Improved external market and economic conditions affecting the medical device industry such as improved year-over-year growth rates in both the U.S. and international markets, and FDA approval of new motion preservation products;

 

   

Continued expansion of our global distribution network to include 55 new hires of direct employees on a net basis and expansion to new markets in the Middle East, South Africa and Canada;

 

   

Revenue growth for the year ended December 31, 2013 of 17% year over year; and

 

   

The launch of several new products and research and development initiatives.

Recently Issued Accounting Pronouncements

We qualify as an emerging growth company pursuant to the provisions of the JOBS Act. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. We are electing to delay the adoption of new or revised accounting standards until those standards would otherwise apply to private companies, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result of this election, our financial statements may not be comparable to the financial statements of other public companies. We may take advantage of these reporting exemptions until we are no longer an emerging growth company.

Deformity Business Seasonality and Other Quarterly Fluctuations in Revenue

Our revenue is typically higher in the second and fourth quarters of our fiscal year, driven by higher sales of our complex spine products, which is influenced by the higher incidence of adolescent surgeries during these periods to coincide with the beginning of summer vacation and holiday periods. In addition, our international revenue fluctuates quarterly based on the timing of product registrations, expansion to new markets and product orders from our exclusive international distribution partners.

 

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Quantitative and Qualitative Disclosures about Market Risk

We are exposed to various market risks, which may result in potential losses arising from adverse changes in market rates, such as interest rates and foreign exchange rates. We do not enter into derivatives or other financial instruments for trading or speculative purposes and do not believe we are exposed to material market risk with respect to our cash and cash equivalents.

Interest Rate Risk

We are exposed to interest rate risk in connection with any future borrowings under our revolving credit facility, which bears interest at a floating rate based upon the prime lending rate plus one percent. For variable rate debt, interest rate changes do not affect the fair value of the debt instrument, but do impact future earnings and cash flows, assuming other factors are held constant. We do not believe that a 10% change in interest rates would have a significant impact on our net income (loss) for the period or on cash flow.

Foreign Exchange Risk

We operate in countries other than the United States, and, therefore, we are exposed to foreign currency risks. In the European markets where we manage billing relationships, we transact our business in local currencies, which are comprised primarily of Pounds Sterling and the Euro. As of December 31, 2013, revenue denominated in currencies other than U.S. Dollars represented less than 15% of our total revenue. Operating expenses related to these sales are largely denominated in the same respective currency, thereby limiting our transaction risk exposure. We therefore believe that the risk of an impact on our operating income from foreign currency fluctuations is not significant. In addition, we have intercompany foreign transactions between our subsidiaries, which are denominated in currencies other than their functional currency. Fluctuations from the beginning to the end of any given reporting period result in the re-measurement of our intercompany foreign transactions generating transaction gains or losses in the respective period and are reported in total other income (expense), net in our consolidated financial statements. We recorded a foreign currency transaction gain of $1.0 million and $1.5 million in 2012 and 2013, respectively. The monetary assets and liabilities of our foreign subsidiaries denominated in other currencies are translated into U.S. dollars at each balance sheet date resulting in a foreign currency translation adjustment reflected in accumulated other comprehensive loss. We recorded foreign currency translation losses of $0.4 million and $0.7 million in 2012 and 2013, respectively.

Controls and Procedures

Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. We are currently in the process of reviewing, documenting and testing our internal control over financial reporting.

We have not performed an evaluation of our internal control over financial reporting, such as required by Section 404 of the Sarbanes-Oxley Act, nor have we engaged an independent registered public accounting firm to perform an audit of our internal control over financial reporting as of any balance sheet date or for any period reported in our financial statements. Presently, we are not an accelerated filer, as such term is defined by Rule 12b-2 of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and therefore, our management is not presently required to perform an annual assessment of the effectiveness of our internal control over financial reporting. This requirement will first apply to our Annual Report on Form 10-K for the year ending December 31, 2015. Our independent public registered accounting firm will first be required to attest to the effectiveness of our internal control over financial reporting for our Annual Report on Form 10-K for the first year we are no longer an “emerging growth company.”

 

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BUSINESS

Overview

We are a global medical device company focused on designing, developing and commercializing innovative and proprietary complex spine technologies and techniques. Our complex spine products are used by spine surgeons to treat some of the most difficult and challenging spinal pathologies, such as deformity (primarily scoliosis), trauma and tumor. We believe these procedures typically receive a higher rate of positive insurance coverage and often generate more revenue per procedure as compared to traditional degenerative spine surgery procedures. We have applied our product development expertise in innovating complex spine technologies and techniques to the design, development and commercialization of an expanding number of proprietary MIS products. These proprietary MIS products are designed to allow for less invasive access to the spine and faster patient recovery times as compared to traditional open access surgical approaches. We have also leveraged these core competencies in the design, development and commercialization of an increasing number of products for patients suffering from degenerative spinal conditions.

Our products consist of implants, disposables and instruments which are marketed and sold primarily to hospitals for use by spine surgeons. During our 10 year history, we have commercialized 57 product lines that are used in complex spine surgery, MIS and degenerative surgery, enabling us to favorably compete in the $10.0 billion global spinal surgery market. We believe many of our products offer simplified surgical techniques and promote improved clinical outcomes for patients, although these beliefs are not yet supported by long-term clinical data. Some of our key proprietary technologies include the following:

 

   

MESA: a low-profile spinal screw technology, which accounted for approximately 39%, 37% and 35% of our revenue for the years ended December 31, 2011, 2012 and 2013, respectively, used primarily during deformity correction, featuring our proprietary locking mechanism that eliminates the need for a secondary locking feature and reduces rotational force on the spine during implantation, which has been used to treat more than 30,000 patients;

 

   

Rail 4D: an innovative “beam-like” implant, utilized with our proprietary MESA spinal screws, that aids in the restoration of spinal balance while providing enhanced rigidity and significantly greater strength as compared to existing titanium and cobalt chrome rod offerings;

 

   

Deformity Cricket: spinal correction instrumentation, utilized with our proprietary MESA spinal screws, that provides surgeons with an innovative approach to more easily capture, manipulate and align a deformed spine as compared to traditional deformity correction instrumentation, such as threaded rod reducers or rod forks;

 

   

SERENGETI: minimally invasive retractor systems featuring one-step placement of screws and retractors, thereby reducing the number of surgical steps, while allowing for direct visualization and improved access to the spine;

 

   

RAVINE: minimally invasive retractor systems that represent an innovative design departure from standard tubular retractors, facilitating retractor placement, positioning and fixation to the patient’s anatomy through a lateral access approach;

 

   

EVEREST: a spinal screw technology that we believe, based on internal testing, provides for improved insertion speed, industry-leading pull-out strength and the ability to accommodate a variety of titanium and cobalt chrome rods of two different diameters; and

 

   

tifix : a locking technology integrated into a number of our interbody and plate implants providing surgeons with the flexibility to insert screws at various angles and lock them to an implant with a one-step locking mechanism that eliminates the need for a secondary locking feature.

 

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We have grown our revenue to $157.6 million in 2013 from $60.4 million in 2008, representing a five-year CAGR of 21% between 2008 and 2013. For the years ended December 31, 2011, 2012 and 2013, our net income (loss) was $13.3 million, $(32.7) million and $(37.9) million and our Adjusted EBITDA was $(7.4) million, $(1.8) million and $(5.3) million, respectively. For information about how we calculate Adjusted EBITDA, see “Summary—Summary Historical Consolidated Financial Data.” We expect to continue to incur additional losses in the near term as we invest in the global expansion of our business. As of December 31, 2013, our accumulated deficit was $70.6 million.

Our focus on our core competences of complex spine and MIS is highlighted by the fact that, for the year ended December 31, 2013, 58% of our revenue in the United States was derived from the use of our products in complex spine and MIS surgeries. We believe this represents a greater proportion of total revenue devoted to these markets as compared to our competitors. We further believe the proportion of our international revenue derived from complex spine and MIS is even higher than in the United States.

We have developed and maintain an expanding portfolio of intellectual property, which included 163 issued patents globally and 175 pending patent applications globally as of December 31, 2013. In addition to our current product offerings, we continue to invest in the research and development necessary to design, develop and commercialize new surgical solutions for unmet clinical needs. Our highly efficient product development process utilizes an integrated design team approach that involves collaboration among select teams of leading surgeons in their respective specialties, our product management team, our engineers and our clinical and regulatory personnel. We believe that utilizing these integrated design teams enables us to develop innovative and differentiated technologies and techniques that meet the needs of the market and allow surgeons and hospitals to better serve their patients. Since the beginning of 2011, we have introduced 34 new product lines, including products driven by our Rail 4D and EVEREST technology platforms, demonstrating our ability to leverage our product development process to rapidly innovate new products.

We currently market and sell our products in the United States and 28 other countries. For the year ended December 31, 2013, international sales represented approximately 29% of our revenue. We have made significant investments in building a hybrid sales organization consisting of direct sales employees, independent sales agencies and distributor partners. As of December 31, 2013, our U.S. sales force consisted of 114 direct sales employees and 48 independent sales agencies and our international distribution network consisted of 37 direct sales employees, five independent sales agencies and 15 independent distributorships. We expect to continue to invest in our global hybrid sales organization by increasing the number of our direct sales employees and broadening our relationships with independent sales agencies and distributor partners. We believe the continuing expansion of our global sales force will provide us with significant opportunities for future growth as we increase our penetration of existing geographic markets and enter new ones. We do not sell our products through or participate in PODs and no surgeons own any shares of our common stock.

Corporate History

K2M, Inc. was incorporated in 2004 and began working with leading spine surgeons for the purpose of designing, developing and commercializing innovative and proprietary complex spine technologies and techniques. Between 2005 and 2010, we developed spinal surgery products while expanding our business, including through the investment of venture capital raised from Ferrer Freeman & Company, LLC, or FFC. On August 12, 2010, K2M Group Holdings, Inc., an entity controlled by our existing owners, acquired the equity of K2M, Inc. through the merger of Altitude Merger Sub, Inc. with and into K2M, Inc. Upon the closing of such transaction, K2M, Inc. and its stockholders were paid total cash consideration of approximately $169.4 million, of which $14.9 million was placed in escrow and eventually released in 2012. Since 2010, we have continued to invest in our business by expanding our global sales force and related operations, including through the investment of additional capital raised from our existing owners.

 

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Industry Background

Overview of Spine Anatomy

The spine is the central core of the human skeleton and provides structural support, alignment and flexibility to the body. It consists of 24 interlocking bones, called vertebrae, which are stacked on top of one another. The spine is comprised of five regions, of which there are three primary regions: cervical, thoracic and lumbar. There are seven vertebrae in the cervical, or neck, region of the spine, 12 vertebrae in the thoracic, or central, region of the spine, and five vertebrae in the lumbar, or lower back which is the primary load-bearing region of the spine. The bottom of the spine, comprised of the sacrum and the coccyx, consists of naturally fused vertebrae connected to the hip bones to provide support for the spine. A healthy spine has a natural curvature when viewed from the side and is straight when viewed from the back. The cervical and lumbar regions contain forward convex curves referred to as lordosis while the thoracic region contains a backward concave curve referred to as kyphosis. Between each pair of vertebrae is an intervertebral disc that acts as a shock absorber during movement. Vertebrae are paired as motion segments, or levels, and are connected to each other by facet joints that provide flexibility and enable the spine to bend and twist. The back, or posterior, part of each vertebra is comprised of a bony arch called the lamina and the spinous process. Soft tissues, including ligaments, tendons and muscles are attached to these structures, which provide stability to the spinal column and facilitate movement of the spine. The largest load bearing bony structure, which is in the front, or anterior, and middle part of each vertebra, is referred to as the vertebral body. These collective spinal elements serve as a protective cage for the spinal cord, which runs through the center of the spine, or spinal canal, carrying nerves that exit through openings between the vertebrae, or foramen, which run from every area of the body to the brain, delivering sensation and control to the entire body.

 

 

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Overview of Spine Disorders

Complex spine pathologies and back pain related to spine disorders affect an estimated 31 million people in the United States and are a leading driver of healthcare costs globally. Spine disorders range in severity from mild discomfort and numbness, to curvatures of the spine, extreme pain and paralysis. Spine disorders can be categorized as either complex, which consists of deformity (primarily scoliosis), trauma and tumor, or degenerative.

Spine deformity is any variation in the natural curvature of the spine. The most common form of spine deformity is scoliosis which is either a lateral, or side-to-side curvature of the spine, or an extreme rotation of the vertebral body. Other common types of deformity include hyperlordosis which is an over-extension of the normal convex curvature of the cervical and lumbar spine, and hyperkyphosis which is an over-flexion of the normal concave curvature of the thoracic spine.

 

 

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Normal

Front

 

Scoliosis

Front

     

Normal

Side

 

Hyperlordosis

Side

 

Hyperkyphosis

Side

Spine deformity can be further grouped into the following four categories which are known to have different spine characteristics:

 

   

Pediatric infantile scoliosis , presents in children under 10 years of age as a result of conditions present at birth or congenital conditions;

 

   

Adolescent scoliosis , presents in patients between the ages of 10 and 18 as a result of congenital conditions, neuromuscular conditions such as cerebral palsy or muscular dystrophy, or other unknown previously existing conditions;

 

   

Adult scoliosis , presents in patients between the ages of 19 and 64 as a result of scoliosis, which typically starts after the age of 40 due to arthritis or other conditions of aging, or as a result of scoliosis that started when the patient was younger; and

 

   

Aging spine , presents in patients 65 years of age or older as a result of a pre-existing deformity that has progressed or the onset of severe degenerative spine disorders.

Spine trauma is often the result of impact from a fall, car accident or other external forces. Spine traumas include fractures, dislocations, soft tissue damage and other musculoskeletal and nervous system injuries.

Spine tumors are relatively rare. Benign tumors are typically removed surgically while malignant tumors are more difficult to treat and often originate in other areas of the body such as the lungs, thyroid or kidneys.

 

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Degenerative spine disorders are typically the result of repetitive stresses experienced during the normal aging process and are the most common type of spine disorders. Degenerative spine disorders occur when the intervertebral disc at a motion segment weakens and loses its normal height, thereby compressing the spinal nerves. Compression of the spinal nerves often leads to pain and/or loss of feeling in the arms, back and legs.

Treatment Alternatives for Degenerative Spine Disorders

Treatment for degenerative spine disorders usually begins with conservative therapies including observation to determine if the spine disorder is progressing, lifestyle changes such as exercise and weight loss, anti-inflammatory and pain medication and physical therapy. If and when conservative therapies fail to provide adequate quality of life improvements, patients may ultimately require spine surgery.

The goals of spine surgery are to reduce patient pain and restore structural support and alignment while maintaining natural flexibility within the spine, if possible. Surgical options for degenerative spine disorders vary greatly depending on each patient’s unique pathology and include procedures that (1) do not utilize spinal implants or (2) do utilize spinal implants. Decompression procedures are typically performed earlier in the continuum of care and may or may not include the use of spinal implants. These procedures include discectomies and laminectomies, which involve the removal of part of a damaged disc or lamina in order to relieve pressure on the spinal nerves. Decompression procedures may occasionally result in spinal instability due to the removal of these spinal elements and as a result require the utilization of spinal implants.

In the case of advanced degenerative spine disorders, treatment often turns to procedures that involve the use of spinal implants, the most common of which is a fusion procedure. The goal of fusion is to permanently decompress the spinal nerves exiting the spine by restoring the natural height of the disc and eliminating motion at the affected level. A fusion procedure involves the surgical removal of bone and/or diseased or damaged disc material that is believed to be the source of the pain and insertion of spinal implants to the spine to stabilize the affected vertebrae. Spinal implants used in fusion procedures include interbody devices that replace the disc space between the vertebrae, as well as spinal implants such as Rails, stabilization rods, screws, plates and biomaterials that provide stability and promote fusion between the vertebrae. Treatments for degenerative spine disorders may also include motion preservation technologies such as cervical and lumbar disc replacement, dynamic stabilization, annular closure, nucleus replacement and facet arthroplasty devices. In some instances, degenerative spine disorders may progress to complex spine disorders, depending on the severity and advancement of the pathology or structural deformity.

Treatment Alternatives for Complex Spine Disorders

Treatments for complex spine disorders, such as deformity, address patients with severe curves in their spine seeking to prevent curve progression and obtain curve correction. The treatment pathway for deformity cases may begin with bracing or casting which are designed to slow or correct the progression of the adverse curvature of the spine. Bracing and casting are typically utilized as the first course of treatment in young children who are still growing. If a child’s curve has shown progression despite bracing or casting, surgery is often considered. Surgical treatment for deformity conditions in young patients that have not stopped growing typically seek to correct the deformity while avoiding long fusions of the spine. These procedures include the use of spinal implants, such as pedicle screws and expandable rods that are periodically lengthened, to control the spine deformity while still allowing for the spine to grow until the child reaches an appropriate size or age for a more permanent solution, such as spinal fusion. In skeletally mature patients with spine deformities, spinal fusions are typically considered after more conservative measures have failed.

 

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Treatment of more intricate complex spine disorders, such as traumas and tumors, may require the use of one or several procedural alternatives, such as (1) decompression, (2) fusion or (3) corpectomy techniques, where the vertebral body may be completely removed and replaced by a vertebral body replacement device.

The indications for surgical treatment of complex spine disorders such as deformity are determined by anatomical angle measurements that are established and well defined among hospitals, physicians, and third-party payors. Conversely, fusion procedures for degenerative conditions are typically indicated when the source of the patient’s pain originates from the vertebral level in question and a diagnostic confirmation of degenerative disc disease is made. Current techniques to identify the source of a patient’s degenerative back pain are imprecise and it may be difficult to locate the source of pain. Third-party payors typically require a confirmed diagnosis of degenerative disc disease in order to reimburse for surgical procedures. We believe complex spine procedures typically receive a higher rate of positive insurance coverage and often generate more revenue per case, as compared to degenerative procedures.

MIS Treatment Alternatives for Complex and Degenerative Spine Disorders

Traditional approaches for complex spine and degenerative spine surgery require large incisions in order to provide surgeons with access to, and visibility of, the spine and surrounding areas. Consequently, traditional surgical procedures are considered highly invasive and are often associated with several limitations including significant blood loss, extensive soft tissue disruption, long operative times, extended hospital stays and lengthy patient recovery times.

Over time, there has been significant increase in surgeon and patient interest for less invasive surgical techniques for treating both complex and degenerative spine disorders. MIS techniques are designed to allow for less invasive access to the spine and, as a consequence, faster patient recovery times as compared to traditional open access surgical techniques. The figures below illustrate the different incision sizes in a multi-level deformity case utilizing both traditional open and MIS surgical techniques.

 

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Biomaterials Treatment Alternatives for Complex and Degenerative Spine Disorders

Biomaterial treatments are typically derived from human bone or synthetic sources and come in a variety of forms. These biomaterials are used by spine surgeons during the surgical treatment of certain complex spine and degenerative pathologies to augment spinal implants and to promote fusion by accelerating, augmenting or substituting for the normal regenerative capacity of bone.

Market Opportunity

According to iData, the global spine surgery market was valued at approximately $10.0 billion in 2012 and is expected to grow to $14.9 billion by 2019. The table below provides the estimated size of the 2012 global spine market:

 

     2012 Estimated Global Spine Market Size
(dollars in millions)
 
     United
States
     Europe      Asia-
Pacific
     Latin
America
     Total  

Complex Spine

   $ 855       $ 112       $ 170       $ 51       $ 1,188   

MIS

     1,195         66         87         25         1,372   

Degenerative Spine

     3,816         909         958         284         5,967   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Spine Implants and Instrumentation

   $ 5,866       $ 1,086       $ 1,215       $ 360       $ 8,527   

Biomaterials (1)

     1,284         26         198         *         1,509   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 7,150       $ 1,113       $ 1,413       $ 360       $ 10,036   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

* Not included in market sizing estimates
(1) We report revenue related to the sale of biomaterials as part of our complex spine, MIS and degenerative spine revenue categories.
Source: iData Research, Inc.

Overviews of the global spine markets in which we compete, and their associated growth drivers, are as follows:

Complex Spine

The approximately $1.2 billion global complex spine market includes technologies utilized to treat cases of spine deformity, trauma and tumor. While many advancements in the treatment of complex spine disorders have been made, considerable challenges and limitations associated with performing complex spine surgery remain. For example, many of the spinal implants and instruments currently used to perform complex spine surgeries are not designed to sufficiently address the variable and unpredictable nature of complex spine surgeries caused by the different sizes, shapes, densities and growth characteristics of each individual spine. It is not always possible for spine surgeons to anticipate which of these variables will be present in any given spine surgery, which may result in suboptimal patient outcomes and longer procedure times if they do not have the proper spinal implants and instruments readily available during the procedure. Further, many existing complex spine surgery implants, instruments and surgical approaches are not designed to concurrently access multiple levels of the spine through a MIS approach.

We believe the global complex spine market has been underserved and underdeveloped by major spine market competitors, which generally focus on the larger degenerative spine market. As a result, we believe the complex spine patient population has and will continue to benefit from innovative technologies and techniques that enable simplified surgical procedures, MIS approaches and surgical treatment earlier in the continuum of care.

 

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MIS

The approximately $1.4 billion global MIS market includes technologies utilized in treating both complex spine and degenerative spine disorders through minimally invasive approaches to the spine. These technologies and techniques include MIS pedicle screws that are affixed to the spine through either percutaneous, or puncture-like, incisions or retractors that provide direct visualization of the spine with a smaller incision than traditional open procedures. The MIS market also includes minimally invasive interbody devices, including posterior, transforaminal and lateral lumbar interbody fusion, or LLIF, devices. LLIF devices are inserted from the side and are associated with less disruption to the soft tissues of the back. We believe the vast majority of surgeons and patients, when given the option, will utilize MIS procedures rather than traditional open procedures due to the advantages of MIS approaches, which often include less soft tissue disruption, reduced frequency of surgical morbidity, faster operating times, improved scarring-related aesthetics and, as a consequence of these advantages, shorter patient recovery times. Finally, we believe the overall improvement to the standard of care resulting from the introduction of new MIS products will increase global demand for MIS technologies and techniques.

Degenerative Spine

The approximately $6.0 billion global degenerative spine market includes technologies and techniques utilized to treat degenerative spine disorders. These technologies and techniques include products such as cervical, thoracic and lumbar spinal fusion devices, interbody devices, motion preservation technologies and vertebral compression fracture devices. We believe that several factors will continue to influence the growth in the global degenerative spine market, including aging patient demographics, increased life expectancies, the desire for maintaining and/or improving lifestyles and demand from patients and surgeons for innovative technologies and techniques that enable simplified surgical procedures, faster procedure times and improved clinical outcomes.

Our Competitive Strengths

Our executive management team is highly experienced in the spinal surgery industry. We believe this experience and the following competitive strengths have been instrumental to our success and position us well to grow our revenue and market share.

 

   

Focus in Complex Spine and MIS .    Our strategic focus and core competencies are the design, development and commercialization of innovative complex spine and MIS technologies and techniques. In addition to our innovative product portfolio, our dedication to the complex spine and MIS markets is evidenced by our strong relationships with key opinion leaders and spine societies focused on the complex spine and MIS markets, such as the Scoliosis Research Society and the Pediatric Orthopedic Society of North America. Furthermore, we dedicate significant global resources to educating spine surgeons on the safe and effective use of our complex spine and MIS technologies. We offer a comprehensive complex spine and MIS certification program to our sales organization, which includes a multi-level program incorporating classroom and hands-on training with spine surgeons in our cadaveric lab, to promote a sophisticated clinical proficiency amongst our sales force.

 

   

Comprehensive Portfolio of Innovative Proprietary Technologies .    We have developed a comprehensive portfolio of products that address a broad array of spinal pathologies, anatomies and surgical approaches in the complex spine and MIS markets. We believe the benefits of our product offerings in these two markets include simplified surgical techniques, less invasive access to implant sites, enhanced capabilities to manipulate and correct the spinal column, lower profile spinal implant technology and improved clinical outcomes as compared to traditional alternatives such as open surgical techniques utilizing higher profile screws and other implants that provide more limited manipulation of the spine and often require the use of more components, including additional locking parts and set screws. Our

 

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strength in complex spine and MIS provides us with an opportunity to cross-sell our broad portfolio of product offerings in the degenerative market. To protect our innovative technologies and techniques, we maintain and continue to grow our intellectual property portfolio. As of December 31, 2013, we owned 163 issued patents globally, including 103 in the United States, with an additional 175 patent applications pending globally, including 105 of such patent applications pending in the United States. We also maintain a growing portfolio of trademarks, which includes 27 U.S. trademark registrations and 62 foreign trademark registrations.

 

   

Highly Efficient Product Development Process .    Responding quickly and efficiently to the needs of patients, surgeons and hospitals is central to our culture and critical to our success. Our integrated teams of surgeons, product managers, engineers and clinical and regulatory personnel conceptualize, design and develop potential new products through an iterative process that allows for rapid product development. We believe that our entrepreneurial culture and integrated approach to product development allows us to (1) quickly assess the market, (2) address evolving patient, surgeon and hospital needs, (3) evaluate new treatment options and (4) accelerate the development of a potential product from concept to commercialization. We have a proven track record of success in the development of new technologies as evidenced by our introduction of 57 product lines since our inception. Of our 57 commercialized product lines, our MESA technology or products that incorporate MESA have accounted for approximately 39%, 37% and 35% of our revenue for the years ended December 31, 2011, 2012 and 2013, respectively.

 

   

Broad Global Distribution Network .    We have made significant investments in our global distribution network, which as of December 31, 2013, included 151 direct sales employees and contractual relationships with 53 independent sales agencies and 15 distributor partners. The contractual relationships with our independent sales agencies and distributor partners generally have terms of one to five years, with automatic renewal unless otherwise terminated. Our independent sales agents are compensated based on a commission structure while our distributor partners purchase and take title to our products and resell them to their customers. These contractual arrangements may generally be terminated by us for failure to meet certain sales quotas or minimum purchase requirements or upon breach of the agreement by the counterparty. The nature of these contractual relationships vary, with certain contracts that are exclusive, some of which have limited exceptions to the exclusivity provisions, and others that are nonexclusive. In addition, we have broadened our operational capabilities by investing in increased inventory levels and opening sales offices in strategic markets worldwide, such as the United Kingdom and Germany. We believe that our significant global distribution footprint provides us with the opportunity to effectively introduce new products in the markets in which we have a sales presence.

 

   

Demonstrated Track Record of Innovation and Execution .    Our executive management team has achieved the following milestones:

 

   

Designed and commercialized 57 product lines;

 

   

Established a global distribution network with a sales presence in 29 countries, including the United States;