As filed with the Securities and Exchange Commission on June 8, 2006.

Registration No. 333-134187

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Amendment No. 2 to

Form S-1

REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933

 

 

 

 

NxStage Medical, Inc.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

 

 

439 South Union Street, 5th Floor

Lawrence, Massachusetts 01843

(978) 687-4700

(Address, including zip code, and telephone number,

including area code, of registrant’s principal executive offices)

 

 

 

 

Jeffrey H. Burbank

President and Chief Executive Officer

439 South Union Street, 5th Floor

Lawrence, Massachusetts 01843

(978) 687-4700

(Name, address, including zip code, and telephone number,

including area code, of agent for service)

 

 

 

 

Copies to:

 

 

Approximate date of commencement of proposed sale to the public:  As soon as practicable after the effective date of this registration statement.

 

 

 

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, as amended, check the following box.  o

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

 

 

 

CALCULATION OF REGISTRATION FEE

 

 

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

Subject to Completion

Preliminary Prospectus dated June 8, 2006

 

PROSPECTUS

 

5,613,371 Shares

 

NxStage Medical, Inc.

 

Common Stock

 

 

 

 

We are selling 5,500,000 shares and the selling stockholders named in this prospectus are selling 113,371 shares. We will not receive any proceeds from the sale of our shares by the selling stockholders.

 

Our shares of common stock are quoted on the Nasdaq National Market under the symbol “NXTM.” On June 7, 2006, the last sale price of the shares as quoted on the Nasdaq National Market was $9.53 per share.

 

Investing in the common stock involves risks that are described in the “Risk Factors” section beginning on page 8 of this prospectus.

 

 

 

 

 

The underwriters may also purchase up to an additional 825,000 shares of common stock from us at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus to cover over-allotments.

 

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

 

The shares will be ready for delivery on or about          , 2006.

 

 

 

 

 

 

 

 

 

 

The date of this prospectus is          , 2006.

 

TABLE OF CONTENTS

 

 

 

You should rely only on the information contained in this prospectus. We, the selling stockholders and the underwriters have not authorized anyone to provide you with information different from or in addition to that contained in this prospectus. If anyone provides you with different or inconsistent information, you should not rely on it. We and the selling stockholders are offering to sell, and are seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of the common stock. Our business, financial condition, results of operations and prospects may have changed since that date.

 

For investors outside the United States: Neither we, the selling stockholders nor any of the underwriters have done anything that would permit this offering or possession or distribution of this prospectus in any jurisdiction where action for that purpose is required, other than in the United States. You are required to inform yourselves about and to observe any restrictions relating to this offering and the distribution of this prospectus.

 

PROSPECTUS SUMMARY

	•	The NxStage Cycler.  A compact, portable electromechanical device containing pumps, control mechanisms, safety sensors and remote data capture functionality.
	•	The NxStage Cartridge.  A single-use, disposable, integrated treatment cartridge that loads simply and easily into the cycler. The cartridge incorporates a proprietary volumetric fluid management system and includes a pre-attached dialyzer.
	•	Premixed Dialysate.  The System One uses high-purity premixed dialysate for hemodialysis applications. The volume of fluids used varies with treatment options and prescription, but typical weekly volumes are similar to the amount of dialysate used by a patient on PD. Currently, we supply our premixed dialysate in five liter bags. In March 2006, we received FDA clearance for the PureFlow SL module, a proprietary dialysate preparation product used with the System One, which allows for the automated preparation of dialysate fluid in the patient’s home using ordinary tap water and dialysate concentrate thereby eliminating the need for bagged fluids. We expect to make this product broadly available to our customers beginning in July 2006.

	•	Versatility.  We have developed the System One so that the same system can be used in clinical or non-clinical settings, for either chronic or critical care.
	•	Portability.  The System One, which weighs approximately 75 pounds and measures 15x15x18 inches, is flexible enough to use in any environment prescribed by the physician, including the patient’s home, dialysis clinic, intensive care unit, or ICU, and cardiac care unit, or CCU. When therapy is prescribed in the home, we ship the necessary supplies directly to the patient. If the patient travels with the System One, we ship the necessary disposables to the patient’s destination.
	•	Simplicity and convenience.  The System One is designed for simple operation and convenience. It employs a drop-in cartridge and is operated by an icon-based touch pad that is simple and intuitive.
	•	No unique infrastructure requirements.  The System One can plug into any standard grounded outlet. The use of bagged fluids eliminates the need for a customized water source at the site of treatment, facilitating therapy in any setting, especially the ICU and patient travel destinations. Waste dialysate is discarded to any drain. The PureFlow SL module also can be plugged into

		any standard grounded outlet and can be hooked up to a sink or any other standard water line with a simple connection, and no other special infrastructure requirements are necessary.

	•	Highly responsive customer support and service.  We offer 24 hour per day, seven day per week customer support service through a team of experienced nurses and engineers. Due to the portability of the System One, we are able to offer an overnight equipment exchange program, avoiding the need for a large field service organization.
	•	Designed for safety.  With automatic loading and calibration of all safety systems and simple dialysate solution preparation, the System One is designed to minimize operator error, although such errors do still occur. The cartridge is preconnected to a filter to reduce connection errors. Our cycler includes redundant safety systems, which provide further protection to patients undergoing treatment.
	•	High Fluid Purity.  Our fluids, whether bagged or prepared by the PureFlow SL, meet United States Pharmacopeia, or USP, standards for fluid purity and exceed the Association for the Advancement of Medical Instrumentation, or AAMI, industry standards for dialysate purity. Recent studies have shown that the use of high purity dialysate, which exceeds AAMI standards, helps in the reduction of inflammatory disorders commonly experienced by ESRD patients.

	•	Promote high ESRD patient and physician awareness of the benefits of the System One.  We are increasing our efforts to actively educate ESRD patients, nurses, technicians and physicians about the clinical and lifestyle benefits of home and more frequent hemodialysis and about the ease-of-use and portability of the System One. Primarily through cooperative marketing initiatives with our dialysis clinic customers, we are currently expanding our patient and physician education programs.
	•	Drive adoption of the System One through a targeted sales and marketing program focused on selected dialysis clinics and hospitals in both the ESRD and critical care markets.  We have expanded and intend to continue to expand our direct sales and marketing force to address our two markets. In the ESRD market, we target leading dialysis clinics with experience in home dialysis therapies. In the critical care market, we intend to continue to target leading institutions that we believe can benefit from the versatility of our system to address a number of critical care applications.

	•	Leverage our existing technology and continue to innovate the System One.  We will continue to invest in research and development to enhance our existing products. Our development team integrates skills across the range of technologies required to innovate dialysis systems, including: filters, tubing sets, mechanical systems, fluids, software and electronics.
	•	Focus on developing operations in the United States.  For the near and intermediate-term, we are focusing our efforts on the United States market. We believe there is a substantial opportunity outside the United States for the System One and plan, over the long term, to pursue international growth when we have developed the appropriate scale and infrastructure to expand into other geographic regions.

	•	We expect to derive substantially all of our future revenues from the rental or sale of our System One and the sale of our related products for use with the System One.
	•	We are in the second year of our commercial launch in the United States of the System One hemodialysis system to dialysis clinics for the treatment of ESRD, and our success will depend on our ability to achieve market acceptance of the System One.
	•	We cannot accurately predict the size of the home hemodialysis market, and it may be smaller and slower to develop than we expect.
	•	We will require significant capital to build our business, and our ability to become profitable and to generate positive cash flow is dependent upon maintaining adequate pricing, lowering costs of manufacturing and distributing our products efficiently.
	•	In the ESRD market, our ability to set prices for our products is limited by existing Medicare reimbursement rates for dialysis treatment. In addition, the cost of manufacturing the System One and the related disposables currently exceeds the market price. We may not be able to achieve a profit margin sufficient to support our business. We cannot guarantee if and when we will become profitable, or that we will be able to maintain profitability. As of March 31, 2006, our accumulated deficit was $(93.3) million.

Common stock offered
By NxStage		5,500,000 shares
By the selling stockholders		113,371 shares
Total		5,613,371 shares
Common stock to be outstanding after this offering		26,684,287 shares

Use of proceeds		We estimate that we will receive net proceeds from this offering of approximately $48.6 million assuming an offering price of $9.53 per share, based on the last reported sale price of our common stock on the Nasdaq National Market on June 7, 2006, after deducting estimated underwriting discounts and commissions and offering expenses payable by us ($56.0 million if the underwriters exercise their over-allotment option in full). We intend to use the net proceeds of this offering to fund continuing operations, including the expansion of sales and marketing programs and the hiring of additional personnel, to finance working capital needs, including investment in System One field equipment, and for general corporate purposes. We will not receive any of the proceeds from the sale of shares by the selling stockholders. See “Use of Proceeds.”

Risk factors		See “Risk Factors” and other information included in this prospectus for a discussion of factors you should carefully consider before deciding to invest in shares of our common stock.
Nasdaq National Market symbol		NXTM

	•	Excludes 2,723,005 shares of common stock issuable upon the exercise of stock options outstanding as of March 31, 2006, with a weighted-average exercise price of $6.46 per share;
	•	Excludes 169,736 shares of common stock issuable upon exercise of outstanding warrants as of March 31, 2006, with a weighted-average exercise price of $7.67 per share; and
	•	Excludes 706,522 shares reserved as of March 31, 2006 for future stock option grants and purchases under our equity compensation plans. See “Management — Equity Benefit Plans.”

														Three Months Ended
		Years Ended December 31,												March 31,
		2003				2004				2005				2005				2006
														(Unaudited)
		(In thousands, except share and per share amounts)
Consolidated Statements of Operations Data:
Revenues		$	286			$	1,885			$	5,994			$	1,034			$	3,401
Cost of revenues			940				3,439				9,585				1,782				4,858
Gross profit (deficit)			(654	)			(1,554	)			(3,591	)			(748	)			(1,457	)
Operating expenses:
Research and development			4,526				5,970				6,305				1,432				1,779
Selling and marketing			2,181				3,334				7,550				1,321				3,193
Distribution			33				495				2,059				309				1,289
General and administrative			2,868				3,604				4,855				1,025				1,975
Total operating expenses			9,608				13,403				20,769				4,087				8,236
Loss from operations			(10,262	)			(14,957	)			(24,360	)			(4,835	)			(9,693	)
Interest income			146				130				643				72				595
Interest expense			(92	)			(15	)			(763	)			(146	)			(157	)
Net loss		$	(10,208	)		$	(14,842	)		$	(24,480	)		$	(4,909	)		$	(9,255	)
Basic and diluted net loss per share		$	(4.10	)		$	(5.81	)		$	(4.31	)		$	(1.91	)		$	(0.44	)
Shares used in per share calculations			2,489,688				2,555,605				5,680,566				2,566,399				21,182,717

		As of
		December 31,				As of March 31, 2006
		2005				Actual				As Adjusted
		(In thousands)
Consolidated Balance Sheet Data(1):
Cash, cash equivalents and short-term investments		$	61,223			$	49,728			$	98,327
Working capital			62,100				50,059				98,658
Total assets			76,431				70,463				119,063
Long-term liabilities			2,106				1,690				1,690
Accumulated deficit			(84,011	)			(93,266	)			(93,266	)
Total stockholders’ equity			67,354				58,645				107,244

(1)		This data does not reflect the impact of our $20.0 million equipment line of credit that we entered into in May 2006. Under the line of credit agreement, $8.0 million is currently available with an additional $2.0 million available through December 31, 2006 and a further $10.0 million available through December 31, 2007. The availability of the line of credit is subject to a number of covenants, including maintaining certain levels of liquidity, adding specified numbers of patients and operating within net loss parameters. We are also required to maintain operating and/or investment accounts with the lender in an amount at least equal to the outstanding debt obligation. Concurrent with the signing of the line of credit, we repaid outstanding debt and accrued interest of approximately $3.4 million. All borrowings are secured by substantially all of our assets.

 

This offering involves a high degree of risk. You should carefully consider the risks and uncertainties described below and the other information in this prospectus, including the consolidated financial statements and the related notes included at the end of this prospectus, before deciding to invest in shares of our common stock. If any of the following risks or uncertainties actually occurs, our business, prospects, financial condition and operating results would likely suffer, possibly materially. In that event, the market price of our common stock could decline and you could lose all or part of your investment.

 

Risks Related to our Business

 

We expect to derive substantially all of our future revenues from the rental or sale of our System One and the sale of our related disposable products used with the System One.

 

Since our inception, we have devoted substantially all of our efforts to the development of the System One and the related products used with the System One. We commenced marketing the System One and the related disposable products to the critical care market in February 2003. We commenced marketing the System One for chronic hemodialysis treatment in September 2004. We expect that the rental or sale of the System One and the sale of related products will account for substantially all of our revenues for the foreseeable future. Most of our related products cannot be used with any other dialysis systems and, therefore, we will derive little or no revenues from related products unless we sell or otherwise place the System One. To the extent that the System One is not a successful product or is withdrawn from the market for any reason, we do not have other products in development that could replace revenues from the System One.

 

We cannot accurately predict the size of the home hemodialysis market, and it may be smaller or slower to develop than we expect.

 

Although home hemodialysis treatment options are available, adoption has been limited. The most widely adopted form of dialysis therapy used in a setting other than a dialysis clinic is peritoneal dialysis. Based on the most recently available data from the United States Renal Data System, or USRDS, the number of patients receiving peritoneal dialysis was approximately 26,000 in 2003, representing approximately 8% of all patients receiving dialysis treatment for ESRD in the United States. Very few ESRD patients receive hemodialysis treatment outside of the clinic setting; USRDS data indicates approximately 1,300 patients were receiving home-based hemodialysis in 2003. Because the adoption of home hemodialysis has been limited to date, the number of patients who desire to, and are capable of, administering their own hemodialysis treatment with a system such as the System One is unknown and there is limited data upon which to make estimates. Our long-term growth will depend on the number of patients who adopt home-based hemodialysis and how quickly they adopt it, and we do not know whether the number of home-based dialysis patients will be greater or fewer than the number of patients performing peritoneal dialysis or how many peritoneal dialysis patients will switch to home-based hemodialysis. We received our home use clearance for the System One from the FDA in June 2005 and we will need to devote significant resources to developing the market. We cannot be certain that this market will develop, how quickly it will develop or how large it will be.

 

We will require significant capital to build our business, and financing may not be available to us on reasonable terms, if at all.

 

We believe that the chronic care market is the largest market opportunity for our System One hemodialysis system. We typically bill the dialysis clinic for the rental of the equipment and the sale of the related disposable cartridges and treatment fluids. As a result, we expect that we will generate revenues and cash flow from the use of the System One over time rather than upfront from the sale of the System One equipment, and we will need significant amounts of working capital to manufacture System One equipment for rental to dialysis clinics.

 

We only recently began marketing our System One to dialysis clinics for the treatment of ESRD, and we have not achieved widespread market acceptance of our product. We may not be able to generate sufficient cash flow to meet our capital needs. If our existing resources are insufficient to satisfy our liquidity requirements, we may need to sell additional equity or debt securities. Any sale of additional equity or

issuance of debt securities may result in additional dilution to our stockholders, and we cannot be certain that additional public or private financing will be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to delay, reduce the scope of, or eliminate one or more aspects of our business strategy, which could harm the growth of our business.

 

We have limited operating experience, a history of net losses and an accumulated deficit of $(93.3) million at March 31, 2006. We cannot guarantee if, when and the extent that we will become profitable, or that we will be able to maintain profitability once it is achieved.

 

Since inception, we have incurred losses every quarter and, at March 31, 2006, we had an accumulated deficit of approximately $(93.3) million. We expect to incur increasing operating expenses as we continue to grow our business. Additionally, in the chronic care market, the cost of manufacturing the System One and related disposables currently exceeds the market price. We cannot provide assurance that we will be able to lower the cost of manufacturing the System One and related disposables below the current chronic care market price, that we will achieve profitability, when we will become profitable, the sustainability of profitability should it occur, or the extent to which we will be profitable. Our ability to become profitable is dependent in part upon achieving a sufficient scale of operations, obtaining better purchasing terms and prices, achieving efficiencies in manufacturing overhead costs, implementing design and process improvements to lower our costs of manufacturing our products and achieving efficient distribution of our products.

 

Our new PureFlow SL module, which we plan to commercially launch in the chronic care market beginning in July 2006, is an important part of our cost reduction plans. Any delay in our plans to launch the PureFlow SL module, or any failure to gain rapid market acceptance of the PureFlow SL module, including converting our base of patients currently using bagged fluid, could adversely affect our ability to achieve profitability.

 

We only recently began marketing our System One hemodialysis system to dialysis clinics for the treatment of ESRD, and our success will depend on our ability to achieve market acceptance of our System One.

 

We only recently began marketing our System One for the treatment of ESRD. Our products have limited product and brand recognition and have only been used at a limited number of dialysis clinics and hospitals. In the chronic care market, we will have to convince four distinct constituencies involved in the choice of dialysis therapy, namely operators of dialysis clinics, nephrologists, dialysis nurses and patients, that our system provides an effective alternative to other existing dialysis equipment. Each of these constituencies will use different considerations in reaching their decision. Lack of acceptance by any of these constituencies will make it difficult for us to grow our business. We may have difficulty gaining widespread or rapid acceptance of the System One for a number of reasons including:

 

 

Current Medicare reimbursement rates limit the price at which we can market the System One, and adverse changes to reimbursement could affect the adoption of the System One.

 

Our ability to attain profitability will be driven in part by our ability to set or maintain adequate pricing for our System One. As a result of legislation passed by the U.S. Congress more than 30 years ago, Medicare provides comprehensive and well-established reimbursement in the United States for ESRD. With over 80% of U.S. ESRD patients covered by Medicare, the reimbursement rate is an important factor in a potential customer’s decision to use the System One and limits the fee for which we can rent the System One and sell the related disposable cartridges and treatment fluids. Current CMS rules limit the number of hemodialysis treatments paid for by Medicare to three times a week, unless there is medical justification for additional treatments. Most patients using the System One in the home treat themselves, with the help of a partner, up to six times per week. To the extent that Medicare contractors elect not to pay for the additional treatments, adoption of the System One may be slowed. Changes in Medicare reimbursement rates could negatively affect demand for our products and the prices we charge for them.

 

As we continue to commercialize the System One and related products, we may have difficulty managing our growth and expanding our operations successfully.

 

As the commercial launch of the System One continues, we will need to expand our regulatory, manufacturing, sales and marketing and on-going development capabilities or contract with other organizations to provide these capabilities for us. As our operations expand, we expect that we will need to manage additional relationships with various partners, suppliers, manufacturers and other organizations. Our ability to manage our operations and growth requires us to continue to improve our operational, financial and management controls and reporting systems and procedures. Such growth could place a strain on our administrative and operational infrastructure. We may not be able to make improvements to our management information and control systems in an efficient or timely manner and may discover deficiencies in existing systems and controls.

 

We compete against other dialysis equipment manufacturers with much greater financial resources and better established products and customer relationships, which may make it difficult for us to penetrate the market and achieve significant sales of our products.

 

Our System One competes directly against equipment produced by Fresenius Medical Care AG, Baxter Healthcare Corporation, Gambro AB, and others, each of which markets one or more FDA-cleared medical devices for the treatment of acute or chronic kidney failure. Each of these competitors offers products that have been in use for a longer time than our products and are more widely recognized by physicians, patients and providers. In addition, Aksys, Ltd. sells a hemodialysis machine, which is also specifically cleared by the FDA for home use. Most of our competitors have significantly more financial and human resources, more established sales, service and customer support infrastructures and spend more on product development and marketing than we do. Many of our competitors also have established relationships with the providers of dialysis therapy and, in the case of Fresenius, own and operate a chain of dialysis clinics. Most of these companies manufacture additional complementary products enabling them to offer a bundle of products and have established sales forces and distribution channels that may afford them a significant competitive advantage.

 

The market for our products is competitive, subject to change and affected by new product introductions and other market activities of industry participants, including increased consolidation of ownership of clinics by large dialysis chains. If we are successful, our competitors are likely to develop products that offer features and functionality similar to our System One. Improvements in existing competitive products or the introduction of new competitive products may make it more difficult for us to compete for sales, particularly if those competitive products demonstrate better safety, convenience or effectiveness or are offered at lower prices than our System One. Our ability to successfully market our products could also be adversely affected by pharmacological and technological advances in preventing the progression of ESRD and/or in the treatment of acute kidney failure or fluid overload. If we are unable to compete effectively against existing and future competitors and existing and future alternative treatments and pharmacological and

technological advances, it will be difficult for us to penetrate the market and achieve significant sales of our products.

 

The two largest dialysis clinic chains in the United States are affiliated with, or have contractual arrangements with, other dialysis equipment manufacturers, which may present a barrier to adoption of the System One at these chains.

 

Fresenius and DaVita own and operate the two largest chains of dialysis clinics in the United States. Fresenius controls approximately 33% of the U.S. dialysis clinics, after the completion of its acquisition of Renal Care Group and assuming the completion of the recently announced sale of 100 clinics to National Renal Institutes. Fresenius is also the largest worldwide manufacturer of dialysis systems. DaVita controls approximately 27% of the U.S. dialysis clinics, and has entered into a preferred supplier agreement with Gambro pursuant to which Gambro will provide a significant majority of DaVita’s dialysis equipment and supplies for a period of at least 10 years. Each of Fresenius and DaVita may choose to offer to patients in their dialysis clinics only the dialysis equipment manufactured by them or their affiliates, to offer the equipment they contractually agreed to offer or to otherwise limit access to the equipment manufactured by competitors. We are presently renting the System One to several DaVita dialysis clinics under a two-year contract with DaVita that expires on March 16, 2007. Revenues from DaVita clinics represented 13% of our revenues during the three months ended March 31, 2006. We cannot be sure that DaVita will continue to rent the System One from us or that any future decision by DaVita to stop or limit the use of the System One would not adversely affect our business.

 

If kidney transplantation becomes a viable treatment option for more patients with ESRD, the market for our System One may be limited.

 

While kidney transplantation is the treatment of choice for most ESRD patients, it is not currently a viable treatment for most patients due to the limited number of donor kidneys, the high incidence of kidney transplant rejection and the higher surgical risk associated with older ESRD patients. According to the most recent USRDS data, in 2003 approximately 16,000 patients received kidney transplants in the United States. The development of new medications designed to reduce the incidence of kidney transplant rejection, progress in using kidneys harvested from genetically engineered animals as a source of transplants or any other advances in kidney transplantation could limit the market for our System One.

 

If we are unable to convince hospitals and healthcare providers of the benefits of our products for the treatment of acute kidney failure and fluid overload, we may not be successful in penetrating the critical care market.

 

We sell the System One for use in the treatment of acute kidney failure and fluid overload associated with, among other conditions, congestive heart failure. Physicians currently treat most acute kidney failure patients using conventional hemodialysis systems or dialysis systems designed specifically for use in the ICU. We will need to convince hospitals and healthcare providers that using the System One is as effective as using conventional hemodialysis systems or ICU specific dialysis systems for treating acute kidney failure and that it provides advantages over conventional systems or other ICU specific systems because of its significantly smaller size and ease of operation.

 

Fluid overload resulting from congestive heart failure is most often treated with a variety of drugs rather than with ultrafiltration because ultrafiltration is a less well-known, less studied treatment option and as a result, there is a lack of clinical evidence to support its effectiveness. Because the System One would be used to deliver ultrafiltration, we will need to convince hospitals, healthcare providers and third-party payors that ultrafiltration using the System One is as effective and cost-efficient as existing treatments for fluid overload resulting from congestive heart failure.

 

We are subject to the risk of costly and damaging product liability claims and may not be able to maintain sufficient product liability insurance to cover claims against us.

 

If our System One is found to have caused or contributed to injuries or deaths, we could be held liable for substantial damages. Claims of this nature may also adversely affect our reputation, which could

damage our position in the market. As is the case with a number of other medical device companies, it is likely that product liability claims will be brought against us. Since their introduction into the market, our products have been subject to two voluntary recalls and one voluntary product withdrawal. Our first voluntary recall occurred in February 2001 in Canada and related to a software glitch that we detected in our predecessor system, which could have increased the likelihood of a clotted filter during treatment. There were no patient injuries associated with this recall, and the software glitch was remedied with a subsequent software release. The second voluntary recall occurred in April 2004 in the United States relating to pinhole-sized dialysate leaks in our cartridge. The leaks were readily observable and required a cartridge replacement to continue treatment. There were no patient injuries associated with this recall; we subsequently switched suppliers and instituted additional testing requirements to minimize the chance for pinhole-sized leaks in our cartridges. The voluntary market withdrawal occurred in the United States in May 2002 when we suspended sales of our predecessor system while we addressed issues involving limited instances of contaminated hemofiltration fluids compounded by a pharmacy and supplied by a third-party. Six patients exposed to contaminated fluids reported fevers and/or chills, with no lasting clinical effect. We subsequently modified our cartridge to allow for an additional filter to remove contaminants from fluids used with our product. Our products may be subject to further recalls or withdrawals, which could increase the likelihood of product liability claims. We have also received several reports of operator error from both patients in the home hemodialysis setting and nurses in the critical care setting. We have sought to address many potential sources of operator error with product design changes to simplify the operator process. In addition, we have made improvements in our training materials and product labeling. However, instances of operator error cannot be eliminated and could also increase the likelihood of product liability claims.

 

Although we maintain insurance, including product liability insurance, we cannot provide assurance that any claim that may be brought against us will not result in court judgments or settlements in amounts that are in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions, and we may be subject to a product liability claim for which we have no coverage. We will have to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance.

 

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 additional insurance coverage in the future. A product liability claim, whether meritorious or not, could be time consuming, distracting and expensive to defend and could result in a diversion of management and financial resources away from our primary business, in which case our business may suffer.

 

We have had limited sales, marketing, customer service and distribution experience. We need to expand our sales and marketing, customer service and distribution infrastructures to be successful in penetrating the dialysis market.

 

We currently market and sell the System One through our own sales force, and we have had limited experience in sales, marketing and distribution of dialysis products. As of March 31, 2006, we had 73 employees in our sales, marketing and distribution organization, including 25 direct sales representatives. We plan to expand our sales, marketing, customer service and distribution infrastructures. We cannot provide assurance that we will be able to attract experienced personnel to our early-stage company and build an adequate sales and marketing, customer service and distribution staff or that the cost will not be prohibitive.

 

We face risks associated with having international manufacturing operations, and if we are unable to manage these risks effectively, our business could suffer.

 

In addition to our operations in Lawrence, Massachusetts, we operate a manufacturing facility in Rosdorf, Germany and we purchase components and supplies from foreign vendors. We are subject to a number of risks and challenges that specifically relate to these international operations, and we may not be successful if we are unable to meet and overcome these challenges. These risks include fluctuations in foreign currency exchange rates that may increase the U.S. dollar cost of the disposables we purchase from foreign third-party suppliers, costs associated with sourcing and shipping goods internationally, difficulty managing

operations in multiple locations and local regulations that may restrict or impair our ability to conduct our operations.

 

Risks Related to the Regulatory Environment

 

We are subject to significant regulation, primarily by the FDA. We cannot market or commercially distribute our products without obtaining and maintaining necessary regulatory clearances or approvals.

 

Our System One and related products, including the disposables required for its use, are all medical devices subject to extensive regulation in the United States, and in foreign markets we may wish to enter. To market a medical device in the United States, approval or clearance by the FDA is required, either through the pre-market approval process or the 510(k) clearance process. We have obtained the FDA clearances necessary to sell our current products under the 510(k) clearance process. Medical devices may only be promoted and sold for the indications for which they are approved or cleared. In addition, even if the FDA has approved or cleared a product, it can take action affecting such product approvals or clearances if serious safety or other problems develop in the marketplace. We may be required to obtain 510(k) clearances or pre-market approvals for additional products, product modifications, or for new indications for the System One. We cannot provide assurance that such clearances or approvals would be forthcoming, or, if forthcoming, what the timing and expense of obtaining such clearances or approvals might be. Delays in obtaining clearances or approvals could adversely affect our ability to introduce new products or modifications to our existing products in a timely manner, which would delay or prevent commercial sales of our products.

 

Modifications to our marketed devices may require new regulatory clearances or pre-market approvals, or may require us to cease marketing or recall the modified devices until clearances or approvals are obtained.

 

Any modifications to a 510(k) cleared device that could significantly affect its safety or effectiveness, or would constitute a major change in its intended use, requires the submission of another 510(k) pre-market notification to address the change. Although in the first instance we may determine that a change does not rise to a level of significance that would require us to make a pre-market notification submission, the FDA may disagree with us and can require us to submit a 510(k) for a significant change in the labeling, technology, performance specifications or materials or major change or modification in intended use, despite a documented rationale for not submitting a pre-market notification. We have modified various aspects of the System One and have filed and received clearance from the FDA with respect to some of the changes in the design of our products. If the FDA requires us to submit a 510(k) for any modification to a previously cleared device, or in the future a device that has received 510(k) clearance, we may be required to cease marketing the device, recall it, and not resume marketing until we obtain clearance from the FDA for the modified version of the device. Also, we may be subject to regulatory fines, penalties and/or other sanctions authorized by the Federal Food, Drug, and Cosmetic Act. In the future, we intend to introduce new products and enhancements and improvements to existing products. We cannot provide assurance that the FDA will clear any new product or product changes for marketing or what the timing of such clearances might be. In addition, new products or significantly modified marketed products could be found to be not substantially equivalent and classified as products requiring the FDA’s approval of a pre-market approval application, or PMA, before commercial distribution would be permissible. PMAs usually require substantially more data than 510(k) submissions and their review and approval or denial typically takes significantly longer than a 510(k) decision of substantial equivalence. Also, PMA products require approval supplements for any change that affects safety and effectiveness before the modified device may be marketed. Delays in our receipt of regulatory clearance or approval will cause delays in our ability to sell our products, which will have a negative effect on our revenues growth.

 

Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply with ongoing regulatory requirements our products could be subject to restrictions or withdrawal from the market.

 

We are subject to the Medical Device Reporting, or MDR, regulations that require us to report to the FDA if our products may have caused or contributed to patient death or serious injury, or if our device

malfunctions and a recurrence of the malfunction would likely result in a death or serious injury. We must also file reports of device corrections and removals and adhere to the FDA’s rules on labeling and promotion. Our failure to comply with these or other applicable regulatory requirements could result in enforcement action by the FDA, which may include any of the following:

 

 

Our products are subject to market withdrawals or product recalls after receiving FDA clearance or approval, and market withdrawals and product recalls could cause the price of our stock to decline and expose us to product liability or other claims or could otherwise harm our reputation and financial results.

 

Complex medical devices, such as the System One, can experience performance problems in the field that require review and possible corrective action by us or the product manufacturer. We cannot provide assurance that component failures, manufacturing errors, design defects and/or labeling inadequacies, which could result in an unsafe condition or injury to the operator or the patient will not occur. These could lead to a government mandated or voluntary recall by us. The FDA has the authority to require the recall of our products in the event a product presents a reasonable probability that it would cause serious adverse health consequences or death. Similar regulatory agencies in other countries have similar authority to recall devices because of material deficiencies or defects in design or manufacture that could endanger health. We believe that the FDA would request that we initiate a voluntary recall if a product was defective or presented a risk of injury or gross deception. Any recall would divert management attention and financial resources, could cause the price of our stock to decline and expose us to product liability or other claims and harm our reputation with customers. A recall involving the System One could be particularly harmful to our business and financial results, because the System One is our only product.

 

If we or our contract manufacturers fail to comply with FDA’s Quality System regulations, our manufacturing operations could be interrupted, and our product sales and operating results could suffer.

 

Our finished goods manufacturing processes, and those of some of our contract manufacturers, are required to comply with the FDA’s Quality System regulations, or QSRs, which cover the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, sterilization, storage and shipping of our devices. The FDA enforces its QSRs through periodic unannounced inspections of manufacturing facilities. We and our contract manufacturers have been, and anticipate in the future being, subject to such inspections. Our U.S. manufacturing facility has previously had three FDA QSR inspections. The first resulted in one observation, which was rectified during the inspection and required no further response from us. Our last two inspections, including our most recent inspection in March 2006, resulted in no observations. We cannot provide assurance that any future inspections would have the same result. If one of our manufacturing facilities or those of any of our contract manufacturers fails to take satisfactory corrective action in response to an adverse QSR inspection, FDA could take enforcement action, including issuing a public warning letter, shutting down our manufacturing operations, embargoing the import of components from outside of the United States, recalling our products, refusing to approve new marketing applications, instituting

legal proceedings to detain or seize products or imposing civil or criminal penalties or other sanctions, any of which could cause our business and operating results to suffer.

 

Changes in reimbursement for treatment for ESRD could affect the adoption of our System One and the level of our future product revenues.

 

In the United States, all patients who suffer from ESRD, regardless of age, are eligible for coverage under Medicare, after a requisite coordination period if other insurance is available. As a result, more than 80% of patients with ESRD are covered by Medicare. Although we rent and sell our products to hospitals, dialysis centers and other healthcare providers and not directly to patients, the reimbursement rate for ESRD treatments is an important factor in a potential customer’s decision to purchase the System One. The dialysis centers that purchase our product rely on adequate third-party payor coverage and reimbursement to maintain their ESRD facilities. There is some regional variation in the composite rate for dialysis services, but the national average rate is currently approximately $149 per treatment for independent clinics and $154 per treatment for hospital-based dialysis facilities, which is intended to cover most items and services related to the treatment of ESRD, but does not include payment for physician services or separately billable laboratory services or drugs. Changes in Medicare reimbursement rates could negatively affect demand for our products and the prices we charge for them.

 

Most ESRD patients who use our product for dialysis therapy in the home treat themselves six times per week. CMS rules, however, limit the number of hemodialysis treatments paid for by Medicare to three a week, unless there is medical justification for the additional treatments. The determination of medical justification must be made at the local Medicare contractor level on a case-by-case basis. If daily therapy is prescribed, a clinic’s decision as to how much it is willing to spend on dialysis equipment and services will be at least partly dependent on whether Medicare will reimburse more than three treatments per week for the clinic’s patients.

 

Unlike Medicare reimbursement for ESRD, Medicare only reimburses healthcare providers for acute kidney failure and fluid overload treatment if the patient is otherwise eligible for Medicare, based on age or disability. Medicare and many other third party payors and private insurers reimburse these treatments provided to hospital inpatients under a traditional diagnosis related group system. Under this system, reimbursement is determined based on a patient’s primary diagnosis and is intended to cover all costs of treating the patient. The presence of acute kidney failure or fluid overload increases the severity of the primary diagnosis and, accordingly, may increase the amount reimbursed. For care of these patients to be cost-effective, hospitals must manage the longer hospitalization stays and significantly more nursing time typically necessary for patients with acute kidney failure and fluid overload. If we are unable to convince hospitals that our System One provides a cost-effective treatment alternative under this diagnosis related group reimbursement system, they may not purchase our product.

 

Legislative or regulatory reform of the healthcare system may affect our ability to sell our products profitably.

 

In both the United States and foreign countries, there have been legislative and regulatory proposals to change the healthcare system in ways that could affect our ability to sell our products profitably. The federal government and some states have enacted healthcare reform legislation, and further federal and state proposals are likely. We cannot predict the exact form this legislation may take, the probability of passage, and the ultimate effect on us. Our business could be adversely affected by future healthcare reforms or changes in Medicare.

 

Failure to obtain regulatory approval in foreign jurisdictions would prevent us from marketing our products outside the United States.

 

Although we have not initiated any marketing efforts in jurisdictions outside of the United States and Canada, we intend in the future to market our products in other markets. In order to market our products in the European Union or other foreign jurisdictions, we must obtain separate regulatory approvals and comply with numerous and varying regulatory requirements. The approval procedure varies from country to country and can involve additional testing. The time required to obtain approval abroad may be longer than the time

required to obtain FDA clearance. The foreign regulatory approval process includes many of the risks associated with obtaining FDA clearance and we may not obtain foreign regulatory approvals on a timely basis, if at all. FDA clearance does not ensure approval by regulatory authorities in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries. We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market outside the United States, which could negatively affect our overall market penetration.

 

We currently have obligations under our contracts with dialysis clinics to protect the privacy of patient health information.

 

In the course of performing our business we obtain, from time to time, confidential patient health information. For example, we learn patient names and addresses when we ship our System One supplies to home hemodialysis patients. We may learn patient names and be exposed to confidential patient health information when we provide training on System One operations to our customer’s staff. Our home hemodialysis patients may also call our customer service representatives directly and, during the call, disclose confidential patient health information. U.S. Federal and state laws protect the confidentiality of certain patient health information, in particular individually identifiable information, and restrict the use and disclosure of that information. At the federal level, the Department of Health and Human Services promulgated health information and privacy and security rules under the Health Insurance Portability and Accountability Act of 1996, or HIPAA. At this time, we are not a HIPAA covered entity and consequently are not directly subject to HIPAA. However, we have entered into several business associate agreements with covered entities that contain commitments to protect the privacy and security of patients’ health information and, in some instances, require that we indemnify the covered entity for any claim, liability, damage, cost or expense arising out of or in connection with a breach of the agreement by NxStage. If we were to violate one of these agreements, we could lose customers and be exposed to liability and/or our reputation and business could be harmed. In addition, conduct by a person that is not a covered entity could potentially be prosecuted under aiding and abetting or conspiracy laws if there is an improper disclosure or misuse of patient information.

 

Many state laws apply to the use and disclosure of health information, which could affect the manner in which we conduct our business. Such laws are not necessarily preempted by HIPAA, in particular those laws that afford greater protection to the individual than does HIPAA. Such state laws typically have their own penalty provisions, which could be applied in the event of an unlawful action affecting health information.

 

We are subject to federal and state laws prohibiting “kickbacks” and false and fraudulent claims which, if violated, could subject us to substantial penalties. Additionally, any challenges to or investigation into our practices under these laws could cause adverse publicity and be costly to respond to, and thus could harm our business.

 

The Medicare/ Medicaid anti-kickback laws, and several similar state laws, prohibit payments that are intended to induce physicians or others either to refer patients or to acquire or arrange for or recommend the acquisition of healthcare products or services. These laws affect our sales, marketing and other promotional activities by limiting the kinds of financial arrangements, including sales programs, we may have with hospitals, physicians or other potential purchasers or users of medical devices. In particular, these laws influence, among other things, how we structure our sales and rental offerings, including discount practices, customer support, education and training programs and physician consulting and other service arrangements. Although we seek to structure such arrangements in compliance with applicable requirements, these laws are broadly written, and it is often difficult to determine precisely how these laws will be applied in specific circumstances. If one of our sales representatives were to offer an inappropriate inducement to purchase our System One to a customer, we could be subject to a claim under the Medicare/ Medicaid anti-kickback laws.

 

Other federal and state laws generally prohibit individuals or entities from knowingly presenting, or causing to be presented, claims for payments from Medicare, Medicaid or other third-party payors that are false or fraudulent, or for items or services that were not provided as claimed. Although we do not submit claims directly to payors, manufacturers can be held liable under these laws if they are deemed to “cause” the

submission of false or fraudulent claims by providing inaccurate billing or coding information to customers, or through certain other activities. In providing billing and coding information to customers, we make every effort to ensure that the billing and coding information furnished is accurate and that treating physicians understand that they are responsible for all billing and prescribing decisions, including the decision as to whether to order dialysis services more frequently than three times per week. Nevertheless, we cannot provide assurance that the government will regard any billing errors that may be made as inadvertent or that the government will not examine our role in providing information to our customers concerning the benefits of daily therapy. Anti-kickback and false claims laws prescribe civil, criminal and administrative penalties for noncompliance, which can be substantial. Moreover, an unsuccessful challenge or investigation into our practices could cause adverse publicity, and be costly to respond to, and thus could harm our business and results of operations.

 

Foreign governments tend to impose strict price controls, which may adversely affect our future profitability.

 

Although we have not initiated any marketing efforts in jurisdictions outside of the United States and Canada, we intend in the future to market our products in other markets. In some foreign countries, particularly in the European Union, the pricing of medical devices is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after the receipt of marketing approval for a product. To obtain reimbursement or pricing approval in some countries, we may be required to supply data that compares the cost-effectiveness of the System One to other available therapies. If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, it may not be profitable to sell our products outside of the United States, which would negatively affect the long-term growth of our business.

 

Our business activities involve the use of hazardous materials, which require compliance with environmental and occupational safety laws regulating the use of such materials. If we violate these laws, we could be subject to significant fines, liabilities or other adverse consequences.

 

Our research and development programs as well as our manufacturing operations involve the controlled use of hazardous materials. Accordingly, we are subject to federal, state and local laws governing the use, handling and disposal of these materials. Although we believe that our safety procedures for handling and disposing of these materials comply in all material respects with the standards prescribed by state and federal regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of an accident or failure to comply with environmental laws, we could be held liable for resulting damages, and any such liability could exceed our insurance coverage.

 

Risks Related to Operations

 

We depend on the services of our senior executives and certain key engineering, scientific, clinical and marketing personnel, the loss of whom could negatively affect our business.

 

Our success depends upon the skills, experience and efforts of our senior executives and other key personnel, including our chief executive officer, certain members of our engineering staff, our marketing executives and managers and our clinical educators. Much of our corporate expertise is concentrated in relatively few employees, the loss of which for any reason could negatively affect our business. Competition for our highly skilled employees is intense and we cannot prevent the resignation of any employee. On May 16, 2006, we announced that David Gill, our Chief Financial Officer, plans to resign as an officer and employee of NxStage at the end of July 2006. Although we have initiated a search, we do not know how long it will take to recruit successfully a new Chief Financial Officer. We have agreements with all of our executive officers that contain non-competition provisions that may prevent a former employee of ours from working for a competitor for a period of time; however, these clauses may not be enforceable, or enforceable only in part, or the company may choose not to seek enforcement. We do not maintain “key man” life insurance on any of our senior executives, other than our chief executive officer.

We obtain some of the components, subassemblies and completed products included in the System One from a single source or a limited group of manufacturers or suppliers, and the partial or complete loss of one of these manufacturers or suppliers could cause significant production delays, an inability to meet customer demand and a substantial loss in revenues.

 

We depend on single source suppliers for some of the components and subassemblies we use in the System One. KMC Systems, Inc. is our only contract manufacturer of the System One cycler; B. Braun Medizintechnologie GmbH is our only supplier of bicarbonate-based dialysate used with the System One; Membrana GmbH is our only supplier of the fiber used in our filters; PISA is a primary supplier of lactate-based dialysate and Medisystems Corporation is our primary supplier of our disposable cartridge and several cartridge components. We also obtain certain other components included in the System One from other single source suppliers or a limited group of suppliers. Medisystems is a related party to NxStage. David Utterberg, the chief executive officer and sole stockholder of Medisystems, is a member of our board of directors and as of March 31, 2006, held approximately 9.4% of our common stock. Our dependence on single source suppliers of components, subassemblies and finished goods exposes us to several risks, including disruptions in supply, price increases, late deliveries, or an inability to meet customer demand. This could lead to customer dissatisfaction or damage to our reputation or cause customers to switch to competitive products. Any interruption in supply could be particularly damaging to our customers using the System One to treat chronic ESRD and who need weekly access to the System One and related disposables.

 

Finding alternative sources for these components and subassemblies would be difficult in many cases and may entail a significant amount of time and disruption. In some cases, we would need to change the components or subassemblies if we sourced them from an alternative supplier. This, in turn, could require a redesign of our System One and, potentially, further FDA clearance or approval of any modification, thereby causing further costs and delays.

 

We do not have long-term supply contracts with many of our third-party suppliers.

 

We purchase components and subassemblies from third-party suppliers, including some of our single source suppliers, through purchase orders and do not have long-term supply contracts with many of these third-party suppliers. Many of our third-party suppliers, therefore, are not obligated to perform services or supply products to us for any specific period, in any specific quantity or at any specific price, except as may be provided in a particular purchase order. We do not maintain large volumes of inventory from most of these suppliers. If we inaccurately forecast demand for components or subassemblies, our ability to manufacture and commercialize the System One could be delayed and our competitive position and reputation could be harmed. In addition, if we fail to effectively manage our relationships with these suppliers, we may be required to change suppliers which would be time consuming and disruptive.

 

Risks Related to Intellectual Property

 

If we are unable to protect our intellectual property and prevent its use by third parties, we will lose a significant competitive advantage.

 

We rely on patent protection, as well as a combination of copyright, trade secret and trademark laws to protect our proprietary technology and prevent others from duplicating our products. However, these means may afford only limited protection and may not:

 

 

Any of our patents may be challenged, invalidated, circumvented or rendered unenforceable. We cannot provide assurance that we will be successful should one or more of our patents be challenged for any reason. If our patent claims are rendered invalid or unenforceable, or narrowed in scope, the patent coverage afforded our products could be impaired, which could make our products less competitive.

As of March 31, 2006, we had 51 pending patent applications, including foreign, international and U.S. applications, and 21 U.S. and international issued patents. We cannot specify which of these patents individually or as a group will permit us to gain or maintain a competitive advantage. We cannot provide assurance that any pending or future patent applications we hold will result in an issued patent or that if patents are issued to us, that such patents will provide meaningful protection against competitors or against competitive technologies. The issuance of a patent is not conclusive as to its validity or enforceability. The United States federal courts or equivalent national courts or patent offices elsewhere may invalidate our patents or find them unenforceable. Competitors may also be able to design around our patents. Our patents and patent applications cover particular aspects of our products. Other parties may develop and obtain patent protection for more effective technologies, designs or methods for treating kidney failure. If these developments were to occur, it would likely have an adverse effect on our sales.

 

The laws of foreign countries may not protect our intellectual property rights effectively or to the same extent as the laws of the United States. If our intellectual property rights are not adequately protected, we may not be able to commercialize our technologies, products or services and our competitors could commercialize similar technologies, which could result in a decrease in our revenues and market share.

 

Our products could infringe the intellectual property rights of others, which may lead to litigation that could itself be costly, could result in the payment of substantial damages or royalties, and/or prevent us from using technology that is essential to our products.

 

The medical device industry in general has been characterized by extensive litigation and administrative proceedings regarding patent infringement and intellectual property rights. Products to provide kidney replacement therapy have been available in the market for more than 30 years and our competitors hold a significant number of patents relating to kidney replacement devices, therapies, products and supplies. Although no third party has threatened or alleged that our products or methods infringe their patents or other intellectual property rights, we cannot provide assurance that our products or methods do not infringe the patents or other intellectual property rights of third parties. If our business is successful, the possibility may increase that others will assert infringement claims against us.

 

Infringement and other intellectual property claims and proceedings brought against us, whether successful or not, could result in substantial costs and harm to our reputation. Such claims and proceedings can also distract and divert management and key personnel from other tasks important to the success of the business. In addition, intellectual property litigation or claims could force us to do one or more of the following:

 

 

Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.

 

In order to protect our proprietary technology and processes, we also rely in part on confidentiality agreements with our corporate partners, employees, consultants, outside scientific collaborators and sponsored researchers, advisors and others. These agreements may not effectively prevent disclosure of confidential information and trade secrets and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover or reverse engineer trade secrets and proprietary information, and in such cases we could not assert any trade secret rights against such party.

Costly and time consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive position.

 

We may be subject to damages resulting from claims that our employees or we have wrongfully used or disclosed alleged trade secrets of other companies.

 

Many of our employees were previously employed at other medical device companies focused on the development of dialysis products, including our competitors. Although no claims against us are currently pending, we may be subject to claims that these employees or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. Even if we are successful in defending against these claims, litigation could result in substantial costs, damage to our reputation and be a distraction to management.

 

Risks Related to our Common Stock and this Offering

 

Our stock price is likely to be volatile, and the market price of our common stock may drop.

 

The market price of our common stock could be subject to significant fluctuations. Market prices for securities of early stage companies have historically been particularly volatile. As a result of this volatility, you may not be able to sell your common stock at or above the price you paid for the stock. Some of the factors that may cause the market price of our common stock to fluctuate include:

 

The stock markets in general have experienced substantial volatility that has often been unrelated to the operating performance of individual companies. These broad market fluctuations may adversely affect the trading price of our common stock.

 

In the past, following periods of volatility in the market price of a company’s securities, stockholders have often instituted class action securities litigation against those companies. Such litigation, if instituted, could result in substantial costs and diversion of management attention and resources, which could significantly harm our profitability and reputation.

 

Anti-takeover provisions in our restated certificate of incorporation and amended and restated bylaws and under Delaware law could make an acquisition of us more difficult and may prevent attempts by our stockholders to replace or remove our current management.

 

Provisions in our restated certificate of incorporation and our amended and restated bylaws may delay or prevent an acquisition of us. In addition, these provisions may frustrate or prevent attempts by our stockholders to replace or remove members of our board of directors. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt by our stockholders to replace current members of our management team. These provisions include:

 

 

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits a person who owns in excess of 15% of our outstanding voting stock from merging or combining with us for a period of three years after the date of the transaction in which the person acquired in excess of 15% of our outstanding voting stock, unless the merger or combination is approved in a prescribed manner. These provisions would apply even if the offer may be considered beneficial by some stockholders.

 

If there are substantial sales of our common stock in the market by our existing stockholders, our stock price could decline.

 

If our existing stockholders sell a large number of shares of our common stock or the public market perceives that existing stockholders might sell shares of common stock, the market price of our common stock could decline significantly. We have 21,184,287 shares of common stock outstanding as of March 31, 2006. Shares held by our affiliates may only be sold in compliance with the volume limitations of Rule 144. These volume limitations restrict the number of shares that may be sold by an affiliate in any three-month period to the greater of 1% of the number of shares then outstanding, which approximates 211,843 shares, or the average weekly trading volume of our common stock during the four calendar weeks preceding the filing of a notice on Form 144 with respect to the sale. In connection with this offering, officers, directors and stockholders holding an aggregate of approximately 14,800,000 shares of our common stock and rights to acquire an additional 1,900,000 shares have agreed, with exceptions, not to sell or transfer any common stock until 90 days after the date of this prospectus. Upon expiration or termination of these lock-up agreements, all of these shares of common stock will be freely tradeable, subject in some cases to the volume limitations and other applicable conditions of Rule 144.

 

Subject to certain conditions, holders of an aggregate of approximately 13,432,652 shares of common stock have rights with respect to the registration of these shares of common stock with the Securities and Exchange Commission, or SEC. If we register their shares of common stock following the expiration of the lock-up agreements, they can sell those shares in the public market.

As of March 31, 2006, 3,429,527 shares of common stock are authorized for issuance under our stock incentive plan, employee stock purchase plan and outstanding stock options. As of March 31, 2006, 2,723,005 shares were subject to outstanding options, of which 1,797,193 were exercisable and which can be freely sold in the public market upon issuance, subject to the lock-up agreements referred to above and the restrictions imposed on our affiliates under Rule 144.

 

Our costs have increased significantly as a result of operating as a public company, and our management is required to devote substantial time to comply with public company regulations.

 

As a public company, we incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, as well as new rules subsequently implemented by the SEC and the Nasdaq National Market, have imposed various new requirements on public companies, including changes in corporate governance practices. Our management and other personnel now need to devote a substantial amount of time to these new requirements. Moreover, these rules and regulations increase our legal and financial compliance costs and make some activities more time-consuming and costly.

 

In addition, the Sarbanes-Oxley Act requires, among other things, that we maintain effective internal controls for financial reporting and disclosure controls and procedures. In particular, commencing in fiscal 2006, we must perform system and process evaluation and testing of our internal controls over financial reporting to allow management and our independent registered public accounting firm to report on the effectiveness of our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. Our compliance with Section 404 will require that we incur substantial accounting expense and expend significant management efforts. If we are not able to comply with the requirements of Section 404 in a timely manner, or if we or our independent registered public accounting firm identify deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses, the market price of our stock could decline and we could be subject to sanctions or investigations by the Nasdaq National Market, SEC or other regulatory authorities.

 

We do not anticipate paying cash dividends, and accordingly stockholders must rely on stock appreciation for any return on their investment in us.

 

We anticipate that we will retain our earnings for future growth and therefore do not anticipate paying cash dividends in the future. As a result, only appreciation of the price of our common stock will provide a return to investors. Investors seeking cash dividends should not invest in our common stock.

 

Management will have broad discretion in the use of the net proceeds from this offering and may not use them effectively or in a manner that differs from the uses described in the prospectus.

 

Although we intend to use the net proceeds of this offering to, among other things, finance working capital needs, including investment in System One field equipment and in sales and marketing programs, expand our manufacturing capabilities and fund continuing operations, we cannot specify with certainty the particular uses of the net proceeds that we will receive from this offering. We will have broad discretion in the application of the net proceeds, including for any of the purposes described in the “Use of Proceeds” section of this prospectus. However, our plans may change and we could use the net proceeds in ways with which stockholders do not agree, or for corporate purposes that may not result in a significant or any return on your investment. Pending their use, we may invest the net proceeds from this offering in a manner that does not produce income or that loses value.

 

If you purchase our common stock in this offering, you will experience immediate and substantial dilution in the book value of your shares.

 

The offering price is substantially higher than the net tangible book value per share of our common stock. Investors purchasing common stock in this offering will pay a price per share that substantially exceeds the book value of our tangible assets after subtracting our liabilities. As a result, investors purchasing common stock in this offering will incur immediate dilution of $5.51 per share, assuming an offering price of $9.53 per share, based on the last reported sale price of our common stock on the Nasdaq National Market on June 7,

2006. Further, investors purchasing common stock in this offering will contribute approximately 25.1% of the total amount invested by stockholders since our inception, but will own only approximately 20.6% of the shares of common stock outstanding.

 

This dilution is due to our existing investors having purchased shares prior to this offering for substantially less than the price offered to the public in this offering, as well as the exercise of stock options granted to our employees with exercise prices lower than the price offered to the public in this offering. As of March 31, 2006, options to purchase 2,723,005 shares of common stock at a weighted-average exercise price of $6.46 per share were outstanding, and warrants to purchase and common stock totaling 169,736 shares with a weighted-average exercise price of $7.67, were outstanding. The exercise of any of these options or warrants would result in additional dilution. As a result of this dilution, investors purchasing stock in this offering may receive significantly less than the purchase price paid in this offering in the event of liquidation.

 

Our executive officers, directors and current and principal stockholders own a large percentage of our voting common stock and could limit new stockholders’ influence on corporate decisions or could delay or prevent a change in corporate control.

 

After this offering, our directors, executive officers and current holders of more than 5% of our outstanding common stock, together with their affiliates and related persons, will beneficially own, in the aggregate, approximately 48.0% of our outstanding common stock, or 46.6% if the underwriters exercise their overallotment option in full. As a result, these stockholders, if acting together, will have the ability to determine the outcome of all matters submitted to our stockholders for approval, including the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets and other extraordinary transactions. The interests of this group of stockholders may not always coincide with our corporate interests or the interests of other stockholders, and they may act in a manner with which you may not agree or that may not be in the best interests of other stockholders. This concentration of ownership may have the effect of:

 

 

This prospectus contains forward-looking statements that involve substantial risks and uncertainties. All statements, other than statements of historical facts, included in this prospectus regarding our strategy, future operations, future financial position, future revenues, projected costs, prospects and plans and objectives of management are forward-looking statements. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We have based these forward-looking statements on our current expectations and projections about future events. Although we believe that the expectations underlying any of our forward-looking statements are reasonable, these expectations may prove to be incorrect and all of these statements are subject to risks and uncertainties. Should one or more of these risks and uncertainties materialize, or should underlying assumptions, projections or expectations prove incorrect, actual results, performance or financial condition may vary materially and adversely from those anticipated, estimated or expected. We have identified below some important factors that could cause our forward-looking statements to differ materially from actual results, performance or financial conditions:

 

 

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. We have included important factors in the cautionary statements included in this prospectus, particularly in the section entitled “Risk Factors” that we believe could cause actual results or events to differ materially from the forward-looking statements that we make. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make. We do not assume any obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

 

We estimate that net proceeds to us from this offering of approximately $48.6 million, assuming an offering price of $9.53 per share, based on the last reported sale price of our common stock on the Nasdaq National Market on June 7, 2006, and after deducting the estimated underwriting discounts and commissions and offering expenses payable by us. If the underwriters’ overallotment option is exercised in full, we estimate that net proceeds to us of approximately $56.0 million. We will not receive any of the proceeds from the sale of shares by the selling stockholders.

 

We currently estimate that of the net proceeds of this offering we will spend:

 

 

 

We intend to use any remaining proceeds for general corporate purposes.

 

This expected use of the net proceeds that we receive in this offering represents our current intentions based upon our present plans and business condition. The amounts and timing of our actual expenditures will depend upon numerous factors, including the success of our ongoing commercial efforts.

 

Pending the application of the net proceeds of the offering to us as described above, we intend to invest the net proceeds of this offering in short-term, interest-bearing, investment-grade securities.

 

We have never declared or paid any dividends on our common stock. We currently intend to retain any future earnings to finance our research and development efforts, the development of our proprietary technologies and the expansion of our business and do not intend to declare or pay cash dividends on our capital stock in the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors and will depend upon a number of factors, including our results of operations, financial condition, future prospects, contractual restrictions, restrictions imposed by applicable law and other factors our board of directors deems relevant.

 

Our common stock has been traded on the Nasdaq National Market under the symbol “NXTM” since October 27, 2005. Prior to that date, there was no public market for our common stock. The following table sets forth, for the periods indicated, the intra-day high and low sale prices of our common stock, as reported by the Nasdaq National Market.

 

 

On June 7, 2006, the last reported sale price of our common stock on the Nasdaq National Market was $9.53. As of May 25, 2006, there were 21,316,131 shares of our common stock outstanding held by 120 holders of record.

 

The following table sets forth our unaudited capitalization as of March 31, 2006:

 

 

 

You should read this information together with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus.

 

 

If you invest in our common stock, your interest will be immediately diluted to the extent of the difference between the assumed public offering price per share of our common stock and the as adjusted net tangible book value per share of our common stock after this offering. The net tangible book value of our common stock as of March 31, 2006 was $58.6 million, or $2.77 per share of common stock outstanding. Net tangible book value per share represents the amount of stockholders’ equity divided by 21,184,287 shares of common stock outstanding at that date. Dilution per share to new investors represents the difference between the amount per share paid by purchasers of common stock in this offering and the as adjusted net tangible book value per share of common stock immediately after completion of this offering.

 

After giving effect to the receipt of net proceeds of $48.6 million from the sale of the 5,500,000 shares of common stock in this offering assuming a public offering price of $9.53 per share, based on the last reported sale price of our common stock on the Nasdaq National Market on June 7, 2006, less estimated underwriting discounts and commissions and offering expenses payable by us, our as adjusted net tangible book value as of March 31, 2006 would have been $107.2 million, or approximately $4.02 per share. This represents an immediate increase in net tangible book value of $1.25 per share to existing stockholders and an immediate dilution in net tangible book value of $5.51 per share to purchasers of common stock in this offering, as illustrated in the following table:

 

 

Assuming the exercise in full of the underwriters’ overallotment option, our as adjusted net tangible book value at March 31, 2006 would have been approximately $4.17 per share, representing an immediate increase in the as adjusted net tangible book value of $1.40 per share to our existing stockholders and an immediate dilution in net tangible book value of $5.36 per share to new investors.

 

The foregoing tables and calculations are based on shares of our common stock outstanding as of March 31, 2006 and exclude:

 

 

To the extent that outstanding warrants and options are exercised in the future, there will be further dilution to new investors. To the extent all of such outstanding options and warrants had been exercised as of March 31, 2006, net tangible book value per share after this offering would have been $4.26 and total dilution per share to new investors would have been $5.27.

 

The following tables summarize our consolidated financial data for the periods presented. You should read the following financial information together with the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes to those consolidated financial statements appearing elsewhere in this prospectus. The selected consolidated statements of operations data for the fiscal years ended December 31, 2003, 2004 and 2005, and the selected consolidated balance sheet data as of December 31, 2004 and 2005 are derived from the consolidated financial statements, which are included elsewhere in this prospectus, and have been audited by Ernst & Young LLP, an independent registered public accounting firm, as indicated in their report. The selected consolidated statements of operations data for the years ended December 31, 2001 and 2002, and the consolidated balance sheet data at December 31, 2001, 2002 and 2003 are derived from our audited consolidated financial statements not included in this prospectus. The selected consolidated financial data as of March 31, 2006 and for the periods ended March 31, 2005 and March 31, 2006, are derived from our unaudited consolidated financial statements. The unaudited consolidated financial statements have been prepared on the same basis as our audited financial statements (except with respect to the adoption of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, effective January 1, 2006) and include, in the opinion of management, all adjustments, consisting of only normal recurring adjustments, that management considers necessary for the fair presentation of the financial information set forth in those statements. Reclassifications have been made to our results from prior years to conform to our current presentation. Historical results are not necessarily indicative of the results to be expected in future periods.

 

 

 

You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes appearing elsewhere in this prospectus. Some of the information contained in this discussion and analysis or set forth elsewhere in this prospectus, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. You should review the “Risk Factors” section of this prospectus for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

 

Overview

 

We are a medical device company that develops, manufactures and markets innovative systems for the treatment of ESRD, acute kidney failure and fluid overload. Our primary product, the NxStage System One, is a small, portable, easy-to-use hemodialysis system designed to provide physicians and patients improved flexibility in how hemodialysis therapy is prescribed and delivered. We believe the largest market opportunity for our product is the home hemodialysis market for the treatment of ESRD.

 

From our inception in 1998 until 2002 our operations consisted primarily of start-up activities, including designing and developing the System One, recruiting personnel and raising capital. Historically, research and development costs have been our single largest operating expense. However, with the launch of the System One in the home chronic care market, selling and marketing costs became our largest operating expense in 2005 and this trend continued during the three months ended March 31, 2006 as we expanded our United States sales force to penetrate our markets and grow revenues.

 

Our overall strategy since inception has been to (a) design and develop new products for the treatment of kidney failure, (b) establish that the products are safe, effective and cleared for use in the United States, (c) further enhance the product design through field experience from a limited number of customers, (d) establish reliable manufacturing and sources of supply, (e) execute a market launch in both the chronic and critical care markets and establish the System One as a preferred system for the treatment of kidney failure, (f) obtain the capital necessary to finance our working capital needs and build our business and (g) achieve profitability. The evolution of NxStage, and the allocation of our resources since we were founded, reflects this plan. We believe we have largely completed steps (a) through (d), and we plan to continue to pursue the other strategic objectives described above.

 

We sell our products in two markets: the chronic care market and the critical care market. We define the chronic care market as the market devoted to the treatment of patients with ESRD and the critical care market as the market devoted to the treatment of hospital-based patients with acute kidney failure or fluid overload. We offer a different configuration of the System One for each market. The FDA has cleared both configurations for hemodialysis, hemofiltration and ultrafiltration. Our products may be used by our customers to treat patients suffering from either condition, although the site of care, the method of delivering care and the duration of care are sufficiently different that we have separate sales and marketing efforts dedicated to each market.

 

We received clearance from the FDA in July 2003 to market the System One for treatment of renal failure and fluid overload using hemodialysis as well as hemofiltration and ultrafiltration. In the first quarter of 2003, we initiated sales of the System One in the critical care market to hospitals and medical centers in the United States. In late 2003, we initiated sales of the System One in the chronic care market and commenced full commercial introduction in the chronic care market in September 2004 in the United States. At the time of these early marketing efforts, our System One was cleared by the FDA under a general indication statement, allowing physicians to prescribe the System One for hemofiltration, hemodialysis and/or ultrafiltration at the location, time and frequency they considered in the best interests of their patients. Our indication did not include a specific home clearance, and we were not able to promote the System One for home use at that time. In order to be able to specifically promote the System One for home use, the FDA required that we

conduct a clinical study, referred to as an investigational device exemption study, or IDE, comparing center-based and home-based therapy with the System One. After submitting the results of that study to the FDA, together with an application for a specific home indication for the System One, the FDA cleared our System One in June 2005 for hemodialysis in the home.

 

During the three months ended March 31, 2006, we received clearance from the FDA to market our PureFlow SL module as an alternative to the bagged fluid currently used with our System One. This accessory to the System One prepares high purity dialysate, which meets and exceeds dialysis industry standards for purity, from ordinary tap water in the dialysis patient’s home. This product is designed to help patients with ESRD more conveniently and effectively manage their home hemodialysis therapy by eliminating the need to store and hang bagged fluids. Instead, our PureFlow SL module automatically produces a batch of dialysate fluid ready for use with the System One. We expect to commercially launch this product beginning in July 2006. We expect that our chronic care home patients will predominantly use our PureFlow SL module at home and will use bagged fluid for travel and outside of the home. Bagged fluids will continue to be used in the critical care market.

 

Medicare provides comprehensive and well-established reimbursement in the United States for ESRD. Reimbursement claims for the System One therapy are typically submitted by the dialysis clinic or hospital to Medicare and other third-party payors using established billing codes for dialysis treatment or, in the critical care setting, based on the patient’s primary diagnosis. Expanding Medicare reimbursement over time to cover more frequent therapy may be critical to our market penetration and revenue growth in the future.

 

Our System One is produced through internal and outsourced manufacturing. We purchase many of the components and subassemblies included in the System One, as well as the disposable cartridges used in the System One, from third-party manufacturers, some of which are single source suppliers. In addition to outsourcing with third-party manufacturers, we assemble, package and label disposable cartridges in our leased facility in Lawrence, Massachusetts. NxStage GmbH & Co. KG, our wholly-owned German subsidiary, is the sole manufacturer of the dialyzing filter that is a component of the disposable cartridge used in the System One.

 

We market the System One through a direct sales force in the United States primarily to dialysis clinics and hospitals and we expect revenues to continue to increase in the near future. Our revenues were $3.4 million for the three months ended March 31, 2006, a 229% increase from revenues of $1.0 million in the three months ended March 31, 2005. We have increased the number of sales representatives in our combined sales force from 10 at March 31, 2005 to 20 at December 31, 2005, and to 25 at March 31, 2006. We expect to add additional sales and marketing personnel as needed for the remainder of 2006. As of March 31, 2006, 459 ESRD patients were using the System One at 97 dialysis clinics, compared to 82 ESRD patients at 19 dialysis clinics as of March 31, 2005, and compared to 292 ESRD patients at 70 dialysis clinics as of December 31, 2005. In addition, as of March 31, 2006, 54 hospitals were using the System One for critical care therapy, compared to 25 and 50 hospitals as of March 31, 2005 and December 31, 2005, respectively.

 

The following table sets forth the amount and percentage of revenues derived from each market for the periods indicated:

 

 

We have not been profitable since inception, and we expect to incur net losses for the foreseeable future as we expand our sales efforts and grow our operations. Our accumulated deficit at March 31, 2006 was $(93.3) million. Our goal is to increase our sales volume and revenues to gain scale of operation and to drive

product cost reductions, which we believe, when combined with other design improvements, will allow us to reach profitability. We expect our revenues in the chronic care market to increase faster than those in the critical care market and believe they will continue to represent the majority of our revenues.

 

Statement of Operations Components

 

Revenues

 

Our products consist of the NxStage System One cycler, an electromechanical device used to circulate the patient’s blood during therapy; a single-use, disposable cartridge, which contains a preattached dialyzer, and dialysate fluid used in our therapy, sold either in premixed bags or prepared with our PureFlow SL module. We distribute our products in two markets: the chronic care market and the critical care market. We define the chronic care market as the market devoted to the treatment of ESRD patients in the home and the critical care market as the market devoted to the treatment of hospital-based patients with acute kidney failure or fluid overload. We offer a different configuration of the System One for each market. The FDA has cleared both configurations for hemodialysis, hemofiltration and ultrafiltration. Our products may be used by our customers to treat patients suffering from either condition, although the site of care, the method of delivering care and the duration of care are sufficiently different that we have separate marketing and sales efforts dedicated to each market.

 

We derive our revenues from the sale and rental of equipment and the sale of the related disposable cartridges and treatment fluids. In the critical care market, we generally sell the System One and disposables to hospital customers. In the chronic care market, customers generally rent the machine and then purchase the related disposable cartridges and treatment fluids based on a specific patient prescription. We generally recognize revenues when a product has been delivered to our customer, or, in the chronic care market, on a monthly basis in accordance with a contract under which we supply the use of a cycler and the amount of disposables needed to perform a set number of dialysis therapy sessions during a month.

 

Our contracts with dialysis centers for ESRD patients include terms providing for the sale of disposable products to accommodate up to 26 treatments a month per patient and the monthly rental of a System One cycler with our PureFlow SL module. These contracts typically have a term of one year and are cancelable at any time by the dialysis clinic with 30 days’ notice. Under the contract, if home hemodialysis is prescribed, supplies are shipped directly to patient homes and paid for by the treating dialysis clinic. We also include vacation delivery terms, providing for the free shipment of products to a designated vacation destination. We derive an insignificant amount of revenues from the sale of ancillary products, such as extra lengths of tubing. We do not currently derive any revenues from service contracts. Over time, as more chronic patients are treated with the System One and more systems are placed in patient homes under monthly agreements that provide for the rental of the machine and the purchase of the related disposable cartridges and treatment fluids, we expect that a recurring revenue stream will become a meaningful component of our revenues.

 

Cost of Revenues

 

Cost of revenues consists primarily of direct product costs, including material and labor required to manufacture our products, depreciation and maintenance of System One cyclers that we rent to customers, production overhead and the cost of purchasing system components from vendors which we then resell to our customers. It also includes the cost of inspecting, servicing and repairing equipment prior to sale or during the warranty period and stock-based compensation. The cost of our products depends on several factors, including the efficiency of our manufacturing operations, the cost at which we can obtain products from third party suppliers and the design of the products.

 

We are currently operating at negative gross profit as we are building a base of recurring revenues. We expect the cost of revenues as a percentage of revenues to decline over time for two general reasons. First, we anticipate that increased sales volume will lead to better purchasing terms, prices and efficiencies in indirect manufacturing overhead costs. For example, during the three months ended March 31, 2006, we have transitioned our purchases of dialysate to a new lower cost vendor. Second, we have plans to introduce several

process and product design changes that have inherently lower cost than our current products. In addition, we plan to commercially launch the PureFlow SL module beginning in July 2006, which we believe will reduce our cost of revenues and distribution costs by reducing the volume of dialysate fluid that we currently manufacture and ship to customers. We expect that, over time, unit cost of revenues will become less than unit revenues as we expand the scale of our operations.

 

Operating Expenses

 

Research and Development.  Research and development expenses consist primarily of salary, benefits and stock-based compensation for research and development personnel, supplies, materials and expenses associated with product design and development, clinical studies, regulatory submissions, reporting and compliance and expenses incurred for outside consultants or firms who furnish services related to these activities. We expect research and development expenses will continue to increase in the foreseeable future as we seek to further enhance our System One and related products, but not as rapidly as other expense categories as we have substantially completed basic development of the System One.

 

Selling and Marketing.  Selling and marketing expenses consist primarily of salary, benefits and stock-based compensation for sales and marketing personnel, travel, promotional and marketing materials and other expenses associated with providing clinical training to our customers. Included in selling and marketing are the costs of clinical educators, usually nurses, we employ to teach our customers about our products and prepare our customers to instruct their patients in the operation of the System One. We anticipate that selling and marketing expenses will continue to increase as we broaden our marketing initiatives in the chronic care market to increase public awareness of the System One and as we add additional sales and marketing personnel.

 

Distribution.  Distribution expenses include salary, benefits and stock-based compensation for distribution personnel and the cost of delivering our products to our customers, or our customers’ patients, depending on the market and the specific agreement with our customers. We use common carriers and freight companies to deliver our products and we do not operate our own delivery service. Also included in this category are the expenses of shipping products from customers back to our service center for repair if the product is under warranty, and the related expense of shipping a replacement product back to our customers. We expect that distribution expenses will increase at a lower rate than revenues, due to expected efficiencies gained from increased business volume and the expected launch of our Pure Flow SL module.

 

General and Administrative.  General and administrative expenses consist primarily of salary and benefits and stock-based compensation for our executive management, legal, and finance and accounting staff, fees of outside legal counsel, fees for our annual audit and tax services, and general expenses to operate the business, including insurance and other corporate-related expenses. Rent and utilities are initially included in general and administrative expense and, within the same operating period are allocated to operating expenses based on personnel and square footage usage. We expect that general and administrative expenses will increase in the near term as we add support structure for our growing business.

Results of Operations

 

The following table presents, for the periods indicated, information expressed as a percentage of revenues. This information has been derived from our consolidated statements of operations included elsewhere in this prospectus. You should not draw any conclusions about our future results from the results of operations for any period.

 

 

Comparison of Three Months Ended March 31, 2005 to Three Months Ended March 31, 2006

 

Revenues

 

Our revenues for the three month periods ended March 31, 2005 and 2006 were as follows:

 

 

The increase in revenues was attributable to increased sales and rentals of the System One in both the critical care and chronic care markets, primarily as a result of increased sales and marketing efforts as we continue our commercial launch of the System One. Revenues in the chronic market increased to $1.8 million in the three months ended March 31, 2006 compared to $0.4 million in the three months ended March 31, 2005, an increase of 388%, while revenues in the critical care market increased 139% to $1.6 million in the three months ended March 31, 2006, compared to $0.7 million in the three months ended March 31, 2005.

Cost of Revenues and Gross Profit (Deficit)

 

 

The increase in absolute cost of revenues was attributable to our increased revenues. We added 167 net patients during the three months ended March 31, 2006 and 37 during the three months ended March 31, 2005, which resulted in a $2.2 million increase in cost of revenues. A 63% larger employee base resulted in additional salaries, health benefits and payroll taxes of $0.3 million during the three months ended March 31, 2006 compared to the same period in 2005. In addition, inbound freight costs to support our higher production volume increased $0.2 million during the first quarter of 2006 compared to the same period in 2005. We are currently operating at negative gross profit as we are building a base of recurring revenues. We expect the cost of revenues as a percentage of revenues to decline over time as increased sales volume should lead to better purchasing terms and prices, and efficiencies in indirect manufacturing overhead costs. We expect that over time unit cost of revenues will become less than unit revenues as we build the scale of our operations.

 

Research and Development

 

 

The increase in research and development expenses was attributable to increased salary, benefits and payroll taxes of $166,000 as a result of increased headcount, approximately $28,000 of stock-based compensation (no comparable charge in 2005) and $190,000 of development costs associated with our PureFlow SL module. We expect research and development expenses will continue to increase in the foreseeable future as we seek to further enhance our System One and related products, but not as rapidly as other expense categories as we have substantially completed basic development of the System One. We expect research and development expenses to continue to decline as a percentage of revenues.

 

Selling and Marketing

 

 

The increase in selling and marketing expenses was the result of several factors. Approximately $1.2 million of the increase was due to higher salary and benefits resulting from increased headcount, stock-based compensation amounted to $112,000 (no comparable charge in 2005), approximately $348,000 of the increase related to higher travel expenses and the balance of the increase was due to a general higher level of

sales and marketing activity in both the chronic and critical care markets. We increased our sales force from 10 sales representatives as of March 31, 2005, to 25 sales representatives as of March 31, 2006. We anticipate that selling and marketing expenses will continue to increase in absolute dollars as we broaden our marketing initiatives to increase public awareness of the System One in the chronic care market and as we add additional sales and marketing personnel.

 

Distribution

 

 

The increase in distribution expenses was due to increased volume of shipments of disposable products to a growing number of patients in the chronic care market. We expect that distribution expenses will increase at a lower rate than revenues in the later half of 2006 due to expected shipping efficiencies gained from increased business volume and density of customers, the reduction of higher cost deliveries associated with bagged fluid due to the commercial launch of our PureFlow SL module scheduled to begin in July 2006 and the use of an outsourced logistics provider located in the central part of the continental United States.

 

General and Administrative

 

 

The increase in general and administrative expenses was primarily due to an increase in salary and benefits as a result of the addition of three employees to headcount, approximately $342,000 of stock-based compensation recorded in the three months ended March 31, 2006 (no comparable charge in 2005), and approximately $392,000 of legal and corporate expenses incurred as a result of operating as a public company. We expect that general and administrative expenses will continue to increase in the near term as we add support structure for our growing business and as a result of costs related to operating a public company.

 

Interest Income and Interest Expense

 

Interest income is derived primarily from U.S. government securities, certificates of deposit, commercial paper and money market accounts. For the three months ended March 31, 2006, interest income increased to $595,000 from $72,000 in the same period in 2005 primarily due to increased cash and investment balances after our initial public offering and higher interest rates during the three months ended March 31, 2006.

 

Interest expense relates to a debt agreement signed in December 2004. Interest expense increased slightly from $146,000 to $158,000 in the three months ended March 31, 2006 compared to the three months ended March 31, 2005.

Comparison of Years Ended December 31, 2004 and 2005

 

Revenues

 

Our revenues for 2004 and 2005 were as follows:

 

 

The increase in revenues was attributable to increased sales and rentals of the System One in both the chronic and critical care markets, primarily as a result of increased sales and marketing efforts as we continue our commercial launch of the System One. Revenues in the chronic market increased to $3.2 million in 2005 from $0.6 million in 2004, an increase of 473%, while revenues in the critical care market increased 112% to $2.8 million in 2005, compared to $1.3 million in 2004.

 

Cost of Revenues and Gross Profit (Deficit)

 

 

The increase in cost of revenues was attributable to our increased revenues. Contributing to the 2005 negative gross margin was a lower of cost or market valuation allowance in the amount of $0.3 million relating to disposable cartridge and fluid inventory designated for the chronic market, as well as service costs of approximately $0.5 million to upgrade 100 older cyclers to meet the specifications of our current product generation. We are currently operating at negative gross profit as we are building a base of recurring revenues. We expect the cost of revenues as a percentage of revenues to decline over time as increased sales volume should lead to efficiencies in production, better purchasing terms and reduced material costs, and as we introduce product design changes to lower the manufacturing cost of our current products. We expect that over time unit cost of revenues will become less than unit revenues as we build the scale of our operations.

 

Research and Development

 

 

The increase in research and development expenses was attributable to increased salary and benefits of approximately $840,000 as a result of increased headcount and development costs associated with our PureFlow SL module, partially offset by a decrease of approximately $520,000 in clinical trial expenses due to the completion of the IDE home trial for System One in 2004. We expect research and development expenses will continue to increase in the foreseeable future as we seek to further enhance our System One and related products, but not as rapidly as other expense categories as we have substantially completed basic development of the System One. We expect research and development expenses to continue to decline as a percentage of revenues.

Selling and Marketing

 

 

The increase in selling and marketing expenses was the result of several factors. Approximately $2.7 million of the increase was due to higher salary and benefits resulting from increased headcount, approximately $0.8 million of the increase related to higher travel expenses and the balance of the increase was due to a generally higher level of sales and marketing activity in both the chronic and critical care markets. We increased our sales force from six sales representatives as of December 31, 2004, to 20 sales representatives as of December 31, 2005. We anticipate that selling and marketing expenses will continue to increase in absolute dollars as we broaden our marketing initiatives, particularly in the chronic market, to increase public awareness of the System One and as we add additional sales and marketing personnel.

 

Distribution

 

 

The increase in distribution expenses was due to increased volume of shipments of disposable products to a growing number of patients in the chronic market. We expect that distribution expenses will increase at a lower rate than revenues due to expected efficiencies from increased business volume and the use of an outsourced logistics provider located in the central part of the continental United States.

 

General and Administrative