Investing in our common
stock involves a high degree of risk. You should carefully consider the risks described below and the other information in this Quarterly Report on Form 10-Q. If any of such risks actually occur, our business, operating results or financial
condition could be adversely affected. In those cases, the trading price of our common stock could decline and you may lose all or part of your investment.
Risks Related to the Announcement and Pendency of Agreement to be Acquired
On
September 15, 2012, the Company, BGI, and the Purchaser entered into the Merger Agreement, pursuant to which BGI, through the Purchaser, has commenced the Offer to acquire all of the outstanding Shares for the Offer Price net to the selling
stockholders in cash, without interest. Following successful consummation of the Offer and satisfaction of certain conditions, the Merger will occur with the Company surviving as a wholly owned subsidiary of BGI.
In connection with the Merger Agreement, the Company, BGI and the Lender entered into the Note. As of September 30, 2012, pursuant to the terms of
the Note, the Company has drawn $6.0 million and may draw up to an aggregate principal amount of $30 million.
The announcement and pendency
of the Merger has adversely affected our business, due to customers and employees uncertainty and other disruptions as well as intensified competition from our competitors as they attempt to take advantage of the uncertainties. Some
employees have resigned, and it may be difficult to hire new employees due to the pendency of the Merger. In addition, we have incurred legal and other expenses in connection with the pending Merger. All of these factors are likely to continue to
adversely affect our business and have an adverse effect on our financial condition or results of operations.
Under the terms of the Merger
Agreement, we have agreed to operate our business in the ordinary course consistent with past practice, as well as to refrain from taking certain actions in the conduct of our business without BGIs prior written consent until the consummation
of the Merger. Actions that may require BGIs consent include, but are not limited to, new indebtedness, capital expenditures, loans and investments, certain agreements and issuance of securities. These restrictions could adversely affect our
business and could have an adverse effect on our financial condition or results of operations.
There is no assurance that the Offer will be
successful or the Merger will occur. If the Merger is not completed, the share price of our common stock could be negatively impacted to the extent that the current market price of our common stock reflects an assumption that the Merger will be
completed. In addition, any disruptions to our business resulting from the announcement and pendency of the Merger could continue in the event the Merger is not completed. Moreover, under certain circumstances BGI is not required to continue funding
the Company under the Note and we will continue to be obligated to repay amounts drawn under the Note pursuant to the terms of the Note. Since restrictions in the Merger Agreement prevent the Company from securing other financing (equity- or
debt-based) during the pendency of the Merger, if the Merger is not completed it will be very difficult for the Company to secure other financing in a timely manner.
Risks Related to Our Limited Operating History, Financial Condition and Capital Requirements
Without continued funding from BGI, we would not have sufficient cash to fund our operations to January 31, 2013.
Without continued funding from BGI under the Note, as described above, based on the current level of our operations, cash and cash equivalents balances,
including interest income the Company will earn on these balances, would not be sufficient to meet the Companys anticipated cash requirements beyond January 31, 2013. If the Merger does not occur, we may be required to significantly
reduce, restructure or cease operations. The Companys recurring operating losses and negative cash flow from operations and its requirement for additional funding to execute its business objectives beyond this period gives rise to substantial
doubt as to the Companys ability to continue as a going concern absent the funding from BGI under the Note.
We are an early,
commercial-stage company and have a limited operating history, which may make it difficult to evaluate our current business and predict our future performance.
We are an early, commercial-stage company and have a limited operating history. We were incorporated in Delaware in June 2005 and began operations in March 2006. From March 2006 until mid-2009, our
operations focused on research and development of our DNA sequencing technology platform. Our revenue for the nine months ended September 30, 2012 and 2011 was $19.9 million and $16.9 million, respectively. Our limited operating history,
particularly in light of our novel, service-based business model in the rapidly evolving genome sequencing industry, make it difficult to evaluate our current business and predict our future performance. Our lack of a long operating history, and
especially our very short history as a revenue-generating company, make any assessment of our profitability or prediction about our future success or viability subject to significant uncertainty. We have encountered and will continue to encounter
risks and difficulties frequently experienced by early, commercial-stage companies in rapidly evolving industries. If we do not address these risks successfully, our business will suffer.
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On June 5, 2012, we announced a restructuring plan under which we are delaying sequencing capacity
expansion, deferring certain capital expenditures, eliminated approximately 55 employee positions, terminated one of our building leases and shifting our focus from sequencing for research customers to sequencing for clinical customers. Among other
risks, this restructuring as well as the announced Merger Agreement could impact our ability to retain employees and secure new customers or maintain current or obtain anticipated orders for sequencing services from existing customers.
We will require substantial additional funding and may be unable to raise capital when needed, which could force us to delay, reduce or cancel
certain business objectives or we may be unable to continue as a going concern.
Our capital requirements are substantial, particularly
as we further develop our business, eventually resume expansion of sample preparation, sequencing and computing capacities in our Mountain View and Santa Clara, California facilities. Our business model requires us to make significant research and
development investments in many areas including sample preparation, sequencing, and bioinformatics. Historically, we have financed our operations through private placements of preferred stock, convertible debt, borrowings under our credit facility,
secured debt and through public offerings of our common stock.
The amount of additional capital and timing at which we require the additional
capital necessary to fund our operations and expand our business depends on many factors, including:
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the financial success of our genome sequencing business;
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the average selling price per genome at which we are able to sell our whole genome sequencing services;
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whether repayment of our term loan(s) is accelerated if an event of default occurs;
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whether we are successful in obtaining payments from customers;
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whether we can establish a recurring customer base, in particular with clinical customers;
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the progress and scope of our research and development projects;
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our progress in obtaining a federal CLIA license to operate a clinical laboratory;
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the filing, prosecution and enforcement of patent claims; and
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the costs associated with our current litigation with Illumina, Inc. and any other litigation.
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Our term loans contain restrictions that limit our flexibility in operating our business and provisions that enable the lenders to accelerate
repayment of the outstanding amounts in the event of default.
Our term loans with Oxford and ATEL contain various covenants that limit
our ability to engage in specified types of transactions. These covenants limit our ability to, among other things:
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sell, transfer, lease or dispose of our assets;
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create, incur or assume additional indebtedness;
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encumber or permit liens on certain of our assets;
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make restricted payments, including paying dividends on, repurchasing or making distributions with respect to our common stock;
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make specified investments (including loans and advances);
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consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and
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enter into certain transactions with our affiliates.
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A breach of any of these covenants or a material adverse change to our business could result in a default under either or both of our term loans. In addition, our term loan with Oxford provides that an
event of default will occur, among other instances, if there is a material adverse change in our business, operations or condition (financial or otherwise) or if there is a material impairment in the prospects of us repaying any portion of our
obligations under the term loan. These provisions are inherently subjective in nature. If we fail to raise additional capital in a timely manner, an event of default could occur under our term loan with Oxford. Upon the occurrence of an event of
default under either of our term loans, both Oxford and ATEL could elect to declare all amounts outstanding to be immediately due and payable and terminate all commitments to extend further credit. If we were unable to repay those amounts, the
lenders could proceed against the collateral granted to them to secure such indebtedness. We have pledged substantially all of our assets, other than our intellectual property, as collateral under the term loans.
In addition, in connection with the Note entered into in connection with the Merger Agreement, Oxford and the Company agreed to amend the Oxford Loan
Agreement, whereby the Company agreed to, after the Company borrows under the Note, maintain a minimum liquidity ratio covenant. The ratio requires the Company to maintain a cash and cash equivalents balance equal to at least 90% of the outstanding
indebtedness owed to Oxford and ATEL. Failure to comply with the minimum liquidity covenant will be an event of default under the Oxford Loan Agreement and if uncured will result in an event of default under the Atel Loan Agreement.
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We have a history of losses, and we may not achieve or sustain profitability in the future, on a
quarterly or annual basis.
We have not been profitable in any annual or quarterly period since we were formed. We incurred net losses
of $57.0 million and $50.0 million for the nine months ended September 30, 2012 and 2011, respectively. As of September 30, 2012, our accumulated deficit was $268.2 million. Based on our current operating plans and assumptions, we do
not expect to achieve profitability in the near future. In addition, we expect our cash expenditures to remain significant in the near term, including expenditures for the shift and acceleration toward serving clinical customers, and eventually the
expansion of our sample preparation, sequencing and computing capabilities, research and development, sales and marketing and general and administrative expenses relating to that strategic shift. We may encounter unforeseen difficulties,
complications and delays in our existing sequencing facility and other unforeseen factors that require additional expenditures. These costs, among other factors, have had and will continue to have an adverse effect on our working capital and
stockholders equity. We will have to generate and sustain substantially increased revenue to achieve and maintain profitability, which we may never do. If we are unable to achieve and then maintain profitability, the market value of our common
stock will decline.
Our operating results may fluctuate in the future. As a result, we may fail to meet or exceed the expectations of
research analysts or investors, which could cause our stock price to decline.
Our financial condition and operating results may
fluctuate from quarter to quarter and year to year in the future due to a variety of factors, many of which are beyond our control. Factors relating to our business that may contribute to these fluctuations include the following, as well as other
factors described elsewhere in this Quarterly Report:
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our ability to achieve profitability;
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our need for and ability to obtain the capital necessary to operate and shift and expand our business for clinical applications;
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the timing of our receipt of customer samples;
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the size and frequency of customer orders;
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our ability to lower the average cost per genome that we sequence;
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the average selling price we charge our customers for sequencing genomes;
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the presence or absence in a specific quarter of one or more new large orders;
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our ability to expand our sample preparation, sequencing and computing operations, in particular if we see growth in demand from clinical customers;
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our ability to obtain and maintain our license to operate as a CLIA laboratory;
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the demand for the sequencing of complete human genomes, from both research customers and clinical customers;
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the existence and extent of government funding for research and development relating to genome sequencing;
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the emergence of alternative genome sequencing technologies;
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the emergence and rate of growth in demand for genome sequencing for clinical applications;
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risks associated with expanding our business into international markets;
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our dependence on sole- or single-source suppliers;
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our ability to manage our growth;
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our ability to successfully partner with other businesses in joint ventures or collaborations;
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our dependence on, and our need to attract and retain, key management and qualified sales personnel;
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our ability to obtain, protect and enforce our intellectual property rights and avoid infringing the intellectual property rights of others;
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our ability to prevent the theft or misappropriation of our know-how or technologies;
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lawsuits brought against us by third parties;
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business interruptions, such as earthquakes and other natural disasters;
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public concerns about the ethical, legal and social concerns related to the use of genetic information;
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our ability to comply with current laws and regulations and new or expanded regulatory schemes;
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our ability to properly handle and dispose of hazardous materials used in our business and biological waste; and
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our ability to use our net operating loss carryforwards to offset future taxable income.
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Due to the various factors mentioned above, and others, the results of any prior quarterly or annual periods are not necessarily indicative of our future
operating performance.
Our independent registered public accounting firm has included an explanatory paragraph relating to our ability
to continue as a going concern in its report on our audited financial statements included in our last Annual Report.
The report from
our independent registered public accounting firm dated March 8, 2012 for the year ended December 31, 2011 includes an explanatory paragraph stating that our recurring losses from operations and significant negative cash flow from
operations raise substantial doubt about our ability to continue as a going concern. If we are unable to obtain sufficient funding, our business, financial condition and results of operations will be materially and adversely affected and we may be
unable to continue as a going concern. If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our consolidated financial statements, and it is
likely that investors will lose all or a part of their investment.
Risks Related to Our Business
We may experience delays or incur significant expenses in obtaining and maintaining certification under the Clinical Laboratory Improvement
Amendments of 1988.
We are seeking CLIA certification. CLIA, which extends federal oversight over clinical laboratories by requiring
that they be certified by the federal government or by a federally approved accreditation agency, is designed to ensure the quality and reliability of clinical laboratories by mandating specific standards in the areas of personnel qualifications,
administration and participation in proficiency testing, patient test management, quality control, quality assurance and inspections. In order to obtain and maintain CLIA certification, we have expended, and will be required to continue to expend,
time, money and effort to ensure that we meet the applicable quality and safety requirements. In addition, it may take us longer and/or require us to spend considerably more than planned resources to obtain and maintain CLIA certification.
CLIA certification will be based on our own laboratory developed test (LDT) as currently defined by the FDA. The FDA could change
its regulations on LDTs, which could impact our ability to operate a CLIA-certified laboratory.
There is no guarantee that we will obtain
CLIA certification, within the timeframe we expect or at all. Without CLIA certification, we will not able to provide sequencing services to customers that require genomic data from a CLIA-certified laboratory for clinical applications. Obtaining
CLIA certification and providing genomic data for clinical uses is key to our business strategy.
Our only source of revenue is our
human genome sequencing service, which is a new business model in an emerging industry, and failure to achieve market acceptance will harm our business.
Since our inception, all of our efforts have been focused on the creation of a technology platform for our human genome sequencing service, which we commercialized in May 2010. We expect to generate all
of our revenue from our human genome sequencing service for the foreseeable future. As a result, market acceptance of our human genome sequencing service is critical to our future success.
Providing genome sequencing as a service is a new and unproven business model in a relatively new and rapidly evolving industry. We are using proprietary technology, involving multiple scientific and
engineering disciplines, and a novel service model to bring complete human genome sequencing to an unproven market. We incur considerable research and development and general and administrative expenses in providing our services to our customers
and, hence, our revenues will have to grow many fold before we can achieve profitability.
Historically, companies in this industry have sold
sequencing instruments directly to customers, and the customer performs the sequencing itself. We do not know if the purchasers and users of sequencing instruments will adopt our service model. For example, many potential customers want to sequence
human genomes for proprietary studies that may lead to discoveries that they would seek to exploit, either commercially or through the publication of scientific literature. Accordingly, these potential customers may have significant reservations
about allowing a third party to control the sequencing processes for their proprietary studies. Alternatively, other potential customers may want to sequence only portions of human genomes, such as exomes, rather than complete human genomes. There
are many reasons why our services might not become widely adopted, ranging from logistical or quality problems to a failure by our sales force to engage potential customers, and including the other reasons stated in this Risk Factors
section. As a result, our genome sequencing service may not achieve sufficient market acceptance to allow us to become profitable.
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Our success depends on the growth in demand for analysis of genetic variation and biological function,
and the shift and growth in demand to whole human genome sequencing.
We are currently serving customers for our genome sequencing
service in academic centers, medical research centers, government research institutions, biopharmaceutical companies and health care organizations. These customers are using our service for small- and large-scale human genome studies for a wide
variety of diagnostic and discovery applications. We are seeking to shift our focus to clinical customers who would use genome sequencing to diagnose and to determine treatments for diseases.
These customers and applications are new and emerging, and they may not develop as quickly as we anticipate, or reach their full potential. Our success depends on the demand of whole human genome
sequencing increasing substantially from its current levels. The development of demand for whole human genome sequencing and the success of our service depend in part on the following factors:
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demand from researchers for whole human genome sequencing;
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demand from clinicians for whole human genome sequencing;
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the usefulness and cost effectiveness of genomic data in preventing, identifying or treating disease;
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the willingness of third-party payers (such as insurance companies and Medicare) to reimburse for whole human genome sequencing in clinical
applications;
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the ability of our customers to successfully analyze the genomic data we provide;
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the ability of researchers and clinicians to convert genomic data into medically valuable information;
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the capacity and scalability of the hardware storage components necessary to store, manage, backup, retain and safeguard genomic data;
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the development of software tools, such as bioinformatics systems, to efficiently search, correlate and manage genomic data to assist our customers in
effectively analyzing the genomic data we provide; and
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competitive product offerings.
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For instance, demand for our genome sequencing service may develop slowly or decrease if researchers and clinicians are unable to effectively use and ultimately analyze the large amounts of genomic data
from a whole human genome or if they fail to find meaningful correlations between genetic variation and disease susceptibility through whole human genome studies. In February 2012, our Genomic Discovery Partners Program was launched to facilitate
the analysis of large amounts of genomic data. This program is a partnership with other analysis software providers whose analysis tools are compatible with our analysis tools. We cannot be certain this program will be successful. In addition,
factors affecting research and development spending generally, such as changes in the regulatory environment affecting biopharmaceutical and other healthcare organizations and changes in government programs that provide funding to companies and
research institutions, could harm our business. If our target markets do not develop in a timely manner, demand for our service may grow at a slower rate than we expect, or may fall, and we may not achieve profitability.
To date, relatively few whole human genomes have been sequenced, in large part due to the high cost of large-scale sequencing. Our business plan assumes
that the demand for sequencing whole human genomes will increase significantly as the cost of whole human genome sequencing decreases. This assumption may prove to be incorrect, or the increase in demand may take significantly more time than we
anticipate. For example, potential customers may not think our cost reductions are sufficient to permit or justify large-scale sequencing. Moreover, some companies and institutions have focused on sequencing targeted areas of the genome that are
believed to be primarily associated with disorders and diseases, as opposed to the entire genome. Demand for sequencing whole human genomes may not increase if these targeted sequencing strategies, such as exome sequencing, where selected regions
containing key portions of genes are sequenced, prove to be more cost effective or are viewed as a more efficient method of genetic analysis than whole human genome sequencing. Since exome sequencing is significantly less expensive than the
sequencing of an entire human genome, customers, including those with limited budgets, may choose to sequence exomes instead of whole human genomes.
In addition, to date, reimbursement by third-party payers (such as insurance companies and Medicare) for whole genome sequencing for clinical purposes is rare. The cost-effectiveness of genome sequencing
for the diagnosis and treatment planning for diseases is still being questioned. This is currently limiting demand for genome sequencing for clinical purposes.
In addition, customers of whole genome sequencing services have a number of service options available to them. For us to succeed, our customers will need to find our service alternative superior to
services offered by our competitors.
We must eventually significantly increase our production capabilities in order to achieve
profitability.
We have limited experience in running a commercial-scale production facility. We have only one sequencing facility,
which at present has the capacity to sequence approximately 1,000 complete human genomes per month. This capacity is significantly less than what would be required to achieve profitability. Our long-term business plan assumes that we will be able to
increase our capacity multiple fold.
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We plan to eventually increase the capacity of our sequencing facility by increasing our sample preparation
capacity, upgrading our existing sequencers, installing additional sequencers, improving our software and designing and installing newer generations of sequencing instruments that are currently under research and development. We may also eventually
construct satellite genome sequencing centers in the United States and elsewhere in the future. We may encounter difficulties in expanding our sequencing infrastructure, and we may not be able to build and improve this infrastructure in time to meet
the volume, quality or timing requirements necessary to be successful. Manufacturing and supply quality issues may arise, including issues due to third parties who provide the components of our technology platform. We are designing our next
generation of sequencers that are targeted to be faster than our current sequencers. We may experience technical difficulties that may cause substantial delays and as a result hamper our efforts to achieve a significant increase in our capacity. As
our sequencing capacity and demand for our sequencing services increases, we will be required to scale up our sample and library preparation capacity. We encountered delays and difficulties in scaling up our sample and library preparation capacity
in the second half of 2011. We may also encounter delays or difficulties in our future sample and library expansion efforts. Generally, implementing improvements to our sequencing technology may involve significant changes that may result in
delays, or may not achieve expected results. For example, we are experimenting with improved library construction processes and with advanced fluidics for our sequencing platform. These experiments may be unsuccessful and may not lead to feasible
technological improvements that increase the capacity or reduce the costs of our sequencing services. If capacity or cost limitations prevent us from meeting our customers expectations, we will lose revenue and our potential customers may take
their business to our competitors.
Our need to increase capacity will eventually require us to upgrade our machines to enhance our current
production process. This may render our current machines obsolete sooner than anticipated. If this occurs, the value of these machines could be impaired and we may need to write down the value of this equipment, which could have a material impact on
our financial statements.
We also plan to continue our efforts to reduce our turn-around time. We have a number of projects underway to do
so. However, there can be no assurance that we will be successful in these efforts. In addition, from time to time, our turn-around time may increase if we encounter any operator or process failures, if we have to resequence genomes, or if our
capacity does not keep up with our backlog. Failure to improve our turn-around time may cause us to lose existing or prospective orders.
Reduction or delay in research and development budgets and government funding may adversely impact our sales.
We expect that for the immediate future, our revenue will be derived primarily from selling our genome sequencing service to a relatively small number of
academic, governmental and other research institutions, as well as biopharmaceutical and healthcare organizations. Our revenue may decline substantially due to reductions and delays in research and development expenditures by these customers, which
depend, in part, on their budgets and the availability of government funding. Factors that could affect the spending levels of our customers include:
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weakness in the global economy and changing market conditions that affect our customers;
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changes in the extent to which the pharmaceutical and life science industry may use genetic information and genetic testing as a methodology for drug
discovery and development;
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changes in government programs that provide funding to companies and research institutions;
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changes in the regulatory environment affecting biopharmaceutical and life science companies and research and medical institutions;
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impact of consolidation within the biopharmaceutical and life science industry; and
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cost-reduction initiatives of customers.
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Also, government funding of research and development is subject to the political process, which is inherently unpredictable. Any reduction in the funding of life science research and development or delay
surrounding the approval of government budget proposals may cause our customers to delay or forgo purchases of our services. For example, uncertainty regarding the size of the U.S. governments 2012 -2013 budget for the National Institute of
Health, or NIH, and related agencies may cause our customers to slow or delay purchases of our services. In addition, it is unclear what will happen to demand for our services after the stimulus funds provided pursuant to the American Recovery and
Reinvestment Act of 2009 have been allocated and fully spent, or due to the impact of sequestration under the Budget Control Act of 2011. A reduction or delay in demand for our service, due to a reduction in government funding, will
adversely affect our ability to achieve profitability.
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The presence or absence in a specific quarter of one or more new large orders, our ability to process
orders or the cancellation of previous orders, may cause our results of operations and backlog to fluctuate significantly on a quarterly basis.
Since beginning commercial operations, we have received purchase orders or contracts from a growing but limited number of customers each quarter. Historically, the size of each purchase order has
fluctuated between a few genomes and multiple hundreds of genomes. As a result, the presence or absence in a specific quarter of one or more new large orders, delays in our ability to process large orders or the cancellation of previous orders,
combined with our uncertain sales cycle and changes in the variables that influence conversion of orders into revenue, may cause our results of operations and our backlog to fluctuate on a quarterly basis. These fluctuations may be significant from
one quarter to the next. In addition, our limited commercial history and the characteristic of our quarterly orders make it very difficult to predict or forecast our future operating results and backlog.
If we are not successful in reducing the average cost of our sequencing service, demand for our services, as well as our ability to achieve
profitability, will suffer.
Our ability to expand our customer base depends largely on our ability to reduce the average cost of
sequencing a human genome. For example, certain academic or government-sponsored research organizations may forgo or delay whole genome-wide studies based on the cost required to sequence complete human genomes, in favor of other less expensive
studies, including targeted sequencing strategies such as exome sequencing. Additionally, certain of our target customers may decide it is more cost-effective to purchase sequencing instruments from a competitor than contract for our sequencing
service or may choose to outsource their sequencing projects to another service provider. To compete effectively with competitors who sell and market sequencing instruments or provide sequencing services, our service must provide cost advantages,
superior quality and time savings.
In addition, we have significantly reduced the price of our complete human genome sequencing services over
the past year. This reduction in price has been driven in part by competitive pricing pressure. As our competitors reduce the price of their sequencing services, or as new competitors enter the market or expand their business model to include
sequencing services, we expect increased pricing pressure, which may force us to further decrease the price of our genome sequencing service. Our gross profit and operating results will suffer if we are unable to offset any reductions in our prices
by reductions in our costs through developing new or enhanced technologies or methods, or increasing our sales volumes.
We face
significant competition. Our failure to compete effectively could adversely affect our sales and results of operations.
We currently
compete with companies that develop, manufacture and market genome sequencing instruments or provide genome sequencing services. We expect competition to increase as our competitors develop new, improved or cheaper instruments or expand their
businesses to include sequencing services, and as new companies enter the market with innovative technologies.
The genome sequencing industry
is highly competitive and is served by several large companies with significant competitive positions. For example, established companies such as Illumina, Inc., Life Technologies Corporation and Roche Diagnostics Corporation are marketing
instruments for genetic sequencing that impact demand for our services, and these companies have significantly greater financial, technical, marketing and other resources than we do to invest in new technologies and have substantial intellectual
property portfolios and substantial experience in product development and regulatory expertise. Also, many other companies, such as NABsys, Inc., Oxford Nanopore Technologies, Ltd., Pacific Biosciences, Inc. and Perkin Elmer Corporation, have
developed or are developing sequencing technologies or services that would compete with ours. Moreover, large established companies may acquire smaller companies with emerging technologies and use their extensive resources to develop and
commercialize such technologies or incorporate such technologies into their instruments and services. For example, in 2010, Life Technologies acquired Ion Torrent Systems, Inc., a chip-based sequencing technology company, and in September 2012,
announced that the sequencing platform acquired from Ion Torrent may be able to sequence a genome for $1,000, in less than one day, in 2013
In addition, many research, academic and other non-profit institutions are pursuing new sequencing technologies. These institutions often have access to
significant government and other funding. For example, BGI (formerly known as Beijing Genomics Institute) in the Peoples Republic of China offers a service similar to ours and may receive funding from the government of China. In the United
States, agencies such as the National Human Genome Research Institute provide funding to institutions to discover new sequencing technology and to optimize use of sequencing technology developed and sold by competing sequencing instrument suppliers.
We may compete directly with these institutions, or these institutions may license their technologies to third parties with whom we would compete.
While many of our existing competitors primarily sell sequencing instruments, they may also provide sequencing services like us. Since these competitors have already developed their own sequencing
technology, they will not experience significant technological barriers to entry and can likely enter the sequencing services market fairly quickly and with little additional cost. For example, Illumina began providing whole genome sequencing
services in-house and through its Illumina Genome Network. Furthermore, many of these instrumentation companies have already established a significant market presence, have large cash balances and/or positive balances from their current businesses,
and are trusted by customers in the industry. As established instrumentation companies offer sequencing services, many potential customers may purchase sequencing services from these companies instead of us, even if we offer superior technology and
services.
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In addition to commercial companies, there are large, government-funded or research-sponsored organizations,
such as the Broad Institute of MIT and Harvard, the Genome Center at Washington University, the Baylor College of Medicine Human Genome Sequencing Center, the Wellcome Trust Sanger Institute and BGI, that purchase commercial DNA sequencing
instruments and offer DNA sequencing services to academic and commercial customers.
Our order backlog may never be completed, and we
may never earn revenue on backlogged contracts to sequence genomes. In addition, the timing of the conversion of our order backlog into revenue is dependent on the timing of receipt of samples from our customers.
As of September 30, 2012, we had a backlog of orders for sequencing approximately 3,800 genomes, which we believe could contribute approximately
$18.0 million toward revenue over the next 12 months. This figure represents the number of genomes for which customers have placed orders or entered into contracts with volume estimates that we believe are firm and for which we have not yet
recognized revenue. We may not be able to convert order backlog into revenue at the rate or times we anticipate, or at all. Consequently, the order backlog we report in this Form 10-Q and elsewhere from time to time may not be indicative of
future revenue.
We may fail to complete backlog orders as we expect for many reasons. We may experience sequencing delays or customers may
delay providing samples for sequencing or might reduce or cancel orders. We have in the past experienced growing backlog due to our inability to keep pace with new orders, operational challenges in implementing new equipment and procedures, delays
in processing orders and in some cases due to lack of timely arrival of samples. Delays in sequencing for lack of capacity, lack of samples, or for any other reason could cause backlog orders to be delayed or even cancelled by customers, which has
happened on occasion. Even with sufficient throughput capacity, we are not always in control of the rate at which we complete orders and therefore convert backlog to revenue. For example, customers often place orders with us before providing us with
genomic samples, delaying our start of the sequencing process by weeks or months. A delay in receiving samples, particularly from a large order, may cause our results of operations to fluctuate significantly from one quarter to the next.
Additionally, once we receive a customers samples, we test them to assure that they are of sufficient quality and quantity for sequencing. If a sample fails this test, we contact the customer and request additional samples, resulting in
further delay. Also, customers may negotiate a period of time, measured in weeks or in some cases months, to accept or reject our sequencing reports once delivered. Customer acceptance in these instances is a prerequisite for recording revenue for
those orders. For these reasons, you should use caution in adopting changes in, or the absolute amount of, our backlog as a measure for market acceptance of our sequencing services or as an indicator of future revenue.
The emergence of competitive genome sequencing technologies may harm our business.
The success of our genome sequencing services will depend, in part, on our ability to continue to enhance the performance and decrease the cost of our genome sequencing technology. A number of genome
sequencing technologies exist, and new methods and improvement to existing methods are currently being developed, including technology platforms developed by companies that we expect will directly compete with us as providers of sequencing services
or instruments. These new technologies may result in faster, more cost-effective and more accurate sequencing methods than ours. For example, our sequencing technology does not currently cover all of the nucleotides in the genome. If competitive
technologies emerge that sequence portions of the genome that our technology does not, our business could suffer if those portions contain important genomic information. We face competition from a number of companies, including NABsys, Oxford
Nanopore Technologies and Pacific Biosciences, as well as from established companies such as Illumina, Inc., Life Technologies Corporation and Roche Diagnostics Corporation. As a result of the emergence of these competitive sequencing technologies,
demand for our service may decline or never develop sufficiently to sustain our operations.
Our industry is rapidly changing, with emerging
and continually evolving technologies that increase the efficiency and reduce the cost of sequencing genomes. As new technologies emerge, we believe that the cost and error rates of, and the time required to, sequence human genomes will eventually
decrease to a level where competition in the industry will shift to other factors, such as providing related services and analytical technologies. We may not be able to maintain any technological advantage over these new sequencing technologies, and
if we fail to compete effectively on other factors relevant to our customers, our business will suffer.
Our genome sequencing
technology platform was developed for human DNA and is not currently optimized to sequence non-human DNA.
Our technology platform was
developed and has been optimized for sequencing human DNA, and we do not intend to sequence non-human DNA. We face significant competition from established companies that sell genome sequencing instruments that can sequence both human and non-human
DNA. Many of the academic and research institutions that are our target customers conduct studies on both human and non-human DNA. Prospective customers may choose to purchase sequencing instruments rather than services from us because of their
broader sequencing application. Our competitors may also choose to provide sequencing services for non-human DNA. As a result, there may not be sufficient demand for our human genome sequencing service, which will harm our business.
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We depend on a limited number of suppliers, including single-source suppliers, of various critical
components for our sequencing process. The loss of these suppliers, or their failure to supply us with the necessary components on a timely basis, could cause delays in the current and future capacity of our sequencing center and adversely affect
our business.
We depend on a limited number of suppliers, including some sole- and single-source suppliers, of various critical
components for our sequencing process. We do not have long-term contracts with our suppliers or service providers. Because we do not have long-term contracts, our suppliers generally are not required to provide us with any guaranteed minimum
production levels. As a result, we may not be able to obtain sufficient quantities of critical components in the future.
Although alternative
suppliers exist for each of the critical components of our sequencing process, that process has been designed around the functions, limitations, features and specifications of the components that we currently utilize. If we are required to integrate
new components into future sequencers, we would experience a delay in the deployment of these sequencers, and, as a result, our efforts to expand our sequencing capacity would be delayed.
A delay or interruption by our suppliers may also harm our business. For example, the wafers that comprise the base of our sample slide are fabricated by SVTC Technologies, L.L.C. SVTC Technologies
recently closed operations. We have not yet qualified an alternative source for the supply of these wafers, which are critical to our sequencing process, and the custom manner in which these wafers are made may make it difficult to qualify other
semiconductor suppliers to manufacture them for us. We believe we have built sufficient inventory of these wafers to take us through the period before we qualify a new supplier. However, if the stock that we have built is faulty or it takes it
longer than anticipated to qualify a new supplier our business can be adversely impacted. Similarly, an interruption of services by Amazon Web Services, on whom we rely to deliver finished genomic data to our customers, could result in our customers
not receiving their data on time.
In addition, the lead time needed to establish a relationship with a new supplier can be lengthy, and we
may experience delays in meeting demand in the event we must switch to a new supplier. The time and effort to qualify a new supplier could result in additional costs, diversion of resources or reduced manufacturing yields, any of which would
negatively impact our operating results. Our dependence on single-source suppliers exposes us to numerous risks, including the following:
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our suppliers may cease or reduce production or deliveries, raise prices or renegotiate terms;
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delays by our suppliers could significantly limit our ability to sequence customer data and delay our efforts to increase our sequencing capacity;
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quality issues that may not be immediately detected by our quality assurance team may arise causing disruption or delay in our operations;
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we may be unable to locate a suitable replacement on acceptable terms or on a timely basis, if at all; and
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delays caused by supply issues may harm our reputation, frustrate our customers and cause them to turn to our competitors for future projects.
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If our Mountain View genome sequencing facility becomes inoperable, we will be unable to perform our genome
sequencing services and our business will be harmed.
We currently do not have redundant sequencing facilities on a scale that could
support our business. We perform all of our commercial genome sequencing in our facility located in Mountain View, California. Mountain View is situated on or near earthquake fault lines. Our facility, the equipment we use to perform our sequencing
services and our other business process systems are costly to replace and could require substantial time to repair or replace. The facility may be harmed or rendered inoperable by natural or man-made disasters, including earthquakes, wildfires,
floods, acts of terrorism or other criminal activities, infectious disease outbreaks and power outages, which may render it difficult or impossible for us to sequence genomes for some period of time. In addition, these events may temporarily
interrupt our ability to receive samples from our customers or materials from our suppliers and our access to our various systems necessary to operate our business. The inability to perform our sequencing service would result in the loss of
customers and harm our reputation. We do not currently have insurance coverage for damage arising from an earthquake. Our insurance covering damage to our property may not be sufficient to cover all of our potential losses and will not cover us in
the event of an earthquake, and may not continue to be available to us on acceptable terms, or at all.
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Failure to achieve expected sequencing process yields, or variability in our sequencing process
yields, could harm our operating results and damage our reputation.
Our sequencing process, like any other commercial-scale production
process, is not flawless. For example, our DNBs may not adhere to all of the sticky spots on the surface of the silicon wafers we use to sequence DNA, or parts of the wafers may be unreadable. We refer to the efficiency of our sequencing
process as its yield. The sequencing process yields we achieve depend on the design and operation of our sequencing process, which uses a number of complex and sophisticated biochemical, informatics, optical and mechanical processes, many of which
are highly sensitive to external factors. An operational or technology failure in one of these complex processes or fluctuations in external variables may result in sequencing processing yields that are lower than we anticipate or that vary
between sequencing runs. In addition, we are regularly evaluating and refining our sequencing process. These refinements may initially result in unanticipated issues that further reduce our sequencing process yields or increase the
variability of our sequencing yields. Low sequencing yields, or higher than anticipated variability, increases total sequencing costs and reduces the number of genomes we can sequence in a given time period, which can cause variability in our
operating results and damage our reputation.
We may have to resequence genomes due to contamination of DNA samples or other failures in
the sequencing process.
In the past, we have had to resequence various genome samples as a result of DNA samples that are degraded,
improperly prepared or contaminated when we receive them, or as a result of contamination or other failures in the sample preparation and library construction process. The sequencing process is highly sensitive, and the presence of any foreign
substances or variances in external factors, such as heat or moisture, during the preparation of the slide samples can corrupt the results of the sequencing process. The quality of our sequencing runs may also vary for other reasons. As we continue
to refine the efficiency of our sequencing process, we may modify the protocols in various stages of the sequencing process, which may have unintended consequences requiring us to further modify the protocols and/or resequence genomes samples.
Resequencing requires additional expense, time and capacity and delays the delivery of data and the recognition of revenue from the service. Samples may be contaminated in the future or the quality of our sequencing results may vary, which may
damage our reputation and decrease the demand for our service.
Mishandling or switching of DNA samples or genomic data may harm our
reputation and result in litigation against us.
We may unintentionally mishandle DNA samples. For example, if customer samples or
sequencing results are switched, our customers would receive the wrong sequencing data, which could have significant consequences, particularly if that data is used to diagnose or treat disease. Mishandling customer samples or data could lead to
loss of current or future business, harm our reputation and result in litigation against us.
Ethical, legal and social concerns related
to the use of genetic information could reduce demand for our genome sequencing services.
Our genome sequencing services are intended
to facilitate large-scale human genome studies for a wide variety of diagnostic and discovery applications. However, genetic testing has raised ethical, legal and social issues regarding privacy and the appropriate uses of the resulting information.
Governmental authorities could, for social or other purposes, limit or regulate the use of genetic testing or prohibit testing for genetic predisposition to certain conditions, particularly for those that have no known cure. Similarly, these
concerns may lead individuals to refuse to use genetics tests even if permissible.
In addition, we do not control how our customers use the
genomic data we provide. In most cases, we do not know the identity of the individuals whose DNA we sequence, the reason why their DNA is being sequenced or the intended use of the genomic data we provide. If our customers use our services or the
resulting genomic data irresponsibly or in violation of legal restrictions, our reputation could be harmed and litigation could be brought against us.
Ethical and social concerns may also influence U.S. and foreign patent offices and courts with regard to patent protection for technology relevant to our business. These and other ethical, legal and
social concerns may limit market acceptance of our technology for certain applications or reduce the potential demand for our technology, either of which could have an adverse effect on our business, financial condition or results of operations.
We use biological and hazardous materials that require considerable expertise and expense for handling, storage and disposal and may
result in claims against us.
We work with materials, including chemicals, biological agents and compounds and DNA samples that could
be hazardous to human health and safety or the environment. Our operations also produce hazardous and biological waste products. Federal, state and local laws and regulations govern the use, generation, manufacture, storage, handling and disposal of
these materials and wastes. Compliance with applicable environmental laws and regulations is expensive, and current or future environmental laws and regulations may restrict our operations. If we do not comply with applicable regulations, we may be
subject to fines and penalties.
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In addition, we cannot eliminate the risk of accidental injury or contamination from these materials or
wastes. While our property insurance policy provides limited coverage in the event of contamination from hazardous and biological products and the resulting cleanup costs, we do not currently have any additional insurance coverage for legal
liability for claims arising from the handling, storage or disposal of hazardous materials. Further, our general liability insurance and workers compensation insurance policies do not cover damages and fines arising from biological or
hazardous waste exposure or contamination. Accordingly, in the event of contamination or injury, we could be liable for damages or penalized with fines in an amount exceeding our resources and our operations could be suspended or otherwise adversely
affected.
We have limited selling and marketing resources and may be unable to successfully commercialize our human genome sequencing
service.
To grow our business as planned, we must eventually expand our sales, marketing and customer support capabilities. We may be
unable to attract, retain and manage the specialized workforce necessary to gain market acceptance and successfully commercialize our services. In addition, developing these functions is time consuming and expensive.
We have recently reduced some of these capabilities, as part of the restructuring plan that we announced on June 5, 2012. The employee headcount
reductions impacted our sales, marketing and customer support capabilities, which may make it even more difficult to retain remaining employees and to eventually hire new employees when growth in our business supports new hiring.
The sale of genome sequencing services involves extensive knowledge about genomic research and sequencing technology, including the sequencing technology
of our competitors. To be successful, our sales force and related personnel must be technically proficient in a variety of disciplines. For example, many of our existing salespersons have a Ph.D. or other advanced degree in relevant scientific
fields. There are relatively few people that have the necessary knowledge and qualifications to be successful salespersons or support personnel in our industry.
In certain regions or for certain customers, we may seek to partner with others to assist us with sales, marketing and customer support functions. However, we may be unable to find appropriate third
parties with whom to enter into these arrangements. Furthermore, if we do enter into these arrangements, these third parties may not perform as expected.
Our software may incorrectly analyze the raw genomic data produced by our sequencing equipment.
Our sequencing instruments generate raw genomic data from various segments of the genome being sequenced. This data must be arranged into the correct order to reconstruct the original genomic structure of
the sample. We have developed software algorithms that facilitate this reconstruction. However, these algorithms rely on statistical models that provide only relative assurance, and not absolute assurance, that the original genomic structure has
been reconstructed.
In addition, the genomic data we provide our customers includes a comparison of the sequenced genome against a reference
genome to help identify possible mutations or variations. This reference genome is designed to approximate a standard human genome. However, this approximation may not be accurate. If the algorithms we use to reconstruct genomic data
incorrectly reconstruct the sequenced genome, or if our reference genome is significantly flawed, the genomic data we deliver could be inaccurate and of little or no use to our customers.
An inability to manage our planned growth or expansion of our operations could adversely affect our business, financial condition or results of operations.
To effectively manage our operations and growth, we must continue to expend funds to enhance our operational, financial and management controls, reporting
systems and procedures and to attract and retain sufficient numbers of talented employees. If we are unable to eventually expand our genome sequencing capacity and implement improvements to our control systems efficiently and quickly, or if we
encounter deficiencies in existing systems and controls, then we will not be able to successfully expand the commercialization of our services. In addition to enhancing our sequencing capacity, our future operating results will depend on our
managements ability to:
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implement and improve our sales, marketing and customer support programs and our research and development efforts;
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enhance our operational and financial control systems;
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expand, train and manage our employee base;
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manage the operating expenses of our business as we expand;
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integrate acquired businesses, if applicable; and
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effectively address new issues related to our growth as they arise.
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We may not manage our expansion successfully, which could adversely affect our business, financial condition
or results of operations.
If we expand our operations outside of the United States, we will face risks that may increase our operating
costs.
Our long-term plan is to expand our operations to include satellite genome sequencing centers outside of the United States.
Because the laws of certain countries currently prohibit the export of DNA, we will have to establish local facilities to access customers in those countries and establish a presence there. To date, we have not expanded our sequencing operations
outside the United States. Operating in international markets requires significant resources and management attention and will subject us to regulatory, economic and political risks that are different from those in the United States. Because of our
limited experience with international operations, our international expansion efforts may be unsuccessful. In addition, we will face risks in doing business internationally that could increase our operating costs, including the following:
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economic conditions in various parts of the world;
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unexpected and more restrictive laws and regulations, including those laws governing ownership of intellectual property, collection and use of personal
information and other privacy considerations, hazardous materials and other activities important to our business;
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new and different sources of competition;
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multiple, conflicting and changing tax laws and regulations that may affect both our international and domestic tax liabilities and result in increased
complexity and costs;
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the difficulty of managing and staffing satellite genome sequencing centers and the increased travel, infrastructure and legal compliance costs
associated with multiple international locations;
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difficulties in enforcing contracts and collecting accounts receivable, especially in developing countries;
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fluctuations in exchange rates; and
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tariffs and trade barriers, import/export controls and other regulatory or contractual limitations on our ability to sell or develop our services in
certain foreign markets.
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The success of the expansion of our business internationally will depend, in part, on our ability
to anticipate and effectively manage these and other risks associated with international operations. Our failure to manage any of these risks successfully could increase our operating costs.
Because demand and applications for genome sequencing is relatively new and rapidly evolving, we may become subject to additional future governmental regulation, which may place additional cost and
time burdens on our operations.
We are subject, both directly and indirectly, to the potential adverse impact of existing and
potential future government regulation of our business and services. The life sciences, pharmaceutical and medical services industries, which are important target industries for our services, have historically been heavily regulated. There are
comprehensive federal and state laws regarding matters such as the privacy of patient information, quality of laboratory services and research in genetic engineering. For example, if we inadvertently disclose private personal information in the
course of providing our sequencing services, we could face liability for violations of federal law.
Legislative bodies or regulatory
authorities may adopt additional regulation that adversely affects our growth opportunities. They could also extend existing regulations to cover our services. For example, medical diagnostic services may, depending on their intended use, be
regulated as medical devices by the Food and Drug Administration, or FDA
Medical devices generally cannot be marketed without first receiving
clearance or approval (depending on the regulatory pathway) from the FDA. We do not believe that our sequencing services are currently subject to the FDAs medical device requirements. However, we cannot control how the genomic information we
provide will be used by our customers.
In addition, the FDA is focusing on genomic and diagnostic-related services, which has created
uncertainty regarding the regulatory landscape. The FDA has recently taken actions suggesting that it interprets the applicable regulations expansively to cover certain genomic devices and services, particularly those sold directly to consumers.
Since June 2010, the FDA has sent numerous letters to certain companies in DNA sequencing, including 23andMe, Inc., deCODE Genetics, Knome, Inc., Navigenics, Inc. and Pathway Genomics. In these letters, the FDA noted that it considers genetic tests
marketed by these companies to be subject to FDA regulation and, accordingly, unapproved medical devices. Additionally, in March 2011, the FDA held a public two-day meeting discussing the appropriate regulation of the direct-to-consumer genetic
tests. The FDA may extend this position to services such as ours. In addition, the FDA may implement new regulations that may be broad enough to cover our operations. Changes to the current regulatory framework, including the imposition of new
regulations, could arise anytime, and we may be unable to obtain or maintain FDA or comparable regulatory approval or clearance for our services, if required. For example, the FDA may impose restrictions on the types
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of customers to which we can market and sell our services and the types of persons whose DNA we may sequence. Also, future legislation may require that research subjects or patients provide
specific consent to have their DNA sequenced. This could require our customers to obtain new consents before they can submit DNA samples to us for sequencing.
As we look to expand our business to include sequencing services for the diagnosis of disease, we will become subject to further regulation by the FDA or other comparable agencies of other countries,
which may require us to obtain regulatory approval or clearance before we can offer those services.
These regulatory approval processes may
be expensive, time-consuming and uncertain, and our failure to obtain or comply with these approvals or clearances could harm our business, financial condition or operating results.
Disruption to or failure of our data center or other technical systems may disrupt our business and harm our operating results.
We rely on our network infrastructure, data centers, enterprise applications and technology systems for the development and support of our sequencing service, including the preparation, analysis and
transmission of data from our sequencing center, as well as for the internal operation of our business. These systems are susceptible to disruption or failure in the event of natural disasters such as a major earthquake, fire, flood, cyber-attack,
terrorist attack, telecommunications failure, power outage or other catastrophic event. Further, our data center and our sequencing facility, which houses certain of our technology systems, are located near major earthquake faults. Disruptions to or
the failure of our data center or any of these technology systems, including the network connection between our Mountain View facility and our data center, and the resulting loss of critical data, could cause delays in the transmission and analysis
of the sequencing data, prevent us from fulfilling our customers orders and severely affect our ability to conduct normal business operations.
If we fail to retain the services of our key executives or if we are unable to attract and retain skilled personnel, our ability to grow our business and our competitive position would be impaired.
We believe our future success will depend in large part upon our ability to attract, retain and motivate highly skilled personnel. In
particular, we depend highly on the contributions of Clifford A. Reid, Ph.D., our President and Chief Executive Officer, and Radoje T. Drmanac, Ph.D., our Chief Scientific Officer. The loss of either of these executives could make it more difficult
to manage our operations and research and development activities, reduce our employee retention and revenue and impair our ability to compete. If either of these key executives were to leave us unexpectedly, we could face substantial difficulty in
hiring qualified successors and could experience a loss in productivity, both during the search for, and integration of, any such successor.
Our research and development, operations and sales and marketing personnel represent a significant asset and serve as the source of our business
strategy, scientific and technological innovations and sales and marketing initiatives. As a result, our success substantially depends on our ability to retain and attract personnel for all areas of our organization. Competition for qualified
personnel is intense, and we may not be successful in attracting and retaining qualified personnel on a timely basis or on competitive terms, if at all. In addition, many qualified personnel are located outside of Northern California, where we are
located, and some qualified personnel that we may recruit may not be interested in relocating. If we are unable to attract and retain the necessary personnel on a cost-effective basis, our ability to grow our business and our competitive position
would be impaired.
We may engage in joint ventures or acquisitions that could disrupt our business, cause dilution to our stockholders,
reduce our financial resources and result in increased expenses.
In the future, we may enter into joint ventures or acquire other
businesses, products or technologies. Because we have not entered into any joint ventures or made any acquisitions to date, our ability to do so successfully is unproven. We may not be able to find suitable partners or acquisition candidates, and we
may not be able to complete such transactions on favorable terms, if at all, or successfully integrate any acquired business, products or technologies into our operations. If we do enter into any joint ventures or complete acquisitions, we may not
strengthen our competitive position or achieve our goals; alternatively these transactions may be viewed negatively by customers or investors. In addition, we may have difficulty integrating personnel, technologies and operations from acquired
businesses and retaining and motivating key personnel from those businesses. Joint ventures and acquisitions may disrupt our ongoing operations, divert management from day-to-day responsibilities and increase our expenses. Future acquisitions may
reduce our cash available for operations and other uses, and could result in an increase in amortization expense related to identifiable intangible assets acquired, potentially dilutive issuances of equity securities or the incurrence of debt. We
cannot predict the number, timing or size of future joint ventures or acquisitions, or the effect that any such transactions might have on our operating results.
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We incur significant costs as a result of operating as a public company, and our management devotes
substantial time to new compliance initiatives. We may fail to comply with the rules that apply to public companies, including section 404 of the Sarbanes-Oxley Act of 2002.
We have incurred and will continue to incur significant legal, accounting and other expenses as a public company, including costs resulting from public company reporting obligations under the Securities
Exchange Act of 1934, as amended, and regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global Market require that we satisfy certain corporate governance requirements relating to director independence,
distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conflicts of interest and a code of conduct. Our management and other personnel devote a substantial amount of time to all of these
requirements. Moreover, the reporting requirements, rules and regulations increase our legal and financial compliance costs and make some activities more time-consuming and costly. These reporting requirements, rules and regulations, coupled with
the increase in potential litigation exposure associated with being a public company, could make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or to serve as executive
officers. In addition, the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley Act, and the related rules of the Securities and Exchange Commission require that we maintain effective internal control over financial reporting and disclosure controls and
procedures. In particular, our management and independent registered public accounting firm are required to provide a report on the effectiveness of our internal control over financial reporting with our annual report, as required by
Section 404 of the Sarbanes-Oxley Act. During the course of our review and testing, we may identify deficiencies and be unable to remediate them before we must provide the required reports. We or our independent registered public accounting
firm may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting, which could harm our operating results, cause investors to lose confidence in our reported financial information and cause the
trading price of our stock to fall.
Our compliance with Section 404 may require that we incur substantial expense and expend significant
management time on compliance-related issues. Moreover, if we are unable to comply with the requirements of Section 404 in a timely manner, or if we or our independent registered public accounting firm is unable to conclude that our internal
control over financial reporting is effective or otherwise identifies material weaknesses in our internal control, the market price of our stock would likely decline and we could be subject to sanctions or investigations by NASDAQ, the Securities
and Exchange Commission or other regulatory authorities, which would require additional financial and management resources.
Our ability
to use our net operating loss carryforwards to offset future taxable income may be subject to certain limitations.
In general, under
Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, a corporation that undergoes an ownership change is subject to limitations on its ability to use its pre-change net operating loss carryforwards, or NOLs, to
offset future taxable income. If the Internal Revenue Service challenges our analysis that our existing NOLs will not expire before utilization due to previous ownership changes, our ability to use our NOLs could be limited by Section 382 of
the Code. Future changes in our stock ownership, some of which are outside of our control, could result in an ownership change under Section 382 of the Code. Furthermore, our ability to use NOLs of companies that we may acquire in the future
may be subject to limitations. For these reasons, we may not be able to use a material portion of the NOLs reflected on our balance sheet, even if we attain profitability.
Unfavorable global economic conditions could adversely affect our business, financial condition or results of operations.
Our results of operations could be adversely affected by general conditions in the global economy and in the global financial markets. The recent global financial crisis caused extreme volatility and
disruptions in the capital and credit markets. A severe or prolonged economic downturn, such as the recent global financial crisis, could result in a variety of risks to our business, including, reductions or delays in planned research and
development and other expenditures by our customers or decreased funding of genomic research by governmental entities. A weak or declining economy could also put strain on our suppliers, possibly resulting in supply disruption, or cause our
customers to delay making payments for our services. Any of the foregoing could harm our business.
Risks Related to Intellectual Property
We currently are, and could in the future be, subject to litigation regarding patent and other proprietary rights that could harm
our business.
Our commercial success depends in part on not infringing patents and proprietary rights of third parties. Illumina, Inc.
and affiliated entities have filed two lawsuits against the Company alleging patent infringement by us. See Part II, Item 1. Legal Proceedings
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As we enter our markets, it is possible other competitors will claim that our services infringe their
intellectual property rights as part of a business strategy to impede our successful entry into those markets. Such competitors and other third parties may have obtained and may in the future obtain patents covering products or processes that are
similar to or may include steps or processes used in our sequencing technology, allowing them to claim that the use of our technologies infringes these patents. In particular, we are aware of issued U.S. patents owned by competitors and other
third parties, including Illumina, to which we do not have licenses that may relate to our sequencing technology and which pertain to, among other things:
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sample preparation techniques;
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processes for making nucleic acid templates, or library construction;
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processes for making DNBs from nucleic acid templates;
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methods of making arrays of DNBs;
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sequencing methods, including those involving ligation;
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identifying genomic sequences on nucleic acid arrays;
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devices and apparatus used in nucleic acid detection systems, including optical systems; and
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information processing systems including software for base calling, sequence mapping and assembly.
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Some of the third parties that own these patents, including Illumina, have strong economic incentives, and substantial financial resources, to claim that
we are infringing their patent rights. In a patent infringement claim against us, we may assert, as a defense, that we do not infringe the relevant patent claims, that the patent is invalid or both. The strength of our defenses will depend on the
patents asserted, the breadth and scope of the construction of the claims of these patents, our ability to identify prior art in order to invalidate the asserted patent and on other factors.
However, we could be unsuccessful in advancing non-infringement and/or invalidity arguments in our defense. In the United States, issued patents enjoy a
presumption of validity, and the party challenging the validity of a patent claim must present clear and convincing evidence of invalidity, which is a high burden of proof. Conversely, the patent owner need only prove infringement by a preponderance
of the evidence, which is a lower burden of proof.
If we were found by a court to have infringed a valid patent claim, we could be prevented
from using the patented technology or be required to pay the owner of the patent rights for the rights to use that technology and/or pay monetary damages, including, for example, treble damages if we are found to have willfully infringed. If we
decide to pursue a license to one or more of these patents, we may not be able to obtain such a license on commercially reasonable terms, if at all, or the license we obtain may require us to pay substantial royalties or grant cross licenses to our
patent rights. For example, if the relevant patent is owned by a competitor, that competitor may choose not to license patent rights to us, as it would be under no obligation to do so. If we decide to develop alternative technology, we may not be
able to do so on a timely or cost-effective manner, if at all.
In addition, because patent applications can take years to issue and are often
afforded confidentiality for some period of time, there may currently be pending applications, unknown to us, which later result in issued patents that processes in our sequencing technology infringe. Processes in our sequencing technology may also
infringe existing issued patents of which we are currently unaware. Even though we own or have other rights to patents, these patents do not provide us with the freedom to offer our sequencing services unimpeded by the patent rights of
others. For example, we may be required to pursue or defend a patent infringement action in order to protect our intellectual property rights or practice our sequencing technology. If we expand our business to include sequencing services
intended to be used for the diagnosis of disease, it may be necessary to license patents related to such services.
It is possible that, in
addition to our current litigation, we may in the future receive communications from competitors and others alleging that we may be infringing their patents, trade secrets or other intellectual property rights or offering licenses to such
intellectual property or threatening litigation. For example, an educational institution has invited us to engage in negotiations for the license of certain of that institutions patent rights. We have not yet determined whether we will seek
such a license. In addition to patent infringement claims, third parties may assert copyright, trademark or other proprietary rights against us. We may not be able to successfully defend against the claims asserted by Illumina, or future
claims, and our business may suffer if we are found to have infringed upon the patents held by Illumina, or if future claims are brought against us.
We may not be able to protect our patent rights or other intellectual property which could impair our ability to compete effectively.
We depend on proprietary technology for our success and ability to compete. If others are able to reproduce our technology, our business will suffer significantly unless we can prevent them from competing
with us. To protect our proprietary technology, we rely on patents and other intellectual property laws, as well as nondisclosure agreements, licensing arrangements and confidentiality provisions. U.S. patent, copyright and trade secret laws afford
us only limited protection, and the laws of some foreign countries do not protect proprietary rights to the same extent.
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We have licensed, from Callida Genomics, Inc., U.S. and international patents and patent applications
relating to our business. Because the issuance of a patent is not conclusive of its validity or enforceability, our existing patent rights, and rights we may obtain in the future, may not provide us with meaningful protection. The patent rights on
which we rely may be challenged and invalidated or may be interpreted not to be broad enough to cover the critical components of our technology. Our pending patent applications may have their claims limited or may not result in issued patents.
Moreover, our patent rights become more limited as owned or licensed patents begin to expire in 2014. We will be able to protect our technologies from unauthorized use by third parties only to the extent that valid and enforceable patents or other
proprietary rights cover them. Even if we have valid and enforceable patents or other proprietary rights, competitors may be able to design alternative methods or devices that avoid infringement of those patents or rights. Our key patent rights are
licensed from Callida, which is owned by our Chief Scientific Officer and his spouse. If we materially breach the terms of this license, Callida may seek to terminate the license. If we lose our rights to use these patents, we may be forced to
re-design our sequencing technology, which would be expensive and may not be possible.
The patent positions of biotechnology companies,
including us, can be highly uncertain and involve complex and evolving legal and factual questions. No consistent policy regarding the breadth of claims allowed in biotechnology patents has emerged to date in the United States. Legal developments
may preclude or limit the patent protection available for our sequencing technology.
Despite our efforts to protect our proprietary rights,
attempts may be made to copy or reverse engineer aspects of our sequencing technology or to obtain and use information that we regard as proprietary. Accordingly, we may be unable to protect our proprietary rights against unauthorized third-party
copying or use. Furthermore, policing the unauthorized use of our intellectual property is difficult. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity
and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of resources and could harm our business.
We may incur substantial costs as a result of our current, or future, litigation or other proceedings relating to patent and other proprietary rights.
The genomic sequencing industry includes several large companies that have rights to many broad issued patents and pending patent applications.
Competitors in this industry have fiercely litigated their patent positions and alleged infringements by others. For example, Illumina and Affymetrix were involved in long and expensive patent litigation relating to DNA sequencing technology. This
litigation resulted in a settlement involving the payment of $90 million by one party to the other.
Our current litigation with Illumina or
our involvement in any other future intellectual property litigation, including, or administrative proceedings could result in significant expense. Some of our competitors, including Illumina, Life Technologies and Roche, have considerable resources
available to them. We, on the other hand, are an early-stage commercial company with comparatively few resources available to us to engage in costly and protracted litigation. Intellectual property infringement claims asserted against us, whether
with or without merit, could be costly to defend and could limit our ability to use some technologies in the future. They will be time consuming, will divert our managements and scientific personnels attention and may result in liability
for substantial damages. For example, we have incurred and anticipate that we will continue to incur significant expense and substantial time in defending against our current intellectual property infringement dispute with Illumina. In addition, our
standard customer contract requires us to indemnify our customers for claims alleging that any of our products misappropriate or violate any third party patent, copyright, trade secret or other intellectual property or proprietary rights.
If third parties file patent applications or are issued patents claiming technology also claimed by us in pending applications, we may be
required to participate in interference or other proceedings with the U.S. Patent Office or U.S. courts or in other proceedings outside the United States, including oppositions, to determine priority of invention or patentability. Even if we are
successful in these proceedings, we may incur substantial costs, and the time and attention of our management and scientific personnel will be diverted in pursuit of these proceedings.
We may not be able to enforce our intellectual property rights throughout the world.
The laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Many companies have
encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. The legal systems of some countries, particularly developing countries, do not favor the enforcement of patents and other
intellectual property protection, especially those relating to biotechnology. This could make it difficult for us to stop the infringement of our patents or the misappropriation of our other intellectual property rights. For example, many foreign
countries have compulsory licensing laws under which a patent owner must grant licenses to third parties. In addition, many countries limit the enforceability of patents against third parties, including government agencies or government contractors.
In these countries, patents may provide limited or no benefit.
Proceedings to enforce our patent rights in foreign jurisdictions could result
in substantial costs and divert our efforts and attention from other aspects of our business. Accordingly, our efforts to protect our intellectual property rights in such countries may be inadequate. In addition, changes in the law and legal
decisions by courts in the U.S. and foreign countries may affect our ability to obtain adequate protection for our technology and the enforcement of intellectual property.
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Confidentiality agreements with employees and others may not adequately prevent disclosures of our
trade secrets and other proprietary information.
We rely in part on trade secret protection to protect our confidential and
proprietary information and processes. However, trade secrets are difficult to protect. We have taken measures to protect our trade secrets and proprietary information, but these measures may not be effective. We require new employees and
consultants to execute confidentiality agreements upon the commencement of an employment or consulting arrangement with us. These agreements generally require that all confidential information developed by the individual or made known to the
individual by us during the course of the individuals relationship with us be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of
rendering services to us will be our exclusive property. Despite these measures, our proprietary information may be disclosed, third parties could reverse engineer our sequencing technologies and others may independently develop substantially
equivalent proprietary information and techniques or otherwise gain access to our trade secrets. 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 business position.
Risks Related to Ownership of Our Common Stock
Our stock price is volatile and purchasers of our common stock could incur substantial losses.
Our stock price is volatile, and from December 31, 2010 to September 30, 2012, the trading prices of our stock have ranged from $18.55 to $1.57
per share. The market price of our common stock may fluctuate significantly in response to a number of factors. These factors include those discussed in this Risk Factors section of this Quarterly Report and others such as:
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our ability to raise capital to continue our operations as a going concern;
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quarterly variations in our results of operations or those of our competitors;
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changes in financial estimates or guidance, including our ability to meet our future revenue and operating profit or loss estimates or guidance;
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changes in earnings estimates or recommendations by securities analysts;
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announcements by us or our competitors of new products or services, significant contracts, commercial relationships, acquisitions, capital commitments
or changes in the outlook of the market for genomic sequencing products and services;
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developments with respect to intellectual property rights;
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whether repayment of our term loan(s) is accelerated if an event of default occurs;
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our commencement of, or involvement in, litigation;
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announcements regarding equity or debt financing transactions;
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any major changes in our board of directors or management;
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changes in governmental regulations; and
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a decrease in government funding of research and development or a slowdown in the general economy; and
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speculation in our stock due our announced Merger Agreement with BGI.
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In recent years, the stock market in general, and the market for technology and life sciences companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated
or disproportionate to the operating performance of those companies. Broad market and industry factors may seriously affect the market price of our common stock, regardless of our actual operating performance. In addition, in the past, following
periods of volatility in the overall market and the market price of a particular companys securities, securities class action litigation has often been instituted against these companies. This litigation, if instituted against us, could result
in substantial costs and divert our managements attention and resources.
If securities or industry analysts do not publish
research or reports about our business or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.
The trading market for our common stock will be influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an
adverse or misleading opinion regarding us, our business model,
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technology or stock performance, our stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility
in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, the unpredictability of our financial results likely reduces the certainty, and therefore reliability, of the forecasts by securities or
industry analysts of our future financial results, adding to the potential volatility of our stock price.
Our directors, executive
officers and principal stockholders and their respective affiliates will continue to have substantial influence over us and could delay or prevent a change in corporate control.
Our directors, executive officers and the holders of more than 5% of our common stock, together with their affiliates, are deemed to beneficially own over 40% of our outstanding common stock based on the
number of shares outstanding on September 21, 2012, . These stockholders, acting together, have significant influence over the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger,
consolidation or sale of all or substantially all of our assets. In addition, these stockholders, acting together, have significant influence over our management and affairs. Accordingly, this concentration of ownership might harm the market price
of our common stock by:
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delaying, deferring or preventing a change in control;
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impeding a merger, consolidation, takeover or other business combination involving us; or
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discouraging a potential acquiror from making a tender offer or otherwise attempting to obtain control of us.
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Future sales of shares by existing stockholders could cause our stock price to decline.
If our existing stockholders sell, or if the market believes our existing stockholders will sell, substantial amounts of our common stock in the public
market, the trading price of our common stock could decline significantly. As of October 31, 2012, we had 34,488,711 shares of common stock outstanding. On August 23, 2011, 17,817,281 shares that were previously subject to contractual
lock-up agreements entered into by certain of our stockholders with the underwriters in connection with our follow-on public offering became freely tradable, except for shares of common stock held by directors, executive officers and our other
affiliates, which are subject to volume limitations under Rule 144 of the Securities Act of 1933, as amended.
Certain of our existing
stockholders have demand and piggyback rights to require us to register with the SEC shares of our common stock, including shares issuable upon exercise of outstanding options. If we register these shares of common stock, the stockholders would be
able to sell those shares freely in the public market, subject to the volume limitations described above.
We also registered 6,468,272 shares
of our common stock that are subject to outstanding stock options, RSUs and reserved for issuance under our equity plans and we may to register an additional 1,968,192 shares of our common stock for issuance under our equity plans. Once registered,
these shares can be freely sold in the public market upon issuance, subject to vesting restrictions.
Provisions in our charter
documents and under Delaware law could discourage a takeover that stockholders may consider favorable and may lead to entrenchment of management.
Our amended and restated certificate of incorporation and amended and restated bylaws contain provisions that could delay or prevent changes in control or changes in our management without the consent of
our board of directors. These provisions include the following:
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a classified board of directors with six-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of
our board of directors;
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no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates;
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the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the
resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors;
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the ability of our board of directors to authorize the issuance of shares of preferred stock and to determine the price and other terms of those
shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquiror;
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the ability of our board of directors to alter our bylaws without obtaining stockholder approval;
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the required approval of at least 66
2
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3
% of the shares entitled to vote at an election of directors to adopt, amend or repeal our bylaws or repeal the provisions
of our amended and restated certificate of incorporation regarding the election and removal of directors;
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a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our
stockholders;
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the requirement that a special meeting of stockholders may be called only by the chairman of the board of directors, the chief executive officer, the
president or the board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors; and
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advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be
acted upon at a stockholders meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquirors own slate of directors or otherwise attempting to obtain control of us.
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We are also subject to the anti-takeover provisions contained in Section 203 of the Delaware General Corporation Law.
Under Section 203, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for six years or, among other exceptions, the board of directors has
approved the transaction.