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+Risk Factors
+
+ Investing in our common stock involves a high degree of risk. You should carefully review and consider the risks listed in the "Risk Factors" section beginning on page 5 of this prospectus, as well as the other information contained in this prospectus, before purchasing any shares of our common stock.
+
+ 
+
+Summary Consolidated Financial Information
+
+ The following table provides summary consolidated financial data of our company for the periods ended and as of the dates indicated. You should read the summary consolidated financial data set forth below in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and with our consolidated financial statements and related notes appearing elsewhere in this prospectus.
+
+SUMMARY FINANCIAL DATA
+
+(In thousands, except per share amounts)
+
+ 
+
+Year Ended December 31,
+
+ 
+
+2001
+
+2000
+
+1999
+
+1998
+
+1997
+
+Statement of Operations Data:
+ 
+ 
+ 
+ 
+ 
+
+Net sales 
+
+$46,182
+
+$56,272
+
+$60,709
+
+$83,710
+
+$86,774
+
+Gross profit 
+
+15,011
+
+25,928
+
+26,058
+
+39,460
+
+39,830
+
+Operating expenses:
+ 
+ 
+ 
+ 
+ 
+
+ Selling, general and administrative 
+
+28,952
+
+29,858
+
+28,166
+
+31,420
+
+29,662
+
+ Research and development 
+
+5,635
+
+6,862
+
+7,315
+
+9,537
+
+6,822
+
+ Restructuring and other unusual
+
+ Charges 
+
+12,468
+ 
+
+6,681
+
+3,979
+
+3,082
+
+Total operating expenses 
+
+47,055
+
+36,720
+
+42,162
+
+44,936
+
+39,566
+
+Operating (loss) income 
+
+(32,044)
+
+(10,792)
+
+(16,104)
+
+(5,476)
+
+264
+
+(Loss) on sale of investments 
+
+(328)
+
+607
+
+541
+
+1,194
+ 
+
+Interest and other expense, net 
+
+(1,295)
+
+(1,723)
+
+(1,272)
+
+(1,786)
+
+(1,242)
+
+Loss 
+
+(33,667)
+
+(11,908)
+
+(29,784)
+
+(4,447)
+
+(760)
+
+Loss per common share - 
+ 
+ 
+ 
+ 
+ 
+
+ Basic 
+
+$(0.86)
+
+$ (.34)
+
+$ (.93)
+
+$ (.14)
+
+$ (.02)
+
+ Diluted 
+
+$(0.86)
+
+$ (.34)
+
+$ (.93)
+
+$ (.14)
+
+$ (.02)
+
+Weighted average number of common
+
+ shares outstanding (1) -
+ 
+ 
+ 
+ 
+ 
+
+ Basic 
+
+39,352
+
+34,824
+
+32,084
+
+32,058
+
+32,538
+
+ Diluted 
+
+39,352
+
+34,824
+
+32,084
+
+32,058
+
+32,538
+
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+As of December 31,
+
+ 
+
+2001
+
+2000
+
+1999
+
+1998
+
+1997
+
+Balance Sheet Data:
+ 
+ 
+ 
+ 
+ 
+
+Cash and cash equivalents 
+
+$4,342
+
+$15,332
+
+$ 5,453
+
+$1,585
+
+$2,968
+
+Working capital 
+
+4,366
+
+31,019
+
+17,761
+
+30,036
+
+38,955
+
+Total assets 
+
+33,899
+
+65,828
+
+58,381
+
+83,116
+
+94,080
+
+Long-term obligations 
+
+16,027
+
+18,602
+
+21,622
+
+17,315
+
+21,959
+
+Shareholders' equity 
+
+313
+
+32,961
+
+22,512
+
+49,770
+
+53,962
+
+ 
+
+ 
+
+(1) Adjusted to reflect the reverse stock split effected on February 7, 1997.
+
+Risk Factors
+
+ Before you invest in our common stock, you should understand the high degree of risk involved. You should carefully consider the risks and uncertainties described below and the other information in this prospectus, including our historical consolidated financial statements and related notes, before deciding whether to invest in shares of our common stock. The following risks and uncertainties are not the only ones we face. However, these are the risks management believes are material. If any of the following risks actually occur, our business, financial condition and operating results could be adversely affected. As a result, the trading price of our common stock could decline and you could lose part or all of your investment.
+
+We cannot assure you that we will reach profitability because we have a history of losses.
+
+ We incurred significant losses from 1997 through 2001. Our accumulated deficit in these five years as of December 31, 2001 was $70.6 million. We had a net loss of $33.7 million in 2001. We cannot assure you that we will achieve profitability in any future periods, and you should not rely on our historical revenue or our previous profitability as any indication of our future operating results or prospects. If we continue to generate losses and do not generate sufficient cash, we will not have cash to maintain operations at current levels. In addition, we may need additional financing to sustain our operations in the future. There can be no assurance that additional financing will be available or if available that it will be on terms acceptable to us.
+
+Our future operating results are likely to fluctuate and therefore may fail to meet expectations, which could cause our stock price to decline.
+
+ Our operating results have varied widely in the past and are likely to do so in the future. In addition, our operating results may not follow any past trends. Our future operating results will depend on many factors and may fail to meet our expectations for a number of reasons, including those set forth in these risk factors. Any failure to meet expectations could cause our stock price to significantly fluctuate or decline.
+
+ Factors that relate to our internal operations and could cause our operating results to fluctuate include:
+
+the need for continual, rapid new product introductions,
+
+changes in our product mix,
+
+our inability to adjust our fixed costs in the face of any declines in sales, and
+
+successful execution of our strategy to develop and market products for the TV broadcasting markets, namely, character generators, routing equipment, routing switchers, routing peripherals, master control, automation, signal processing, switchers network management, video clip and stillstore and media management.
+
+ Factors that depend upon our suppliers and customers and could cause our operating results to fluctuate include:
+
+the timing of significant product orders, order cancellations and reschedulings,
+
+the availability of production capacity and fluctuations in the manufacturing yields at the facilities to which we subcontract our critical components, and
+
+the cost of raw materials and manufacturing services from our suppliers.
+
+Factors that are industry risks and could cause our operating results to fluctuate include:
+
+intense competitive pricing pressures,
+
+introductions of or enhancements to our competitors' products, and
+
+the cyclical nature of the industry.
+
+ Our day-to-day business decisions are made with these factors in mind. Although certain of these factors are out of our immediate control, unless we can anticipate and be prepared with contingency plans that respond to these factors, we will be unsuccessful in carrying out our business plan.
+
+If we fail to successfully develop, introduce and sell new products, we may be unable to compete effectively in the future.
+
+ We operate in a highly competitive, quickly changing environment marked by rapid obsolescence of existing products. Our future success depends on our ability to develop, introduce and successfully market new products, including Duet products that replaced our existing iNFiNiT!, Max and Maxine product lines. To date, we have been selling our Duet products in increasing quantities, and we must continue to increase our sales or our business will suffer. If any of the following occur, our business will be materially harmed:
+
+We fail to complete and introduce new product designs in a timely manner,
+
+We are unable to have these new products manufactured according to design specifications,
+
+Our customers do not perceive value in our new products and demand deep discounts,
+
+Our sales force and independent distributors do not create adequate demand for our products, or
+
+Market demand for our new products does not develop as anticipated.
+
+If we are unable to keep up with rapid change in our industry, our business will not grow.
+
+ The markets for our products are characterized by rapidly changing technology, evolving industry standards and frequent new product introductions and enhancements. Due to technological advancements and changes in industry standards, our products may become obsolete or the prices at which we can sell them may decline. Future technological advances in the television and video industries may result in the availability of new products or services that could compete with our products or reduce the price of our existing products or services. The availability of competing or less expensive products could cause our existing or potential customers to fulfill their needs better and more cost efficiently with products other than ours.
+
+ For example, customers are beginning to use personal computers to edit graphics. This is a task that traditionally would have been completed on our lower-end stand-alone machines. We may not be successful in enhancing our products or developing, manufacturing or marketing new products that satisfy customer needs or achieve market acceptance. In addition, services, products or technologies developed by others may render our products or technologies uncompetitive, unmarketable or obsolete. Announcements of currently planned or other new product offerings by either our competitors or us may cause customers to defer or fail to purchase our existing products or services.
+
+ In addition, errors or failures may be found in our products. Such errors or failures could cause delays in product introductions and shipments or require design modifications that could adversely affect our competitive position. This could result in an increase in the inventory of our products. If we do not develop, on a timely basis, new products, and enhancements to existing products or correct errors should they arise, or if such new products or enhancements do not achieve market acceptance, our business, financial condition and results of operations may suffer. Furthermore, the trend toward the use of open systems may cause price erosion in our products, create opportunities for new competitors, allow existing competitors enhanced opportunities and limit the sale of our proprietary systems. Customers may also have unique product requirements such as support of foreign languages, which may be difficult and expensive for us to support and may have limited acceptability.
+
+We expend substantial resources in developing and selling our products, and we may be unable to generate significant revenue as a result of these efforts.
+
+ To establish market acceptance of our products, we must dedicate significant resources to research and development, production and sales and marketing. We experience a long delay between the time when we expend these resources and the time when we begin to generate revenue, if any, from these expenditures. Typically, this delay is one year or more. We record as expenses the costs related to the development of new products as these expenses are incurred. As a result, our profitability from quarter to quarter and from year to year may be material and adversely affected by the number and timing of our new product introductions in any period and the level of acceptance gained by these products.
+
+Our customers may cancel or change their product plans after we have expended substantial time and resources in the design of their products.
+
+ If one of our potential customers cancels, reduces or delays product orders from us or chooses not to release equipment that incorporates our products after we have spent substantial time and resources in designing a product, our business could be materially harmed. Our customers often evaluate certain of our products for six to twelve months or more before designing them into their systems, and they may not commence volume shipments for up to an additional six to twelve months, if at all. During this lengthy sales cycle, our potential customers may also cancel or change their product plans. Even when customers integrate one or more of our products into their systems, they may ultimately discontinue the shipment of their systems that incorporate our products. System integrators whose products achieve customer acceptance may choose to replace our products with other products giving them higher margins or better performance.
+
+If the digital video market does not grow, we will be unable to increase our revenues.
+
+ 
+
+ Our future growth and success in our existing business lines will depend to a significant degree on the rate at which broadcasters and cable operators convert to digital video systems and the rate at which digital video technology expands to additional market segments. Television broadcasters and cable television operators have historically relied on and utilized traditional analog technology for video management, storage and distribution. Digital video technology is still a relatively new technology and the move from traditional analog technology to digital video technology requires a significant initial expense for television broadcasters and cable television operators. Accordingly, the use of digital video technology may not expand among television broadcasters and cable television operators or into additional markets. If television broadcasters and cable television operators do not accept and implement digital video technology, or if the October 1996 ruling of the U.S. Federal Communications Commission (the "FCC") mandating these changes is repealed or amended, we may not be able to grow our existing business lines and our financial condition will suffer.
+
+ 
+
+We will be unable to compete effectively if we fail to anticipate product opportunities based upon emerging technologies and standards and fail to develop products that incorporate these technologies and standards.
+
+ We may spend significant time and money on research and development to design and develop products around an emerging technology or industry standard. If an emerging technology or industry standard that we have identified fails to achieve broad market acceptance in our target markets, we may be unable to generate significant revenue from our research and development efforts. Moreover, even if we are able to develop products using adopted standards, our products may not be accepted in our target markets. As a result, our business would be materially harmed.
+
+ We have limited experience in designing and developing products that support industry standards. If systems manufacturers move away from the use of industry standards that we support with our products and adopt alternative standards, we may be unable to design and develop new products that conform to these new standards. The expertise required is unique to each industry standard, and we would have to either hire individuals with the required expertise or acquire this expertise through a licensing arrangement or by other means. The demand for individuals with the necessary expertise to develop a product relating to a particular industry standard is generally high, and we may not be able to hire such individuals. The cost to acquire this expertise through licensing or other means may be high and such arrangements may not be possible in a timely manner, if at all.
+
+We may not successfully develop strategic relationships that may be important to our business.
+
+ We believe the formation of strategic relationships will be important to our Interactive television business. The inability to find strategic partners or the failure of any existing relationships to achieve meaningful positive results for us could harm our business. We will rely in part on strategic relationships to help us:
+
+Maximize adoption of our products through distribution arrangements,
+
+Enhance our brand,
+
+Expand the range of commercial activities based on our technology, and
+
+Increase the performance, functionality and utility of our products and services.
+
+ Many of these goals are beyond our traditional strengths. We anticipate that the efforts of our strategic partners will become more important as the use of Interactive television matures. For example, we may become more reliant on strategic partners to provide multimedia content and build the necessary infrastructure for media delivery. We may not be successful in forming strategic relationships. In addition, the efforts of our strategic partners may be unsuccessful. Furthermore, these strategic relationships may be terminated before we realize any benefit.
+
+We operate in a highly competitive environment and industry and we may lack resources needed to capture increased market share
+
+ We may not be able to compete successfully against our current or future competitors. The markets for graphics imaging and editing, signal routing and media storage systems and products are highly competitive. These markets are characterized by constant technological change and evolving industry standards. Many of our competitors have significantly greater financial, technical, manufacturing and marketing resources than we have. In addition, certain vendors dominate certain product categories and market segments, on a region-by-region basis, in which we currently operate or may wish to operate in the future. As a result, our ability to compete and operate in these areas may be limited.
+
+ We anticipate increased competition from companies with which we currently compete and from companies that may enter our industry. We are currently aware of several major and a number of smaller competitors:
+
+In the graphics area, we believe our primary competitors are Pinnacle Systems Inc., Aston Electronic Designs Limited, Pixel Power and Inscriber.
+
+In the signal management area, we believe our primary competitors are nVision, Leitch Incorporated, Thomson, Sony Corporation and Grass Valley Group.
+
+In the control and automation area, we believe our primary competitors are Encoda, Harris Corporation and Omnibus.
+
+ We believe that our ability to compete depends on factors both within and outside our control, including the success and timing of new product developments introduced by us and our competitors, product performance and price, market presence and customer support. We may not be able to compete successfully with respect to these factors. Maintaining any advantage that we may have, now or in the future, over our competitors will require our continuing investments in research and development, sales and marketing and customer service and support. In addition, as we enter new markets, we may encounter distribution channels, technical requirements and competitive factors that differ from those in the markets in which we currently operate. We may not be able to compete successfully in these new markets. In addition, increased competition in any of our current markets could result in price reductions, reduced margins or loss of market share, any of which could harm our business, financial condition and results of operations.
+
+We may encounter periods of industry-wide surface mount components shortage, resulting in pricing pressure and a risk that we could be unable to fulfill our customers' requirements.
+
+ The semiconductor industry (from which surface mount components are derived) has historically been characterized by wide fluctuations in the demand for, and supply of, its products, which feed the electronics, telecommunications and computer markets. These fluctuations have resulted in circumstances when supply and demand for the industry's products have been widely out of balance. Our operating results may be materially harmed by industry-wide surface mount component shortage, which could result in severe pricing pressure. In a market with undersupply, we would have to compete with the larger customers of our vendors for limited manufacturing capacity. In such an environment, we may be unable to have our products manufactured in a timely manner or in quantities necessary to meet our requirements. Since we outsource a large proportion of our products, we are particularly vulnerable to such supply shortages. As a result, we may be unable to fulfill orders and may lose customers. Any future industry-wide shortage of surface mount components or manufacturing capacity would materially harm our business.
+
+We depend on a limited number of suppliers of surface mount components.
+
+ We depend on a limited number of contract manufacturers to produce surface mount components for our products. Our principal suppliers may experience unanticipated events that could inhibit their ability to provide us with adequate manufacturing capacity on a timely basis, or at all. Introducing new surface mount components or transferring existing design and specifications to a new third party manufacturer would require significant development time to adapt our designs to their manufacturing processes and could cause product shipment delays. In addition, the costs associated with manufacturing our components may increase if we are required to use a new third party manufacturer. If we fail to satisfy our manufacturing requirements, our business would be materially harmed.
+
+If we fail to adequately forecast demand for our products, we may incur product shortages or excess product.
+
+ Our agreements with third-party manufacturers require us to provide forecasts of our anticipated manufacturing orders, and place binding manufacturing orders in advance of receiving purchase orders from our customers. This may result in product shortages or excess product inventory because it may not be practical to increase or decrease our rolling forecasts under such agreements. Obtaining additional supply in the face of product shortages may be costly or not possible, especially in the short term. Our failure to forecast adequately demand for our products would materially harm our business.
+
+Problems in manufacturing our products, especially our new products, may increase the costs of our manufacturing process.
+
+ Difficulties or delays in the manufacturing of our products in the U.S. and the U.K. can adversely impact our gross margin. In the past we have experienced production and supply problems that affected the gross margin. We may experience in the future the same type of problems or other problems. This would be especially true if we face cash constraints, slowing payments to our suppliers. That in turn affects our ability to manufacture products in a timely manner, which would adversely affect our profitability.
+
+We may be unable to grow our business if the markets in which we sell our products do not grow.
+
+ Our success depends in large part on the continued growth of various markets that use our products. Any decline in the demand for our products in the following markets could materially harm our business:
+
+Broadcasting infrastructure projects,
+
+Video/audio, graphics and imaging,
+
+Advertising,
+
+Corporate customers,
+
+Military and security systems.
+
+ Slower growth in any of the other markets in which our products are sold may also materially harm our business. Many of these markets are characterized by rapid technological change and intense competition. As a result, our products may face severe price competition, become obsolete over a short time period, or fail to gain market acceptance. In addition, customers may require replacements and upgrades of equipment rather than the purchase of new, more expensive products. Any of these occurrences would materially harm our business, financial condition and results of operations. 
+
+Our business will suffer if our systems fail or become unavailable.
+
+ 
+
+ A reduction in the performance, reliability and availability of our network infrastructure will harm our ability to distribute our products and services to our users, as well as our reputation and ability to attract and retain funding, users and content providers. Our systems and operations could be damaged or interrupted by fire, flood, power loss, telecommunications failure, Internet breakdown, earthquake and similar events. Our systems are also subject to viruses, break-ins, sabotage, acts of physical terrorism, intentional acts of vandalism, hacking, cyber-terrorism and similar misconduct. Our computer and communications infrastructure are located at Melville, NY and Reading, U.K. We do not have fully redundant systems or a formal disaster recovery plan, and we do not carry adequate business interruption insurance to compensate us for losses that may occur from a system outage. Any system error or failure that causes interruption in availability of products or content or an increase in response time could result in a loss of potential or existing customers or content providers and declines in stock values. If we suffer sustained or repeated interruptions, our products and services could be less attractive to our users and our business would be harmed.
+
+In order to become profitable, we will need to offset the general pattern of declines and fluctuations in the prices of our products.
+
+ The legacy iNFiNiT!, MAX!> and MAXINE! products sold at prices that are a multiple of the current Duet line prices. With advances in technology and introduction of Windows-based operating systems, we have to strive continuously to provide more performance and characteristics in our products at lower prices. We may not be able to do so successfully in the future, thus negatively affecting our performance.
+
+We depend upon third party dealers to market and sell our products and they may discontinue sale of our products, fail to give our products priority or be unable to successfully market, sell and support our products.
+
+ We employ independent, third party dealers to market and sell a significant portion of our products. During 2001, 23% of our sales were made through our dealers and representatives. Although we have contracts with our dealers and representatives, any of them may terminate their relationship with us on short notice. The loss of one or more of our principal dealers, or our inability to attract new dealers, could materially harm our business. We may lose dealers in the future and we may be unable to recruit additional or replacement dealers. As a result, our future performance will depend in part on our ability to retain our existing dealers and representatives and attract new dealers and representatives that will be able to market, sell and support our products effectively.
+
+ Furthermore, with advances in technology we have been able to introduce lower-priced products. It may be that our distribution strategy needs to be modified as new product prices are lowered. It is possible we may not be successful in modifying our distribution strategy, thus adversely impacting our ability to sell our new products.
+
+Problems associated with international business operations could subject us to risks from financial, operational and political situations, and affect our ability to manufacture and sell our products.
+
+ Sales to customers located outside the United States accounted for 57%, 42% and 46% of our total sales in 2001, 2000 and 1999, respectively. We anticipate that sales to customers located outside the United States will continue to represent a significant portion of our total sales in future periods and the trend of foreign customers accounting for an increasing portion of our total sales may continue. Accordingly, our operations and revenues are subject to a number of risks associated with foreign commerce, including the following:
+
+Managing foreign dealers and foreign customers, which may be state corporations or government agencies,
+
+Staffing and managing foreign branch offices,
+
+Political and economic instability,
+
+Foreign currency exchange fluctuations,
+
+Changes in tax laws, tariffs, environmental directives, freight rates and governmental royalties,
+
+Timing and availability of export licenses,
+
+Changes in laws and policies governing operations of foreign-based companies,
+
+Inadequate protection of intellectual property rights in some countries, and
+
+Obtaining governmental approvals for certain products.
+
+ In 2001 we denominated sales of our products in foreign countries exclusively in U.S. dollars, Pounds Sterling and Euros. As a result, any increase in the value of the U.S. dollar relative to the local currency of a foreign country will increase the price of our products in that country so that our products become more expensive to customers in the local currency of that foreign country. As a result, sales of our products in that foreign country may decline. To the extent any such risks materialize, our business would be materially harmed.
+
+We may be unable to accurately predict quarterly results if we are inaccurate in our sales projections, which could adversely affect the trading price of our stock.
+
+ We build up our sales projections from information obtained by the sales force and our dealers. We recognize revenue from sales to our dealers only when these dealers make sales to customers. Furthermore, in certain large contracts, applicable to both Graphics division and Pro-Bel division, there are acceptance and/or commissioning conditions. It is possible our products are delivered but are not paid for because acceptance and/or commissioning have not taken place to the satisfaction of the customer. We would not be able to recognize the revenue until the customer has accepted and/or commissioned the products.
+
+ Any deviation or inaccuracy in these above factors could affect our quarterly revenue and results of operations. As a result, on a quarterly basis, our stock price could materially fluctuate.
+
+We may be unable to successfully grow our business if we fail to compete effectively with others to attract and retain key personnel.
+
+ We believe our future success will depend upon our ability to attract and retain engineers and other highly skilled personnel and sales people. Our employees are at-will and only a few are subject to employment contracts. Hiring qualified sales and technical personnel will be difficult due to the limited number of qualified professionals. Competition for these types of employees is intense. We have in the past experienced difficulty in recruiting and retaining qualified sales and technical personnel necessary for the development of our business. Failure to attract and retain personnel, particularly sales and technical personnel, would materially harm our business. We are also highly dependent upon the efforts of our senior management. The loss of the services of one or more of these individuals may delay or prevent us from achieving our objectives.
+
+We may not be able to protect our proprietary technology and may be sued for infringing on the rights of others.
+
+ 
+
+ Protection of intellectual property rights is crucial to our business, since that is how we keep others from copying innovations that are central to our existing and future products. Our success also depends, in part, upon our ability to operate without infringing the rights of others. We rely on a combination of methods to protect our proprietary intellectual property, technology and know-how, such as:
+
+trade secret laws,
+
+copyright law,
+
+trademark law,
+
+patent law,
+
+contractual provisions,
+
+confidentiality agreements, and
+
+certain technology and security measures.
+
+ Because it is critical to our success that we are able to prevent competitors from copying our innovations, we intend to continue to seek patent and trade secret protection for our products. The process of seeking patent protection can be long and expensive and we cannot be certain that any currently pending or future applications will actually result in issued patents, or that, even if patents are issued, they will be of sufficient scope or strength to provide meaningful protection or any commercial advantage to us. 
+
+ The steps we have taken regarding our proprietary technology, however, may not be sufficient to deter misappropriation. For example, we have rights in trademarks, service marks and copyrights that are not registered. In addition, the laws of certain countries in which our products are or may be developed, manufactured, sold or otherwise distributed do not protect our products and intellectual rights to the extent of the laws of the U.S. We also rely on trade secret protection for our technology, in part through confidentiality agreements with our employees, consultants and third parties. However, employees may breach these agreements, and we may not have adequate remedies for any breach. In any case, others may come to know about or determine our trade secrets through a variety of methods.
+
+ In the systems and software industries, companies receive notices from time to time alleging infringement of patents, copyrights or other intellectual property rights of others. In the past we have been, and may from time to time continue to be, notified of claims that we may be infringing patents, copyrights or other intellectual property rights owned by third parties. Companies may pursue claims against us with respect to the alleged infringement of patents, copyrights or other intellectual property rights owned by third parties. In addition, litigation may be necessary to protect our intellectual property rights and trade secrets, to determine the validity of and scope of the proprietary rights of others or to defend against third party claims of invalidity. Any litigation could result in substantial costs and diversion of resources.
+
+ Existing copyright, trademark, patent and trade secret laws afford only limited protection. Moreover, effective protection of copyrights, trade secrets, trademarks and other proprietary rights may be unavailable or limited in certain foreign countries and territories. Domestic and foreign laws, in combination with the steps we have taken to protect our proprietary rights may not be adequate to prevent misappropriation of our technology or other proprietary rights. Also, these protections do not preclude competitors from independently developing products with functionality or features similar or superior to our products and technologies or designing around the patents we own or the technology we create.
+
+ Litigation may be necessary to defend against claims of infringement, to enforce our proprietary rights, or to protect trade secrets and that could result in substantial cost, and a diversion of resources away from the day-to-day operation of our business.
+
+Our future operating results may fluctuate or deteriorate and we would be in violation of restrictive bank covenants.
+
+ Our borrowing facility with our U.S. bank requires that for 2002, we achieve certain quarterly financial covenants with respect to our U.S. operations: a designated minimum EBITDA; maintain a stated minimum cash balance at all times; and, achieve a set fixed charge ratio financial covenant for each of the quarters of 2002. While we met the financial covenants for the first two quarters of 2002, our operating results in the past, including 2001, have caused us to violate the minimum EBITDA financial covenants in place at the time for which we either obtained waivers or amended our bank agreement. The bank financial covenants for the third and fourth quarters of 2002 require that the U.S. operations achieve a minimum EBITDA of $0.19 million and $0.22 million, respectively, maintain a minimum cash balance of $1 million at all times, and achieve a fixed charge ratio of 1:1. We are uncertain whether we will attain the EBITDA or minimum cash balance financial covenants for these two quarters, although we believe that based on current forecasts we will be close. Unless there is a material adverse change in the results of operations we expect to be able to attain the fixed charge ratio covenant. There is no assurance we will not be in violation of bank covenants in the future because of fluctuations or even deterioration in our operating results. At that point there is no assurance we will be able to obtain waivers or amend our bank agreements. If not, we would be in violation of our restrictive bank financial covenants and the bank would have the right to demand full payment of all amounts owed them. We would then be required to settle the outstanding obligation. At December 31, 2001, we owed the U.S. bank $4.8 million, consisting of $2.7 million under our revolving credit line and $2.1 million under our outstanding term loan. At June 30, 2002 we owed the U.S. bank $3.68 million, consisting of $1.8 million under our revolving credit line and $1.88 million under our outstanding term loan.
+
+ Our expectation is that we would not have the financial resources to meet the bank obligation in one payment. We would expect to agree to a payment plan to pay off the bank debt over a specific period of time. We cannot provide any assurance that the bank would accept any plan. Furthermore, we cannot provide any assurance that the sources of capital to pay off the bank would materialize in a timely manner and to the extent we had planned for.
+
+ In specific terms, the contemplated sources of capital to meet our bank obligation are listed below:
+
+Sale or sale-leaseback of our Pro-Bel office building in Reading, U.K.: Net of the existing mortgage, a sale or sale-leaseback could generate proceeds of between $1.5 million to $2.5 million. However, this may not materialize.
+
+Cash on the balance sheet: There may be no cash on the balance sheet at the time of covenant violation.
+
+Cuts in staff and overhead: A further restructuring may not be achievable without impairing the business
+
+Third party financial support: Sufficient additional financial support from third parties, which may include directors and principal shareholders, may not materialize as it has in the past.
+
+We may not be able to successfully implement our contingency plan upon a decline in revenues.
+
+ During 2001 we effected a restructuring that involved reductions in staff and overhead, as well as reduced capital expenditures and discretionary spending, so as to reduce costs and expenses and reduce cash outflows in response to lower revenues. If sales decline we could be forced to further reduce staff and other costs and expenses, as contemplated in our contingency plan. Were this to occur, we may be unable to reduce personnel and other costs and expenses on a timely basis, which could have a material adverse effect on our business, financial condition and results of operations. In addition, further reductions in personnel and costs and expenses may adversely affect our ability to generate revenues.
+
+We are uncertain of our ability to obtain additional financing or refinance existing obligations for our future needs, and liquidity issues have and may continue to increase our cost of capital.
+
+ At December 31, 2001 we had cash and cash equivalents of $4.3 million and working capital of $4.4 million. We also had repayment obligations on revolving lines of credit, term debt, leases, a mortgage, senior subordinated convertible notes, and Series A and Series B convertible debentures of $5.1 during 2002, $7.9 million during 2003, $13.3 million during 2004, $0.8 million during 2005, $0.7 million during 2006 and $5.9 million thereafter. We believe that cash on hand and net cash expected to be generated in the business will be sufficient to meet our needs for the next twelve months if we are able to achieve our planned results of operations. However, we may need to raise additional funds in order to fund our business, expand our sales and marketing activities, develop or enhance new products, respond to competitive pressures and satisfy our existing and any new obligations that may arise. Additional financing may not be available on terms favorable to us, or at all. While we significantly reduced our cash usage for operations during the latter part of 2001, capital is critical to our business, and our inability to raise capital in the event that ongoing losses use our available cash would have a material adverse effect on our business. 
+
+ Our need for cash in late 2001 in order to maintain liquidity necessitated that we borrow additional monies and modify the terms of existing obligations, which actions increased our cost of capital. Due to the level of our current and non-current debt in relation to cash, as well as our results of operations and cash flows, we expect our cost of capital to remain at relatively higher levels. In December 2001 the holders of the existing Series A and Series B subordinated debentures agreed to an amendment of those debentures to change their maturity dates from December 31, 2003 to December 31, 2004. In return we were required to increase the interest rate payable on the debentures from 8% to 12% annual percentage rate and issue 861,027 warrants to the holders thereof to permit them to purchase stock at a price of $0.35 per share at any time until the debentures mature. The effect of the amendment to the debentures and the related issuance of warrants is to increase interest expense by $0.41 million, $0.48 million and $1.38 million for years 2002, 2003 and 2004 respectively. The increased risk to note holders associated with our ability to repay the $2.1 million in Senior Notes issued December 2001 and maturing December 31, 2003 resulted in us having to agree to pay an annual percentage rate of 12% on that debt.
+
+The TV broadcast industry has historically expected substantial marketing expenses.
+
+ In the past we have spent generously on marketing. We have attended major trade shows in the U.S. and Europe, which cost us substantial sums. Our plan going forward is to participate in the principal trade shows and some of the minor shows. We plan to control these expenditures and be more frugal in our expenditures. We cannot provide any assurance we will remain frugal and judicious in expensing our marketing dollars, because of market demands. Furthermore, we cannot provide any assurance that selective spending of our marketing dollars will pay off in the areas in which we are expecting results.
+
+We sell hardware and software service agreements to our customers that may become onerous because of product problems or the age of our products.
+
+ We generated approximately 5% of our 2001 revenues from hardware and software service agreements sold to our customers. The customary term of such agreements is one year, and as they are sold throughout the year, they tend to expire throughout the year. In order to maintain our customer relations, we may need to support customers' products beyond their useful life, which may require us to expend significant resources. It is possible that our products, current and prospective, will not provide sufficient customer satisfaction and require inordinate and expensive service support for each product category, beyond the level planned in the service agreements in place. That, by itself, would increase our expenses and make these service agreements unprofitable. In addition, customers who purchase service agreements and experience problems may be disinclined to renew their service agreements in subsequent years, hence affecting the revenues generated from service agreements.
+
+ 
+
+Our warranties on products may prove insufficient and could cause us unexpected costs.
+
+ We warranty our products from 90 days to two years, depending on the type of product and industry practices. It is possible that our products, current and prospective, do not provide sufficient customer satisfaction and we are required to extend our warranty for a particular product or product line. In addition, we may extend the warranty period in certain special situations to win a particular contract, hence extending our liability period.
+
+ Any unplanned increase of our warranty periods would increase our costs and reduce our profitability. Because of the attendant contingent liabilities, it is possible that a reserve would have to be established, further affecting our operating results.
+
+If a new law or regulation is created pertaining to the telecommunications and television industries it could cause our customers to suffer and impede our ability to increase profits.
+
+ The enactment by U.S. federal or state or international governments of new laws or regulations, changes in the interpretation of existing regulations or a reversal of the trend toward deregulation in these industries could cause our customers to suffer, and thereby adversely affect our ability to continue to be profitable. Television operators are subject to extensive government regulation by the FCC and other U.S. federal and state regulatory agencies. These regulations could limit capital expenditures by television operators and if that happens our business, financial condition and results of operations may suffer.
+
+ 
+
+ The telecommunications and television industries are subject to extensive regulation in the United States and other countries. Our business is dependent upon the continued growth of these industries in the United States and internationally. Recent legislation has lowered the legal barriers to entry for telecommunications companies into the United States' multi-channel television market, but telecommunications companies may not successfully enter this or related markets. Moreover, the growth of our business internationally is dependent in part on similar deregulation of the telecommunications industry abroad, which deregulation may not occur.
+
+Our principal stockholders have significant voting power and may vote for actions that may not be in the best interests of our stockholders.
+
+ Our officers, directors and principal stockholders together control approximately 44% (as of October 1, 2002) of our issued and outstanding common stock. As a result, these stockholders, if they act together, will be able to significantly influence the management and affairs of our company and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control or other business combination and might affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders.
+
+ 
+
+We have not issued dividends on our common stock for over twelve years and do not anticipate doing so in foreseeable future.
+
+ We have not paid cash dividends on our common stock since November 27, 1989 and do not anticipate paying any cash dividends in the foreseeable future. We intend to retain any earnings for use in our business. The decision to pay dividends in the future will be at the discretion of our board of directors and is subject to certain restrictions under our loan agreements. The historical and prospective lack of issuing dividends may diminish the value of the common stock.
+
+If operating results decrease, our stock price may also decrease and our shareholders may not be able to resell their shares.
+
+ Due to a variety of factors that may affect our revenues or our expenses in any particular quarter, our quarterly operating results may decrease significantly in the future. It is possible that in some future periods our results of operations or other performance measures may be below the expectations of public market analysts and investors. If this occurs, the price of our common stock will likely fall.
+
+ You should not rely on our results of operations during any particular quarter as an indication of our future results for a full year or any other quarter. Our quarterly operating results have in the past varied and in the future will be affected by factors such as:
+
+the timing and recognition of revenue from significant orders,
+
+the success of our products,
+
+increased competition,
+
+changes in our pricing policies or those of our competitors,
+
+the financial stability of our major customers,
+
+new product introductions or enhancements by our competitors,
+
+delays in the introduction of our products or product enhancements,
+
+customer order deferrals in anticipation of upgrades and new products,
+
+our ability to access a sufficient supply of sole source and third-party components,
+
+the quality and market acceptance of new products,
+
+the timing and nature of selling and marketing expenses (such as trade shows and other promotions),
+
+personnel changes,
+
+the lengthy sales cycle associated with our switching and routing systems and certain other products,
+
+high per unit list prices for our equipment, thereby posing significant barriers to the purchase of equipment for potential customers, and
+
+economic conditions affecting our customers and us.
+
+The price of our common stock may be volatile.
+
+ The trading price of our common stock has been and may continue to be subject to fluctuations in response to quarter-to-quarter variations in operating results, changes in earnings estimates by analysts, general conditions in the digital media industry, announcements of technological innovations or new products introduced by us or our competitors and other events or factors. The stock market in general, and the shares of technology companies in particular, have experienced extreme price fluctuations in recent years. During the period October 1, 2001 through October 1, 2002 the closing price of our common stock has ranged between $0.21 and $0.76. This volatility has had a substantial impact on the market prices of securities issued by many companies for reasons unrelated to the operating performance of the companies affected. These broad market fluctuations may adversely affect the market price of our common stock. In addition, our common stock is now traded on the OTC Bulletin Board. You may expect trading volume to be low in such a market. Consequently, the activity of only a few shares may affect the market and may result in wide swings in price and in volume.
+
+ 
+
+Shares of our common stock eligible for public sale after the offering could reduce the price of our common stock.
+
+ As of October 1, 2002, 39,563,691 shares of common stock were issued and outstanding. Of these shares, approximately 20,711,678 shares will be freely tradable without restriction under the Securities Act of 1933, as amended (the "Securities Act") after giving effect to this prospectus. The remaining 18,852,013 outstanding shares are "restricted securities" as defined in Rule 144 of the Securities Act. All of the approximately 18,852,013 restricted shares may be eligible for immediate sale under Rule 144. Sales of a substantial number of shares of common stock in the public market, or the perception that sales could occur, could adversely affect the market price for our common stock. This offering will result in additional shares of our common stock being available on the public market. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.
+
+We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate your ability to sell your shares for a premium in a change of control transaction.
+
+ Various provisions of our Amended and Restated Certificate of Incorporation and Amended and Restated By-Laws and in New York corporate law may discourage, delay or prevent a change in control or takeover attempt of our company by a third party which is opposed to by our management and board of directors. Public stockholders who might desire to participate in such a transaction may not have the opportunity to do so. These anti-takeover provisions could substantially impede the ability of public stockholders to benefit from a change of control or change in our management and board of directors. These provisions include:
+
+authorizing the issuance of "blank check" preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt,
+
+limiting who may call special meetings of our stockholders, and
+
+establishing advance notice requirements for nominations of candidates for election to our board of directors or for proposing matters that can be acted upon by our stockholders at stockholder meetings.
+
+It may be difficult to sell your shares and the value of your investment may be reduced because our common stock has experienced low trading volumes on the OTC Bulletin Board and currently lacks public market research analyst coverage
+
+ Our common stock trades on the OTC Bulletin Board and it experiences lower trading volumes than many stocks listed on a national exchange, and therefore it may be difficult for an investor to sell the shares and to realize any return on an investment in our common stock. Because our common stock lacks public market research analyst coverage it is more difficult to obtain reliable information about its value or the extent of risks to which the investment is exposed. Even if a liquid market for the shares of our common stock exists in the future, there can be no assurance that the securities could be transferred at or above the price paid in this offering. The price of our common stock may fall against the investor's interests, and the investor may get back less than he or she invested.

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+RISK FACTORS An investment in our common stock involves a high degree of risk. You should carefully consider the following risk factors and other information in this prospectus and the documents we incorporate by reference in evaluating our company before you purchase any shares of our common stock. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In this case, the trading price of the common stock could decline and you may lose all or part of your investment. RISKS RELATED TO OUR BUSINESS AND THE LITIGATION WE HAVE A HISTORY OF LOSSES AND ANTICIPATE FURTHER LOSSES, WHICH COULD CAUSE US TO DISCONTINUE OUR BUSINESS. Our business has never had substantial revenues and has operated at a loss in each year since our inception in 1953. We recorded a loss of $554,000 for the three month period ended March 31, 2002, a loss of $6,585,000 for the year December 31, 2001, a loss of $1,386,000 for the year 2000 and a loss of $1,105,000 for the year 1999. If we continue to sustain losses and are unable to achieve profitability, we may not be able to continue our business and may have to curtail, suspend or cease operations. YOU SHOULD ALSO SEE NOTE 1 TO OUR FINANCIAL STATEMENTS REGARDING THE UNCERTAINTY AS TO OUR ABILITY TO CONTINUE AS A GOING CONCERN. During the three years ended December 31, 2001 and the three months ended March 31, 2002, we spent approximately $3.0 million on legal expenses primarily for the lawsuits against the State of Florida relating to drilling permits and royalty interests. If we continue to incur significant expenses and are unable to raise additional funds to meet these expenses, we may have to cease or suspend our lawsuits and/or cease operations entirely. In the unlikely event that we were to receive drilling permits related to the St. George Island prospect or other exploratory wells, we would be required to incur a significant amount of operating expenditures to commence drilling operations and would need to generate significant revenues to achieve profitability. We may not be able to achieve or sustain revenues, profitability or positive cash flow and cannot assure that profitability, if achieved, will be sustained. OUR AUDITORS HAVE EXPRESSED THE VIEW THAT OUR NEGATIVE WORKING CAPITAL, NEGATIVE STOCKHOLDERS' EQUITY AND CAPITAL DEFICIENCIES RAISE SUBSTANTIAL DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN. Our auditors have included an explanatory paragraph in their report for the year ended December 31, 2001, indicating there is substantial doubt regarding our ability to continue as a going concern. The financial statements included elsewhere in this prospectus do not include any adjustments to asset values or recorded liability amounts that might be required in the event we are unable to continue as a going concern. If we are in fact unable to continue as a going concern, you may lose your entire investment in our common stock. WITHOUT ADDITIONAL FINANCING, WE ONLY HAVE ENOUGH LIQUID ASSETS ON HAND TO CONTINUE TO OPERATE THE COMPANY FOR PART OF THE YEAR 2002. We believe that our funds on hand will be sufficient to permit us to continue to operate through the second quarter of 2002 and to pay the remaining expenses related to this offering which are estimated to be approximately $114,000 (total amount $350,000). After that time, we may have to suspend or cease operations unless and until we can secure additional financing. Effective February 20, 2002, our directors, officers, legal counsel and administrative consultants have agreed to defer the payment of all of their salaries and fees until we have working capital of at least $1 million. We currently do not have any commitments for additional financing. We may be unable to obtain additional financing in the future on acceptable terms or at all. IF ULTIMATELY THE COURTS RULE THAT THE STATE OF FLORIDA MAY DENY US A PERMIT AND NOT COMPENSATE US FOR THE TAKING OF OUR PROPERTY, WE MAY BE UNABLE TO CONTINUE OUR BUSINESS. In the event that the courts determine that the State of Florida is entitled to deny Coastal Petroleum a permit without compensation, it is likely that we would be unable to continue our business and that shareholders would suffer a complete loss of their investment. WE MAY BE UNABLE TO RAISE THE ADDITIONAL FINANCING NEEDED TO COVER THE SUBSTANTIAL LITIGATION COSTS OF PROVING OUR PROPERTIES HAVE BEEN TAKEN AND THEIR VALUE. Coastal Petroleum has filed a claim with the Florida Circuit Court that its property has been taken by the State of Florida, and that Coastal Petroleum is owed compensation by the State of Florida. We will need to secure additional financing to cover the costs of this litigation, which we estimate will be substantial. If we are unable to secure the additional financing adequate to fund the costs of such litigation for a lengthy period of time, we might not be able to conclude the litigation and might have to cease the lawsuits against the State of Florida without any meaningful recovery. THE STATE OF FLORIDA HAS FAR GREATER RESOURCES THAN WE DO TO PROSECUTE THE LITIGATION. The State of Florida utilizes lawyers from the Florida Attorney General's Office, the Department of Environmental Protection and at least two private law firms to represent its interests in the litigation. In the event that our funds are exhausted before the conclusion of the litigation, we may be unable to conclude the litigation and might be required to cease business which could result in the complete loss of your investment. IF THE AMOUNT OF MONEY WE RECOVER FROM THE STATE OF FLORIDA IS INADEQUATE TO COVER OUR COSTS, WE MAY SUFFER ADDITIONAL LOSSES. Coastal Petroleum's lawsuits against the State of Florida involve highly specialized technical engineering and legal judgments. Any recovery that Coastal Petroleum may receive as a result of a court judgment against the State of Florida may be insufficient to cover the costs of prosecuting the claims at trial. If this occurs, we may be forced to cease operations, the value of your investment in our common stock could decline significantly, and you may realize a total loss of your investment. COASTAL CARIBBEAN IS CURRENTLY A PASSIVE FOREIGN INVESTMENT COMPANY, OR PFIC, FOR U.S. FEDERAL INCOME TAX PURPOSES, WHICH COULD RESULT IN NEGATIVE TAX CONSEQUENCES TO YOU. If, for any taxable year, our passive income or our assets that produce passive income exceed levels provided by U.S. law, we would be a "passive foreign investment company," or PFIC, for U.S. federal income tax purposes. For the years 1987 through 2001, Coastal Caribbean's passive income and assets that produce passive income exceeded those levels and for those years Coastal Caribbean constituted a PFIC. Based upon Coastal Caribbean's current passive income, it is likely that Coastal Caribbean will be classified as a PFIC in 2002. If Coastal Caribbean is a PFIC for any taxable year, then our U.S. shareholders potentially would be subject to adverse U.S. tax consequences of holding and disposing of shares of our common stock for that year and for future tax years. Any gain from the sale of, and certain distributions with respect to, shares of our common stock, would cause a U.S. holder to become liable for U.S. federal income tax under Code section 1291 (the interest charge regime). The tax is computed by allocating the amount of the gain on the sale or the amount of the distribution, as the case may be, to each day in the U.S. shareholder's holding period. To the extent that the amount is allocated to a year, other than the year of the disposition or distribution, in which the corporation was treated as a PFIC with respect to the U.S. holder, the income will be taxed as ordinary income at the highest rate in effect for that year, plus an interest charge. Please see a discussion of these consequences below under the heading "MATERIAL TAX CONSEQUENCES - PASSIVE FOREIGN INVESTMENT COMPANY RULES". We encourage you to consult with a personal tax advisor for advice relating to the potential adverse tax consequences related to an investment in our common shares. RISKS RELATED TO THE OFFERING THE PRICE OF OUR COMMON STOCK IS VOLATILE, WHICH COULD HINDER YOUR ABILITY TO SELL YOUR STOCK AND AVOID A LOSS ON YOUR INVESTMENT. Our common stock has been quoted and traded in the over-the-counter market on the "Electronic Bulletin Board" of the National Association of Securities Dealers, Inc. under the symbol COCBF.OB and on the Boston Stock Exchange under the symbol COCBF. The market price of our common stock has fluctuated in the past and may continue to be volatile in the future. As a result of this volatility, you may find it more difficult to sell our stock in a declining market and avoid a loss on your investment. This volatility is a result of a variety of factors, including our current and anticipated results of operations, and the anticipated outcome of our litigation with the State of Florida. BECAUSE SHARES PURCHASED IN THE OFFERING WILL BE DISTRIBUTED ON A DELAYED BASIS, YOU ARE AT RISK OF DOWNWARD PRICE FLUCTUATIONS PRIOR TO RECEIPT OF CERTIFICATES REPRESENTING YOUR SHARES. Until certificates representing the shares you purchase are delivered upon expiration of the rights offering, you will not be able to resell your shares. Certificates representing the shares you purchase will be delivered as soon as practicable after expiration of the rights offering. However, during this interim time period, you may sustain an immediate unrealized loss on your investment if our stock price declines below the offering price. PURCHASERS IN THIS OFFERING WILL EXPERIENCE IMMEDIATE NET TANGIBLE ASSET DILUTION AND MAY EXPERIENCE FURTHER DILUTION FROM THE FUTURE EXERCISE OF STOCK OPTIONS OR FROM FUTURE STOCK OFFERINGS. We expect that the offering price of our common stock in this offering will be substantially higher than the net tangible book value per share of our outstanding common stock. Accordingly, if the offering is successful, purchasers of common stock in the offering will experience immediate and substantial dilution of approximately $.40 in net tangible book value per share, or approximately 80% of the assumed public offering price of $.50 per share. Investors will incur additional dilution upon the exercise of outstanding stock options and warrants. See "Dilution" at page 14 for further discussion of the dilution that new investors will incur. Finally, if we raise additional funds by issuing equity or convertible debt securities, your percentage ownership may be further diluted. Any securities issued could have rights, preferences and privileges senior to our common stock. OUR BYE-LAWS CONTAIN PROVISIONS WHICH MAY LIMIT A SHAREHOLDER'S EFFORTS TO INFLUENCE OUR POLICIES AND PREVENT OR DELAY A CHANGE IN CONTROL OF OUR COMPANY. Bye-Law 1 provides that any matter to be voted on at any meeting of shareholders must be approved not only by a simple majority of the shares voted at such meeting, but also by a majority of the shareholders present in person or by proxy and entitled to vote at the meeting. This provision may have the effect of making it more difficult to take corporate action than customary "one share one vote" provisions, because it may not be possible to obtain the necessary majority of both votes. As a consequence, Bye-Law 1 may make it more difficult that a takeover of the company will be consummated, which could prevent the company's shareholders from receiving a premium for their shares. In addition, an owner of a substantial number of shares of our common stock may be unable to influence our policies and operations through the shareholder voting process (e.g., to elect directors). Our Bye-Laws also require the approval of 75% of the voting shareholders and of the voting shares for the consummation of any business combination (such as a merger, amalgamation or acquisition proposal) involving our company. This higher vote requirement may deter business combination proposals which shareholders may consider favorable. YOU MAY FACE OBSTACLES TO BRINGING SUIT IN BERMUDA AGAINST OUR OFFICERS AND DIRECTORS. We are a Bermuda company and certain of our directors and officers are residents of Bermuda and are not citizens of the United States. As a result, it may be difficult for investors to effect service of process on us or on these directors and officers within the United States or to enforce against these directors and officers judgments of U. S. courts predicated on the civil liabilities under the federal securities laws. If investors are unable to bring such suits, they may be unable to recover a loss on their investment resulting from any violations of the federal securities laws. There is no precedent for, and therefore no assurance that, the courts in Bermuda would enforce civil liabilities, whether in original actions in Bermuda or in the form of final judgments of U. S. courts, arising under the federal securities laws against us or the persons signing this registration statement. In addition, there is no treaty in effect between the U. S. and Bermuda providing for the enforcement of civil liabilities and there are grounds upon which Bermuda Courts may not enforce judgments of U. S. courts. In addition, some remedies available under the laws of U. S. jurisdictions, including some remedies available under the United States federal securities laws, may not be allowed in Bermuda courts as contrary to that nation's public policy. OUR DIVIDEND POLICY COULD DEPRESS OUR STOCK PRICE. We have never declared or paid dividends on our common stock and do not anticipate declaring or paying any dividends in the foreseeable future. We plan to retain any future earnings to reduce our deficit accumulated during the development stage of $36,549,000 at March 31, 2002 and to finance our operations. As a result, our dividend policy could depress the market price for our common stock. ANY DIVIDENDS ARE SUBJECT TO A 30% WITHHOLDING TAX. We are a Bermuda corporation. Bermuda currently imposes no taxes on corporate income or capital gains realized outside of Bermuda. However, any dividends we receive from Coastal Petroleum are subject to a 30% United States withholding tax. As a result, our investors may realize a smaller rate of return on their investment in our common stock. OUR COMMON STOCK MAY BE DELISTED FROM THE BOSTON STOCK EXCHANGE. We are currently not in compliance with certain of the listing requirements of the Boston Stock Exchange. We currently fail to meet the Exchange's requirements of total assets of $1,000,000 and shareholders' equity of $500,000. The Exchange has advised us that if these deficiencies are not remedied it will result in the suspension of trading in our common stock and delisting of the stock from the Exchange. If this occurs, the market for and liquidity of our common stock will be adversely affected. RISKS RELATED TO OUR INDUSTRY THE STATE OF FLORIDA HAS STATED THAT ITS POLICY IS NOT TO PERMIT OIL AND GAS DRILLING OFFSHORE FLORIDA AND THE STATE HAS DENIED COASTAL PETROLEUM A PERMIT WITH RESPECT TO ITS ST. GEORGE'S ISLAND PROSPECT. CONSEQUENTLY, WE DO NOT BELIEVE THAT THE STATE OF FLORIDA WILL GRANT DRILLING PERMITS TO COASTAL PETROLEUM WITH RESPECT TO ITS LEASES. IN THE UNLIKELY EVENT THAT THE STATE EVER DOES GRANT COASTAL PETROLEUM A DRILLING PERMIT, COASTAL PETROLEUM WOULD HAVE TO CONTEND WITH OTHER RISKS. After obtaining a state drilling permit, Coastal Petroleum would have to do the following: - obtain a federal drilling permit; - finance drilling of the well (including the cost of the recommended surety), which is currently estimated to cost approximately $5.5 million; and - begin drilling the well within one year of the date the state permit is issued. We may be unable to obtain the necessary federal permits or we may be unable to finance and commence drilling operations in a timely manner. If we fail to discover and develop sufficient oil and gas reserves, we would be unable to generate sufficient revenues to cover our costs and might have to curtail, suspend or cease our business operations. Drilling activities involve numerous risks, including the risk that no commercially productive natural gas or oil reservoirs will be discovered. The cost of drilling, completing and operating wells is often uncertain, and drilling operations may be curtailed, delayed or canceled as a result of adverse conditions beyond our control. Poor results from our exploration and drilling activities could prevent us from developing sufficient oil and gas reserves at a commercially acceptable cost. COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENTAL REGULATIONS COULD BE COSTLY. Our operations and right to obtain interests in and hold properties or to conduct our business might be affected to an unpredictable extent by limitations imposed by the laws and regulations which are now in effect or which might be adopted by the jurisdictions in which we carry on our business. Further measures that have been or might be imposed include increased bond requirements, conservation, proration, curtailment, cessation or other forms of limiting or controlling production of hydrocarbons or minerals, as well as price controls or rationing or other similar restrictions. In particular, environmental control and energy conservation laws and regulations adopted by federal, state and local authorities may have to be complied with by leaseholders such as Coastal Petroleum. WE FACE STRONG COMPETITION FROM LARGER OIL AND GAS COMPANIES THAT MAY IMPAIR OUR ABILITY TO CARRY ON OPERATIONS. If we receive the necessary state and federal permits to conduct operations, we will operate in the highly competitive areas of oil and gas exploration, development and production. We might not be able to compete with, or enter into cooperative relationships with, our potential competitors, which include major integrated oil companies, substantial independent energy companies, affiliates of major interstate and intrastate pipelines and national and local gas gatherers. If we were unable to establish and maintain competitiveness, our business would be threatened. Many of our competitors possess greater financial, technical and other resources than we do. Factors which affect our ability to successfully compete in the marketplace include: - the financial resources of our competitors; - the availability of alternate fuel sources; and - the costs related to the extraction and transportation of oil and gas. CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS In this prospectus, we make statements that relate to our future plans, objectives, expectations and intentions that involve risks and uncertainties. We have based these statements on our current expectations and projections about future events. These statements may be identified by the use of words such as "expect," "anticipate," "intend," "plan," "believe" and "estimate" and similar expressions. Any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and are subject to the safe harbor created by that Act. Forward-looking statements necessarily involve risks and uncertainties. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could contribute to such differences include, but are not limited to, those discussed in the "Risk Factors" section at page 5 and elsewhere in this prospectus. The factors set forth in the Risk Factors section and other cautionary statements made in this prospectus should be read and understood as being applicable to all related forward-looking statements wherever they appear in this prospectus. All subsequent written and oral forward-looking statements attributable to us are expressly qualified in their entirety by the cautionary statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

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+RISK FACTORS EXERCISING YOUR RIGHTS AND INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION CONTAINED IN THIS PROSPECTUS BEFORE INVESTING IN OUR COMMON STOCK. THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE DUE TO ANY OF THESE RISKS AND YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT. RISKS RELATED TO THE PHARMACEUTICAL INDUSTRY OUR SUCCESS DEPENDS ON REGULATORY APPROVALS AND COMPLIANCE The development, manufacture, marketing and sale of pharmaceutical products is subject to extensive federal, state and local regulation in the U.S. and similar regulation in other countries. Like our competitors, we must obtain approval from the federal Food and Drug Administration (sometimes known by its initials FDA) before marketing most drugs. Such approval process often requires extensive and expensive testing. The level of testing depends upon the nature of the drug. Our ability to successfully market new drugs is dependent on our ability to meet such tests in a timely fashion. We may not be able to obtain timely FDA approval for our planned new drugs. In addition, our plants must satisfy the FDA's current good manufacturing practices regulations, which may require expenditures of significant funds. WE ARE DEPENDENT UPON NEW PRODUCTS AND THE ABILITY TO BE QUICK TO MARKET THEM The success of generic drug companies depends, to a significant extent, upon the ability to develop and commercialize new pharmaceutical products in a timely manner. Following the expiration of patents and any other market exclusivity periods for branded drugs, the first pharmaceutical manufacturers successfully to market generic equivalents of such drugs usually achieve higher revenues and gross profits from the sale of such generic drugs than do others whose products are subsequently approved or marketed. As competing generic products reach the market, the prices, sales volumes and profit margins of the first generic versions often decline significantly. While we have new drugs in our pipeline, these may not be successfully developed or approved by the FDA so that we would be among the first to the market or otherwise achieve significant revenues and profitability. MANY OF OUR COMPETITORS ARE BETTER POSITIONED Many of our competitors, including large pharmaceutical companies and other generic drug manufacturers, have greater financial and other resources than we do, and are therefore able to spend more than us on research, product development and marketing. In addition, following the expiration of patents on branded drugs, manufacturers of the patented products have employed various strategies intended to maximize their share of the markets for these products, as well as, in some cases, generic equivalents of these products. DEVELOPMENTS MAY RENDER OUR PRODUCTS OBSOLETE Innovations or developments by others, including better financed competitors, may render any products we produce obsolete or otherwise non-competitive. WE MAY NOT OBTAIN FUNDS TO MAINTAIN TECHNOLOGICAL PARITY Any failure to maintain adequate research and development programs could be harmful to our ability to introduce new products in a timely manner. We must expend significant funds to develop and gain regulatory approval of products which are comparable to national brand products under the FDA's approval process for generic drugs. We are also engaged in R&D efforts related to certain prescription (sometimes referred to as ethical) products and are exploring potential acquisition candidates or joint ventures to facilitate entry into other drug categories. These activities may require significant resources in order to succeed. INCREASED CONSOLIDATION OF THE DRUG DISTRIBUTION NETWORK MAY RESULT IN LOWER SALES Growing consolidation in the wholesale drug industry may increase pricing and other competitive pressures on generic drug manufacturers, possibly leading to lower levels of purchases. Our principal customers are wholesale drug distributors and major drug store chains. This distribution network is continuing to undergo significant consolidation, marked by consolidation of wholesale distributors and the growth of large retail drug store chains. As a result, a small number of large wholesale distributors control a significant share of the market, and the number of independent drug stores and small drug store chains has decreased. WE ARE DEPENDENT ON COLLABORATIVE RELATIONSHIPS WHICH ARE OFTEN BEYOND OUR CONTROL We develop and market many of our products through collaborative arrangements with other companies through which we gain access to dosage forms, proprietary drug delivery technology, specialized formulation capabilities and active pharmaceutical ingredients. We rely on our collaborative partners for any number of functions, including product formulation, approval and supply. There can be no assurance these products will be successfully developed or that our partners will perform their obligations under these collaborative arrangements. Further, we may not be able to enter into future collaborative arrangements on favorable terms, or at all. WE FACE RISKS RELATED TO PRODUCT LIABILITY CLAIMS AND DRUG TAMPERING PROBLEMS AGAINST WHICH WE MAY NOT BE ADEQUATELY INSURED The testing, manufacture and sale of pharmaceutical products involve a risk of product liability claims and the adverse publicity that may accompany such claims. Although we maintain what we believe to be an adequate amount of product liability insurance coverage, our existing product liability insurance may not cover all current and future claims or we may not be able to maintain existing coverage or obtain, if we determine to do so, insurance providing additional coverage at reasonable rates. RISKS RELATED TO OUR FINANCIAL CONDITION WE WILL REQUIRE AN ADDITIONAL CASH INFUSION IN ORDER TO MEET PRINCIPAL PAYMENT OBLIGATIONS AND TO CONTINUE OPERATIONS We have issued certain subordinated convertible debentures and obtained an economic development corporation loan, currently aggregating approximately $6 million in outstanding principal amount, which come due in June 2002. During the next twelve months, we will need a minimum of $10,000,000 in additional equity or debt just to continue our operations at their current level and fund scheduled debt repayments. Absent this amount of funding, we may be unable to continue our operations. In the past, ICC has demonstrated its confidence in our management and business plan by providing loans, providing working capital and converting debt to equity. While ICC has committed to continue to provide us with financial support until December 31, 2003, events may arise which may cause ICC to not provide the necessary support for continued operations. WE MAY CONTINUE TO SUSTAIN LOSSES AND ACCUMULATED DEFICITS IN THE FUTURE We had an accumulated deficit of $73,380,000 (unaudited) as of December 29, 2001. We had a loss from operations of $9,134,000 for the fiscal year ended June 30, 2001, and an operating loss of $2,633,000 (unaudited) for the six months ended December 29, 2001. Our ability to achieve profitability in the future will depend on many factors, including those detailed in this risk factors section. We currently depend on financing transactions to support our operations. During 1999, 2000 and 2001, we relied primarily upon significant borrowings under our loan facility with CIT and financings by our largest stockholder, ICC Industries Inc., to satisfy our funding requirements for working capital. Our loan agreement with The CIT Group expires on December 31, 2003 but we cannot assure you that ICC will continue to provide the additional required funding, as it has in the past, or that financing alternatives will be available to us in the future, to support continued growth. WE ARE SUBJECT TO RISKS ASSOCIATED WITH THE IMPLEMENTATION OF OUR BUSINESS STRATEGY We are subject to our ability to implement our business strategy as outlined above under "Objectives" in the Summary and improve our operating results, which will depend in part on our ability to realize significant cost savings. RESTRICTIONS IMPOSED BY TERMS OF INDEBTEDNESS POSE SIGNIFICANT RISKS TO STOCKHOLDER EQUITY IN THE EVENT OF DEFAULT ON SUCH INDEBTEDNESS Our loan agreement with The CIT Group requires us to maintain specified financial ratios and satisfy certain financial tests. Our ability to meet such financial tests may be affected by events beyond our control, and we may not be able to meet such tests. A breach of any of these financial tests could result in an event of default under the loan agreement, in which case the lenders could elect to declare all liabilities and obligations under such agreement to be immediately due and payable and to terminate all commitments to us. If we were unable to repay or refinance all amounts declared due and payable, such lenders could proceed against the collateral that secures the liabilities and obligations under the loan agreement. Substantially all of our assets secure our liabilities and obligations under the loan agreement. If the loan agreement were accelerated, we may not be able to repay in full such indebtedness, and in such event our equity holders could lose their entire investment. In recent years, we have been late in payment of periodic interest payments on outstanding debentures. However, all payments were made within the period allowed to prevent such nonpayment from becoming an event of default under the respective debenture indenture. RISKS RELATED TO OUR BUSINESS WE ARE HEAVILY DEPENDENT ON CERTAIN KEY PRODUCTS We derive and expect to continue to derive a significant portion of our revenues and gross profit from a limited number of products. Total sales of ibuprofen were 26% of our total sales in fiscal 2001 and 36% of our total sales in fiscal 2000, with gross profit from ibuprofen as a percentage of total gross profit being significantly greater each year. Any material decline in sales or gross profit from ibuprofen or other significant products could have a material adverse effect on our business, results of operations and financial condition. WE ARE HEAVILY DEPENDENT ON CERTAIN KEY CUSTOMERS Sales to three customers (Costco Wholesale, Walgreens and CVS) exceeded 10% of total sales in at least one of the past three years and, in the aggregate, approximated 30% of our gross sales for fiscal 2001. The loss of any of these customers could materially and adversely affect our business, results of operations and financial condition. Sales to our ten largest customers in that year represented approximately 62% of our total net revenues. WE ARE DEPENDENT UPON CERTAIN KEY SUPPLIERS OF RAW MATERIALS Any interruption of supply of raw material could have a material adverse effect on our ability to manufacture our products or to obtain or maintain regulatory approval of such products. The principal components of our products are active and inactive pharmaceutical ingredients and certain packaging materials. Many of these components are available only from a single source. While we currently do not rely on ICC as a source of raw materials, we may in the future directly source utilizing their more favorable buying power for more favorable price treatment. Changes in ICC's source of materials or its buying power may therefore adversely impact us. Additionally, our government approvals may be based on a single supplier, even in instances when multiple sources exist. The qualification of a new supplier could delay our development and marketing efforts. Furthermore, some of our suppliers are also competitors, and if our supply relationship with them deteriorates, it could harm our business. OUR RELIANCE ON FOREIGN SUPPLIES POSES ADDITIONAL RISKS TO OUR OPERATIONS We obtain a significant portion of our raw materials from foreign suppliers. Arrangements with international raw material suppliers are subject, among other things, to FDA regulation, various import duties and other government clearances. Acts of governments outside the U.S. may affect the price or availability of raw materials needed for the development or manufacture of generic drugs. In addition, recent changes in patent laws in jurisdictions outside the U.S. may make it increasingly difficult to obtain raw materials for research and development prior to the expiration of the applicable U.S. patents. WE ARE CONTROLLED BY OUR PRINCIPAL STOCKHOLDER, WHOSE INTERESTS MAY NOT BE ALIGNED WITH THOSE OF OUR OTHER STOCKHOLDERS Our common stock is largely held by one stockholder, ICC Industries Inc. Therefore, our Board of Directors and the future success of our business may be controlled by the decisions of one entity. ICC is not prohibited from selling a controlling interest in us to a third party. We have historically had significant commercial and finance transactions with ICC. While we believe that all of those activities have been beneficial to us, and have been as good or better than any similar transactions with third parties, there is a risk that any such transactions may be adverse to our interests. If ICC acquires 90% or more of our common stock, it may seek to engage in a merger with us without any action by our stockholders, which may result in our public shareholders being forced to sell their stock at a stated price or our stock no longer being registered with the SEC under the Securities Exchange Act. We have been advised by ICC that it has no intention to cause any such actions to happen but such assurances are not binding commitments by ICC. RESULTS OF OPERATIONS MAY CONTINUE TO FLUCTUATE IN THE FUTURE During the past three years, our results of operations have fluctuated materially on both an annual and a quarterly basis. These fluctuations have resulted from several factors, including, the timing of introductions of new products by us and our competitors, our dependence on a limited number of products, and weak performance by the generic drug industry. We expect these fluctuations in net revenues, gross profit and net income to continue as a result of, among other things, the timing of regulatory approvals and market introduction of new products by us and our competitors, and downward pressure on pricing for generic products available from multiple approved sources. A number of factors, many of which are discussed in more detail in other risk factors, may cause variations in the results of our operations, including: o the proportion of large to small orders; o our product mix; o the timing of orders that we receive from our customers; o changes in the cost and availability of our raw materials; o our manufacturing capacity and yield. PROTECTION OF TRADEMARKS AND PATENTS IS NOT ASSURED ALLERFED(R), LEG EASE(R), HEALTH+CROSS(R) and HEALTH PHARM(R) are federally registered trademarks owned by us. To the extent that our packaging and labeling of generic OTC products may be considered similar to the brand name products to which they are comparable, and to the extent that a court may determine that such similarity may constitute confusion over the source of the product, we may be subject to legal actions under state and Federal statutes and case law to enjoin the use of the packaging and for damages. WE HAVE POTENTIAL ENVIRONMENTAL LIABILITY IN CONNECTION WITH OUR PRIMARY MANUFACTURING FACILITY The prior owner of our Edison, New Jersey manufacturing facility conducted certain remedial actions under state supervision. Although CVS (as the successor to such prior owners) is primarily responsible for the entire cost of the cleanup, we guaranteed the cleanup. In addition, we agreed to indemnify the owner of the facility under the terms of a sale lease-back. If CVS defaults in its obligations to pay the cost of the clean-up, and such costs exceed the amount of the posted bond, we may be required to make payment for any cleanup. WE ARE DEPENDENT ON KEY PERSONNEL We depend on key personnel. The loss of any key personnel could disrupt our operations, adversely affecting our business and result in reduced revenues. Our future success will depend on the continued services and on the performance of our senior management and other key employees. In particular, we depend on our President, James C. Ingram. While we have entered into an employment agreement with Dr. Ingram, the loss of his services for any reason could seriously impair our ability to execute our business plan, which could reduce our revenues and have a materially adverse effect on our business and results of operations. We have not purchased any key-man life insurance. DISRUPTIONS COULD ADVERSELY EFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION We believe that our success to date has been, and future results of operations will be, dependent in large part upon our ability to provide prompt and efficient service to our customers. As a result, any disruption of our day-to-day operations could have a material adverse effect upon us. Our manufacturing operations, marketing, management information systems, customers service and distribution functions are housed in two closely situated buildings in Edison, New Jersey. A fire, flood, earthquake or other disaster affecting our facility could disable these functions. Any significant damage to this facility would have a material adverse effect on our business, results of operations and financial condition. Furthermore, if a disaster struck our primary business facility, our business, results of operations and financial condition may be harmed. FAILURE TO EXPAND OUR MANUFACTURING FACILITIES MAY INHIBIT FUTURE GROWTH While our manufacturing facilities are adequate for our current level of production, if our net sales were to grow, we will need to increase our manufacturing capacity. If we are unable to expand our manufacturing capacity on a timely basis, we may lose sales opportunities and not be able to realize our growth potential. RISKS RELATED TO OUR COMMON STOCK NO ACTIVE TRADING MARKET FOR OUR COMMON STOCK CURRENTLY EXISTS Our common stock is not traded on any major exchange or quoted in any interdealer quotation system. It is currently traded on the OTC Bulletin Board (OTC Bulletin Board sm, symbol: PHFR). It ceased trading on the OTC Bulletin Board between November 20, 2000 and January 16, 2002. While it is currently traded on the OTC Bulletin Board, it may again cease to be traded if we are unsuccessful in meeting the trading criteria. Trading on the OTC Bulletin Board has been limited. While we will attempt to have the stock relisted on the Nasdaq Stock Market if the per share price and other criteria are met, there is a significant risk that we will not be able to have it relisted. There can be no assurance that an active trading market will ever develop for the common stock. The absence of an active trading market for our common stock may reduce the marketability and liquidity of our common stock. OUR STOCK IS SUBJECT TO SUBSTANTIAL DILUTION AND MARKET VOLATILITY RISKS There may be sales of a substantial amount of our common stock after this offering that could cause our stock price to fall. The volatility of the stock market may have a harmful effect on the price of our common stock and our ability to raise capital. In addition, the market prices for stock of companies in the same industry experience significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stocks are traded. Broad market fluctuations, as well as general economic conditions, in the United States or internationally, may adversely affect the market price of our common stock. The market price of the common stock may decline below the price at which shares are initially sold to the public in this offering. SHARES ELIGIBLE FOR FUTURE SALE MAY CAUSE SUBSTANTIAL DILUTION AND MAY IMPAIR OUR ABILITY TO RAISE CAPITAL THROUGH ADDITIONAL OFFERINGS The shares of common stock being offered by us in the offering will be immediately freely tradable without restriction under the Securities Act, except for any shares purchased by an "affiliate" of ours (as that term is defined under the rules and regulations of the Securities Act), which will be subject to the resale limitations of Rule 144 under the Securities Act. We are unable to predict the effect that sales made under Rule 144, or otherwise, may have on the then prevailing market price of the common stock. Such sales may have an adverse effect on the market price for the common stock and could impair our ability to raise capital through an offering of our equity securities. ANTI-TAKEOVER PROVISIONS MAY LIMIT THE PRICE INVESTORS MAY PAY FOR SHARES OF OUR COMMON STOCK Certain provisions of our certificate of incorporation and by-laws in effect as of the effective date of the Offering, as well as the Delaware General Corporation Law (the "DGCL"), could discourage a third party from attempting to acquire, or make it more difficult for a third party to acquire, control of our Company without approval of the Company's Board of Directors. Such provisions could also limit the price that certain investors might be willing to pay in the future for shares of the common stock. Such provisions allow the Board of Directors to authorize the issuance of preferred stock with rights superior to those of the common stock. Moreover, the provisions of Delaware law and our certificate of incorporation and by-laws relating to the removal of directors and the filling of vacancies on the Board of Directors preclude a third party from removing incumbent directors without cause and simultaneously gaining control of the Board of Directors by filling, with its own nominees, the vacancies created by removal. These provisions also reduce the power of stockholders generally, even those with a majority of the voting power in our Company, to remove incumbent directors and to fill vacancies on the Board of Directors without the support of the incumbent directors. In addition, our certificate of incorporation and by-laws provide that stockholder action may not be effected without a duly called meeting. Our certificate of incorporation and by-laws also do not permit our stockholders to call special meetings of stockholders. This effectively limits the ability of our stockholders to conduct any form of consent solicitation. See "Description of Capital Stock" and "Principal Stockholders." OUR STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES Trading in our common stock is subject to an SEC rule that imposes additional sales practice requirements on broker-dealers who sell such securities to persons other than established customers and accredited investors. "Penny stock" is defined as a stock that trades below $5 per share. For transactions covered by this rule, the broker-dealer must make a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior to sale. The rules require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule prepared by the SEC explaining important concepts involving the penny stock market, the nature of such market, terms used in such market, broker-dealer's duties to the customer, a toll-free telephone number for inquiries about the broker-dealer's disciplinary history and the customer's rights and remedies in case of fraud or abuse in the sale. Disclosure must also be made about commissions payable to both the broker-dealer and the registered representative, and current quotations for the securities. Finally, monthly statements must be sent disclosing recent price information for penny stock held in the account and information on the limited market in penny stocks. RISKS RELATING TO THE RIGHTS OFFERING IF YOU DO NOT EXERCISE ALL OF YOUR RIGHTS, YOU MAY SUFFER SIGNIFICANT DILUTION OF YOUR PERCENTAGE OWNERSHIP OF OUR COMMON STOCK This rights offering is designed to enable each of the stockholders on the record date other than ICC the right to acquire our stock at a price equal to stock acquired by ICC in December 2001 and January 2002 pursuant to its exercise of certain rights to convert preferred stock and indebtedness into common stock and thereby maintain their relative proportionate voting and economic interest. To the extent that you do not exercise your rights and shares are purchased by other stockholders in the rights offering, your proportionate voting interest will be reduced, and the percentage that your original shares represent of our expanded equity after the exercise of the rights will be disproportionately diluted. ONCE YOU EXERCISE YOUR RIGHTS, YOU MAY NOT REVOKE THE EXERCISE Once you exercise your rights, you cannot revoke your exercise even if you later learn information about us that you consider to be unfavorable. You should not exercise your rights unless you are certain that you wish to purchase additional shares of common stock at the subscription price. If we cancel the rights offering, we are obligated only to refund payments actually received, without interest. THE PRICE OF OUR COMMON STOCK MAY DECLINE BEFORE OR AFTER THE RIGHTS EXPIRE We cannot assure you that the public trading market price of our common stock as quoted on the OTC Bulletin Board will not decline after you elect to exercise your subscription rights. If that occurs, you will have committed to buy shares of common stock at a price above the prevailing market price and you will have an immediate unrealized loss. Moreover, we cannot assure you that following the exercise of your rights you will be able to sell your shares of common stock at a price equal to or greater than the subscription price. Until shares are delivered upon expiration of the rights offering, you may not be able to sell the shares of our common stock that you purchase in the rights offering. Certificates representing shares of our common stock purchased will be delivered as soon as practicable after expiration of the rights offering. We will not pay you interest on funds delivered to us pursuant to the exercise of rights. YOUR INVESTMENT WILL BE SUBSTANTIALLY DILUTED A purchase of our common stock in the offering will result in substantial and immediate dilution in your investment. (Dilution is the reduction of a purchaser's investment measured by the difference between the price paid per share of common stock and the net tangible book value per share at the time of purchase.) As of January 2, 2002 we had a net tangible book deficiency of $.20 per share. The $.34 per share to be paid for the new shares will result in an increase in the per share net book value of $.15, resulting in a net book deficiency of $0.05 after the offering (assuming all offered shares are purchased). Accordingly, you will incur substantial dilution when you purchase our common stock. However, because the market price of our common stock fluctuates, we cannot predict the actual dilution you will incur. THE LIABILITY OF DIRECTORS IS LIMITED Our certificate of incorporation limits the liability of our directors for breach of their fiduciary duty or duty of care to our company. The effect is to eliminate liability of directors for monetary damages arising out of negligent or grossly negligent conduct. However, liability of directors under the federal securities law will not be affected. Any of our stockholders would be able to institute an action against a director for monetary damages only if he, she or it can show a breach of the individual director's duty of loyalty, a failure to act in good faith, intentional misconduct, a knowing violation of the law, an improper personal benefit, or an illegal dividend or stock purchase, and not for such director's negligence or gross negligence in satisfying his duty of care. <PAGE>

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+RISK FACTORS Each prospective investor should carefully consider all of the following risk factors in addition to the information set forth elsewhere in this Prospectus. 1. We Have Accumulated a Deficit From Net Losses and Cannot Be Certain of Future Profitability. From June 1983 through March 31, 2002, we accumulated approximately $52 million in losses from operations. Although we earned money during 1997, 1999, and 2001, we could lose money in the future. 2. Losses Could Impair Our Ability to Pay Our Debts. In January 1998, we entered into a Credit Security Agreement (the Wells Fargo Credit Agreement) with Wells Fargo Business Credit (Wells Fargo). The Wells Fargo Credit Agreement, as amended, consists of (i) a term loan of $3.185 million bearing interest at prime + 1.25%; (ii) a revolving line of credit, payable on demand, of not more than $6.0 million or 85% of our eligible trade accounts receivable bearing interest at prime + 1%; (iii) a capex note of up to $3.5 million for the purchase of capital equipment bearing interest at prime + 1.25% and (iv) availability of letters of credit in amounts not to exceed the lesser of $300,000 (less outstanding letters of credit) or the unborrowed portion of the revolving line of credit (less outstanding letters of credit). <PAGE> In October and November 2001, we received approximately $1.05 million from private placements of subordinated debt. The notes require payment of the principal amounts on September 30, 2004. Interest at 10% per annum is paid semi-annually on June 30 and December 31. In connection with the issuance of the subordinated notes, we issued warrants to purchase 60,294 shares of common stock at $8.7075 per share. We received a total of $575,000 from private placements of subordinated debt and warrants from 1998 through 1999. The notes require payment of the principal amounts on December 31, 2001. Interest at 12% per annum is paid semi-annually on June 30 and December 31. In connection with the issuance of the subordinated notes, we issued warrants to purchase 54,604 shares of common stock at $2.6325 per share. At December 31, 2001, we had repaid $475,000 of the principal amount of the notes. The remaining $100,000 was renewed at 8.5% interest per annum paid semi-annually and requires payment of the principal amount on December 31, 2002. 3. Our Products Could Become Outdated and Adversely Affect Our Future Operating Results. Modern biotechnology has changed and continues to change very quickly. We require adequate financial resources in order to maintain a competitive position with respect to our technology and to continue to attract and retain qualified technical personnel. These financial resources may be unavailable. We focus our research and development resources on those products which we believe will most quickly maximize revenue. There can be no guarantee that future technological developments will not cause our existing or proposed products to become outdated, thereby adversely affecting our future operating results. 4. We Face Intense Competition in Both of Our Business Segments. Laboratory Services. As of December 31, 2001 approximately 59 labs, including MEDTOX Laboratories, Inc. were certified by the Department of Health and Human Services as having met the standards for Subpart C of Mandatory Guidelines for Federal Workplace Drug Testing Programs (59 FR 29916, 29925). Competitors and potential competitors include forensic testing units of large clinical laboratories and other independent laboratories, specialized laboratories, and in-house testing facilities maintained by hospitals. Competitive factors include reliability and accuracy of tests, price structure, service, transportation and collection networks and the ability to establish relationships with hospitals, physicians, and users of drug abuse testing programs. It should be recognized, however, that many of the competitors and potential competitors have substantially greater financial and other resources than us. Our ability to successfully compete in the future and maintain our margins will be based on our ability to maintain our quality and customer service strength while maintaining efficiencies and low cost operations. There can be no assurance that price competitiveness will not increase in importance as a competitive factor in the laboratory testing business. Product Sales. The diagnostics market has become highly competitive with respect to the price, quality and ease of use of various tests and is characterized by rapid technological and regulatory changes. We have designed our diagnostic products to be inexpensive, on-site tests for use by <PAGE> unskilled personnel, and has not endeavored to compete with laboratory-based systems. Numerous large companies with greater research and development, marketing, financial, and other capabilities, as well as government-funded institutions and smaller research firms, are engaged in research, development and marketing of diagnostic assays for application in the areas for which we produce our products. We have experienced increased competition with respect to our immunoassay tests from systems and products developed by others, many of whom compete solely on price. As the number of firms marketing diagnostic tests has grown, we have experienced increased price competition. A further increase in competition may have a material adverse effect on our business and future financial prospects. 5. Protection of Our Patents and Proprietary Information Could be Inadequate. We hold eight issued United States patents. Seven of these patents generally form the basis for the EZ-SCREEN and one-step technologies. Additionally, we have one patent that relates to methods of using whole blood as a sample medium on our immunoassay devices. We also hold various patents in several foreign countries and two United States patents which it acquired in the acquisition of Granite Technological Enterprises, Inc. in 1986. Of the seven U.S. patents, which generally form the basis for the EZ-SCREEN and one-step technologies, one expires in 2004, five expire in 2007, and one expires in 2010. The patent which relates to the methods of using whole blood as a sample medium expires in 2012. There can be no assurance that there will not be a challenge to the validity of the patents. If challenged, we might be required to spend significant funds to defend our patents, and there can be no assurance that we would be successful in any such action. We hold twelve registered trade names and/or trademarks in reference to our products and corporate names. Our trade names and/or trademarks range in duration from 10 to 20 years with expiration dates from 2003 to 2009. Additionally, applications have been made for additional trade names. We believe that the basic technologies required to produce antibodies are in the public domain and are not patentable. We intend to rely upon trade secret protection of certain proprietary information, rather than patents, where it believes disclosure could cause the Company to be vulnerable to competitors who could successfully copy our production and manufacturing techniques and processes. 6. Our Business and Products are Subject to Extensive Government Regulation. Our products and services are subject to the regulations of a number of governmental agencies as listed below. We believe that we are currently in compliance with all the regulations and requirements of such regulatory authorities, but we cannot predict whether future changes in governmental regulations might significantly increase compliance costs or adversely affect the time or cost required to develop and introduce new products. In addition, our products are or may become subject to foreign regulations. Any failure by us to comply with government regulations or requirements could have a material adverse effect us. <PAGE> (a) Substance Abuse and Mental Health Services Administration (SAMHSA). MEDTOX Laboratories, Inc. has been certified by SAMHSA since 1988. SAMHSA certifies laboratories meeting strict standards under Subpart C of Mandatory Guidelines for Federal Workplace Drug Testing Programs. Continued certification is accomplished through periodic inspection by SAMHSA to assure compliance with applicable regulations. (b) United States Food and Drug Administration (FDA). Certain tests for human diagnostic purposes must be cleared by the FDA prior to their marketing for in vitro diagnostic use in the United States. The FDA regulated products produced by the Company are in vitro diagnostic products subject to FDA clearance through the 510(k) process which requires the submission of information and data to the FDA that demonstrates that the device to be marketed is substantially equivalent to a currently marketed device. This data is generated by performing clinical studies comparing the results obtained using our device to those obtained using an existing test product. Although no maximum statutory response time has been set for review of a 510(k) submission, as a matter of policy the FDA has attempted to complete review of 510(k) submissions within 90 days. To date, we have received 510(k) clearance for 16 different products. Products subject to 510(k) regulations may not be marketed for in vitro diagnostic use until the FDA issues a letter stating that a finding of substantial equivalence has been made. As a registered manufacturer of FDA regulated products, we are subject to a variety of FDA regulations including the Good Manufacturing Practices (GMP) regulations which define the conditions under which FDA regulated products are to be produced. These regulations are enforced by FDA and failure to comply with GMP or other FDA regulations can result in the delay of pre-market product reviews, fines, civil penalties, recall, seizures, injunctions and criminal prosecution. (c) Centers for Medicare and Medicaid Services (CMS), formerly Health Care Financing Administration (HCFA). The Clinical Laboratory Improvement Act (CLIA) introduced in 1992 requires that all in vitro diagnostic products be categorized as to level of complexity. A request for CLIA categorization of any new clinical laboratory test system must be made simultaneously with FDA 510(k) submission. The EZ-SCREEN, PROFILE, PROFILE II, VERDICT and VERDICT II drugs of abuse tests currently marketed by MEDTOX Diagnostics, Inc. have been categorized as moderately complex. The complexity category to which a clinical laboratory test system is assigned may limit the number of laboratories qualified to use the test system thus impacting product sales. MEDTOX Laboratories, Inc. is a CLIA licensed laboratory. (d) Drug Enforcement Administration (DEA). Our primary business involves either testing for drugs of abuse or developing test kits for the detection of drugs/drug metabolites in urine. MEDTOX Laboratories, Inc. is registered with the DEA to conduct chemical analyses with controlled substances. The MEDTOX Diagnostics, Inc. facility in Burlington, North Carolina is registered by the DEA to manufacture and distribute controlled substances and to conduct research with controlled substances. Maintenance of these registrations requires that we comply with applicable DEA regulations. <PAGE> (e) Additional Laboratory Regulations. The laboratories of MEDTOX Laboratories, Inc. and certain of our laboratory personnel are licensed or otherwise regulated by certain federal agencies, states, and localities in which it conducts business. Federal, state and local laws and regulations require MEDTOX Laboratories, Inc. among other things, to meet standards governing the qualifications of laboratory owners and personnel, as well as the maintenance of proper records, facilities, equipment, test materials, and quality control programs. In addition, the laboratories are subject to a number of other federal, state, and local requirements which provide for inspection of laboratory facilities and participation in proficiency testing, as well as govern the transportation, packaging, and labeling of specimens tested by either laboratory. The laboratories are also subject to laws and regulations prohibiting the unlawful rebate of fees and limiting the manner in which business may be solicited. The laboratory receives and uses small quantities of hazardous chemicals and radioactive materials in their operations and are licensed to handle and dispose of such chemicals and materials. Any business handling or disposing of hazardous and radioactive waste is subject to potential liabilities under certain of these laws. 7. We Are Dependent on Key Personnel. Our growth is dependent on our ability to continue to attract the services of qualified executive, technical and marketing personnel. We currently do not maintain any life insurance policy on any key personnel. There can be no assurance we will be able to attract and retain the key personnel it requires. 8. We Have Never Paid Cash Dividends. Our ability to declare or pay such dividends is restricted by certain covenants in the Wells Fargo Credit Agreement. Therefore, our stock may not be a suitable investment for people seeking dividend income. On November 9, 2001, we paid a 10% stock dividend to holders of record of our Common Stock on October 26, 2001. There can be no assurance that any future stock dividend will be declared or paid. 9. We Face Potential Product Liability Claims. Manufacturing and marketing our products entail a risk of product liability claims. On August 13, 1993, we procured insurance coverage against the risk of product liability arising out of events after such date, but such insurance does not cover claims made after that date based on events that occurred prior to that date. Consequently, for uncovered claims, we could be required to pay any and all costs associated with any product liability claims brought against us, the cost of defense whatever the outcome of the action, and possible settlement or damages if a court rendered a judgment in favor of any plaintiff asserting such a claim against us. Damages may include punitive damages, which may substantially exceed actual damages. The obligation to pay such damages could have a material adverse effect on the Company and exceed our ability to pay such damages. Our laboratory testing services are primarily diagnostic and expose the laboratory to the risk of liability claims. We have maintained continuous professional and general liability insurance coverage since 1984. There are no product liability claims that are pending against us currently. <PAGE>

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+RISK FACTORS We are subject to various risks that may materially harm our business, financial condition and results of operations. YOU SHOULD CAREFULLY CONSIDER THE RISKS AND UNCERTAINTIES DESCRIBED BELOW AND THE OTHER INFORMATION IN THIS FILING BEFORE DECIDING TO PURCHASE OUR COMMON STOCK. IF ANY OF THESE RISKS OR UNCERTAINTIES ACTUALLY OCCURS, OUR BUSINESS, FINANCIAL CONDITION OR OPERATING RESULTS COULD BE MATERIALLY HARMED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE AND YOU COULD LOSE ALL OR PART OF YOUR INVESTMENT. RISKS RELATED TO OUR BUSINESS WE HAVE HISTORICALLY LOST MONEY AND LOSSES MAY CONTINUE IN THE FUTURE At June 30, 2002, our accumulated deficit was $22,903,940. We have historically lost money. In the year ended June 30, 2002, we had net losses of $4,247,586 or $0.14 per share. Future losses are likely to occur. Accordingly, we may experience significant liquidity and cash flow problems because our operations are not profitable. No assurances can be given that we will be successful in reaching or maintaining profitable operations. WE WILL NEED TO RAISE ADDITIONAL CAPITAL TO FINANCE OPERATIONS We have relied on significant external financing to fund our operations. Such financing has historically come from a combination of borrowings and sale of common stock from third parties and funds provided by certain officers and directors. We cannot assure you that financing, whether from external sources or related parties, will be available if needed or on favorable terms. Our inability to obtain adequate financing will result in the need to curtail business operations. Any of these events would be materially harmful to our business and may result in a lower stock price. We will need to raise additional capital to fund our anticipated operating expenses and future expansion. Among other things, external financing may be required to cover our operating costs. OUR INDEPENDENT ACCOUNTANTS HAVE ADDED GOING CONCERN LANGUAGE TO THEIR REPORT ON OUR FINANCIAL STATEMENTS Our independent accountants have added an explanatory paragraph to their audit opinions issued in connection with the financial statements for 2002 and 2001, which states that Azco requires additional funds to continue operations, including production and marketing of Mica products, and other exploration commitments on mineral properties, and to meet other obligations as they are due. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty. Unless additional funding is obtained before November 15, 2002 production will be curtailed. THE PRICE OF OUR COMMON STOCK MAY BE AFFECTED BY A LIMITED TRADING VOLUME AND MAY FLUCTUATE SIGNIFICANTLY Prior to this offering there has been a limited public market for our common stock and there can be no assurance that an active trading market for our stock will develop. An absence of an active trading market could adversely affect our stockholders' ability to sell our common stock in short time periods, or possibly at all. Our common stock has experienced, and is likely to experience in the future, significant price and volume fluctuations which could adversely affect the market price of our common stock without regard to our operating performance. In addition, we believe that factors such as quarterly fluctuations in our financial results and changes in the overall economy or the condition of the financial markets could cause the price of our common stock to fluctuate substantially. WE COULD FAIL TO ATTRACT OR RETAIN KEY PERSONNEL Our success largely depends on the efforts and abilities of key executives and consultants, including Lawrence G. Olson, our Chief Executive Officer, President and Chairman. The loss of the services of Mr. Olson could materially harm our business because of the cost and time necessary to replace and train a replacement. Such a loss would also divert management attention away from operational issues. We do not presently maintain a key-man life insurance policy on Mr. Olson. WE ARE SUBJECT TO STOCK PRICE VOLATILITY AND AMERICAN STOCK EXCHANGE LISTING REQUIREMENTS The market price of Azco's common stock has been highly volatile. In order to maintain its listing on the American Stock Exchange, Azco must maintain a closing sales price of at least $3.00 per share for a certain period of time. Since January 2, 2002, Azco's common stock has traded between $0.53 and $1.20

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+RISK FACTORS Before making an investment in our Class A common stock you should carefully consider the risks described below, as well as the other information set forth in this prospectus, including our consolidated financial statements and related notes. Some of the following risks relate principally to the industry in which we operate and to our business. Other risks relate principally to the securities markets and ownership of our stock. Additional risks and uncertainties not presently known to us, or risks that we currently consider immaterial, may also impair our operations. Any of the risk factors described below could significantly and negatively affect our business, prospects, financial condition or operating results, which could cause the trading price of our Class A common stock to decline and could cause you to lose all or part of your investment. RISKS RELATED TO OUR BUSINESS We are dependent on contracts with the U.S. federal government for substantially all of our revenues. For the year ended December 31, 2001 and for the nine months ended September 30, 2002, we derived 96.2% and 96.3%, respectively, of our revenues from federal government contracts, either as a prime contractor or a subcontractor. For the year ended December 31, 2001 and for the nine months ended September 30, 2002, we derived approximately 85.1% and 87.1%, respectively, of our revenues from contracts with agencies in the intelligence community and Department of Defense. We expect that federal government contracts will continue to be the primary source of our revenues for the foreseeable future. If we were suspended or debarred from contracting with the federal government generally, or any significant agency in the intelligence community or Department of Defense, if our reputation or relationship with government agencies were impaired, or if the government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our business, prospects, financial condition or operating results would be materially harmed. Federal government spending priorities may change in a manner adverse to our business. Our business depends upon continued federal government expenditures on intelligence, defense and other programs that we support. The overall U.S. defense budget declined from time to time in the late 1980s and the early 1990s. While spending authorizations for intelligence and defense-related programs by the government have increased in recent years, and in particular after the September 11, 2001 terrorist attacks, future levels of expenditures and authorizations for those programs may decrease, remain constant or shift to programs in areas where we do not currently provide services. A significant decline in government expenditures, or a shift of expenditures away from programs that we support, could adversely affect our business, prospects, financial condition or operating results. Federal government contracts contain provisions that are unfavorable to us. Federal government contracts contain provisions and are subject to laws and regulations that give the government rights and remedies not typically found in commercial contracts, including allowing the government to: Terminate existing contracts for convenience, as well as for default; Reduce or modify contracts or subcontracts; Cash and cash equivalents at end of period $ 118 $ 1,894 $ Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion, Dated December 16, 2002 6,150,000 Shares ManTech International Corporation Class A Common Stock Table of Contents Cancel multi-year contracts and related orders if funds for contract performance for any subsequent year become unavailable; Decline to exercise an option to renew a multi-year contract; Claim rights in products and systems produced by us; Suspend or debar us from doing business with the federal government or with a governmental agency; and Control or prohibit the export of our products. If the government terminates a contract for convenience, we may recover only our incurred or committed costs, settlement expenses and profit on work completed prior to the termination. If the government terminates a contract for default, we may not recover even those amounts, and instead may be liable for excess costs incurred by the government in procuring undelivered items and services from another source. As is common with government contractors, some of our contracts have had or are currently experiencing performance issues. We have received and may in the future receive show cause or cure notices under contracts that, if not addressed to the government s satisfaction, could give the government the right to terminate those contracts for default or to cease procuring our services under those contracts in the future. We must comply with complex procurement laws and regulations. We must comply with and are affected by laws and regulations relating to the formation, administration and performance of federal government contracts, which affect how we do business with our customers and may impose added costs on our business. For example, we are subject to the Federal Acquisition Regulations and all supplements, which comprehensively regulate the formation, administration and performance of federal government contracts, and to the Truth in Negotiations Act, which requires certification and disclosure of cost and pricing data in connection with contract negotiations. Our performance under our federal government contracts and our compliance with the terms of those contracts are subject to periodic review by our contracting agency customers. In addition, we routinely conduct our own internal reviews relating to our performance under our federal government contracts and our compliance with their terms. From time to time, such internal reviews and reviews by government contracting agencies result in discoveries by us or by our government contract customers of occurrences of non-compliance by us with the terms of our contracts. If a government review or investigation uncovers improper or illegal activities, we may be subject to civil or criminal penalties or administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with federal government agencies, and may suffer reputational harm which could impair our ability to win awards of contracts in the future or receive renewals of existing contracts. If we were subject to civil and criminal penalties and administrative sanctions or suffer reputational harm, our business, prospects, financial condition or operating results could be materially harmed. From time to time in the past, we have been subject to government investigations. Currently, we are subject to certain government investigations. For additional information regarding these investigations, see Business Legal Proceedings. In addition, we are subject to industrial security regulations of Department of Defense and other federal agencies that are designed to safeguard against foreigners access to classified information. If we were to come under foreign ownership, control or influence, our federal government customers could terminate or decide not to renew our contracts, and it could impair our ability to obtain new contracts. The government may reform its procurement practices or adopt new contracting rules and regulations, including cost accounting standards, that could be costly to satisfy or that could impair our ability to obtain new contracts. We are offering 4,500,000 shares of our Class A common stock and the selling stockholders identified in this prospectus are offering 1,650,000 shares of our Class A common stock through a syndicate of underwriters. The underwriters also have a 30-day option to purchase up to an additional 876,500 shares of Class A common stock from us and 46,000 shares of Class A common stock from a selling stockholder solely to cover over-allotments. We will not receive any of the proceeds from the sale of shares by the selling stockholders. Our Class A common stock is listed on the Nasdaq National Market under the symbol MANT. The last reported sale price of our Class A common stock on the Nasdaq National Market on November 26, 2002 was $20.00. Investing in our common stock involves risks. See Risk Factors beginning on page 9. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Table of Contents We face competition from other firms, many of which have substantially greater resources. We operate in highly competitive markets and generally encounter intense competition to win contracts. We compete with many other firms, ranging from small specialized firms to large diversified firms, many of which have substantially greater financial, management and marketing resources than we do. Our competitors may be able to provide customers with different or greater capabilities or benefits than we can provide in areas such as technical qualifications, past contract performance, geographic presence, price and the availability of key professional personnel. Our failure to compete effectively with respect to any of these or other factors could have a material adverse effect on our business, prospects, financial condition or operating results. In addition, our competitors also have established or may establish relationships among themselves or with third parties to increase their ability to address customer needs. Accordingly, it is possible that new competitors or alliances among competitors may emerge. We derive significant revenues from contracts awarded through a competitive bidding process. We derive significant revenues from federal government contracts that were awarded through a competitive bidding process. For example, after giving effect to our acquisition of ManTech Aegis Research Corporation, in each of the past three fiscal years, nine out of our ten largest contracts, in terms of revenues, were awarded through a competitive bidding process. Much of the business that we expect to seek in the foreseeable future likely will be awarded through competitive bidding. Competitive bidding presents a number of risks, including the: Need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and cost overruns; Substantial cost and managerial time and effort that we spend to prepare bids and proposals for contracts that may not be awarded to us; Need to accurately estimate the resources and cost structure that will be required to service any contract we are awarded; and Expense and delay that may arise if our competitors protest or challenge contract awards made to us pursuant to competitive bidding, and the risk that any such protest or challenge could result in the resubmission of bids on modified specifications, or in termination, reduction or modification of the awarded contract. We may not be provided the opportunity in the near term to bid on contracts that are held by other companies and are scheduled to expire if the government determines to extend the existing contract. If we are unable to win particular contracts that are awarded through the competitive bidding process, we may not be able to operate in the market for services that are provided under those contracts for a number of years. If we are unable to consistently win new contract awards over any extended period, our business and prospects will be adversely affected. Failure to maintain strong relationships with other contractors could result in a decline in our revenues. For the year ended December 31, 2001 and for the nine months ended September 30, 2002, we derived 8.1% and 9.2%, respectively, of our revenues from contracts in which we acted as a subcontractor to other contractors or to joint ventures which we and other contractors have formed to bid on and execute particular contracts or programs. We expect to continue to depend on relationships with other contractors for a portion of our revenues in the foreseeable future. Our business, prospects, financial condition or operating results could be adversely affected if other contractors eliminate or reduce their subcontracts or joint venture relationships with us, either because they choose to establish relationships with our competitors or because they choose to directly offer services that compete with Per Share Table of Contents our business, or if the government terminates or reduces these other contractors programs or does not award them new contracts. We may not receive the full amount authorized under contracts that we have entered into and may not accurately estimate our backlog and GSA schedule contract value. The maximum contract value specified under a government contract that we enter into is not necessarily indicative of revenues that we will realize under that contract. For example, we derive some of our revenues from government contracts in which we are not the sole provider, meaning that the government could turn to other companies to fulfill the contract, and from indefinite delivery, indefinite quantity contracts, which specify a maximum but only a token minimum amount of goods or services that may be provided under the contract. In addition, Congress often appropriates funds for a particular program on a yearly basis, even though the contract may call for performance that is expected to take a number of years. As a result, contracts typically are only partially funded at any point during their term, and all or some of the work to be performed under the contracts may remain unfunded unless and until Congress makes subsequent appropriations and the procuring agency allocates funding to the contract. Nevertheless, we look at these contract values, including values based on the assumed exercise of options relating to these contracts, in estimating the amount of our backlog. Because we may not receive the full amount we expect under a contract, we may not accurately estimate our backlog. Similarly, in recent years we have been deriving an increasing percentage of our revenues under GSA schedule contracts. GSA schedule contracts are procurement vehicles under which government agencies may, but are not required to, purchase professional services or products. As a result, we believe that potential GSA schedule contract values are not fully reflected in traditional backlog calculations. We have developed a method of calculating GSA schedule contract value that we use to evaluate estimates for the revenues we may receive under our GSA schedule contracts. Although we believe our method of determining GSA schedule contract value is based on reasonable estimates and assumptions, our experience with GSA schedule contracts has been limited to date. We are not currently aware of other companies within our market that employ comparable methods of determining GSA schedule contract value. Estimates of future revenues included in backlog and GSA schedule contract value are not necessarily precise and the receipt and timing of any of these revenues are subject to various contingencies, many of which are beyond our control. For a discussion of these contingencies see Business Backlog and GSA Schedule Contract Value. The actual accrual of revenues on programs included in backlog and GSA schedule contract value may never occur or may change. We may not accurately estimate the expenses, time and resources necessary to satisfy our contractual obligations. We enter into three types of federal government contracts for our services: cost-plus, time-and-materials and fixed-price. For the nine months ended September 30, 2002, we derived 37.7%, 44.6% and 17.7% of our revenues from cost-plus, time-and-materials and fixed-price contracts, respectively. For the year ended December 31, 2001, the revenues were 35.2%, 36.2% and 28.6%, respectively. Under cost-plus contracts, we are reimbursed for allowable costs and paid a fee, which may be fixed or performance-based. To the extent that the actual costs incurred in performing a cost-plus contract are within the contract ceiling and allowable under the terms of the contract and applicable regulations, we are entitled to reimbursement of our costs, plus a profit. However, if our costs exceed the ceiling or are not allowable under the terms of the contract or applicable regulations, we may not be able to recover those costs. Under time-and-materials contracts, we are reimbursed for labor at negotiated hourly Total Table of Contents billing rates and for certain expenses. We assume financial risk on time-and-material contracts because we assume the risk of performing those contracts at negotiated hourly rates. Under fixed-price contracts, we perform specific tasks for a fixed price. Compared to cost-plus contracts, fixed-price contracts generally offer higher margin opportunities, but involve greater financial risk because we bear the impact of cost overruns and receive the benefit of cost savings. Our profits could be adversely affected if our costs under any of these contracts exceed the assumptions we used in bidding for the contract. Although we believe that we have recorded adequate provisions in our consolidated financial statements for losses on our contracts, as required under U.S. generally accepted accounting principles, our contract loss provisions may not be adequate to cover all actual losses that we may incur in the future. Our contracts are subject to audits and cost adjustments by the federal government. The federal government audits and reviews our performance on contracts, pricing practices, cost structure and compliance with applicable laws, regulations and standards. Like most large government contractors, our contract costs are audited and reviewed on a continual basis. Although audits have been completed on our incurred contract costs through 2000, audits for costs incurred or work performed after 2000 remain ongoing and, for much of our work in recent years, have not yet commenced. In addition, non-audit reviews by the government may still be conducted on all our government contracts. An audit of our work, including an audit of work performed by companies we have acquired or may acquire, could result in a substantial adjustment to our revenues because any costs found to be improperly allocated to a specific contract will not be reimbursed, and revenues we have already recognized may need to be refunded. If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with federal government agencies. In addition, we could suffer serious harm to our reputation if allegations of impropriety were made against us. We may be liable for systems and service failures. We create, implement and maintain information technology and technical services solutions that are often critical to our customers operations, including those of federal, state and local governments. We have experienced and may in the future experience some systems and service failures, schedule or delivery delays and other problems in connection with our work. If our solutions, services, products or other applications have significant defects or errors, are subject to delivery delays or fail to meet our customers expectations, we may: Lose revenues due to adverse customer reaction; Be required to provide additional services to a customer at no charge; Receive negative publicity, which could damage our reputation and adversely affect our ability to attract or retain customers; or Suffer claims for substantial damages against us. In addition to any costs resulting from product warranties, contract performance or required corrective action, these failures may result in increased costs or loss of revenues if they result in customers postponing subsequently scheduled work or canceling or failing to renew contracts. While many of our contracts with the federal government limit our liability for damages that may arise from negligence in rendering services to our customers, we cannot be sure that these contractual Public offering price $ $ Underwriting discount and commissions $ $ Proceeds to us (before expenses) $ $ Proceeds to selling stockholders (before expenses) $ $ The underwriters expect to deliver the shares to purchasers on or about , 2002. Jefferies/Quarterdeck, LLC Legg Mason Wood Walker Incorporated U.S. Bancorp Piper Jaffray Adams, Harkness & Hill, Inc. BB&T Capital Markets Table of Contents provisions will protect us from liability for damages if we are sued. Furthermore, our errors and omissions and product liability insurance coverage may not continue to be available on reasonable terms or in sufficient amounts to cover one or more large claims, or the insurer may disclaim coverage as to some types of future claims. The successful assertion of any large claim against us could seriously harm our business. Even if not successful, these claims could result in significant legal and other costs and may be a distraction to our management. In certain new business areas, including in the area of homeland security, we may not be able to obtain sufficient indemnification or insurance and may decide not to accept or solicit business in these areas. Security breaches in classified government systems could adversely affect our business. Many of the programs we support and systems we develop, install and maintain involve managing and protecting information involved in intelligence, national security and other classified government functions. A security breach in one of these systems could cause serious harm to our business, damage our reputation and prevent us from being eligible for further work on critical classified systems for federal government customers. Losses that we could incur from such a security breach could exceed the policy limits that we have for errors and omissions or product liability insurance. Our quarterly operating results may vary widely. Our quarterly revenues and operating results may fluctuate significantly in the future. A number of factors cause our revenues, cash flow and operating results to vary from quarter to quarter, including: Fluctuations in revenues earned on fixed-price contracts and contracts with a performance-based fee structure; Commencement, completion or termination of contracts during any particular quarter; Variable purchasing patterns under government GSA schedule contracts, blanket purchase agreements and indefinite delivery, indefinite quantity contracts; Changes in Presidential administrations and senior federal government officials that affect the timing of technology procurement; Changes in policy or budgetary measures that adversely affect government contracts in general; Acquisitions of other technology service providers; and Increased purchase requests from customers for equipment and materials in connection with the federal government s fiscal year end, which may affect our fourth quarter operating results. Changes in the volume of services provided under existing contracts and the number of contracts commenced, completed or terminated during any quarter may cause significant variations in our cash flow from operations because a relatively large amount of our expenses are fixed. We incur significant operating expenses during the start-up and early stages of large contracts and typically do not receive corresponding payments in that same quarter. We may also incur significant or unanticipated expenses when contracts expire or are terminated or are not renewed. In addition, payments due to us from government agencies may be delayed due to billing cycles or as a result of failures of governmental budgets to gain Congressional and Administration approval in a timely manner. (unaudited) Accrual to cash conversion $ 907 $ (2,862 ) Depreciation and amortization 29 The date of this prospectus is , 2002. Table of Contents Our senior management and advisory board are important to our customer relationships. We believe that our success depends in part on the continued contributions of our co-founder, Chairman of the Board of Directors, Chief Executive Officer and President, George J. Pedersen, our Executive Vice President, Chief Financial Officer, Treasurer and Director, John A. Moore, Jr., and other members of our senior management and advisory board. We rely on our executive officers and senior management to generate business and execute programs successfully. In addition, the relationships and reputation that members of our management team and advisory board have established and maintain with government and military personnel contribute to our ability to maintain good customer relations and to identify new business opportunities. While we have employment agreements with some of our executive officers, these agreements do not prevent them from terminating their employment. The loss of Mr. Pedersen, Mr. Moore or any other senior management or advisory board member could impair our ability to identify and secure new contracts and otherwise to manage our business. We must recruit and retain skilled employees to succeed in our labor-intensive business. We believe that an integral part of our success is our ability to provide employees who have advanced information technology and technical services skills and who work well with our customers in a government or defense-related environment. These employees are in great demand and are likely to remain a limited resource in the foreseeable future. If we are unable to recruit and retain a sufficient number of these employees, our ability to maintain and grow our business could be negatively impacted. In addition, some of our contracts contain provisions requiring us to commit to staff a program with certain personnel the customer considers key to our successful performance under the contract. In the event we are unable to provide these key personnel or acceptable substitutions, the customer may terminate the contract, and we may not be able to recover our costs in the event the contract is terminated. Our business is dependent upon obtaining and maintaining required security clearances. Many of our federal government contracts require our employees to maintain various levels of security clearances, and we are required to maintain certain facility security clearances complying with Department of Defense requirements. Obtaining and maintaining security clearances for employees involves a lengthy process, and it is difficult to identify, recruit and retain employees who already hold security clearances. If our employees are unable to obtain or retain security clearances or if our employees who hold security clearances terminate employment with us, the customer whose work requires cleared employees could terminate the contract or decide not to renew it upon its expiration. In addition, we expect that many of the contracts on which we will bid will require us to demonstrate our ability to obtain facility security clearances and perform work with employees who hold specified types of security clearances. To the extent we are not able to obtain facility security clearances or engage employees with the required security clearances for a particular contract, we may not be able to bid on or win new contracts, or effectively rebid on expiring contracts. If we are unable to manage our growth, our business could be adversely affected. Sustaining our growth has placed significant demands on our management, as well as on our administrative, operational and financial resources. For us to continue to manage our growth, we must continue to improve our operational, financial and management information systems and expand, motivate and manage our workforce. If we are unable to successfully manage our growth without Table of Contents compromising our quality of service and our profit margins, or if new systems that we implement to assist in managing our growth do not produce the expected benefits, our business, prospects, financial condition or operating results could be adversely affected. We may undertake acquisitions that could increase our costs or liabilities or be disruptive. One of our key operating strategies is to selectively pursue acquisitions. We have made a number of acquisitions in the past, we currently are pursuing a number of potential acquisition opportunities, and we will consider other acquisitions in the future. We may not be able to consummate the acquisitions we currently are pursuing on favorable terms or at all. We may not be able to locate other suitable acquisition candidates at prices that we consider appropriate or to finance acquisitions on terms that are satisfactory to us. If we do identify an appropriate acquisition candidate, we may not be able to successfully negotiate the terms of an acquisition, finance the acquisition or, if the acquisition occurs, integrate the acquired business into our existing business. Negotiations of potential acquisitions and the integration of acquired business operations could disrupt our business by diverting management away from day-to-day operations. The proceeds we receive from this offering may not be sufficient to fund the full cost of acquisitions that we may determine to pursue. Acquisitions of businesses or other material operations may require additional debt or equity financing, resulting in additional leverage or dilution of ownership. The difficulties of integration may be increased by the necessity of coordinating geographically dispersed organizations, integrating personnel with disparate business backgrounds and combining different corporate cultures. We also may not realize cost efficiencies or synergies that we anticipated when selecting our acquisition candidates. In addition, we may need to record write downs from future impairments of intangible assets, which could reduce our future reported earnings. At times, acquisition candidates may have liabilities or adverse operating issues that we fail to discover through due diligence prior to the acquisition. We may be exposed to liabilities or losses from operations that we have discontinued. In September 2001, we decided to dispose of five of our businesses, either by selling them or by winding down their operations. For more information on these discontinued operations, please see Management s Discussion and Analysis of Financial Condition and Results of Operations Discontinued Operations and note 15 to our consolidated financial statements. Our consolidated financial statements reflect, under the heading Discontinued Operations , our estimate of the net losses we expected from these operations through the date we estimated they would be disposed, and all losses expected to be realized upon the disposal of these operations. To date, we have disposed of four of these operations, and only our Australian-based software solutions business remains to be disposed of. If the proceeds we receive from this disposition are less than what we have estimated, or if its operations generate greater losses than we expect prior to disposition, there could be a negative impact on discontinued operations. If we fail to dispose of our Australian-based software solutions business in a timely manner in accordance with generally accepted accounting principles in the United States, we could have to reclassify the business as a continuing operation and restate our financial data for the effected periods to reflect such reclassification. Subsequent to the disposal of these businesses, we may continue to be exposed to some liabilities arising from their prior operations. For example, we are involved in a lawsuit where defendants have added one of our subsidiaries as a third-party defendant with respect to allegations that they caused or contributed to soil and groundwater contamination. For more information on this lawsuit, see Business Legal Proceedings. The operations from this subsidiary, our former environmental Table of Contents Table of Contents consulting and remediation business, particularly the performance of environmental consulting and remediation services, may not have been or in the future may not be conducted in compliance with environmental laws, exposing us to further liability and damages for the costs of investigating and cleaning up sites of spills, disposals or other releases of hazardous materials. We cannot assure you that our liability in these matters, or any other environmental liabilities that arise in the future, will not exceed our resources or will be covered by insurance. Even though we have disposed of this and three of the other four discontinued operations, we likely will remain liable for any costs, damages or other liabilities imposed upon them that result from or relate to their operations prior to the disposition. We may be affected by intellectual property infringement claims. Our business operations rely extensively on procuring and deploying intellectual property. Our employees develop some of the software solutions and other forms of intellectual property that we use to provide information technology solutions to our customers, but we also license technology from primary vendors. Typically, under federal government contracts, our government customers may claim rights in the intellectual property we develop, making it impossible for us to prevent their future use of our intellectual property. We are and may in the future be subject to claims from our employees or third parties who assert that software solutions and other forms of intellectual property that we used in delivering services and solutions to our customers infringe upon intellectual property rights of such employees or third parties. If our vendors, our employees or third parties assert claims that we or our customers are infringing on their intellectual property, we could incur substantial costs to defend these claims. In addition, if any of these infringement claims are ultimately successful, we could be required to: Cease selling or using products or services that incorporate the challenged software or technology; Obtain a license or additional licenses; or Redesign our products and services that rely on the challenged software or technology. Covenants in our credit facility may restrict our financial and operating flexibility. Our credit facility contains covenants that limit or restrict, among other things, our ability to borrow money outside of the amounts committed under the credit facility, make investments in certain of our subsidiaries that are borrowers under the credit facility and designated as discontinued operations or in other entities not listed as borrowers under the credit facility, make other restricted payments, pay dividends on our common stock, sell or otherwise dispose of assets other than in the ordinary course of business, merge or consolidate, or make acquisitions, in each case without the prior written consent of our lenders. Our credit facility also requires us to maintain specified financial covenants relating to fixed charge coverage, interest coverage, debt coverage, capital expenditure limits and minimum consolidated net worth. Our ability to satisfy these financial ratios can be affected by events beyond our control, and we cannot assure you that we will meet these ratios. For example, on two occasions in the past five years, in March 2001 and in November 2000, we obtained waivers for failure to maintain the required fixed charge coverage ratio as of the end of the preceding quarters under the credit facility that was in effect at that time. Default under our credit facility could allow the lenders to declare all amounts outstanding to be immediately due and payable. We have pledged substantially all of our assets, including the stock of certain of our subsidiaries to secure the debt under our credit facility. If the lenders declare amounts outstanding under the credit facility to be due, the lenders could proceed against those assets. Any event of default, therefore, could have a material TABLE OF CONTENTS Page Table of Contents adverse effect on our business if the creditors determine to exercise their rights. We also may incur future debt obligations that might subject us to restrictive covenants that could affect our financial and operational flexibility, restrict our ability to pay dividends on our common stock or subject us to other events of default. Any such restrictive covenants in any future debt obligations we incur could limit our ability to fund our businesses with equity investments or intercompany advances, which would impede our ability to operate or expand our business. From time to time we may require consents or waivers from our lenders to permit actions that are prohibited by our credit facility. If in the future our lenders refuse to provide waivers of our credit facility s restrictive covenants and/or financial ratios, then we may be in default under our credit facility, and we may be prohibited from undertaking actions that are necessary or desirable to maintain and expand our business. Our employees or subcontractors may engage in misconduct or other improper activities. We are exposed to the risk that employee fraud or other misconduct could occur. In addition, from time to time we enter into arrangements with subcontractors and joint venture partners to bid on and execute particular contracts or programs and we are exposed to the risk that fraud or other misconduct or improper activities by such persons may occur. Misconduct by employees, subcontractors or joint venture partners could include intentional failures to comply with federal laws, federal government procurement regulations or the terms of contracts that we receive and failing to disclose unauthorized or unsuccessful activities to us, which could lead to civil, criminal, and/or administrative penalties (including fines, imprisonment, suspension and/or debarment from performing federal government contracts) and reputational harm. Misconduct by our employees, subcontractors or joint venture partners could also involve the improper collection, handling or use of our customers sensitive or classified information, which could result in regulatory sanctions and serious harm to our reputation. We have from time to time experienced occurrences of misconduct and improper activities by our employees, subcontractors or joint venture partners. It is not always possible to deter misconduct by our employees, subcontractors or joint venture partners. Under certain circumstances, conduct of our employees can be imputed to the ManTech subsidiary for which they work and the conduct of ManTech subsidiaries can be imputed to ManTech International Corporation with the consequence that ManTech International Corporation could be subject to sanctions and penalties for actions taken by its subsidiaries and/or the employees of its subsidiaries. The precautions we take to prevent and detect such activity may not be effective in controlling unknown or unmanaged risks or losses and such misconduct by employees, subcontractors or joint venture partners could result in serious civil or criminal penalties or sanctions or reputational harm to us. RISKS RELATED TO OUR COMMON STOCK AND THIS OFFERING Mr. Pedersen, our Chairman, Chief Executive Officer and President, will continue to control our company. Upon completion of this offering, Mr. Pedersen will own or control approximately 91.04% of the combined voting power of the Class A and Class B common stock, or 90.57% if the underwriters over-allotment option is exercised in full, and he will own approximately 50.39% of the outstanding shares of Class A and Class B common stock, or 49.00% if the underwriters over-allotment option is exercised in full. Accordingly, Mr. Pedersen will control the vote on all matters submitted to a vote of the holders of our common stock. For more information, see Description of Capital Stock, Certificate Table of Contents of Incorporation and Bylaws Common Stock. As long as Mr. Pedersen beneficially owns a majority of the combined voting power of our common stock, he will have the ability, without the consent of our public stockholders, to elect all members of our board of directors and to control our management and affairs. Mr. Pedersen s voting control may have the effect of preventing or discouraging transactions involving an actual or a potential change of control of our company, regardless of whether a premium is offered over then-current market prices. Mr. Pedersen will be able to cause a change of control of our company. Mr. Pedersen also will be able to cause a registration statement to be filed and to become effective under the Securities Act of 1933, thereby permitting him to freely sell or transfer the shares of common stock that he owns. In addition, the interests of Mr. Pedersen may conflict with the interests of other holders of our common stock. Provisions in our charter documents could make a merger, tender offer or proxy contest difficult. Our certificate of incorporation and bylaws may discourage, delay or prevent a change in control of our company that stockholders may consider favorable. Our certificate of incorporation and bylaws: Authorize the issuance of blank check preferred stock that could be issued by our board of directors to thwart a takeover attempt; Prohibit cumulative voting in the election of directors, which would otherwise allow holders of less than a majority of the stock to elect some directors; Limit who may call special meetings of stockholders; Prohibit stockholder action by written consent, requiring all actions to be taken at a meeting of the stockholders; Establish advance notice requirements for nominating candidates for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings; and Require that vacancies on our board of directors, including newly-created directorships, be filled only by a majority vote of directors then in office. In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting the company from engaging in a business combination with an interested stockholder for a period of three years after the person becomes an interested stockholder. For more information, see Description of Capital Stock, Certificate of Incorporation and Bylaws. The market price of our Class A common stock may fluctuate widely and trade at prices below the public offering price. The price of our Class A common stock after this offering may fluctuate widely, depending upon many factors, including our perceived prospects, and the prospects of the information technology and government contracting industries in general, differences between our actual financial and operating results and those expected by investors and analysts, changes in analysts recommendations or projections, changes in general valuations for information technology and technical services companies, changes in general economic or market conditions and broad market fluctuations. In addition, the terrorist attacks of September 11, 2001 and subsequent terrorism concerns have contributed to an economic slowdown and to significant instability in the U.S. and other global financial equity markets. Future actions by the federal government, including the initiation of, or participation in, armed hostilities, may lead to further acts of terrorism in the United States or Table of Contents elsewhere, and such actions or developments would likely cause further instability in financial markets. All of these factors subject our operations to increased risks and could have a material adverse effect on your investment in our Class A common stock. As a result, our Class A common stock may trade at prices significantly below the offering price. We will have broad discretion over the use of proceeds from this offering. We intend to use the net proceeds from this offering to pursue possible acquisitions and for working capital and other general corporate purposes. We may not use the proceeds from this offering for each of these purposes. Future events, including changes in competitive conditions, our ability to identify appropriate acquisition candidates, the availability of other financing and funds generated from operations and the status of our business from time to time, may lead us to change the allocation of the net proceeds of this offering among these possible uses or to apply the net proceeds to other uses. We will have broad discretion with respect to the use of these funds and the determination of the timing of expenditures. We cannot assure you that we will use these funds in a manner that you would approve of or that the allocations will be in the best interests of all of our stockholders. We make forward-looking statements in this prospectus that involve risks, uncertainties and assumptions. We have made forward-looking statements in this prospectus, including in the section entitled Management s Discussion and Analysis of Financial Condition and Results of Operations, that are based on our management s beliefs and assumptions and on information currently available to our management. Forward-looking statements include all statements that are not historical facts and can be identified by the use of forward-looking terminology such as the words believes, expects, anticipates, intends, plans, estimates or similar expressions. Forward-looking statements include the information concerning our possible or assumed future results of operations, business strategies, anticipated expenses, anticipated backlog and GSA schedule contract value, financing plans, competitive position, potential growth opportunities, the future of our industry, the effects of future regulation and the effects of competition. Forward-looking statements involve risks, uncertainties and assumptions. You should not put undue reliance on any forward-looking statements. You should understand that many important factors discussed in this Risk Factors section and elsewhere in this prospectus could cause our results to differ materially from those expressed in forward-looking statements. We do not have any intention or obligation to update forward-looking statements after the underwriters cease to distribute this prospectus, except as provided by law.

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+RISK FACTORS Set forth are the risks that we believe are material. This Prospectus including the risks discussed below, contains forward looking statements made pursuant to the safe harbor provision of the Private Securities Reform Act of 1995. Forward looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results and future events to differ materially from those set forth or contemplated in the forward looking statements. Forward looking statements depend on assumptions, data or methods which may be incorrect or imprecise. RISKS RELATED TO THE NEW NOTES OUR SUBSTANTIAL INDEBTEDNESS COULD ADVERSELY AFFECT OUR FINANCIAL HEALTH AND PREVENT US FROM FULFILLING OUR OBLIGATIONS UNDER THE NEW NOTES. We have a significant amount of indebtedness due to our issuance of the New Notes and our incurrence of indebtedness under a loan agreement among us, certain of our subsidiaries, G.E. Capital, previously Heller Healthcare Finance, Inc., and certain other lenders party thereto (the "G.E. Capital Loan Agreement"). The following chart shows certain important credit statistics and is presented assuming we had completed the offering of the New Notes, the issuance of the New Common Stock and the incurrence of the indebtedness under the G.E. Capital Loan Agreement as of the dates or at the beginning of the periods specified below and applied the proceeds as intended: <Table> <Caption> AT MARCH 31, 2002 ($ IN MILLIONS) ----------------- <S> <C> Total indebtedness.......................................... $165.2 Stockholders' equity........................................ $ 31.3 Debt to equity ratio........................................ 5.3x </Table> <Table> <Caption> FOR THE YEAR FOR THE YEAR FOR THE PERIOD FOR THE PERIOD ENDED ENDED ENDED ENDED DECEMBER 31, 2000 DECEMBER 31, 2001(1) MARCH 31, 2001(1) MARCH 31, 2002(1) -------------------- -------------------- ----------------- ----------------- <S> <C> <C> <C> <C> Ratio of earnings to fixed charges:....... -- -- -- -- </Table> --------------- (1) Deficiency of earnings to cover fixed charges for the five years ended December 31, 2001 and the three months ended March 31, 2001 and 2002 is $11.6 million, $17.0 million, $31.0 million, $25.8 million, $143.4 million, $4.2 million and $1.5 million respectively. Our substantial indebtedness could have important consequences for holders of New Notes. For example, it could: - make it more difficult for us to satisfy our obligations with respect to the New Notes; - increase our vulnerability to general adverse economic and industry conditions; - limit our ability to fund future working capital, capital expenditures and other general corporate requirements; - require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes; - limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; - place us at a competitive disadvantage compared to our competitors that have less debt; and - limit, along with the financial and other restrictive covenants in our indebtedness, among other things, our ability and the ability of our subsidiaries to borrow or draw down additional funds. Furthermore, failing to comply with those covenants could result in an event of default which, if not cured or waived, could have a material adverse effect on us and our subsidiaries. DESPITE CURRENT INDEBTEDNESS LEVELS, WE AND OUR SUBSIDIARIES MAY STILL BE ABLE TO INCUR SUBSTANTIALLY MORE DEBT. THIS COULD FURTHER EXACERBATE THE RISKS ASSOCIATED WITH OUR AND OUR SUBSIDIARIES' SUBSTANTIAL LEVERAGE. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the Senior Note Indenture and the Junior Note Indenture do not fully prohibit us or our subsidiaries from doing so. In addition, the G.E. Capital Loan Agreement would permit certain additional borrowings which would rank pari passu with the Senior Notes and the related subsidiary guarantees, and senior to the Junior Notes and the related subsidiary guarantees. If new debt is added to our or our subsidiaries' current debt levels, the related risks that we and our subsidiaries now face could intensify. TO SERVICE OUR INDEBTEDNESS AND TO PAY OUR LEASE OBLIGATIONS WILL REQUIRE A SIGNIFICANT AMOUNT OF CASH. OUR ABILITY TO GENERATE CASH DEPENDS ON MANY FACTORS BEYOND OUR CONTROL. Our ability to make payments on and to refinance our indebtedness, including the New Notes, to satisfy our lease obligations and to fund planned capital expenditures will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. In addition, our ability to draw additional amounts under the G.E. Capital Loan Agreement may depend on us meeting the financial covenants in the G.E. Capital Loan Agreement, as well as satisfying certain other conditions to drawing additional amounts under the facility. Our revenues are dependent upon the ability of a retired population, which in turn is largely dependent upon a fixed income or equity asset base, to pay for our services. Based on our current level of operations and anticipated cost savings and operating improvements, we believe our cash flow from operations, available cash and the amounts borrowed under the G.E. Capital Loan Agreement will be adequate to meet our future liquidity needs for at least the next few years. There can be no assurance, however, that our business will generate sufficient cash flow from operations, that currently anticipated cost savings and operating improvements will be realized on schedule or that we will satisfy the conditions to draw additional amounts under the G.E. Capital Loan Agreement, all of which may be necessary to enable us to pay our indebtedness, including the New Notes, to satisfy our lease obligations and to fund our other liquidity needs. As a result, we may need to refinance all or a portion of our indebtedness, including the New Notes, on or before maturity. There can be no assurance that we will be able to refinance any of our indebtedness, including the G.E. Capital Loan Agreement and the New Notes, on commercially reasonable terms or at all. THE INDEBTEDNESS UNDER THE NEW NOTES AND THE RELATED SUBSIDIARY GUARANTEES IS STRUCTURALLY SUBORDINATED TO ANY INDEBTEDNESS OF OUR NON-GUARANTOR SUBSIDIARIES. Some but not all of our subsidiaries guarantee the New Notes. None of the subsidiaries that is party to the G.E. Capital Loan Agreement guarantee the New Notes. Any indebtedness, including trade payables, incurred by any of our subsidiaries that are not subsidiary guarantors will be structurally senior to the indebtedness under the Senior Notes, the Junior Notes and the respective subsidiary guarantees, and the holders of any such indebtedness will have a claim against the assets of any such non-guarantor subsidiary that is prior to the claims of the holders of the Senior Notes and the Junior Notes on those assets. As of January 1, 2002, the New Notes are effectively junior to $80.5 million of indebtedness of non-guarantor subsidiaries, including $40.5 million under the G.E. Capital Loan Agreement. Since January 1, 2002, we have drawn an additional $1.0 million, and may further draw an additional $2.4 million, under the G.E. Capital Loan Agreement. WE MAY NOT HAVE THE ABILITY TO RAISE THE FUNDS NECESSARY TO FINANCE THE OFFERS TO REDEEM NEW NOTES REQUIRED BY THE SENIOR NOTE INDENTURE AND THE JUNIOR NOTE INDENTURE. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all outstanding New Notes. If we incur new indebtedness or sell certain assets that do not secure the New Notes, we will be required to offer to repurchase some or all of the Senior Notes and we may be required to offer to repurchase some or all of the Junior Notes. However, it is possible that we will not have sufficient funds at the time of the change of control, debt incurrence or asset sale to make the required repurchase of New Notes or that restrictions, if any, in the G.E. Capital Loan Agreement or in our or our subsidiaries' other future debt agreements will not allow such repurchases. See the "Description of the Senior Notes -- Certain Rights to Require Repurchase of Senior Notes by the Company" and "Description of the Junior Notes -- Certain Rights to Require Repurchase of Junior Notes by the Company." WE MAY NOT HAVE THE ABILITY TO REPURCHASE THE NEW NOTES UPON AN ASSET SALE OF COLLATERAL. If we sell certain of the collateral securing the New Notes, we will be required to repurchase some or all of the Senior Notes and we may be required to repurchase some or all of the Junior Notes. However, it is possible that restrictions, if any, in the G.E. Capital Loan Agreement or our or our subsidiaries' other future debt agreements will not allow such repurchases. See "Description of the Senior Notes -- Mandatory Redemption -- Asset Sales of Note Collateral" and "Description of the Junior Notes -- Mandatory Redemption -- Asset Sales of Note Collateral." FEDERAL AND STATE STATUTES ALLOW COURTS, UNDER SPECIFIC CIRCUMSTANCES, TO VOID GUARANTEES AND REQUIRE NOTEHOLDERS TO RETURN PAYMENTS RECEIVED FROM GUARANTORS. Under the federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of a guarantee could be subordinated to all other debts of that guarantor if, among other things, the guarantor, at the time it incurred the indebtedness evidenced by its guarantee: - received less than reasonably equivalent value or fair consideration for the incurrence of such guarantee; - was insolvent or rendered insolvent by reason of such incurrence; - was engaged in a business or transaction for which the guarantor's remaining assets constituted unreasonably small capital; or - intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. In addition, any payment by that guarantor pursuant to its guarantee could be voided and required to be returned to the guarantor, or to a fund for the benefit of the creditors of the guarantor. The measures of insolvency for purposes of these fraudulent transfer laws will vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a guarantor would be considered insolvent if: - the sum of its debts, including contingent liabilities, were greater than the fair saleable value of all of its assets, or - if the present fair saleable value of its assets were less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature, or - it could not pay its debts as they become due. After giving effect to the restructuring of their indebtedness described in the Plan and other factors, we believe that each subsidiary guarantor, after giving effect to its guarantee of the New Notes, will not be insolvent, will not have unreasonably small capital for the business in which it is engaged and will not have incurred debts beyond its ability to pay such debts as they mature. We cannot predict, however, what standard a court would apply in making such determinations or that a court would agree with their conclusions in this regard. IF AN ACTIVE TRADING MARKET DOES NOT DEVELOP FOR THE NEW NOTES, THE NOTEHOLDERS MAY NOT BE ABLE TO RESELL THEIR NEW NOTES. For various reasons, including those discussed below, we are unable to predict whether an active trading market will develop or be sustained for the New Notes. To date, an active trading market has not developed for the New Notes. If no active trading market develops, holders of New Notes may not be able to resell their New Notes at their fair market value or at all. The New Notes are a new issuance of securities with no established trading market. We have no present plans to apply to list the New Notes on any United States exchange or the Nasdaq Stock Market. We are not aware of any securities firm that intends to make a market in the New Notes and any securities firm that does act as a market-maker could cease its market-making at any time. In addition, the liquidity of the trading market in the New Notes, and the market price quoted for the New Notes, may be adversely affected by changes in the overall market for debt securities and by changes in our financial performance or prospects and our subsidiaries or in the prospects for companies in our industry generally. While we do not anticipate that we or our securities will be rated by any rating agency, if we or our securities are rated and are subsequently downgraded by any rating agency, the trading price of the New Notes may be adversely effected. RISKS RELATED TO THE JUNIOR NOTES THE NOTEHOLDERS' RIGHT TO RECEIVE PAYMENTS ON THE JUNIOR NOTES IS JUNIOR TO CERTAIN OF OUR SENIOR INDEBTEDNESS, INCLUDING THE SENIOR NOTES. FURTHER, THE JUNIOR NOTE GUARANTEES ARE JUNIOR TO OUR SUBSIDIARY GUARANTORS' SENIOR INDEBTEDNESS, INCLUDING THE SENIOR NOTE GUARANTEES. The Junior Notes rank behind all of our debt incurred under the Senior Notes and the G.E. Capital Loan Agreement. In addition, the Junior Note guarantees rank behind our subsidiary guarantors' debt incurred under the Senior Note guarantees. As a result, upon any distribution to our creditors or the creditors of the Junior Notes guarantors in a bankruptcy, liquidation or reorganization or similar proceeding relating to us or our subsidiary guarantors or of their respective property, the holders of the Senior Notes will be entitled to be paid in full in cash before any payment may be made with respect to the Junior Notes or the Junior Note guarantees. In addition, under certain circumstances, if we default on the Senior Notes, we and our subsidiary guarantors will be prohibited from paying amounts due on the Junior Notes and the Junior Note guarantees or from purchasing or otherwise retiring the Junior Notes. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or our subsidiary guarantors, holders of the Junior Notes will participate with trade creditors and all holders of our subordinated indebtedness and our subsidiary guarantors' subordinated indebtedness in the assets remaining after we and our subsidiary guarantors have paid all of the Senior Notes and the indebtedness under the G.E. Capital Loan Agreement. However, because the Junior Note Indenture requires that amounts otherwise payable to holders of the Junior Notes in a bankruptcy or similar proceeding be paid to holders of the Senior Notes and the indebtedness under the G.E. Capital Loan Agreement instead, holders of the Junior Notes may receive less, ratably, than holders of trade payables in any such proceeding. In any of these cases, we and our subsidiary guarantors may not have sufficient funds to pay all of our respective creditors and holders of Junior Notes may receive less, ratably, than the holders of Senior Notes. As of March 31, 2002, the Junior Notes and the Junior Note guarantees were subordinated to $40.25 million of Senior Notes and $40.25 million of indebtedness under the G.E. Capital Loan Agreement. THE RIGHTS OF THE HOLDERS OF JUNIOR NOTES TO ENFORCE REMEDIES UNDER THE COLLATERAL DOCUMENTS ARE LIMITED AS LONG AS ANY SENIOR NOTES ARE OUTSTANDING. The collateral documents provide holders of Junior Notes with a security interest in certain of our and our subsidiary guarantors' assets but that security interest is subordinated to the security interests in favor of the holders of the Senior Notes. An intercreditor agreement provides that the holders of the Junior Notes will only be able to cause the commencement of steps to realize upon their junior security interest in the collateral if: (1) the final maturity date of the Senior Notes has passed and the Senior Note Trustee or the holders of Senior Notes have not commenced such steps to realize upon their security interest in the collateral within 60 days of such date; or (2) the remaining principal amount of Senior Notes then outstanding constitutes less than 10% of the remaining principal amount of Junior Notes then outstanding; or (3) such time as: (a) holders of Junior Notes have not received interest or any other amounts payable under the Junior Notes for a period of 181 days from the date of required payment, and (b) the principal of the Senior Notes has not been accelerated and the Senior Note Trustee or holders of the Senior Notes have not commenced steps to foreclose or otherwise realize upon the security interest of holders of the Senior Notes in the collateral. Until such time as the principal amount of Senior Notes outstanding is less than the amount of Junior Notes outstanding, the holders of Senior Notes are given the exclusive right to control all decisions relating to the enforcement of remedies under the collateral documents. After that time, the holders of a majority of the aggregate principal amount of New Notes will control such decisions. As a result, the holders of the Junior Notes will not be able to force a sale of the collateral securing the Junior Notes or otherwise independently pursue the remedies of a secured creditor under the collateral documents in most circumstances. The holders of the Senior Notes may have interests that are different from the interests of holders of the Junior Notes and they may elect not to pursue their remedies under the collateral documents at a time when it would be advantageous for the holders of the Junior Notes to do so. RISKS RELATED TO THE NEW COMMON STOCK IF AN ACTIVE TRADING MARKET DOES NOT DEVELOP FOR THE NEW COMMON STOCK, STOCKHOLDERS MAY NOT BE ABLE TO RESELL THEIR NEW COMMON STOCK. For various reasons, including those discussed below, we are unable to predict whether an active trading market will develop or be sustained for the New Common Stock. To date, an active trading market has not developed for the New Common Stock. If no active trading market develops, stockholders may not be able to resell their shares of New Common Stock at their fair market value or at all. The shares of New Common Stock are a new issuance of securities with no established trading market. We have no present plans to apply to list the New Common Stock on any United States exchange or the Nasdaq Stock Market. We are not aware of any securities firm that intends to make a market in the New Common Stock and any securities firm that does act as a market-maker could cease its market-making at any time. In addition, the liquidity of the trading market in the New Common Stock, and the market price quoted for the New Common Stock, may be adversely affected by changes in the overall market for equity securities and by changes in our financial performance or our prospects and our subsidiaries or in the prospects for companies in our industry generally. While we do not anticipate that we or our securities will be rated by any rating agency, if we or our securities are rated and are subsequently downgraded by any rating agency, the trading price of the New Common Stock may be adversely effected. OUR STOCK PRICE MAY BE HIGHLY VOLATILE. THE SHARE PRICE OF THE NEW COMMON STOCK MAY DECREASE AND STOCKHOLDERS COULD LOSE SOME OR ALL OF THEIR INVESTMENT. The price at which our Old Common Stock traded fluctuated significantly, and the price at which the New Common Stock trades may continue to be volatile. From January 1, 2000 through October 26, 2001, the date our Old Common Stock was delisted, the sales price of our Old Common Stock, as reported on the AMEX, ranged from a low of $0.02 to a high of $2.38. From January 1, 2002, the Effective Date of our Plan, through May 31, 2002, the closing sales price of our New Common Stock, quoted on the OTC.BB, ranged from a low of $2.50 to a high of $3.20. If our share price decreases, stockholders could lose some or all of their investment. SUBSTANTIAL SALES OF THE NEW COMMON STOCK COULD CAUSE THE STOCK PRICE TO DECLINE. There were 17,120,745 shares of our Old Common Stock outstanding as of December 31, 2001. Upon cancellation of our Old Common Stock on January 1, 2002, we had 6,431,759 shares of New Common Stock outstanding (with an additional 68,241 shares of New Common Stock authorized for issuance and reserved to cover certain unsecured claims that remained outstanding, which will be issued when those claims are settled; see "Description of Capital Stock -- Reserve.") Stockholders may seek to sell their shares of New Common Stock, and sales of large numbers of shares in the same time period could cause the market price of the New Common Stock to decline significantly. These sales also might make it more difficult for us to sell securities in the future at a time and price that we deem appropriate. BECAUSE IT IS UNLIKELY THAT WE WILL PAY DIVIDENDS, STOCKHOLDERS WILL ONLY BE ABLE TO BENEFIT FROM HOLDING NEW COMMON STOCK IF THE STOCK PRICE APPRECIATES. We currently intend to retain any future earnings to pay principal and interest on our indebtedness and to fund growth and, therefore, we do not expect to pay any dividends in the foreseeable future. As a result of not collecting a dividend, stockholders will not experience a return on their investment, unless the price of the New Common Stock appreciates and they sell their shares of New Common Stock. WE MAY NEED TO RAISE ADDITIONAL CAPITAL IN THE FUTURE, WHICH MAY BE UNAVAILABLE OR WHICH MAY RESULT IN DILUTION TO OUR STOCKHOLDERS AND RESTRICT OUR OPERATIONS. We may seek to sell additional equity or debt securities or obtain a credit facility in order to finance our operations, which we may not be able to do on favorable terms or at all. Our ability to obtain additional debt and equity financing may be limited by restrictions in the Senior Note Indenture, the Junior Note Indenture, the G.E. Capital Loan Agreement and in our other debt agreements. The sale of additional equity or convertible debt securities could result in additional dilution to our stockholders. If additional funds are raised through the issuance of debt securities or preferred stock, these securities could have rights that are senior to the New Common Stock and any debt securities could contain covenants that would restrict our and our subsidiaries' operations. A MAJORITY OF THE NEW COMMON STOCK IS HELD BY A SMALL NUMBER OF STOCKHOLDERS WHO COULD HAVE INTERESTS THAT CONFLICT WITH THE INTERESTS OF THE OTHER STOCKHOLDERS. A majority of the New Common Stock is held by a small number of stockholders and their affiliates. This concentration of ownership gives those stockholders, if they act together, the power to control the outcome of matters requiring stockholder approval, including the election of directors and to hinder or delay a change of control of the Company. RISKS RELATED TO OUR BUSINESS AND THE BUSINESS OF OUR SUBSIDIARIES WE ARE HIGHLY LEVERAGED; OUR LOAN AND LEASE AGREEMENTS CONTAIN FINANCIAL COVENANTS. We are highly leveraged. We had total indebtedness, including short-term portion, of $165.2 million and shareholders' equity of $31.3 million as of March 31, 2002. We obtained some relief through the implementation of our Plan but will continue to be highly leveraged (see Note 1 of the consolidated financial statements included elsewhere herein). The degree to which we are leveraged could have important consequences, including: - making it difficult to satisfy our debt or lease obligations; - increasing our vulnerability to general adverse economic and industry conditions; - limiting our ability to obtain additional financing; - requiring dedication of a substantial portion of our cash flow from operations to the payment of principal and interest on our debt and leases, thereby reducing the availability of such cash flow to fund working capital, capital expenditures or other general corporate purposes; - limiting our flexibility in planning for, or reacting to, changes in our business or industry; and - placing us at a competitive disadvantage to less leveraged competitors. On March 31, 2002, we did not meet the financial requirements established for the Predecessor Company as set forth in the amended U.S. Bank loan agreement. In May 2002, we received a waiver from U.S. Bank regarding the Bank's right to declare an event of default for our failure to meet the March 31, 2002 financial requirements set forth in the amended U.S. Bank loan agreement. Furthermore, we amended our existing agreement with U.S. Bank, establishing new covenants, with which we were in compliance as of March 31, 2002. Failure to comply with any covenant constitutes an event of default, which will allow U.S. Bank (at its discretion) to declare any amounts outstanding under the loan documents to be due and payable. We cannot provide assurance that we will comply in the future with the modified financial covenants included in the agreement, or with the financial covenants set forth in our other debt agreements and leases. If we fail to comply with one or more of the U.S. Bank covenants or any other debt or lease covenants (after giving effect to any applicable cure period), the lender or lessor may declare us in default of the underlying obligation and exercise any available remedies, which may include: - in the case of debt, declaring the entire amount of the debt immediately due and payable; - foreclosing on any residences or other collateral securing the obligation; and - in the case of a lease, terminating the lease and suing for damages Many of our debt instruments and leases contain "cross-default" provisions pursuant to which a default under one obligation can cause a default under one or more other obligations. Accordingly, if enforced, we could experience a material adverse effect on our financial condition. INCREASES IN UTILITY COSTS COULD REDUCE OUR PROFITABILITY. Utility costs represent a significant percentage of our operating costs. The cost of utilities may continue to rise. While we have not historically included utility surcharges in the rental rates we charge to our residents, we may do so in the future. There can be no assurance that we will be able to do so. Increases in the costs of utilities that we are unable to pass on to our residents could significantly reduce our profits. WE ARE INVOLVED IN A DISPUTE WITH OUR CORPORATE LIABILITY INSURANCE CARRIER. In September 2000, we reached an agreement to settle the class action litigation relating to the restatement of our consolidated financial statements for the years ended December 31, 1996 and 1997 and the first three fiscal quarters of 1998. This agreement received final court approval on November 30, 2000 and we were dismissed from the litigation with prejudice. On September 28, 2001, we made our final installment of $1.0 million on our promissory note for the class action litigation settlement. Although we were dismissed from the litigation with prejudice, a dispute which arose with our corporate liability insurance carriers remains unresolved. At the time we settled the class action litigation, the Company and the insurance carriers agreed to resolve this dispute through binding arbitration, and we filed a complaint for a declaratory judgment that we are not liable to the carriers as claimed. The carriers counter-claimed to recover an amount capped at $4.0 million. After filing for bankruptcy on October 1, 2001, we made a motion for dismissal of our complaint for declaratory relief in the arbitration based upon having filed for bankruptcy protection. An objection was filed to our motion, and one of our insurance carriers filed a proof of claim in the amount of $4.0 million in the bankruptcy proceeding. We dispute that claim. We offered (and the offer currently remains outstanding) to settle the dispute for $75,000 to be paid out as a general unsecured claim in the bankruptcy process. See Notes 1 and 13 to the consolidated financial statements of the Company included elsewhere herein. WE ARE PARTY TO OTHER LEGAL PROCEEDINGS. Participants in the senior living and long-term care industry, including us, are routinely subject to lawsuits and claims. Many of the persons who bring these lawsuits and claims seek significant monetary damages, and these lawsuits and claims often result in significant defense costs. As a result, the defense and ultimate outcome of lawsuits and claims against us may result in higher operating expenses. Those higher operating expenses could have a material adverse effect on our business, financial condition, results of operations, cash flow or liquidity. CERTAIN OF OUR LEASES MAY BE TERMINATED AS A RESULT OF INCREASE IN CONCENTRATED OWNERSHIP IN OUR COMMON STOCK AND UPON OCCURRENCE OF OTHER EVENTS. Certain of our leases with LTC provide LTC with the option to exercise certain remedies, including the termination of many of our leases with LTC, upon a change of control under which at least 30% ownership of our common stock is held by a party or combination of parties directly or indirectly. LTC has the same option if the stockholders approve a plan of liquidation or the stockholders approve of a merger or consolidation that meets certain conditions. WE MAY BE LIABLE FOR LOSSES NOT COVERED BY OR IN EXCESS OF OUR INSURANCE. In order to protect ourselves against the lawsuits and claims made against us, we currently maintain insurance policies in amounts and covering risks that are consistent with industry practice. However, as a result of poor loss experience, a number of insurance carriers have stopped providing insurance coverage to the long-term care industry, and those remaining have increased premiums and deductibles substantially. While nursing homes have been primarily affected, assisted living companies, including us, have experienced premium and deductible increases. During our claim year ended December 31, 2000, our professional liability insurance coverage included deductible levels of $100,000 per incident. For the claim years ending December 31, 2001 and 2002, this deductible has been replaced with a retention level of $250,000 per incident, except in Florida and Texas in which the retention level is $500,000 per incident. Our professional liability insurance is on a claims-made basis. In certain states, particularly Florida and Texas, many long-term care providers are facing very difficult renewals. There can be no assurance that we will be able to obtain liability insurance in the future on commercially reasonable terms or at all. A claim against us, covered by, or in excess of, our insurance, could have a material adverse affect on our operations, cash flows. WE ARE SUBJECT TO SIGNIFICANT GOVERNMENT REGULATION. The operation of assisted living facilities and the provision of health care services are subject to state and federal laws, and state and local licensure, certification and inspection laws that regulate, among other matters: - the number of licensed residences and units per residence; - the provision of services; - equipment; - staffing, including professional licensing and criminal background checks; - operating policies and procedures; - fire prevention measures; - environmental matters; - resident characteristics; - physical design and compliance with building and safety codes; - confidentiality of medical information; - safe working conditions; - family leave; and - disposal of medical waste. The cost of compliance with these regulations is significant. In addition, it could adversely affect our financial condition or results of operations if a court or regulatory tribunal were to determine we have failed to comply with any of these laws or regulations. Because these laws and regulations are amended from time to time, we cannot predict when and to what extent liability may arise. See "-- We must comply with laws and regulations regarding the confidentiality of medical information," "-- We must comply with restrictions imposed by laws benefiting disabled persons", "-- We may incur significant costs and liability as a result of medical waste" and "-- We may incur significant costs related to environmental remediation or compliance." In the ordinary course of business, we receive and have received notices of deficiencies for failure to comply with various regulatory requirements. We review such notices and, in most cases, will agree with the regulator upon the steps to be taken to bring the facility into compliance with regulatory requirements. From time to time, we may dispute the matter and sometimes will seek a hearing if we do not agree with the regulator. In some cases or upon repeat violations, the regulator may take one or more adverse actions against a facility, such as: - the imposition of fines -- the Company paid $16,000 and $15,000, respectively, in the aggregate for the years ended December 31, 2000 and 2001; - temporary stop placement of admission of new residents, or imposition of other conditions to admission of new residents to a facility -- these applied to two residences in 2001; - termination of a facility's Medicaid contract; - conversion of a facility's license to provisional status; and - suspension or revocation of a facility's license, which in 2001 included one residence in Washington against which the state commenced license revocation procedures. This matter was provisionally settled in 2002. The operation of our residences is subject to state and federal laws prohibiting fraud by health care providers, including criminal provisions, which prohibit filing false claims or making false statements to receive payment or certification under Medicaid, or failing to refund overpayments or improper payments. Violation of these criminal provisions is a felony punishable by imprisonment and/or fines. We may be subject to fines and treble damage claims if we violate the civil provisions which prohibit the knowing filing of a false claim or the knowing use of false statements to obtain payment. State and federal governments are devoting increasing attention and resources to anti-fraud initiatives against health care providers. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") and the Balanced Budget Act of 1997 expanded the penalties for health care fraud, including broader provisions for the exclusion of providers from the Medicaid program. We have established policies and procedures that we believe are sufficient to ensure that our facilities will operate in substantial compliance with these anti-fraud and abuse requirements. While we believe that our business practices are consistent with Medicaid criteria, those criteria are often vague and subject to change and interpretation. Aggressive anti-fraud actions, however, could have an adverse effect on our financial position, results of operations or cash flows. We are subject to regulation by the Commission. In April, 1999, we received a preliminary inquiry from the Commission regarding the restatement of our financial statements for the years ended December 31, 1996 and 1997 and the first three quarters of 1998 and related matters. We provided the Commission with information and documents in response to the inquiry, and have received no correspondence from the Commission regarding the inquiry since March 2000. The Commission has never alleged any violation of law in connection with the inquiry. There can be no assurance that the Commission will not resume its inquiry. WE MUST COMPLY WITH LAWS AND REGULATIONS REGARDING THE CONFIDENTIALITY OF MEDICAL INFORMATION. In 1996, the HIPAA law created comprehensive new requirements regarding the confidentiality of medical information that is or has been electronically transmitted or maintained. The Department of Health and Human Services has enacted regulations implementing the law, and we may have to significantly change the way we maintain and transmit healthcare information for our residents to comply with these regulations. Although HIPAA was intended ultimately to reduce administrative expenses and burdens faced within the health care industry, we believe the law could initially bring about significant and, in some cases, costly changes. HHS has released two rules to date mandating the use of new standards with respect to certain health care transactions and health information. The first rule requires the use of uniform standards for common health care transactions, including health care claims information, plan eligibility, referral certification and authorization, claims status, plan enrollment and disenrollment, payment and remittance advice, plan premium payments and coordination of benefits. Second, HHS has released new standards relating to the privacy of individually identifiable health information. These standards not only require our operators' compliance with rules governing the use and disclosure of protected health information, but they also require entities to impose those rules, by contract, on any business associate to whom such information is disclosed. Rules governing the security of health information have been proposed but have not yet been issued in final form. HHS finalized the new transaction standards on August 17, 2000, and covered entities will be required to comply with them by October 16, 2002. Congress passed legislation in December 2001 that delays for one year (October 16, 2003) the compliance date, but only for entities that submit a compliance plan to HHS by the original implementation deadline. The privacy standards were issued on December 28, 2000, and, after certain delays, became effective April 14, 2001, with a compliance date of April 14, 2003. The Bush Administration and Congress are taking a careful look at the existing regulations, but it is uncertain whether there will be additional changes to the privacy standards or their compliance date. With respect to the security regulation, once they are issued in final form, affected parties will have approximately two years to be fully compliant. Sanctions for failing to comply with HIPAA include criminal penalties and civil sanctions. WE MUST COMPLY WITH RESTRICTIONS IMPOSED BY LAWS BENEFITING DISABLED PERSONS. Under the Americans with Disabilities Act of 1990, all places of public accommodation are required to meet certain federal requirements related to access and use by disabled persons. A number of additional federal, state and local laws exist that also may require us to modify existing residences to allow disabled persons to access the residences. We believe that their residences are either substantially in compliance with present requirements or are exempt from them. However, if required changes cost more than anticipated, or must be made sooner than anticipated, we would incur additional costs. Further legislation may impose additional burdens or restrictions related to access by disabled persons, and the costs of compliance could be substantial. WE MAY INCUR SIGNIFICANT COSTS AND LIABILITY AS A RESULT OF MEDICAL WASTE. Our facilities generate potentially infectious waste due to the illness or physical condition of the residents, including blood-soaked bandages, swabs and other medical waste products and incontinence products of those residents diagnosed with infectious diseases. The management of potentially infectious medical waste, including handling, storage, transportation, treatment and disposal, is subject to regulation under federal and state laws. These laws and regulations set forth requirements for managing medical waste, as well as permit, record keeping, notice and reporting obligations. Any finding that we are not in compliance with these laws and regulations could adversely affect our business operations and financial condition. Because these laws and regulations are amended from time to time, we cannot predict when and to what extent liability may arise. In addition, because these environmental laws vary from state to state, expansion of our operations to states where they do not currently operate may subject us to additional restrictions on the manner in which they operate their facilities. We may be liable under some laws and regulations as an owner, operator or an entity that arranges for the disposal of hazardous or toxic substances at a disposal site. In that event, we may be liable for the costs of any required remediation or removal of the hazardous or toxic substances at the disposal site. In connection with the ownership or operation of our properties, we could be liable for these costs, as well as some other costs, including governmental fines and injuries to persons or properties. As a result, any hazardous or toxic substances which are present, with or without our knowledge, at any property held or operated by us could have an adverse effect on our business, financial condition or results of operations. WE COULD INCUR SIGNIFICANT COSTS RELATED TO ENVIRONMENTAL REMEDIATION OR COMPLIANCE. We are subject to various federal, state and local environmental laws, ordinances and regulations. Some of these laws, ordinances and regulations hold a current or previous owner, lessee or operator of real property liable for the cost of removal or remediation of some hazardous or toxic substances that could be located on, in or under such property. These laws and regulations often impose liability whether or not we knew of, or were responsible for, the presence of the hazardous or toxic substances. The costs of any required remediation or removal of these substances could be substantial. Furthermore, there is no limit to our liability under such laws and regulations. As a result, our liability could exceed their property's value and aggregate assets. The presence of these substances or failure to remediate these substances properly may also adversely affect our ability to sell or our property, or to borrow using their property as collateral. MANY ASSISTED LIVING MARKETS HAVE BEEN OVERBUILT. Many assisted living markets have been overbuilt, including certain markets in which we currently operate. In addition, the barriers to entry into the assisted living industry are not substantial. The effects of overbuilding include: - it takes significantly longer for our residences and our subsidiaries' residences to fill up, - newly opened facilities may attract residents from some or all of the our current facilities, - there is pressure to lower or not increase rates paid by residents in the our residences, - there is increased competition for workers in already tight labor markets, and - our profit margins and the profit margins of our subsidiaries are lower until vacant units in our residences are filled. If we are unable to compete effectively in markets as a result of overbuilding, we will suffer lower revenue and may suffer a loss of market share. Due to market conditions facing one location in Indiana, we closed the facility, effective March 15, 2002. WE MAY NOT BE ABLE TO ATTRACT AND RETAIN QUALIFIED EMPLOYEES AND CONTROL LABOR COSTS. We compete with other providers of long-term care with respect to attracting and retaining qualified personnel. A shortage of qualified personnel may require us to enhance our wage and benefits packages in order to compete. Some of the states in which we operate impose licensing requirements on individuals serving as administrators at assisted living residences, and others may adopt similar requirements. We also depend upon the available labor pool of lower-wage employees. We cannot guarantee that our labor costs will not increase, or that, if they do increase, they can be matched by corresponding increases in revenues. WE DEPEND ON REIMBURSEMENT BY GOVERNMENTAL PAYORS AND OTHER THIRD PARTIES FOR A SIGNIFICANT PORTION OF OUR REVENUES. Although revenues at a majority of our residences come primarily from private payors, we derive a substantial portion of our revenues from reimbursements by third-party governmental payors, including state Medicaid waiver programs. We expect that state Medicaid waiver programs will continue to constitute a significant source of our revenues in the future, and it is possible that the proportionate percentage of revenue received by us from Medicaid waiver programs will increase. There are continuing efforts by governmental payors and by non-governmental payors, such as commercial insurance companies and health maintenance organizations, to contain or reduce the costs of health care by lowering reimbursement rates, increasing case management review of services and negotiating reduced contract pricing. Also, there have been, and we expect that there will continue to be, additional proposals to reduce the federal and some state budget deficits by limiting Medicaid reimbursement in general. If any of these proposals are adopted at either the federal or the state level, it could have a material adverse effect on our business, financial condition, results of operations and prospects. The state of Washington recently approved legislation which would limit future increase in rental reimbursements. The approval is preliminary and we have not yet quantified the financial impact of such legislation. Additionally, the state of New Jersey currently has a hold on additional beds for Medicaid residences. This hold may impact our ability to move new Medicaid tenants into our facilities. The following table sets forth the sources of our revenue for the three months ended March 31, 2001 and 2002 for states where we participate in Medicaid programs. The portion of revenues received from state Medicaid agencies are labeled as "Medicaid State Paid Portion" while the portion of our revenues that a Medicaid-eligible resident must pay out of his or her own resources is labeled "Medicaid Tenant Paid Portion." <Table> <Caption> THREE MONTHS ENDED MARCH 31, THREE MONTHS ENDED MARCH 31, 2001 2002 ----------------------------- ----------------------------- MEDICAID PRIVATE MEDICAID PRIVATE ------------------ -------- ------------------ -------- STATE RESIDENT RESIDENT STATE RESIDENT RESIDENT PAID PAID PAID PAID PAID PAID PORTION PORTION PORTION PORTION PORTION PORTION ------- -------- -------- ------- -------- -------- <S> <C> <C> <C> <C> <C> <C> Oregon........................... 29.4% 17.8% 52.8% 25.3% 14.6% 60.1% Washington....................... 29.8% 17.8% 52.4% 29.9% 17.2% 52.9% Idaho............................ 13.3% 10.6% 76.1% 14.0% 10.9% 75.1% Arizona.......................... 13.7% 10.7% 75.6% 17.4% 15.2% 67.4% New Jersey....................... 16.7% 9.3% 74.0% 27.1% 4.7% 68.2% Texas............................ 15.5% 8.2% 76.3% 15.6% 8.0% 76.4% Nebraska......................... 8.5% 5.5% 86.0% 10.3% 6.4% 83.3% </Table> In addition, although we manage the mix of private paying tenants and Medicaid paying tenants residing in our facilities, any significant increase in our Medicaid population could have an adverse effect on our financial position, results of operations or cash flows, particularly if the states operating these programs continue to limit, or more aggressively seek limits on, reimbursement rates.

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+RISK FACTORS You should carefully consider the risks described below and the other information in this prospectus before deciding to invest in shares of our common stock. If any of the following risks actually occur, our business could be harmed, the trading price of our common stock could decline, and you may lose all or part of your investment. Risks Relating to Our Business We have a short operating history, which limits your ability to evaluate our business and operating results and may increase the risk of your investment. Our short operating history makes the evaluation of our business operations and our prospects difficult. We were founded in 1996 and began offering version 1.0 of our corporate portal product in March 1998. Version 4.5 of our portal was released in September 2001. We cannot predict whether this version of our portal will be successful. We have derived all of our revenue from licensing our Plumtree Corporate Portal and related products and services. Before buying our common stock, you should consider the risks and difficulties frequently encountered by early stage companies such as ours in new and rapidly evolving markets, particularly those companies whose businesses depend on the Internet. These risks and difficulties include: . potential fluctuations in operating results and uncertain growth rates; . limited market acceptance of our products; . concentration of our revenue in a single product; . our need to expand our direct sales forces and indirect sales channels, particularly for international markets; . our need to manage rapidly expanding operations; and . our need to attract, train and retain qualified personnel. We have a history of losses, and we may never achieve or sustain profitability, which would have a harmful effect on our business and the value of our common stock. We have incurred substantial net losses in each year since our inception in July 1996. For the years ended December 31, 2000 and 2001, we incurred net losses of approximately $21.7 million and $7.8 million, respectively. As of March 31, 2002, we had an accumulated deficit of approximately $41.7 million. Given the level of our planned operating and capital expenditures, we may incur losses and negative cash flows for the foreseeable future. If our revenue does not continue to increase or if our expenses increase at a greater pace than our revenue, we will never become profitable on an annual basis. Our ability to increase revenue and achieve and sustain profitability also will be affected by other risks and uncertainties described in this section and in "Management's Discussion and Analysis of Financial Condition and Results of Operations." Our failure to become profitable on an annual basis or to remain profitable would have a harmful effect on our business and the value of our common stock. Because our quarterly operating results are volatile and difficult to predict, our operating results in one or more future periods are likely to fluctuate significantly, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly. As a result of our limited operating history and the emerging nature of the market in which we compete, our quarterly operating results have varied significantly in the past and are likely to vary significantly in the future. Our success depends upon our ability to continue to increase sales of our products and services to our new and existing customers. Our license revenue is comprised substantially of one-time license fees. As a result, we will be required to regularly and increasingly sign additional customers with substantial license fees on a timely basis to realize comparable or increased license revenue. Our services and maintenance revenue historically has been comprised almost entirely of installation, modification and consulting fees and support and maintenance fees. Our services revenue has lower gross margin than our license revenue. If the percentage of our services revenue increases compared to the percentage of license revenue, our profitability would be impaired. Our maintenance contracts are generally renewable for 12-month periods. If our customers elect not to renew their maintenance contracts, our revenue could decline. We expect to continue to experience significant fluctuations in our results of operations due to a variety of factors, some of which are outside of our control, including: . introduction of products and services and enhancements by us and our competitors; . competitive factors that affect our pricing; . the timing and magnitude of our capital expenditures, including costs relating to the expansion of our operations within the United States and internationally; and . the size and timing of customer orders and deployments, particularly large orders and deployments, some of which may represent more than 10% of total revenue during a particular quarter. As a result of these factors and other factors described in this prospectus, we believe that quarter-to-quarter comparisons of our revenue and operating results are not necessarily meaningful, and that these comparisons may not be accurate indicators of future performance. Because our staffing and operating expenses are based on anticipated revenue levels, and because a high percentage of our costs are fixed, small variations in the timing of the recognition of specific revenue could cause significant variations in operating results from quarter to quarter. If we are unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, any significant revenue shortfall would likely have an immediate negative effect on our operating results. If our operating results in one or more future quarters fail to meet the expectations of securities analysts or investors, we would expect to experience an immediate and significant decline in the trading price of our stock. Because our quarterly results often depend on a small number of large orders, if we were unable to complete one or more of these orders during any future period, our quarterly operating results and the trading price of our stock could be harmed. We derive a significant portion of our software license revenue in each quarter from a small number of relatively large orders. For example, in the quarter ended March 31, 2002, our top 10 customers accounted for approximately 46% of our total revenue. Similarly, in each quarter over the last two years, generally a different customer has represented at least 10% of our total quarterly revenue. Our operating results and stock price could be harmed if we were unable to complete one or more substantial license sales during any future quarterly period. Our business currently depends on revenue related to our flagship product, the Plumtree Corporate Portal, and if the market does not increasingly accept this product and related products and services, our revenue may decline. We generate our revenue from licenses of the Plumtree Corporate Portal and related products and services, including Plumtree Gadget Web Services, the building blocks from which users assemble a personalized Web page. We expect that our portal product, and future upgraded versions of this product, will continue to account for a large portion of our revenue in the foreseeable future. Our future financial performance will depend on increasing acceptance of our current product and on the successful development, introduction and customer acceptance of new and enhanced versions of our product. For example, our future success depends in part on the widespread market acceptance of version 4.51 of our portal product, planned for commercial release in the first half of 2002. If future versions of our products and services, including version 4.51 of the Plumtree Corporate Portal, do not gain market acceptance when released commercially, or if we fail to deliver the product enhancements that customers want, demand for our products and services, and our revenue, may decline. Our efforts to establish and maintain the Plumtree Corporate Portal as an enterprise-wide platform may fail and, as a result, our revenue may not increase and our ability to compete successfully may be impaired. We have expended, and plan to continue to expend, significant resources to establish our portal as an enterprise-wide platform for integrating an organization's diverse systems and applications. To succeed, we must develop and market both enhancements to our Plumtree Corporate Portal and new products and services that expand its functionality. The Plumtree Collaboration Server and the Plumtree Studio Server, each released commercially in the first quarter of 2002, are our most significant new product developments since the introduction of the Plumtree Corporate Portal. These and other new products may not achieve widespread market acceptance. Even if we are successful in establishing our portal as an enterprise-wide platform, we face, among others, the following risks: . We will likely face new and in many cases larger competitors, and some of our current system integrators and technology partners with whom we work closely may come to view our new products and services as competitive. . In order to remain competitive, we must increase the number of systems and applications that can be integrated into our portal platform as Web services, which will increasingly strain our development and support infrastructure and may require us to add significant additional personnel. Our sales and implementation cycles are long, unpredictable and subject to seasonal fluctuations, making it difficult to accurately forecast our revenue and causing it to fluctuate, which could harm our operating results. As a result of our limited operating history and the emerging nature of the market in which we compete, the typical sales cycle of our portal product is long and unpredictable. A successful sales cycle may last six months or longer, and typically includes presentations to both business and technical decision makers, often requiring us to expend substantial resources educating prospective customers about the benefits of our software to their business. The implementation of our product can be time-consuming and often involves a significant commitment of resources by prospective customers. Our sales cycle is also affected by a number of other factors, over some of which we have little or no control, including the business conditions of each prospective customer, seasonal fluctuations as a result of customers' fiscal year budgeting and purchasing cycles and the selection and performance of our technology and of our technology partners, systems integrators and resellers, any of which could harm our operating results. We depend on technology licensed from third-party software developers and our ability to develop and sell our products and services could be delayed or impaired if we fail to maintain these license arrangements. We incorporate into our products third-party software that enables their functionality. This third-party software may not continue to be available on commercially reasonable terms or with acceptable levels of support, or at all. Some of these third-party software developers offer products that compete with the Plumtree Corporate Portal and our other products. Our loss of or inability to maintain these software licenses could delay or impair the sale of our products and services until equivalent software, if available, is identified, licensed or developed, and integrated, which could adversely affect our business and impair our future growth. We depend on our direct sales force to sell our products, and if we fail to hire and train new sales personnel, our future growth will be impaired. We sell our products primarily through our direct sales force and we expect to continue to do so in the future. Our ability to achieve revenue growth in the future will depend on our ability to recruit, train and retain qualified direct sales personnel. We have in the past and may in the future experience difficulty in recruiting qualified sales personnel. Our inability to rapidly and effectively expand our direct sales force could impair our growth and cause our stock price to fall. If we are unable to establish and maintain relationships with systems integrators and resellers, our ability to market, sell and deploy our products and services will be harmed. We have relationships with a large number of systems integrators and resellers, such as Accenture, Cap Gemini Ernst & Young and Computer Sciences Corporation. We rely significantly on these parties to market and sell our products and to provide rapid and comprehensive deployment of our products. These relationships are a key factor in our overall business strategy and involve a number of risks, including: . Systems integrators and resellers may not view their relationships with us as valuable or significant to their own businesses. The related arrangements typically may be terminated by either party with limited notice and in some cases are not covered by a formal agreement. . Systems integrators may attempt to market their own products and services rather than ours. . Our competitors may have stronger relationships with these parties and, as a result, these system integrators and resellers may recommend a competitor's products and services over ours. . Under our co-deployment model, we rely on our system integrators' and resellers' employees to perform implementations. If we fail to work together effectively, or if these parties perform poorly, our reputation may be harmed and deployment of our products may be delayed or performed inadequately. . If we lose our relationships with our systems integrators and resellers, we will not have the personnel necessary to deploy our products effectively, and we will need to commit significant additional sales and marketing resources in an effort to reach the markets and customers served by these parties. If our alliances with technology providers are discontinued, our future growth will be impaired. We have relationships with technology providers, such as Microsoft and Documentum, to provide our customers with support of many applications and services. Although these relationships are a key factor in our overall business strategy, our alliance members may not view their relationships with us as significant to their own businesses. A number of our competitors may have stronger relationships with these technology and content vendors and, as a result, these alliance members may be more likely to support our competitors' products and services over ours. In addition, our technology providers may offer products and services that are competitive to ours. Our arrangements generally do not establish minimum performance requirements but instead rely on voluntary efforts. In addition, most of our agreements with these entities may be terminated by either party with limited notice. In some cases these arrangements are not covered by a formal agreement. We currently invest significant resources to develop these alliances and plan to continue to do so. If we are unable to maintain our existing relationships or fail to enter into additional relationships, our ability to increase our sales could be harmed, and we could also lose anticipated customer introductions and co-marketing benefits. Even if we succeed in establishing and maintaining these relationships, they may not result in additional customers or revenue. If our software contains errors, we may lose customers or experience reduced market acceptance of our products. Our software products are inherently complex and may contain defects and errors that are detected only when the product is in use. The latest version of our portal product, version 4.5, has only recently been released, which increases the risk of undetected defects or errors. It is also possible that our products released commercially in the first quarter of 2002, the Plumtree Collaboration Server and the Plumtree Studio Server, as well as version 4.51 of our corporate portal product scheduled for commercial release in the first half of 2002, may contain undetected defects or errors that are discovered after release. In addition, third-party software that we incorporate into our portal product, or with which we integrate to deploy our solution, has contained, and may in the future contain, defects or errors. Some of our Plumtree Corporate Portal customers require, or may require, enhanced modifications of our software for their specific needs. Modifications may increase the likelihood of undetected defects or errors. Further, we often render implementation, consulting and other technical services, the performance of which typically involves working with sophisticated software, computing and networking systems. As a result of product defects or our failure to meet project milestones for services, we may lose customers, customers may not implement our products more broadly within their organization, we may experience reduced market acceptance of our products, and we may be subject to product liability claims by our customers. If we are unable to develop products that are compatible and can be integrated with a large variety of hardware, software, database and networking systems, our ability to attract and retain customers will be harmed. The Plumtree Corporate Portal is designed to support a broad set of software applications and online services through Plumtree Gadget Web Services. To gain broad market acceptance, we believe that we must support an increased number of applications and services in the future. If the underlying applications and services are upgraded or changed, maintaining this support may be difficult or impossible. If we are unable to support an increased number of applications and services in the future or if we are unable to maintain compatibility with these systems, our ability to attract and retain customers will be harmed. If we do not expand our customer base, we may be unable to increase our revenue and our stock price will likely decline. The market for corporate portal software is newly emerging and there can be no assurance that additional customers will adopt our products. Accordingly, we cannot accurately estimate the potential demand for our products and services. We believe that market acceptance of our products and services depends principally on our ability to: . enhance our portal solution to meet changing customer demand; . effectively market the Plumtree Corporate Portal and related products and services; . hire, train and retain a sufficient number of qualified sales and marketing personnel; . provide high-quality and reliable customer support for our products; . distribute and price our products and services to be more appealing to customers than those of our competitors or of our customers' internally- developed solutions; . develop a favorable reputation among our customers, potential customers and participants in the software industry who can serve as reference accounts for our products and services; and . withstand downturns in general economic conditions or conditions that slow corporate spending on software products. Some of these factors are beyond our control. If our customer base does not expand, we may never become profitable on an annual basis. Some of our customers are in the preliminary phase of implementing our portal product and this implementation may not proceed on a timely basis or at all. Some of our customers, such as Aventis, Department for Education and Services (U.K.), O'Charley's, Washington Mutual and Zurich Insurance, are currently in a pre-deployment or preliminary stage of implementing our portal product and may encounter delays or other problems in introducing it. These delays or other problems may result from matters specific to the customer and unrelated to us or our product. A customer's decision not to implement our product, or a delay in implementation, could result in a delay or loss in related service revenue or otherwise harm our business or prospects. We cannot predict when any customer currently in a pilot or preliminary phase will implement broader use of our product. Security breaches with our software may lead to unexpected capital expenditures and cause a loss in revenue and reputation. Our portal product is designed to facilitate the secure transmission of sensitive business information to specified parties outside the business over the Internet. This includes product information, competitive intelligence, sales and inventory data, sales reports and corporate e-mail. As a result, the reputation of our software for providing security is vital to its acceptance by customers. Problems caused by security breaches could result in loss of or delay in revenue, loss of market share, failure to achieve market acceptance, diversion of research and development resources, harm to our reputation, customer claims against us, increased insurance costs or increased service and warranty costs. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques. Moreover, our products may be even more susceptible to security breaches, since portals require the aggregation of many different Web applications on many different servers, with different security standards and protocols. Capacity restrictions of our software could reduce the demand for and use of our products, which may limit our ability to generate license revenue. Our products are designed to support enterprise-wide deployments with hundreds of thousands of users. However, the maximum amount of information and the maximum number of concurrent users that our products can support in any particular deployment is uncertain. If the capacity boundaries of our products are reached, our customers may be dissatisfied, and we may lose customers or fail to gain new customers. If we are unable to retain key personnel, our growth will be limited. We are highly dependent on certain members of our management staff, including, without limitation, our chief executive officer, John Kunze, our vice president of engineering, John Hogan, and our vice president of worldwide field operations, Jim Flatley. Our ability to continue to deliver products and services that are responsive to customer needs, which is critical to our success, also depends on our ability to retain several members of our engineering team. The loss of one or more of these officers or engineers may impede the achievement of our business objectives. None of our officers or key employees is bound by an employment agreement for any specific term, and no one is constrained from terminating his or her employment relationship with us at any time. In addition, since a number of our long-standing employees have most of their stock options or restricted stock vested, their economic incentive to remain in our employ may be diminished. If we are unable to recruit and train new personnel, our operations will be disrupted and our growth impaired. Recruiting and retaining qualified technical personnel is critical to our success. If our business grows, we will also need to recruit a significant number of management, technical and other personnel for our business. Competition for employees in our industry is intense, particularly in Northern California where our principal offices are located. If we are not able to continue to attract and retain skilled and experienced personnel on acceptable terms, our growth may be limited due to our limited capacity to develop and market our product. We are currently recruiting personnel for technical, marketing, sales and administrative functions. Once hired, these people will need time to familiarize themselves with Plumtree and our business practices. We expect to continue to hire additional employees in order to grow our business. The integration of new personnel has resulted and will continue to result in some disruption to our ongoing operations. Our failure to complete this integration in an efficient manner could harm our business and prospects. Managing the growth of our operations will continue to strain managerial, operational and financial resources, and if we are unable to do so our business and operating results could be harmed. The planned expansion of our operations will place a significant strain on our management, financial controls, operations systems, personnel and other resources. Our ability to manage our future growth, should it occur, will depend in large part upon a number of factors, including our ability to rapidly: . build and train our sales and marketing staff to create an expanding presence in the evolving corporate portal market, and keep them fully informed over time regarding the technical features, issues and key selling points of our product; . attract and retain qualified technical personnel in order to continue to develop reliable and scalable products and services that address evolving customer needs; . develop our customer support capacity as sales of our products increase, so that we can provide customer support without diverting resources from product development efforts; and . expand our internal management and financial controls significantly, so that we can maintain control over our operations and provide support to other functional areas within Plumtree as the number of our personnel and size of our organization increases. Our inability to achieve any of these objectives could harm our business and operating results. We may be unable to grow our international operations, which could impair our overall growth. We have expanded our international operations, and we are seeking to increase the portion of our revenue that is derived from sources outside the United States. Our revenue from sales outside the United States constituted approximately 7.2% of our total revenue during 2000, 8.6% of our total revenue during 2001 and approximately 14.8% of our revenue in the first quarter of 2002. If we are unable to continue to grow our international operations, we may not generate sufficient revenue to offset the expenditures required to establish and maintain the international sales and marketing operations, which could slow or undermine our overall growth. We have committed substantial resources to modify our products for selected international markets, including the United Kingdom, France, Germany, Australia and Japan. We expect to continue to commit additional resources to modify our products for other select international markets and to develop our international sales and support organization. However, even if we successfully expand our international operations and successfully modify our products, there can be no assurance that we will be able to maintain or increase international market demand for our products. Our international operations are subject to a number of risks, including: . costs of modifying our products for foreign countries; . compliance with multiple, conflicting and changing foreign governmental laws and regulations, including intellectual property, securities and employment laws; . increased reliance on systems integrators and resellers abroad; . longer sales cycles; . import and export restrictions and tariffs; . fluctuations in foreign currency exchange rates; . difficulties in staffing and managing international operations; . greater difficulty in enforcing our intellectual property rights; and . greater difficulty or delay in accounts receivable collection. Product liability claims could divert management's attention and be costly to defend. Our license agreements with customers and arrangements with our systems integrators and technology vendors typically contain provisions designed to limit our exposure to potential product liability claims. Not all domestic and international jurisdictions may enforce these limitations. Although we have not experienced any product liability claims to date, we may encounter this type of claim in the future. Product liability claims brought against us, whether or not successful, could divert the attention and resources of our management and key personnel, could be costly to defend and could require us to pay significant monetary damages. If we are unable to effectively protect our proprietary rights, our competitors may be able to copy important aspects of our products or product presentations, which would undermine the relative appeal of our products to customers and reduce our sales. We believe that proprietary rights are important to our business. We have no issued patents. We have filed eight non-provisional patent applications with the U.S. Patent and Trademark Office and two international patent applications with the World Intellectual Property Organization. However, current or future patent applications may not be granted, and it is possible that any patents issued to us may be circumvented by our competitors or otherwise may not provide significant protection or commercial advantage to us. Similarly, our trademark, service mark and copyright rights may not provide significant protection or commercial advantage to us, and the measures we take to maintain the confidentiality of our trade secrets may not be effective. On November 13, 2001, we commenced an action in the District Court in The Hague against an individual, Werner Linssen, to cancel the Benelux trademark registration for "Plumtree" held by Mr. Linssen. That action is pending. In addition, we and Mr. Linssen have each commenced proceedings before the E.U.'s Office of Harmonisation of the Internal Market in opposition to each other's Community Trade Mark applications. Those proceedings have been suspended pending disposition of the Benelux action in The Hague. On November 25, 2001, we also commenced a proceeding before the Swiss Federal Institute of Intellectual Property in opposition to Mr. Linssen's trademark application for "Plumtree". This dispute could cost us significant amounts to resolve and, if we are unsuccessful, we may need to market and sell our products in these jurisdictions using a different name. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our software product or technology without authorization. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as those in the United States. We generally enter into confidentiality or license agreements with our employees, consultants and alliance members, control access to our source code and other proprietary technology and limit distribution of our software, documentation and other proprietary information. These measures afford only limited protection and may be inadequate. Others may develop noninfringing technologies that are similar or superior to our own. If our products employ technology that infringes the proprietary rights of others, we may be subject to infringement claims, forced to pay high prices to license technology or required to stop selling our products. We expect that software products, including ours, may be increasingly subject to third-party infringement claims as the number of competitors in our industry segment grows and the functionality of products in different industry segments expands and overlaps. Third parties may claim our products infringe their intellectual property rights. Regardless of whether these claims have any merit, they could: . be time-consuming to defend; . result in costly litigation; . divert our management's attention and resources; . require us to indemnify technology vendors, system integrators or customers; . require us to refund license fees; . cause product shipment delays; or . require us to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all. On May 17, 2002, Datamize, LLC filed a lawsuit against us in the United States District Court for the District of Montana alleging that we infringe U.S. Patent Number 6,014,137 owned by Datamize. Datamize is seeking, among other things, injunctive relief and unspecified damages. Based on other communications by Datamize's counsel, we expect Datamize may take further legal action against us with respect to additional intellectual property that Datamize purportedly owns or will own in the future. At this time, we do not believe we are infringing any valid patent claim of Datamize and we intend to defend this lawsuit vigorously. Since the outcome of any litigation is uncertain, we may not prevail in the lawsuit brought by Datamize. If our portal were found to infringe U.S. Patent Number 6,014,137 and we are unable to obtain a license on satisfactory terms, or if an injunction were issued, we could be required to modify our portal, cease licensing our portal product, and/or pay substantial damages. Any of these outcomes would likely have a material adverse effect on our business. Even if we prevail, the defense of this litigation could be expensive and could consume substantial amounts of management time and attention. A successful claim of infringement against us or our failure or inability to license the infringed or similar technology could damage our business to the extent that we are required to pay substantial monetary damages or if, as result of a successful claim, we became unable to sell our products without redeveloping them or otherwise were forced to incur significant additional expenses. We may be subject to misappropriation claims by former employers of our personnel, which could be costly and disruptive to our business. From time to time, we hire or retain employees or consultants who have worked for independent software vendors or other companies developing products similar to those offered by us. Those prior employers may claim that our products are based on their products and that we have misappropriated their intellectual property. Any claims of that variety, with or without merit, could cause a significant diversion of management attention, result in costly and protracted litigation, cause product shipment delays, require us to indemnify our alliance members and customers, require us to refund license fees or require us to enter into royalty or licensing agreements. Those royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could harm our business. Acquisitions of companies or technologies may result in disruptions to our business and management due to difficulties in assimilating personnel, acquired products and technology and operations and may dilute stockholder value. We have made and in the future may make acquisitions or investments in other companies or technologies. We may not realize the anticipated benefits of any acquisitions or investments we undertake. For instance, we made three small acquisitions in 2001. Acquisitions such as these require us to assimilate the operations, products, technology and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may cause disruptions in our operations and divert management's attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. If we consummate acquisitions through an exchange of our securities, our existing stockholders could suffer significant dilution. In addition, our profitability may suffer because of acquisition-related costs or impairment costs for acquired goodwill and other intangible assets, or undisclosed liabilities of the acquired business. The terms of our existing Silicon Valley Bank loan and security agreement restrict our ability to acquire other companies or their assets. If we are required to raise additional funds, we may be unable to obtain these funds on terms acceptable to us or at all. The expansion and development of our business will require significant capital to fund our operating expenses, working capital needs and capital expenditures. During the next 18 months, we expect to meet our cash requirements with existing cash and cash equivalents and short-term investments, the net proceeds from this offering, cash flow from sales of our product and services and proceeds from existing and future working capital lines of credit and other borrowings. Our failure to generate sufficient cash flows from sales of products and services or to raise sufficient funds may require us to delay or abandon some or all of our development and expansion plans or otherwise forego market opportunities. Future equity or debt financing may not be available to us on favorable terms or at all. The terms of our existing loan agreement with Silicon Valley Bank limit our ability to incur additional indebtedness. Future borrowing instruments, such as credit facilities and lease agreements, are also likely to contain restrictive covenants and will likely require us to pledge assets as security for borrowings under those future arrangements. If we raise additional funds through the issuance of equity securities, the issuance could result in substantial dilution to existing stockholders. Our inability to obtain additional capital on satisfactory terms may result in a delay or failure to develop and enhance our products, acquire new technologies or businesses, expand operations and hire and train employees. Risks Relating to Our Industry Intense competition and consolidation in our industry could limit our ability to attract and retain customers. The market for our products is intensely competitive and highly fragmented, characterized by rapid technological change, evolving industry standards, changes in customer needs, and new product introductions and improvements. Our current competitors include established software vendors that are Web-enabling their applications or are building infrastructure software, emerging companies offering competitive products and companies choosing to build their own solutions. Some of our large competitors may expand their competitive product offerings through acquisitions. For example, SAP expanded its competitive offerings through its acquisition of TopTier in March 2001. Many of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, greater name recognition, a broader range of products and a larger installed customer base, any of which could provide them with a significant competitive advantage. In addition, new competitors, or alliances among existing and future competitors, may emerge and rapidly gain significant market share. Some of our competitors, particularly established software vendors, may also be able to provide customers with products and services comparable to ours at lower or at aggressively reduced prices in an effort to increase market share or as part of a broader software package they are selling to a customer. We may be unable to match competitors' prices or price reductions, and we may fail to win customers that choose to purchase a portal solution as part of a broader software and services package. If we cannot compete successfully against current and future competitors, we may be unable to attract and retain customers. Increased competition could also result in price reductions for our products and lower profit margins and reduced market share, any of which could harm our business, results of operations and financial condition. Downturns in the software market may decrease our revenue and margins. The market for our products depends on economic conditions affecting the broader software market. Downturns in the economy may cause businesses and governments to delay or cancel corporate portal projects, reduce their overall information technology budgets or reduce or cancel orders for our products. In this environment, customers may experience financial difficulty, fail to or defer the budget for the purchase of our products or cease operations. This, in turn, may lead to longer sales cycles, delays or failures in payment and collection, and price pressures, causing us to realize lower revenues and margins. In particular, capital spending in the information technology sector generally has decreased in the past 18 months, and many of our customers and potential customers have experienced declines in their revenues and operations. In addition, the terrorist acts of September 11, 2001 have created an uncertain economic environment and we cannot predict the impact of these events, any future terrorist acts or any related military action, on our customers or business. We believe that, in light of these events, some businesses and governments may curtail or eliminate capital spending on information technology. If capital spending in our markets declines, it may be necessary for us to gain significant market share from our competitors in order to achieve our financial goals and achieve and maintain profitability. Our failure to introduce new products and enhancements in a timely manner will make market acceptance of our products less likely. New products, platforms and language support can require long development and testing periods. Any delays in developing and releasing new products could harm our business. New products or enhancements may not be released according to schedule or may contain defects when released. For example, version 4.5 of the Plumtree Corporate Portal, the Plumtree Collaboration Server and the Plumtree Studio Server have been recently released commercially, increasing the risk of undetected defects or errors. Product release delays or product defects, including release delays or defects in version 4.51 of the Plumtree Corporate Portal, which is scheduled for commercial release in the first half of 2002, could result in adverse publicity, loss of sales, delay in market acceptance of our products or customer claims against us, any of which could harm our business. We may be unable to successfully develop and market product enhancements or new products that respond to these technological changes, shifting customer tastes or evolving industry standards, and may experience difficulties that could delay or prevent the successful development, introduction and marketing of these products. If we are unable to develop and introduce new products or enhancements of existing products in a timely manner or if we experience delays in the commencement of commercial shipments of new products and enhancements, our ability to attract and retain customers will be harmed. If we fail to manage technological change, demand for our products and services will drop and our revenue will decline. The market for corporate portals is still in an early stage of development and is characterized by rapidly changing technology, evolving industry standards, frequent new service and product introductions and changes in customer demands. Our future success will depend to a substantial degree on our ability to offer products and services that incorporate leading technologies and respond to technological advances and emerging industry standards and practices on a timely and cost-effective basis. You should be aware that: . our technology or systems may become obsolete upon the introduction of alternative technologies; . the technological life cycles of our products may end abruptly and, in any event, are difficult to estimate; . we may not have sufficient resources to develop or acquire new technologies or to introduce new services capable of competing with future technologies or service offerings; and . the price of the products and services we provide may decline as rapidly as, or more rapidly than, the price of any competitive alternatives, particularly if the unique features of our products become widely adopted through new technologies. We may not be able to effectively respond to the technological requirements of the changing market for corporate portals. To the extent we determine that new technologies and equipment are required to remain competitive, the development, acquisition and implementation of those technologies and equipment are likely to continue to require significant capital investment by us. We may not have sufficient capital for these purposes in the future. Even if we successfully raise capital to develop new technologies, investments in these technologies may not result in commercially viable technological processes, or there may not be commercial applications for those technologies. If we do not develop and introduce new products and services, and achieve market acceptance in a timely manner, demand for our products and services will drop and our revenue will decline. If we fail to adequately address our customer support demands, our ability to attract and retain customers will suffer. We expect that our customers increasingly will demand additional information and reports with respect to the services we provide. To meet these demands, we must develop and implement expanded customer support services to enable future sales growth. In addition, if we are successful in implementing our marketing strategy, we expect the demands on our technical support resources to grow rapidly, and we may experience difficulties in responding to customer demand for our services and providing technical support in accordance with our customers' expectations. We expect that these demands will require not only the addition of new management personnel, but also the development of additional expertise by existing management personnel and the establishment of long-term relationships with third-party service vendors. If we are unable to address these customer demands, our ability to attract and retain customers will suffer. Risk Relating to this Offering Future sales of common stock could depress our stock price. We cannot predict if future sales of our common stock, or the availability of our common stock for sale, will depress the market price for our common stock or adversely affect our ability to raise capital by offering equity securities. Sales of substantial amounts of common stock, or the perception that these sales could occur, may depress prevailing market prices for the common stock. After this offering, approximately 29,235,979 shares of common stock will be outstanding. All of the shares sold in this offering will be freely tradeable except for any shares purchased by affiliates of Plumtree. The remaining shares of common stock outstanding after this offering will be restricted as a result of securities laws or lock-up agreements. These remaining shares will be available for sale in the public market as follows: <TABLE> <CAPTION> Date of Availability for Sale Number of Shares ----------------------------- ---------------- <S> <C> As of the date of this prospectus......................... 0 , 2002 (90 days after the date of this prospectus).............................................. 0 , 2002 (180 days after the date of this prospectus).............................................. 23,712,611 At various times thereafter upon expiration of applicable holding periods.......................................... 523,368 </TABLE> Goldman, Sachs & Co. may release all or a portion of the shares subject to lock-up agreements at any time without notice. Stock prices of software companies are especially volatile, and this volatility may depress our stock price. We cannot predict the extent to which investor interest in Plumtree will lead to the development of a trading market or how liquid that market might become. Before this offering, there has been no public market for our common stock. We intend to list the common stock on the Nasdaq National Market. The initial public offering price for the shares of our common stock will be determined by negotiations between us and the representatives of the underwriters and may not be indicative of prices that will prevail in the trading market. The stock market has experienced significant price and volume fluctuations and the market prices of securities of software companies have been highly volatile. You may not be able to resell your shares at or above the initial public offering price or at all. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against the company. The institution of this type of litigation against us could result in substantial costs and a diversion of our management's attention and resources, which could harm our business and prospects. Our stock ownership will continue to be concentrated in the hands of management and existing stockholders, which could adversely affect our business and depress our stock price. Upon completion of this offering, our present directors, executive officers and principal stockholders as a group will beneficially own approximately 45% of the outstanding common stock (44% if the underwriters' over-allotment option is exercised in full). Accordingly, if all or particular stockholders were to act together, they would be able to exercise significant influence over or control the election of our board of directors, the management and policies of our company and the outcome of particular corporate transactions or other matters submitted to our stockholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets. Anti-takeover provisions in our certificate of incorporation and bylaws could discourage or prevent an acquisition of our company, and could affect the price of our common stock. Provisions of the certificate of incorporation and bylaws that we intend to adopt before the closing of this offering may inhibit changes of control that are not approved by our board of directors. These include provisions classifying our board of directors, prohibiting stockholder action by written consent and requiring advance notice for nomination of directors and stockholders' proposals. In addition, as a Delaware corporation, we will be subject to Section 203 of the Delaware General Corporation Law which, in general, prevents an interested stockholder, defined generally as a person owning 15% or more of the corporation's outstanding voting stock, from engaging in a business combination, as defined, for three years following the date that person became an interested stockholder unless specified conditions are satisfied. Our certificate of incorporation and bylaw provisions and Delaware law could diminish the opportunities for a stockholder to participate in tender offers, including tender offers at prices above the then-current fair market value of our common stock, that could result from takeover attempts. In addition, our certificate of incorporation will allow our board of directors to issue, without further stockholder approval, preferred stock that could have the effect of delaying, deferring or preventing a change in control. The issuance of preferred stock also could adversely affect the voting power of the holders of our common stock, including the loss of voting control to others. The provisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, may have the effect of discouraging or preventing an acquisition, or disposition of, our business. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Our management has broad discretion over the use of proceeds from this offering, and the failure of management to apply these funds effectively could seriously harm our business and results of operations. We have not determined and cannot predict in which, if any, of our existing or future opportunities we will ultimately invest. Therefore, we have broad discretion as to how we spend the proceeds from this offering, and stockholders may not agree with how we use the proceeds. We may not be successful in using the proceeds from this offering in ways that will yield favorable results.

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+RISK FACTORS Risks Related To Our Business We Have A History Of Losses And Anticipate Continued Losses In The Future, Which May Have A Material Adverse Effect On Our Business, Our Ability To Implement Our Business Strategy And Our Stock Price. We incurred losses of $5.1 million during the fiscal year ended December 28, 1997, $12.5 million during the fiscal year ended December 27, 1998, $15.4 million during the fiscal year ended December 26, 1999, $6.3 million during the fiscal year ended December 31, 2000, $6.8 million during the fiscal year ended December 30, 2001 and $2.2 million during the thirteen weeks ended March 31, 2002. Since inception, we had accumulated net losses of $50.3 million as of March 31, 2002. These matters raise substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependant upon numerous factors, including our ability to obtain additional financing, our ability to increase our level of future revenues or our ability to reduce operating expenses. Failure to achieve profitability, or maintain profitability if achieved, may have a material adverse effect on our business, our ability to implement our business strategy and our stock price. There can be no assurance that we will be able to obtain additional financing, reduce expenses or successfully complete other steps to continue as a going concern. If we are unable to obtain sufficient funds to satisfy our cash requirements, we may be forced to curtail operations, dispose of assets, or seek extended payment terms from our vendors. Such events would materially and adversely affect our financial position and results of operations. Without Substantial Financing in the Immediate Future, On Terms Favorable To Us, We May Be Required to Limit or Discontinue Our Operations. We believe our current cash and cash equivalents will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for approximately three to six months as of July 16, 2002, depending upon the success of our initiatives with current and potential wholesale customers, including Target and Albertson s. We intend to seek an additional $5 to $10 million in equity financing to fulfill our cash requirements for the near future. We may also seek additional debt financing prior to seeking the $5 to $10 million in equity financing. There can be no assurance that we will be able to obtain additional financing, reduce expenses or successfully complete other steps to reduce or eliminate our losses. In addition, the terms of our outstanding convertible debt may adversely affect our ability to obtain additional financing on terms favorable to us, or at all. If we are unable to obtain additional funds to satisfy our cash requirements on terms favorable to us, we may be forced to limit our operations, dispose of assets, seek extended payment terms from our vendors or discontinue our operations entirely. Such events would adversely affect our business and results of operations. Any Default in the Repayment of the Convertible Note Held By Laurus Master Fund, Ltd. Could Have a Material and Adverse Affect on Our Business, Prospects, Results of Operations or Financial Condition. Unpaid principal and accrued and unpaid interest on our convertible note is payable in 16 equal installments on the first business day of each calendar month, beginning on September 1, 2002. Interest only payments are payable prior to that date, monthly beginning July 18, 2002. Although the convertible note provides us with the option of making such payments by issuing shares, we are not permitted to make such payments in shares and are required to make such payments in cash if any of the following events occurs: (i) there fails to exist an effective resale registration statement with respect to the shares; (ii) such conversion of the note would result in the issuance pursuant to the note and associated warrants of more than 1,163,614 shares of common stock, or 19.9% of the number of shares of common stock outstanding on June 18, 2002, unless the issuance of the shares is approved by our shareholders; or (iii) there occurs any event of default. The events of default under the convertible note are similar to those customary for convertible debt securities, including breaches of material terms, failure to pay amounts owed, delisting of our common stock from the Nasdaq Stock Market (unless our common stock is subsequently listed on the Nasdaq SmallCap Market, the OTC Bulletin Board or a national securities exchange), or failure to comply with the reporting, filing or other obligations of listing on such market. Assuming the note was converted on June 18, 2002 by the holder at the conversion price of $1.20, 1,041,667 shares representing 17.8% of the shares of common stock outstanding on June 18, 2002 would be issued. If we default on our obligations under the convertible note, if we fail to have a resale registration statement declared and maintained as effective with Table of Contents respect to the shares, or if the convertible note becomes exercisable for more than 1,163,614 shares, due to changes in our stock price, anti-dilution adjustments or otherwise, we may be required to immediately repay the outstanding principal amount of the convertible note and any accrued and unpaid interest. We do not currently have cash or cash equivalents or available debt or equity financing sufficient to repay such amounts if such repayment is required. Accordingly, we anticipate that additional financing would be required to repay such amounts. We cannot guarantee that such financing would be available on terms favorable to us, or at all. If we could not arrange for such financing on favorable terms, our business and financial results would be materially adversely affected. In the event of any sale or liquidation of our assets to repay such debt, the note holder, as a secured party, would have priority over other creditors and over our shareholders with respect to such assets and the proceeds of such assets. We May Be Unsuccessful In Developing New Product Lines Or New Distribution Channels For Our Products, Which May Harm Our Business. We frequently review and evaluate new product lines and new distribution channels for our products. We may, however, be unable to successfully implement any new product lines or distribution channels after having dedicated considerable management time and financial resources to them. We are currently testing the sale of frozen panini sandwiches through Target and fresh food with an extended shelf life through Albertson s. In the past, we distributed our products through Safeway, Ralph s and Dominick s grocery stores. We also developed a line of dinner foods for home meal replacement that was tested through one of our Seattle cafes. These attempts were unsuccessful and have been discontinued. Inability to successfully develop new product lines or new distribution channels in the future could slow our growth and divert management s attention from other areas of our business. Our Growth Strategy Requires Us To Open A Significant Number Of New Cafes In Our Existing Markets. If We Are Not Able To Achieve This Planned Expansion, Our Business May Suffer And We May Be Unable To Achieve Or Sustain Profitability. The success of our growth strategy will depend in large part on our ability to open new cafes and to operate our cafes profitably. We do not currently plan to open additional cafes in 2002. In 2001 and 2002, we postponed certain cafe openings due to lower than expected office occupancy rates and poor market conditions in Seattle, San Francisco and Los Angeles. We cannot assure you that we will be able to achieve our current expansion goals, that we will operate profitably, or, if we do achieve profitability, that we will be able to sustain or increase profitability on a quarterly or annual basis. We estimate that a central kitchen must supply at least four to six cafes and generate non-cafe sales to achieve positive cash flow. Any inability to achieve our expansion goals may adversely affect our financial results or stock price. The success of our planned expansion will depend upon numerous other factors, many of which are beyond our control, including our ability to: hire, train and retain qualified operating personnel; identify and obtain suitable cafe sites at favorable lease terms; timely develop new cafes, including our ability to obtain available construction materials and labor; manage construction and development costs of new cafes; develop sufficient sales volumes through our cafes and other distribution channels to support our central kitchens; secure required governmental approvals and permits, and comply with ongoing and changing regulatory requirements; and compete successfully in our markets. In the past, we have closed cafes because they did not generate sufficient revenues and we cannot assure you that additional cafes will not be closed. For the past three quarters ended March 31, 2002, December 30, 2001 and September 30, 2001, our same-store sales have decreased compared to the quarterly periods for the prior year. If our Common stock, no par value, issued in private placement 617,358 $ 0.69 (3) $ 425,977 $ 39.19 Table of Contents same-store sales continue to decline or fail to sufficiently improve, we may be required to close additional cafes. The closing of a significant number of cafes or the failure to increase same-store sales could have an adverse impact on our reputation, operations and financial results. We May Not Be Successful In Implementing Our Business Strategy, Which Would Impede Our Growth And Operating Results. Our business strategy is to focus our retail expansion on cafes in amenity locations (i.e., office buildings where the competition is limited or where we are the only food supplier), maintain our current cafe locations, and expand our box lunch and catering distribution capabilities to serve locations outside the core metropolitan areas in which we operate. Our ability to implement this business strategy depends on our ability to: identify and lease amenity locations suitable for new cafes; increase our brand recognition in our existing markets; and manage growth in administrative overhead and distribution costs likely to result from the planned expansion of our retail and non-retail distribution channels. Any inability to implement our business strategy would have a material adverse impact on our operating results. Any inability to manage our growth effectively could adversely affect our operating results. Failure to manage our growth effectively could harm our business. We have grown significantly since our inception and intend to grow substantially in the future. We have increased the number of our cafes from two cafes as of December 31, 1996 to 47 cafes currently and, subject to available funding, we anticipate opening new cafes in the future. Our existing cafe management systems, financial and management controls and information systems may not be adequate to support our planned expansion. Our ability to manage our growth effectively will require us to continue to expend funds to improve these systems, procedures and controls, which we expect will increase our operating expenses and capital requirements. In addition, we must effectively expand, train and manage our work force. We cannot assure you that we will be able to respond on a timely basis to all of the changing demands that our planned expansion will impose on management and on our existing systems, procedures and controls. In addition, we cannot assure you that we will be able to continue to improve our information systems and financial controls or to manage other factors necessary for us to achieve our growth strategy. For any of these reasons, we could lose opportunities or overextend our resources, which could adversely affect our operating results. If We Are Unable To Continue Leasing Our Retail Locations Or Obtain Acceptable Leases For New Cafes, Our Business May Suffer. All of our 47 cafe locations are on leased premises. If we are unable to renew our leases on acceptable terms, or if we are subject to substantial rent increases, our business could suffer. Because we compete with other retailers for cafe sites and because some landlords may grant exclusive rights to locations to our competitors, we may not be able to obtain new leases or renew existing leases on acceptable terms. Any inability to renew or obtain leases could increase our costs and adversely affect our operating results and brand-building strategy. Our Restaurant Expansion Strategy Focuses Primarily On Further Penetration Of Existing Markets. This Strategy Could Cause Sales In Some Of Our Existing Cafes To Decline. In accordance with our expansion strategy, we intend to open new cafes primarily in our existing markets. Many of our cafes are situated in concentrated downtown areas. As a result, the presence of additional cafes in existing markets may result in diminished sales performance and customer counts for cafes near the area in which a new cafe opens, due to sales cannibalization. Table of Contents Tenant Turnover And Vacancies In Office Buildings Where Our Cafes Are Located Could Cause Our Cafe Sales To Decline. Our business could suffer as a result of tenant turnover and vacancies. Many of our cafes are located in office buildings, and office workers are our target customers. Vacancies, tenant turnover or tenants with few office workers, especially in San Francisco and Seattle, have negatively impacted the operations of our cafes located in office buildings during the last year due to the reduction in the number of potential customers in the building, and could continue to have a negative impact on our operations. The risk related to vacancies and tenant turnover is greater in office buildings with larger tenants, where the loss of a single tenant may have a greater impact on that cafe s sales. If Any Of Our Central Kitchens Were To Close For Any Reason, We Will Be Unable To Supply Our Cafes In That Geographic Market And Our Business Will Suffer. Our central kitchens produce or distribute substantially all of our food products for the cafes and wholesale accounts in their geographic regions, as well as all of the box lunches and catered platters in each region. If any of our central kitchens were to close for any reason, such as fire, natural disaster or failure to comply with government regulations, we would be unable to provide our food products in the areas served by the affected central kitchen. Our four existing central kitchens are geographically dispersed and none could supply another market if a central kitchen were to close. Any closure of a central kitchen, even for a short period of time, would have a material adverse effect on our operating results. The Loss Of One Of Our Major Wholesale Customers Could Negatively Impact Our Results. For the fiscal year ended December 30, 2001, approximately 29.0% of our revenue resulted from branded sales, which consists of box lunch, catering and vending, and wholesale and grocery sales. Our wholesale and grocery sales are made to a relatively small number of companies, including, for example, Quality Food Centers, Inc., a regional grocery store chain, and Tully s Coffee Corporation, a specialty coffee retailer. In 2001, Quality Food Centers accounted for 9% of our total revenue. Until Kozmo.com, Inc., an Internet-based consumer delivery service, ceased operations in April 2001, it was also a wholesale customer which accounted for 1.8% of our total sales in 2000 and approximately 1.0% of our total sales in the 13-week period ended April 1, 2001. We cannot assure you that the remainder of our major wholesale and grocery customers will continue to maintain accounts or that they will successfully maintain or expand their product offerings. Furthermore, we cannot assure you that our major wholesale customers will not exit our existing markets. The loss of any of our other major wholesale customers could harm our business. We Are Substantially Dependent On Third-Party Suppliers And Distributors And The Loss Of Any One Of Them Could Harm Our Operating Results. We are substantially dependent on a small number of suppliers and distributors for our products, including suppliers of meat, breads and soups, and Sysco Distribution Services, which during June 2002 procured from our suppliers and delivered to us approximately 32% of our ingredients and packaging products. As of December 30, 2001, Pacific Coast Fruit Company provided approximately 6.6% of our total cost of food and packaging, while Stockpot, Inc. provided approximately 5.7%. Any failure or delay by any of these suppliers or distributors to deliver products to our central kitchens, even for a short period of time, would impair our ability to supply our cafes and could harm our business. We have limited control over these third parties, and we cannot assure you that we will be able to maintain satisfactory relationships with any of them on acceptable commercial terms. Nor can we assure you that they will continue to provide food products that meet our quality standards. Our relationships with our suppliers are generally governed by short-term contracts. If any of these relationships were to terminate unexpectedly, we may have difficulty obtaining adequate quantities of products of the same quality at competitive prices in a timely fashion, which could limit our product offerings or our ability to adequately supply our cafes and could adversely affect our operating results. Table of Contents If We Fail To Further Develop And Maintain Our Brand, Our Business Could Suffer. We believe that maintaining and developing our brand is critical to our success and that the importance of brand recognition may increase as a result of competitors offering products similar to ours. Subject to available funding, we intend to increase our marketing expenditures to create and maintain brand loyalty and increase awareness of our brand. If our brand-building strategy is unsuccessful, these expenses may never be recovered, and we may be unable to increase or maintain our revenues. Our success in promoting and enhancing the BRIAZZ brand will also depend on our ability to provide customers with high-quality products and customer service. We cannot assure you that consumers will perceive our products as being of high quality. If they do not, the value of our brand may be diminished and, consequently, our ability to implement our business strategy may be adversely affected. If Our Customers Do Not Perceive Pre-Packaged Sandwiches And Salads As Fresh And Desirable, Or If They Would Prefer Made-To-Order Food Items, Our Operating Results Will Suffer. Our business strategy focuses on pre-packaged food items. All of our salads and most of our sandwiches are prepared and assembled in our central kitchens and sold as pre-packaged items. Unlike delicatessens, our cafes generally do not add or omit specific ingredients to or from food items at the customer s request. If customers prefer custom prepared items over pre-packaged items, or if they do not perceive pre-packaged sandwiches and salads as fresh and desirable, we may be unsuccessful in attracting and retaining customers, causing our operating results to suffer. Our Business Could Be Harmed By Litigation Or Publicity Concerning Food Quality, Health And Other Issues, Which May Cause Customers To Avoid Our Products And Result In Liabilities. Our business could be harmed by litigation or complaints from customers or government authorities relating to food quality, illness, injury or other health concerns or operating issues. Because we prepare most of our food products for each geographic market in a central kitchen, health concerns surrounding our food products, if raised, may adversely affect sales in all of our cafes in that market. Adverse publicity about such allegations may negatively affect our business, regardless of whether the allegations are true, by discouraging customers from buying our products. Because we emphasize the freshness and quality of our products, adverse publicity relating to food quality or similar concerns may affect us more than it would food service businesses that compete primarily on other factors. Such adverse publicity could damage our reputation and divert the attention of our management from other business concerns. We could also incur significant liabilities if a lawsuit or claim resulted in an adverse decision or in a settlement payment, and incur substantial litigation costs regardless of the outcome of such litigation. Our Quarterly Operating Results May Fluctuate And Could Fall Below Expectations Of Securities Analysts And Investors, Resulting In A Decline In Our Stock Price. Our quarterly and yearly operating results have varied in the past, and we believe that our operating results will continue to vary in the future. For this reason, you should not rely on our operating results as indications of future performance. In future periods, our operating results may fall below the expectations of securities analysts and investors, causing the trading price of our common stock to fall. In addition, most of our expenses, such as employee compensation and lease payments for facilities and equipment, are relatively fixed. Our expense levels are based, in part, on our expectations regarding future sales. As a result, any shortfall in sales relative to our expectations may cause significant decreases in our operating results from quarter to quarter, cause us to fail to meet the expectations of securities analysts and investors and result in a decline in our stock price. Our Cafes Are Currently Located In Four Geographic Markets. As A Result, We Are Highly Vulnerable To Negative Occurrences In Those Markets. We currently operate our cafes in Seattle, San Francisco, Chicago and Los Angeles. As a result, we are susceptible to adverse trends and economic conditions in these markets. Additionally, given our geographic concentration, negative publicity regarding any of our cafes, or other regional occurrences such as local strikes, earthquakes or Operating Cost of food and packaging $ 3,079 $ 6,979 $ 11,520 $ 13,597 $ 12,480 $ 3,165 $ 2,813 Occupancy expenses 916 2,393 3,602 3,818 4,010 932 996 Labor expenses (including amortization of deferred stock compensation of $186 for 2001 and $81 for 2000) 2,866 6,690 9,506 11,186 11,098 2,763 2,726 Depreciation and amortization 625 1,785 2,628 2,657 2,686 606 788 Other operating expenses 1,135 2,501 2,419 1,921 1,849 435 453 General and administrative expenses (including amortization of deferred stock compensation of $102 for 2001 and $41 for 2000) 3,404 6,492 6,033 6,581 6,837 1,651 1,851 Loss on sale of assets 2 Provision for asset impairment and store closure 1,169 779 63 26 Operating Expenses Cost of food and packaging 12,480 13,597 11,520 2,813 3,165 Occupancy expenses 4,010 3,818 3,602 996 932 Labor expenses (including amortization of deferred stock compensation of $186 for 2001 and $81 for 2000) 11,098 11,186 9,506 2,726 2,763 Depreciation and amortization 2,686 2,657 2,628 788 606 Other operating expenses 1,849 1,921 2,419 453 435 General and administrative expenses (including amortization of deferred stock compensation of $102 for 2001 and $41 for 2000) 6,837 6,581 6,033 1,851 1,651 Loss on sale of assets 2 Provision for asset impairment and store closure 26 63 779 Table of Contents other natural disasters, in these markets, may have a material adverse affect on our business and operations. Our Food Preparation And Presentation Methods Are Not Proprietary, And Therefore Competitors May Be Able To Copy Them, Which May Harm Our Business. We consider our food preparation and presentation methods, including our food product packaging, box lunch packaging and design of the interior of our cafes, essential to the appeal of our products and brand. Although we consider our packaging and store design to be essential to our brand identity, we have not applied to register all trademarks or trade dress in connection with these features, and therefore cannot rely on the legal protections provided by trademark registration. Because we do not hold any patents for our preparation methods, it may be difficult for us to prevent competitors from copying our methods. If our competitors copy our preparation and presentation methods, the value of our brand may be diminished and our market share may decrease. In addition, competitors may be able to develop food preparation and presentation methods that are more appealing to consumers than our methods, which may also harm our business. We Depend On The Expertise Of Key Personnel. If Any Of These Individuals Were To Leave, Our Business May Suffer. We are dependent to a large degree on the services of Victor D. Alhadeff, our Chairman of the Board and Chief Executive Officer, and C. William Vivian, our President and Chief Operating Officer and a director. Our operations may suffer if we were to lose the services of either of these individuals, either of whom could leave BRIAZZ at any time. In addition, competition for qualified management in our industry is intense. Many of the companies with which we compete for experienced management personnel have greater financial and other resources than we do. Two Of Our Customers Account For A Significant Portion Of Our Accounts Receivable Balance. The Failure Of Any Of These Customers To Pay Its Account May Harm Our Operating Results. One of our customers, QFC, accounted for an aggregate of approximately 42.4% of our accounts receivable balance as of December 30, 2001. We anticipate that we will continue to extend credit to QFC and other customers. The failure of any one of these customers to pay its account, now or in the future, may harm our operating results. Risks Relating To Our Industry Our Operations Are Susceptible To Changes In Food And Supply Costs, Which Could Adversely Affect Our Margins. Our profitability depends, in part, on our ability to anticipate and react to changes in food and supply costs. Our purchasing staff negotiates prices for all of our ingredients and supplies based upon current market prices. Various factors beyond our control, including, for example, governmental regulations, rising energy costs and adverse weather conditions, may cause our food and supply costs to increase. We cannot assure you that we will be able to anticipate and react to changing food and supply costs by adjusting our purchasing practices. Any failure to do so may adversely affect our operating results. If We Face Increased Labor Costs Or Labor Shortages, Our Growth And Operating Results May Be Adversely Affected. Labor is a primary component in the cost of operating our business. As of December 30, 2001, we employed 100 salaried and 350 hourly employees. We expend significant resources in recruiting and training our managers and employees. Employee turnover for fiscal 2001 was approximately 137% for hourly employees and 39% for salaried employees. If we face increased labor costs because of increases in competition for employees, the federal minimum wage or employee benefits costs (including costs associated with health insurance coverage), or unionization of our employees, our operating expenses will likely increase and our growth may be adversely affected. Additionally, any increases in employee turnover rates are likely to lead to additional recruiting and training costs. (1) The Registrant has previously calculated the registration fee with respect to 2,507,452 shares being registered, and paid a registration fee of $175.19, pursuant to Rule 457(c) and (g) under the Securities Act of 1933. The amounts set forth in this table represent additional amounts to be registered. (2) Calculated pursuant to Rule 457(c) under the Securities Act of 1933. (3) Estimated pursuant to Rule 457(c) solely for purposes of calculating amount of registration fee, based on the average of the closing bid and ask prices of the Registrant s common stock on August 5, 2002 as quoted on the Nasdaq National Market. Table of Contents Our success depends upon our ability to attract, motivate and retain a sufficient number of qualified employees, including cafe managers and kitchen staff, to keep pace with our growth strategy. Qualified persons to fill these positions are in short supply in the markets in which we operate. Any inability to recruit and retain sufficient numbers of employees may delay or prevent the anticipated openings of new cafes or central kitchens. Competition In Our Markets May Result In Price Reductions, Reduced Margins Or The Inability To Achieve Market Acceptance For Our Products. The market for lunch and breakfast foods in the geographic markets where we operate is intensely competitive and constantly changing. We may be unable to compete successfully against our current and future competitors, which may result in pricing reductions, reduced margins and the inability to achieve market acceptance for our products. Many businesses provide services similar to ours. Our competitors include sandwich shops, company cafeterias, delicatessens, pushcart vendors, fast food chains and catering companies. Pret a Manger has successfully executed a concept similar to ours in Great Britain and has opened 11 stores in New York City. In addition, during 2001 Pret a Manger announced that it had received a significant equity investment from McDonald s Corporation. Pret a Manger may expand its operations to markets in which we operate or expect to enter and it may serve as a model for other competitors to enter into markets in which we operate or expect to enter. Many of our competitors have significantly more capital, research and development, manufacturing, distribution, marketing, human and other resources than we do. As a result, they may be able to adapt more quickly to market trends, devote greater resources to the promotion or sale of their products, receive greater support and better pricing terms from independent distributors, initiate or withstand substantial price competition, or take advantage of acquisition or other opportunities more readily than we can. We May Be Subject To Product Liability Claims, Which May Adversely Affect Our Operations. We may be held liable or incur costs to settle liability claims if any of the food products we prepare or sell cause injury or are found unsuitable during preparation, sale or use. Although we currently maintain product liability insurance, we cannot assure you that this insurance is adequate, and, at any time, it is possible that such insurance coverage may cease to be available on commercially reasonable terms, or at all. A product liability claim could result in liability to us greater than our total assets or insurance coverage. Moreover, product liability claims could have an adverse impact on our business even if we have adequate insurance coverage. Changes In Consumer Preferences Or Discretionary Consumer Spending Could Negatively Impact Our Results. Our success depends, in part, upon the popularity of our food products and our ability to develop new menu items that appeal to consumers. Shifts in consumer preferences away from our cafes or away from our cuisine, our inability to develop new menu items that appeal to consumers, or changes in our menu that eliminate items popular with some consumers could harm our business. Also, our success depends to a significant extent on numerous factors affecting discretionary consumer spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce customer traffic or impose practical limits on pricing, either of which could harm our business. Inability To Obtain Regulatory Approvals, Or To Comply With Ongoing And Changing Regulatory Requirements, For Our Central Kitchens Or Cafes Could Restrict Our Business And Operations. Our central kitchens and our cafes are subject to various local, state and federal governmental regulations, standards and other requirements for food storage, preparation facilities, food handling procedures, other good manufacturing practices requirements and product labeling. We are also subject to license and permit requirements relating to health and safety, building and land use and environmental protection. If we encounter difficulties in obtaining any necessary licenses or permits or complying with these ongoing and changing regulatory requirements: the opening of new cafes or central kitchens could be delayed; The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents existing cafes or central kitchens could be closed temporarily or permanently; or our product offerings could be limited. The occurrence of any of these problems could harm our operating results. Risks Relating To This Offering Our Directors, Executive Officers And Significant Shareholders Hold A Substantial Portion Of Our Stock, Which May Lead To Conflicts With Other Shareholders Over Corporate Governance. Our directors, executive officers and current holders of 5% or more of our outstanding common stock, including the holder of our convertible note, hold a substantial portion of our stock. These shareholders, acting together, and Victor D. Alhadeff, acting alone, will be able to significantly influence all matters requiring shareholder approval, including the election of directors and significant corporate transactions, such as mergers or other business combinations. This control may delay, deter or prevent a third party from acquiring or merging with us, which in turn could reduce the market price of our common stock. Conversion of Our Outstanding Debt Securities Could Substantially Dilute Your Investment Because the Conversion Prices Of Those Securities and/or the Number of Shares of Common Stock Issuable Upon Conversion of Those Securities Are Subject to Adjustment. We have issued and plan to issue in the future various securities that are convertible or exercisable at prices that are subject to adjustment due to a variety of factors, including fluctuations in the market price of our common stock and the issuance of securities at an exercise or conversion price less than the then-current exercise or conversion price of those securities. As of July 25, 2002, the closing price of a share of our common stock on the Nasdaq National Market was $0.6963. The number of shares of common stock that these adjustable securities ultimately may be converted into or exercised for could prove to be greater than this amount if the market price of our common stock declines. You could, therefore, experience substantial dilution of your investment as a result of the conversion or exercise of our outstanding derivative securities. The applicable conversion price of the $1.25 million note issued to Laurus Master Fund, Ltd. is variable and does not have a lower-limit; therefore the dilutive effect to our existing security holders is theoretically limitless. Conversely, because the variable conversion price of this note has an upper limit, an increase in the trading price of a share of our common stock will result in a limited benefit to existing security holders with respect to the conversion of this note. The following table sets forth the number of shares issuable upon conversion of the principal portion of the note based upon the indicated hypothetical trading prices, based on the initial conversion price of $1.20 per share and assuming that the note is converted at our election in accordance with the regular payment schedule: Table of Contents Principal payments due on these notes as of December 30, 2001 are as follows (in thousands): FOR THE FISCAL YEAR: 2002 $ 138 2003 101 2004 100 2005 79 2006 36 Thereafter Table of Contents PART I INFORMATION REQUIRED IN PROSPECTUS (1) Hypothetical average daily volume weighted average (VWAP) of the common stock as reported by Bloomberg, L.P. on the Nasdaq National Market for the 11 trading days preceding a repayment date. (2) Hypothetical average of the five lowest closing prices during the 30 trading days immediately preceding the conversion date. (3) The initial conversion price is $1.20 per share. However, if the average VWAP of the common stock as reported by Bloomberg, L.P. on the principal trading market for our common stock for the 11 trading days preceding a repayment date is less than 125% of the conversion price, and we have elected to pay the monthly repayment amount in shares of our common stock, then the holder is permitted to convert the repayment amount into our common stock at a conversion price of 85% of the average of the five lowest closing prices during the 30 trading days immediately preceding the conversion date. (4) Amounts are based on 5,847,310 shares of our common stock outstanding as of June 18, 2002, plus the corresponding number of shares issuable. The holder has contractually agreed to certain restrictions on the number of shares of common stock that may be issued upon conversion of the note. See Selling Shareholders . In addition to the adjustments described in footnote (3) to the foregoing table, the initial conversion price of $1.20 per share is subject to downward adjustments: on a fully weighted average basis, to adjust for the dilutive effect of any additional issuances of our securities prior to the conversion of the note at prices lower than the conversion price then in effect (subject to customary exclusions); and in the event any event of default has occurred and is continuing under the note, in which case the conversion price shall be the lower of $1.20 or 70% of the average of the three lowest closing prices for the common stock as repost on the principal trading exchange of our common stock for the prior thirty trading days. The foregoing adjustments to the conversion price of the note are cumulative. As a result of conversions of the principal or interest portion of our convertible note and related sales of our common stock by the holder, the market price of our common stock could be depressed, thereby resulting in a significant increase in the number of shares issuable upon conversion of the principal and interest portions of the note. You could, therefore, experience substantial dilution of your investment as a result of the conversion of the principal or interest portions of our convertible debentures. If Our Security Holders Engage in Short Sales Of Our Common Stock, Including Sales of Shares to Be Issued Upon Conversion of Debt Securities, the Price of Our Common Stock May Decline. Selling short is a technique used by a shareholder to take advantage of an anticipated decline in the price of a security. A significant number of short sales or a large volume of other sales within a relatively short period of time can create downward pressure on the market price of a security. The decrease in market price would allow holders of our debt securities that have conversion prices based upon a discount on the market price of our common stock to Table of Contents 3,124,810 BRIAZZ, Inc. COMMON STOCK This is a public offering of 3,124,810 shares of the common stock of BRIAZZ, Inc. ( BRIAZZ ). All of the shares being offered, when sold, will be sold by the selling shareholders as listed in this prospectus on pages 24 through 25. The selling shareholders are offering: 2,083,334 shares of common stock issuable on conversion of note; 250,000 shares of common stock issuable on exercise of warrants; and 791,476 shares of common stock issued in private placements. The selling shareholders may from time to time offer and sell all or a portion of the shares at prices then prevailing or related to the then current market price or at negotiated prices. We will not receive any of the proceeds from the sale of the shares. Our common stock is currently quoted on the Nasdaq National Market under the symbol BRZZ . The last price of our common stock on the Nasdaq National Market on August 5, 2002 was $0.69 per share. Investing in the shares involves risks. See Risk Factors beginning on page 12. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The date of this prospectus is August 8, 2002. Table of Contents convert their debt securities into or for an increased number of shares of our common stock. Further sales of common stock issued upon conversion of our debt securities could cause even greater declines in the price of our common stock due to the number of additional shares available in the market, which could encourage short sales that could further undermine the value of our common stock. You could, therefore, experience a decline in the value of your investment as a result of short sales of our common stock. Our Current Financing Arrangements Could Prevent Our Common Stock From Being Listed on Nasdaq or Other Principal Markets. Nasdaq and other principal markets require that, to be eligible for inclusion in the stock market, a company s common stock have a specified minimum bid price per share. Convertible debt financings, especially those with variable conversion prices with low or no low-price limits, characteristically exert downward pressure on the market for a company s common stock. This pressure, if applied against the market for our common stock, may cause our common stock from to be delisted on Nasdaq or other principal markets due to low stock price. The Aggregate Value of Our Public Float, or the Shares of Our Common Stock Held By Non-Insiders, and the Minimum Bid Price of Our Common Stock Has Recently Not Been in Compliance with Nasdaq s Criteria For Continued Listing on the Nasdaq National Market, and We May Be Transferred to the Nasdaq SmallCap Market or Delisted If We Are Unable to Comply. Our common stock is quoted on the Nasdaq National Market. There are a number of continuing requirements that must be met in order for our common stock to remain eligible for quotation on the Nasdaq National Market or the Nasdaq SmallCap Market. The failure to meet the maintenance criteria in the future could result in the delisting of our common stock from Nasdaq. If our common stock were to be delisted, trading, if any, in the common stock may then continue to be conducted on the OTC Bulletin Board. As a result, an investor may find it more difficult to sell our common stock or to obtain accurate quotations as to the market value of our common stock. On August 6, 2002, we were notified by Nasdaq that we are out of compliance with the Nasdaq National Market rule that requires a National Market-listed company to maintain a $5.0 million minimum aggregate value for its shares held in public float. If we are unable to regain compliance with the rule for a minimum of 10 consecutive trading days prior to November 5, 2002, Nasdaq has informed us that unless we have applied and are accepted for listing on the Nasdaq SmallCap Market, we will be provided with written notification that our shares will be delisted. Based on the bid price and closing price of our common stock on August 5, 2002, we are also out of compliance with the Nasdaq National Market rule that requires a National Market-listed company to maintain a $1.00 minimum bid price. Nasdaq may notify us that we are not in compliance with the minimum bid price rule and, if we are not able to regain compliance with such rule within the prescribed timeframe, Nasdaq may notify us that we will be delisted. We cannot guarantee you that we will be able to regain compliance with the public float or minimum bid rules within the prescribed timeframe, or at all. If Nasdaq provides us with a notice of delisting, we would have the option of appealing the delisting decision to a Nasdaq listing qualifications review panel and presenting our argument for continued National Market listing to such panel, of applying for listing on the Nasdaq SmallCap Market or of allowing the delisting to occur. Even if we appeal and/or apply for listing on the Nasdaq SmallCap Market, we cannot guarantee that the appeal will be successful or that the application will be accepted, as the case may be, in which event delisting will occur and trading of our common stock may thereafter take place on the OTC Bulletin Board. Our Stock Price May Be Volatile Because Of Factors Beyond Our Control, And You May Lose All Or A Part Of Your Investment. The market price of our common stock may fluctuate significantly in response to a number of factors, most of which are beyond our control, including: changes in securities analysts recommendations or estimates of our financial performance; changes in market valuations of similar companies; and announcements by us or our competitors of significant contracts, new products, acquisitions, commercial relationships, joint ventures or capital commitments. In the past, companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. A securities class action lawsuit against us, regardless of its merit, could result in TABLE OF CONTENTS PROSPECTUS SUMMARY THE OFFERING SUMMARY FINANCIAL DATA RISK FACTORS

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+RISK FACTORS You should carefully consider the following risks and other information contained in this prospectus before deciding to invest in shares of our common stock. The risks described below are not the only ones facing our company. Additional risks not presently known to us or which we currently consider immaterial also may adversely affect our company and your investment. If any of the following risks and uncertainties actually occur, our business, financial condition and operating results could be materially and adversely affected. This could cause the trading price of our common stock to decline, and you may lose all or part of your investment. Risks Related to our Business There can be no assurance that our cash flow from operations and cash available from external financing will be sufficient to meet our future cash flow needs, in which case we would need to obtain additional financing. As of September 4, 2002, after the closing of the sale of Stepic we had borrowing capacity of approximately $4.0 million under our credit facility with LaSalle. However, under the minimum availability financial covenant contained in our credit facility with LaSalle, we are required to maintain at all times $4.0 million under the minimum availability test (as defined therein), which currently substantially limits our borrowing capacity without violating this covenant. Any additional financing we undertake could involve issuances of debt or issuances of equity securities which would be dilutive to our shareholders, and any debt facilities could contain covenants that may affect our operations, including our ability to make future acquisitions. Adequate additional funds, whether from the financial markets or from other sources, may not be available on a timely basis, on terms acceptable to us or at all. Insufficient funds may cause us difficulty in financing our accounts receivables and inventory and may result in delay or abandonment of some or all of our product development, licensing, marketing or research and development programs or opportunities, which could have a material adverse effect on our business, financial condition and operating results. Additionally, we are required to make periodic interest and principal payments on our outstanding indebtedness, including the Convertible Notes, the LaSalle credit facility and the Junior Note. Failure to make any such required payments may result in an event of default and the acceleration of all outstanding indebtedness. The conversion of all or a portion of the Convertible Notes issued in the Recapitalization may result in substantial dilution to our shareholders. Our shareholders may be diluted if the holders of our Convertible Notes issued in the Recapitalization convert their notes into shares of our common stock. The holders of the Convertible Notes have the right to convert in the aggregate to total of 27,000,000 shares of common stock, subject to a downward adjustment upon our repayment of all or a portion of the amounts due under the Convertible Notes. To the extent a holder of our Convertible Notes converts and sells shares of our common stock, the price of our common stock may decrease due to the additional number of shares on the market. Our inability to introduce new products to the marketplace could adversely impact our operating results. Although the vascular access product industry has not experienced rapid technological change historically, as our existing products become more mature, the importance of developing or acquiring, manufacturing and introducing new products that address the needs of our customers will increase. The development or acquisition of any such products will entail considerable time and expense, including acquisition costs, research and development costs, and the time and expense required to obtain necessary regulatory approvals, which approvals are not assured, and any of which could adversely affect our business, results of operations or financial condition. There can be no assurance that such development activities will yield products that can be commercialized profitably or that any product acquisition can be consummated on commercially reasonable terms or at all. Historically, many of our products have been William E. Peterson, Jr. Horizon Medical Products, Inc. One Horizon Way P.O. Box 627 Manchester, Georgia 31816 (706) 846-3126 (Name, address, including zip code, and telephone number, including area code, of agent for service) Table of Contents developed in conjunction with third parties or acquired as a result of acquisitions consummated by us. Recently, we have introduced new products developed by us. Our inability to develop or acquire new products to supplement our existing product lines could have an adverse impact on our ability to fully implement our business strategy and further develop our operation. We have limited manufacturing experience and we can not assure you that we will successfully complete the development and manufacture of products integral to our business. Our success will depend in part on our ability to manufacture our products in compliance with international and domestic standards such as ISO 9001, the FDA s Good Manufacturing Practices, or GMP, regulations and other applicable licensing and regulatory requirements in sufficient quantities and on a timely basis, while maintaining product quality and acceptable manufacturing costs. We have historically outsourced the manufacturing of most of our product lines to third parties while remaining responsible for that work but, since 1998 and in subsequent years, have transitioned the manufacturing of our products to the Manchester facility. In the fourth quarter of 1996, we transitioned the manufacturing of our Circle C and Pheres-Flow specialty catheter product lines into our manufacturing facility in Manchester, Georgia. During 1998, we transitioned the manufacturing of our LifePort, Infuse-a-Port and Infuse-a-Cath product lines to the Manchester facility from a facility in Norwood, Massachusetts. During 1999, we transitioned the manufacturing of the Vortex port, TitanPort and OmegaPort product lines to the Manchester facility from Norfolk Medical. In 2001, we transitioned the manufacturing of the Triumph-1 port line to the Manchester facility from Act Medical as well as our infusion sets which had previously been manufactured by a third party. We have undergone and expect to continue to undergo regular GMP inspections in connection with the manufacture of our products at our facilities. Our success will depend, among other things, on our ability to efficiently manufacture different products and to integrate newly developed products with existing products. Our failure to successfully commence the manufacturing of new products, to maintain or increase production volumes of new or existing products in a timely or cost-effective manner or to maintain compliance with ISO 9001, the CE Mark requirements, GMP regulations or other applicable licensing or regulatory requirements could have a material adverse effect on our business, financial condition and operating results. We must maintain our current third party manufacturing relationships, and be able to successfully establish new relationships, in order for our business to be successful. While we believe we have a good relationship with each third party that manufactures certain components for our products, there can be no assurance that such relationships will not deteriorate in the future. Deterioration in these manufacturing relationships could cause us to experience interruptions in our manufacturing and delivery processes and have a material adverse impact on our business, financial condition and operating results. Furthermore, when the arrangements with these third parties expire, we will have to make other manufacturing arrangements or manufacture products or product parts at our facilities. The failure to effectively plan for the expiration of these agreements could also result in interruption of the manufacturing and delivery processes for these products and have a material adverse impact on our business, financial condition and operating results. We rely on third party suppliers, the loss of which may interrupt our operations. We purchase raw materials and components for use in manufacturing our products from many different suppliers. There can be no assurance that we will be able to maintain our existing supplier relationships or secure additional suppliers as needed. The loss of a major supplier, the deterioration of our relationship with a major supplier, changes by a major supplier in the specifications of the components used in our products, or our failure to establish good relationships with major new suppliers could have a material adverse effect on our business, and financial condition and operating results. Copies to: Jon R. Harris, Jr. King Spalding 191 Peachtree Street Atlanta, Georgia 30303-1763 Carl Kleidman ComVest Venture Partners, L.P. 830 Third Avenue New York, New York 10022 Table of Contents We may fail to adequately protect our intellectual property and proprietary rights. We believe that our competitive position and success has depended, in part, on and will continue to depend on the ability of us and our licensors to obtain patent protection for our products, to defend patents once obtained, to preserve our trade secrets and to operate without infringing upon patents and proprietary rights held by third parties, both in the United States and in foreign countries. Our policy is to protect our proprietary position by, among other methods, filing United States and foreign patent applications relating to technology, inventions and improvements that are important to the development of our business. We own numerous United States and foreign patents and United States patent applications. We also are a party to license agreements with third parties pursuant to which we have obtained, for varying terms, the right to make, use and/or sell products that are covered under such license agreements in consideration for royalty payments. Many of our products are subject to such license agreements. There can be no assurance that we or our licensors have or will develop or obtain additional rights to products or processes that are patentable, that patents will issue from any of the pending patent applications filed by us or that claims allowed will be sufficient to protect any technology that is licensed to us. In addition, no assurances can be given that any patents issued or licensed to us or other licensing arrangements will not be challenged, invalidated, infringed or circumvented or that the rights granted thereunder will provide competitive advantages for our business or products. In such event our business, financial condition, and operating results could be materially adversely affected. Asserting, defending and maintaining our patent rights could be difficult and costly and failure to do so may diminish our ability to compete effectively and may harm our operating results. A number of medical device companies, physicians and others have filed patent applications or received patents to technologies that are similar to technologies owned or licensed by us. There can be no assurance that we are aware of all patents or patent applications that may materially affect our ability to make, use or sell our products. United States patent applications are confidential while pending in the United States Patent and Trademark Office, or PTO, and patent applications filed in foreign countries are often first published six or more months after filing. Any conflicts resulting from third-party patent applications and patents could significantly reduce the coverage of the patents owned or licensed by us and limit our ability of or our licensors ability to obtain meaningful patent protection. If patents are issued to other companies that contain competitive or conflicting claims, we may be required to obtain licenses to those patents or to develop or obtain alternative technology. There can be no assurance that we would not be delayed or prevented from pursuing the development or commercialization of our products, which could have a material adverse effect on our operating results. There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry. Although we have not been a party to any material litigation to enforce any intellectual property rights held by us, or a party to any material litigation seeking to enforce any rights alleged to be held by others, future litigation may be necessary to protect patents, trade secrets, copyrights or know-how owned by us or to defend us against claimed infringement of the rights of others and to determine the scope and validity of the proprietary rights of us and others. The validity and breadth of claims covered in medical technology patents involve complex legal and factual questions for which important legal principles are unresolved. Any such litigation could result in substantial cost to and diversion of effort by us. Adverse determinations in any such litigation could subject us to significant liabilities to third parties, could require us to seek licenses from third parties and could prevent us from manufacturing, selling or using certain of our products, any of which could have a material adverse effect on our business, results of operations and financial condition. We rely in part on confidentiality agreements to protect our proprietary technologies, and we can not assure you that these agreements will be effective. We also rely on trade secrets and proprietary technology that we seek to protect, in part, through confidentiality agreements with employees, consultants and other parties. There can be no assurance that these agreements will not be breached, that we will have adequate remedies for any breach, that others Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement is declared effective. If any securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, as amended (the Securities Act ), check the following box. If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. Table of Contents will not independently develop substantially equivalent proprietary information or that third parties will not otherwise gain access to our trade secrets. We rely on trademarks and trade names for the success of our business, and the loss of one or any of these marks or names could materially harm our business. We rely upon trademarks and trade names for the development and protection of brand loyalty and associated goodwill in connection with our products. Our policy is to protect our trademarks, trade names and associated goodwill by, among other methods, filing United States and foreign trademark applications relating to our products and business. We own numerous United States and foreign trademark registrations and applications. We also rely upon trademarks and trade names for which we do not have pending trademark applications or existing registrations, but in which we have substantial trademark rights. Our registered and unregistered trademark rights relate to the majority of our products. There can be no assurance that any of our registered or unregistered trademarks or trade names will not be challenged, canceled, infringed, circumvented, or be declared generic or infringing of other third-party marks or provide any competitive advantage to us. We are potentially subject to product liability claims resulting from the operation of our business, and we can not assure you that we will not incur losses associated with such claims. Because our products are intended to be used in healthcare settings on patients who are physiologically unstable and may be seriously or critically ill, our business exposes us to potential product liability risks which are inherent in the medical device industry. In addition, many of the medical devices manufactured and sold by us are designed to be implanted in the human body for extended periods of time. Component failures, manufacturing flaws, design defects or inadequate disclosure of product-related risks with respect to these or other products manufactured or sold by us could result in injury to, or death of, a patient. The occurrence of such a problem could result in product liability claims and/or a recall of, safety alert relating to, or other FDA or private civil action affecting one or more of our products or responsible officials. We maintain product liability insurance coverage in amounts that we deem sufficient for our business. There can be no assurance, however, that such coverage will be available with respect to or sufficient to satisfy all claims made against us or that we will be able to obtain insurance in the future at satisfactory rates or in adequate amounts. Product liability claims or product recalls in the future, regardless of their ultimate outcome, could result in costly litigation and could have a material adverse effect on our business, results of operations and financial condition. In September 1999, we initiated a voluntary product recall of our dialysis and central venous catheter kit product lines due to small pinholes in the product packaging. Although the recall covers products manufactured since 1994, product returns through December 31, 2001 were approximately 15,300 units. No product complaints have been received to date for either pinholes in the packaging or infection of the implant site that could be attributed to the packaging being contaminated. In 2001, the recall was terminated by the FDA. Our sales are concentrated among a small number of significant customers, the loss of any of which may have a material adverse effect on our operating results. Our net sales to our three largest customers accounted for 7%, 6% and 8% of total sales during 1999, 2000 and 2001, respectively. The loss of, or significant curtailments of purchases by, any of our significant customers could have a material adverse effect on our business, results of operations and financial condition. Our cash flows will be adversely affected by our recent sale of Stepic. On September 3, 2002, we sold substantially all of the assets of Stepic, our distribution division. For the fiscal year ended December 31, 2001, our distribution division accounted for 57.0% of our total sales and 33.9% of our gross profit, and for the six months ended June 30, 2002, our distribution division accounted for 60.0% of our total sales and 34.0% of our gross profit. We anticipate that our sale of Stepic will substantially reduce our cash flow from its historical level for the foreseeable future. We cannot assure The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act, or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents you that in the future our cash flow from operations will be sufficient to allow us to fully execute on our strategic plan, including research and development related to new products. This loss of cash flow may materially adversely affect our liquidity, financial condition and results of operations. We are dependent upon key personnel, the loss of any of which could materially adversely affect our business. Our success is substantially dependent on the performance, contributions and expertise of our executive officers and key employees. Our success to date has been significantly dependent on the contributions of Marshall B. Hunt, our Chairman and Chief Executive Officer, and William E. Peterson, Jr., our President, each of whom is party to an employment agreement with us and on each of whom we maintain key man life insurance in the amount of $1 million. Mr. Hunt s employment agreement expires March 16, 2003, and Mr. Peterson s employment agreement expires September 16, 2002. We are also dependent on our ability to attract, retain and motivate additional personnel. The loss of the services of any of our executive officers or other key employees or our inability to attract, retain or motivate the necessary personnel could have a material adverse effect on our business, financial condition and operating results. Our business is subject to changes in the regulatory and economic environment in the healthcare industry, which could adversely affect our business. The healthcare industry in the United States continues to experience change. In recent years, several healthcare reform proposals have been formulated by members of Congress. In addition, state legislatures periodically consider healthcare reform proposals. Federal, state and local government representatives will, in all likelihood, continue to review and assess alternative healthcare delivery systems and payment methodologies, and ongoing public debate of these issues can be expected. Cost containment initiatives, market pressures and proposed changes in applicable laws and regulations may have a dramatic effect on pricing or potential demand for medical devices, the relative costs associated with doing business and the amount of reimbursement by both government and third-party payors to persons providing medical services. In particular, the healthcare industry is experiencing market-driven reforms from forces within the industry that are exerting pressure on healthcare companies to reduce healthcare costs. Managed care and other healthcare provider organizations have grown substantially in terms of the percentage of the population in the United States that receives medical benefits through such organizations and in terms of the influence and control that they are able to exert over an increasingly large portion of the healthcare industry. Managed care organizations are continuing to consolidate and grow, increasing the ability of these organizations to influence the practices and pricing involved in the purchase of medical devices, including certain of the products sold by us, which is expected to exert downward pressure on product margins. Both short-and long-term cost containment pressures, as well as the possibility of continued regulatory reform, may have an adverse impact on our business, results of operations and financial condition. We are subject to government regulation in the United States and internationally, which can be time-consuming and costly to our business. Our products and operations are subject to extensive regulation by numerous governmental authorities, including, but not limited to, the FDA and state and foreign governmental authorities. In particular, we must obtain specific clearance or approval from the FDA before we can market new products or certain modified products in the United States. The FDA administers the FDC Act. Under the FDC Act, most medical devices must receive FDA clearance through the Section 510(k) notification process, or 510(k), or the more lengthy premarket approval, or PMA, process before they can be sold in the United States. To obtain 510(k) marketing clearance, a company must show that a new product is substantially equivalent in terms of safety and effectiveness to a product already legally marketed and which does not require a PMA. Therefore, it is not always necessary to prove the actual safety and effectiveness of the new product in order to obtain 510(k) clearance for such product. To obtain a PMA, a company must submit extensive data, including clinical trial data, to prove the safety, effectiveness and clinical utility of our products. The Table of Contents process of obtaining such clearances or approvals can be time-consuming and expensive, and there can be no assurance that all clearances or approvals sought by us will be granted or that FDA review will not involve delays adversely affecting the marketing and sale of our products. FDA s quality system regulations also require companies to adhere to certain good manufacturing practices requirements, which include testing, quality control, storage, and documentation procedures. Compliance with applicable regulatory requirements is monitored through periodic site inspections by the FDA. In addition, we are required to comply with FDA requirements for labeling and promotion of our products. The Federal Trade Commission also regulates most device advertising. In addition, international regulatory bodies often establish varying regulations governing product testing and licensing standards, manufacturing compliance, such as compliance with ISO 9001 standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements and pricing and reimbursement levels. Our inability or failure to comply with the varying regulations or the imposition of new regulations could restrict our ability to sell our products internationally and thereby adversely affect our business, results of operations and financial condition. Failure to comply with applicable federal, state or foreign laws or regulations could subject us to enforcement actions, including, but not limited to, product seizures, injunctions, recalls, possible withdrawal of product clearances, civil penalties and criminal prosecutions against us or our responsible officials, any one or more of which could have a material adverse effect on our business, results of operations and financial condition. Federal, state and foreign laws and regulations regarding the manufacture and sale of medical devices are subject to future changes, as are administrative interpretations of regulatory requirements. In August 2002, we received a subpoena from the Office of Inspector General of the Department of Health Human Services requesting documents relating to our agreement with a group purchasing organization. We intend to cooperate fully with this request. No assurance can be given that such changes will not have a material adverse effect on our business, results of operations and financial condition. From time to time, we have received Section FD-483 and Warning Letters from the FDA regarding our compliance with FDA regulations. On September 4, 2002, we received an FD-483 letter specifying five items. Horizon is currently preparing its response to such letter. We have worked with the FDA to resolve these issues. There can be no assurance we will not receive additional FD-483s or Warning Letters in the future or that we will be able to reach an acceptable resolution of the issues raised in such letters. Our business is dependent upon reimbursement from government programs, such as Medicare and Medicaid, and we may face limitations on such third-party reimbursement, which could harm our operating results. In the United States, our products are purchased primarily by hospitals and medical clinics, which then bill various third-party payors, such as Medicare, Medicaid and other government programs and private insurance plans, for the healthcare services provided to patients. Government agencies, private insurers and other payors determine whether to provide coverage for a particular procedure and reimburse hospitals for medical treatment at a fixed rate based on the diagnosis-related group, or DRG, established by the United States Centers for Medicare and Medicaid Services, or CMS. The fixed rate of reimbursement is based on the procedure performed and is unrelated to the specific devices used in that procedure. If a procedure is not covered by a DRG, payors may deny reimbursement. In addition, third-party payors may deny reimbursement if they determine that the device used in a treatment was unnecessary, inappropriate or not cost-effective, experimental or used for a non-approved indication. Reimbursement of procedures implanting our vascular access ports and catheter products is currently covered under a DRG. There can be no assurance that reimbursement for such implantation will continue to be available, or that future reimbursement policies of third-party payors will not adversely affect our ability to sell our products on a profitable basis. Failure by hospitals and other users of our products to obtain reimbursement from third-party payors, or changes in government and private third-party payors policies toward reimbursement for procedures employing our products, would have a material adverse effect on our business, results of operations and financial condition. Table of Contents We are subject to intense competition which could harm our business. The medical device industry is highly competitive and fragmented. We currently compete with many companies in the development, manufacturing and marketing of vascular access ports, dialysis and apheresis catheters and related ancillary products. Some of these competitors have substantially greater capital resources, management resources, research and development staffs, sales and marketing organizations and experience in the medical devices industry than us. These competitors may succeed in marketing their products more effectively, pricing their products more competitively, or developing technologies and products that are more effective than those sold or produced by us or that would render some products offered by us noncompetitive. Our business will be harmed if demand for our products declines due to a sustained economic downturn. Sales of the products manufactured by us may be adversely impacted by a deterioration in the general economic conditions in the markets in which our products are sold. Likewise, a deterioration in general economic conditions could cause our customers and/or third party payors to choose cheaper methods of treatment not utilizing our products. A decline in our sales attributable to these factors could have a material adverse effect on our business, results of operations and financial condition. Risks Related to this Offering Our quarterly operating results may fluctuate and as such, our common stock price may be volatile, and you could lose all or part of your investment. Our revenues and operating results may vary significantly from quarter to quarter depending upon a number of factors which are outside of our control, such as: customer purchasing patterns for our products and services; costs of developing new products and services; the timing of our release of new products and services to the marketplace; the addition or loss of significant customers; costs related to acquisitions of compatible businesses or technology; and general economic conditions, as well as those specific to the healthcare market and related industries. Volatility in the market price of our common stock may prevent investors from being able to sell their common stock at prices, or in the amounts, desired. As a result, you could lose all or a portion of your investment in our common stock. The sale of a substantial number of shares of our common stock in this offering may cause the market price of our common stock to decline. The selling shareholders may collectively sell 30,469,017 shares of our common stock in the public market pursuant to this offering. Sales of a substantial number of these shares within a short period of time following the commencement of this offering could cause the price of our common stock to fall. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional stock. Our executive officers and directors, together with parties to the Recapitalization, will have the ability to exercise control over us. As of the date of this prospectus, Messrs. Hunt, Peterson, both directors of our company, and Roy C. Mallady, Jr., a former director of our company, collectively own more than 50% of our outstanding Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED SEPTEMBER 11, 2002 PROSPECTUS Horizon Medical Products, Inc. 30,469,017 Shares Common Stock (par value $.001 Per Share) Table of Contents common stock. In addition, ComVest, Medtronic and the Additional Note Purchasers have the right to convert a portion of their Convertible Notes into up to 27,000,000 shares of our common stock. ComVest and its affiliates also received 2,720,398 shares of common stock in connection with the Recapitalization. Additionally, LaSalle and its affiliates received warrants to purchase 748,619 shares of our common stock in connection with the Recapitalization. These shareholders, if they were to act together, would have the power to elect all of the members of our board of directors, amend our Restated and Amended Articles of Incorporation, or our articles of incorporation, and our bylaws, and effect or preclude fundamental corporate transactions involving us, including the acceptance or rejection of proposals relating to a merger or the acquisition of our company by another entity. Accordingly, these shareholders are able to exert significant influence over us, including the ability to control decisions on matters on which shareholders are entitled to vote. We have implemented anti-takeover provisions that could prevent a change in control that could be beneficial to our shareholders. Certain provisions of our articles of incorporation and bylaws may delay or prevent a takeover attempt that a shareholder might consider in our best interest. Among other things, these provisions: establish certain advance notice procedures for shareholder proposals to be considered at shareholders meetings; provide for the classification of our board of directors; provide that only our board of directors or shareholders owning 70% or more of our outstanding common stock may call special meetings of the shareholders; and establish supermajority voting requirements with respect to the amendment of certain provisions of our articles of incorporation and bylaws. In addition, our board of directors can authorize and issue shares of preferred stock, no par value, issuable in one or more series, with voting or conversion rights that could adversely affect the voting or other rights of holders of our common stock. The terms of the preferred stock that might be issued could potentially prohibit our consummation of any merger, reorganization, sale of all or substantially all of our assets, liquidation or other extraordinary corporate transaction without the approval of the holders of the outstanding shares of such stock. Furthermore, certain provisions of the Georgia Business Corporation Code, or the Georgia Code, may have the effect of delaying or preventing a change in control of our company. Pursuant to the Recapitalization, we are seeking shareholder approval to eliminate the classified board and to opt out of the statutes restricting certain business combinations and requiring certain fair price requirements be met in a business combination involving an interested shareholder. If we cannot meet the American Stock Exchange maintenance rules and other requirements, the American Stock Exchange may delist our common stock, which could negatively affect the price of our common stock and your ability to sell the common stock. In the future, we may not be able to meet the maintenance rules and requirements of the American Stock Exchange. The maintenance rules of the American Stock Exchange specify that the exchange may initiate the delisting of an issuer s stock if, among other things, the issuer has sustained losses from continuing operations and/or net losses in its five most recent fiscal years, or, if the issuer has sustained losses for three of its past four fiscal years and shareholders equity is less than $4.0 million, or, if the issuer has sustained losses for two of its past three fiscal years and shareholders equity is less than $2.0 million. In addition, the American Stock Exchange rules require shareholder approval prior to the issuance of securities in connection with a transaction involving the sale or issuance of common stock equal to 20.0% or more of a company s outstanding common stock before the issuance for less than the greater of book or market value of the stock. If, at our 2002 annual meeting of shareholders, our shareholders do not approve the issuance of common stock pursuant to conversion of the Convertible Notes, we would have the right to issue up to 19.9% of our outstanding common stock to our noteholders. This prospectus relates to 30,469,017 shares of our common stock being sold by 55 selling shareholders. We will not receive any proceeds from the issuance or sale of these shares. The selling shareholders may offer their shares of common stock from time to time through public or private transactions, in the over-the-counter markets, on any exchanges on which our common stock is traded at the time of sale, at prevailing market prices or at privately negotiated prices. The shares may be sold directly or through agents or broker-dealers acting as principal or agent, or in block trades or through one or more underwriters on a firm commitment or best efforts basis. The selling shareholders may engage underwriters, brokers, dealers or agents, who may receive commissions or discounts from the selling shareholders. We will pay substantially all of the expenses incident to the registration of the shares, except for sales commissions and other seller s compensation applicable to sales of the shares. The selling shareholders and any underwriters, agents or broker-dealers that participate with the selling shareholders in the distribution of the common stock may be deemed to be underwriters within the meaning of the Securities Act of 1933, as amended, and any commissions received by them and any profit on the resale of the common stock may be deemed to be underwriting commissions or discounts under the Securities Act. Horizon Medical Products common stock is currently traded on the American Stock Exchange under the symbol HMP. On September 10, 2002, the closing price of our common stock on the American Stock Exchange was $1.00. Table of Contents If we were no longer in compliance with the American Stock Exchange rules and were unable to receive a waiver or achieve compliance, and if our common stock were to be delisted from the American Stock Exchange, you may find it more difficult to sell your common stock. This lack of liquidity also may make it more difficult for us to raise capital in the future. If the American Stock Exchange delists our common stock, compliance with the penny stock regulations which would result could make it more difficult to sell your common stock. In the event that our securities are not listed on the American Stock Exchange, trading of the common stock would be conducted in the pink sheets or through the National Association of Securities Dealers Electronic Bulletin Board and covered by Rule 15g-9 under the Securities Exchange Act of 1934. Under this rule, broker/dealers who recommend these securities to persons other than established customers and accredited investors must make a special written suitability determination for the purchaser and receive the purchaser s written agreement to a transaction prior to sale. Securities are exempt from this rule if the market price is at least $5.00 per share. The SEC adopted regulations that generally define a penny stock as any equity security that has a market price of less than $5.00 per share. However, our common stock will not constitute penny stock if our common stock is quoted on the American Stock Exchange. If in the future our common stock falls within the definition of penny stock, these regulations would require the delivery, prior to any transaction involving our common stock, of a disclosure schedule explaining the penny stock market and the risks associated with it. Furthermore, the ability of broker/dealers and holders to sell the common stock would be limited. As a result, the market liquidity for the common stock would be severely and adversely affected. We cannot assure you that trading in our securities will not be subject to these or other regulations in the future which would negatively affect the market for our common stock.

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+RISK FACTORS You should carefully read the following risk factors before you decide to buy any of our common stock. You should also consider the other information in this prospectus. RISKS RELATING TO THIS OFFERING THERE HAS BEEN NO PRIOR MARKET FOR OUR COMMON STOCK AND OUR STOCK PRICE MAY BE VOLATILE. Prior to this offering, there has been no public market for our common stock. The offering price for our common stock in this offering will be determined by negotiations between us and the underwriter. Among the factors to be considered in determining the offering price of our common stock, in addition to prevailing market conditions, will be our historical performance, estimates regarding our business potential and earnings prospects, an assessment of our management and the consideration of the above factors in relation to market valuation of companies in related businesses. We believe that each of these factors is important, but we are unable to quantify or otherwise indicate the relative importance of each of these factors. The initial public offering price of our common stock may bear no relationship to the price at which our common stock will trade upon completion of this offering. The stock market has experienced significant price and volume fluctuations recently and you may not be able to resell your shares at or above the initial public offering price. YOU WILL EXPERIENCE SUBSTANTIAL DILUTION IN THE VALUE OF YOUR SHARES IMMEDIATELY FOLLOWING THIS OFFERING. Investors purchasing shares of our common stock in this offering will pay more for their shares than the amount paid by existing stockholders who acquired shares prior to this offering. Accordingly, if you purchase common stock in this offering, you will incur immediate dilution in pro forma net tangible book value of approximately $4.02 per share based on an assumed offering price of $13.00 per share. If the holders of outstanding options exercise those options, you will incur further dilution. See "Dilution." WE CANNOT BE SURE THAT A PUBLIC TRADING MARKET FOR OUR COMMON STOCK WILL DEVELOP OR BE MAINTAINED. We have applied to list our common stock for quotation on the Nasdaq National Market under the symbol "HWFG." There can be no assurance, however, that an established and liquid trading market for our common stock will develop, that it will continue if it does develop, or that after the completion of the offering, the common stock will trade at or above the initial public offering price set forth on the cover of this prospectus. The underwriter has advised us that it intends to make a market in our common stock and to assist in obtaining at least two other market makers for our common stock as required by the Nasdaq National Market. Neither the underwriter nor any other broker-dealer is obligated, however, to make a market in our common stock, and any market making may be discontinued at any time in the sole discretion of the party making a market. In addition, the substantial amount of common stock that is owned by our directors, executive officers and certain other individuals as described above under "-Our ownership is concentrated" and "Principal and Selling Stockholders" may adversely affect the development of an active and liquid trading market. WE MAY SPEND THE PROCEEDS OF THIS OFFERING IN WAYS WITH WHICH YOU MAY NOT AGREE. We will have broad discretion as to the use of the net proceeds of this offering. Accordingly, investors in this offering will be relying on management's judgment with only limited information about our specific intentions regarding the use of proceeds. We may spend most of the net proceeds from this offering in ways with which you may not agree. Our failure to apply these funds effectively could materially and adversely affect our business, financial condition, prospects and profitability. AFTER AN INITIAL PERIOD OF RESTRICTION, THERE WILL BE A SIGNIFICANT NUMBER OF SHARES OF OUR COMMON STOCK AVAILABLE FOR FUTURE SALE, WHICH MAY DEPRESS OUR STOCK PRICE. The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market after the closing of this offering, or even the perception that such sales could occur. We, our directors and executive officers, and certain of our stockholders have also agreed not to, offer, sell, contract to sell or otherwise dispose of, any common stock or options to acquire our common stock, for a period of 180 days after the date of this prospectus without the prior written consent of the underwriter. Notwithstanding these arrangements, there will be 4,973,167 shares of common stock outstanding or subject to currently exercisable options immediately following this offering, or 5,183,167 shares if the underwriter exercises its over-allotment option in full. The 1,400,000 shares sold in this offering (or 1,610,000 shares if the underwriter exercises its over-allotment option in full) will be freely tradable without restriction. In addition, the following will be available for sale in the public market as follows: - 678,618 shares will be eligible for sale upon completion of this offering; - 21,854 shares will be eligible for sale 90 days after the date of this prospectus; and - 2,841,714 shares will be eligible for sale 180 days after the date of this prospectus upon the expiration of the lock-up agreements described above. RISKS RELATING TO OUR BUSINESS OUR BUSINESS IS SUBJECT TO VARIOUS LENDING RISKS WHICH COULD ADVERSELY IMPACT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. Our commercial real estate and multi-family residential loans involve higher principal amounts than other loans, and repayment of these loans may be dependent on factors outside our control or the control of our borrowers. At June 30, 2002, commercial real estate loans totaled $152.4 million, or 35.0%, of our total loan portfolio while multi-family real estate loans totaled $70.5 million, or 16.2%, of our total loan portfolio. Commercial and multi-family real estate lending typically involves higher loan principal amounts and the repayment of such loans generally is dependent, in large part, on the successful operation of the property securing the loan or the business conducted on the property securing the loan. These loans may be more adversely affected by conditions in the real estate markets or in the economy generally. For example, if the cash flow from the borrower's project is reduced due to leases not being obtained or renewed, the borrower's ability to repay the loan may be impaired. In addition, many of our commercial real estate and multi-family residential loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment. Repayment of our commercial and industrial loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value. At June 30, 2002, commercial and industrial loans totaled $31.1 million, or 7.1%, of our total loan portfolio. Our commercial and industrial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral consists of accounts receivable, inventory or equipment. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists. As a result, in the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The collateral securing other loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Our construction loans are based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. At June 30, 2002, construction loans totaled $27.0 million, or 6.2%, of our total loan portfolio while land acquisition and development loans totaled $6.8 million, or 1.6%, of our total loan portfolio. Construction and acquisition and development lending involve additional risks because funds are advanced upon the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction loans and acquisition and development loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Our consumer loans generally have a higher risk of default than our other loans. At June 30, 2002, consumer loans totaled $13.7 million, or 3.2%, of our total loan portfolio. Consumer loans typically have shorter terms and lower balances with higher yields as compared to one- to four-family residential mortgage loans, but generally carry higher risks of default. Consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on these loans. OUR ALLOWANCE FOR LOAN LOSSES MAY PROVE TO BE INSUFFICIENT TO ABSORB PROBABLE LOSSES INHERENT IN OUR LOAN PORTFOLIO. Like all financial institutions, every loan we make carries a certain risk that it will not be repaid in accordance with its terms or that any collateral securing it will not be sufficient to assure repayment. This risk is affected by, among other things: - cash flow of the borrower and/or the project being financed; - in the case of a collateralized loan, the changes and uncertainties as to the future value of the collateral; - the credit history of a particular borrower; - changes in economic and industry conditions; and - the duration of the loan. We maintain an allowance for loan losses which we believe is appropriate to provide for any probable losses inherent in our loan portfolio. The amount of this allowance is determined by management through a periodic review and consideration of several factors which are discussed in more detail under "Business - Asset Quality - Allowance For Loan Losses." At June 30, 2002, our allowance for loan losses as a percentage of total loans was 0.92%. Federal regulatory agencies, as an integral part of their examination process, review our loans and allowance for loan losses. Although we believe our loan loss allowance is adequate to absorb probable losses in our loan portfolio, we cannot predict these losses or whether our allowance will be adequate or that regulators will not require us to increase this allowance. Any of these occurrences could materially and adversely affect our business, financial condition, prospects and profitability. OUR BUSINESS IS SUBJECT TO ECONOMIC AND OTHER GENERAL RISKS WHICH MAY ADVERSELY IMPACT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. Changes in economic conditions, in particular an economic slowdown in the markets in which we operate, could hurt our business. Our business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond our control. A deterioration in economic conditions, in particular an economic slowdown in the markets in which we operate in California, Kansas or Arizona, after we open our Phoenix/Scottsdale, Arizona office, could result in the following consequences, any of which could materially and adversely affect our business, financial condition, prospects and profitability: - loan delinquencies may increase; - problem assets and foreclosures may increase; - demand for our products and services may decline; - low cost or noninterest bearing deposits may decrease; and - collateral for loans made by us, especially real estate, may decline in value, in turn reducing customers' borrowing power. A downturn in the real estate market may adversely affect our business. A majority of the loans in our portfolio are secured by real estate. Negative conditions in the real estate markets where collateral for a mortgage loan is located could adversely affect the borrower's ability to repay the loan and the value of the collateral securing the loan. Our ability to recover on defaulted loans by selling the real estate collateral would then be diminished, and we would be more likely to suffer losses on defaulted loans. As of June 30, 2002, approximately 90.0% of the book value of our loan portfolio consisted of loans secured by various types of real estate. Approximately 86.1% of our real property collateral is located in California and approximately 13.9% is located in the Kansas City metropolitan area. If there is a significant decline in real estate values, the collateral for our loans will provide less security. Real estate values are affected by various other factors, including changes in general or regional economic conditions, governmental rules or policies and among other things, earthquakes and other national disasters particular to California. We are exposed to risk of environmental liabilities with respect to properties to which we take title. In the course of our business, we may foreclose and take title to real estate, and we could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, we could suffer a material and adverse effect on our business, financial condition, prospects and profitability. We may suffer losses in our loan portfolio despite our underwriting practices. We seek to mitigate the risks inherent in our loan portfolio by adhering to certain underwriting practices. These practices include analysis of prior credit histories, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers and verification of liquid assets. Although we believe that our underwriting criteria are appropriate for the various kinds of loans we make, we may incur losses on loans that meet our underwriting criteria, and these losses may exceed the amounts set aside as reserves for losses in the allowance for loan losses. OUR BUSINESS IS SUBJECT TO INTEREST RATE RISK AND VARIATIONS IN INTEREST RATES MAY NEGATIVELY AFFECT OUR FINANCIAL PERFORMANCE. Like other financial institutions, our operating results are largely dependent on our net interest income. Net interest income is the difference between interest earned on loans and securities and interest expense incurred on deposits and borrowings. Our net interest income is impacted by changes in market rates of interest, the interest rate sensitivity of our assets and liabilities, prepayments on our loans and securities and limits on increases in the rates of interest charged on our loans. We expect that we will continue to realize income from the differential or "spread" between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities. We cannot control or accurately predict changes in market rates of interest. The following are some factors that may affect market interest rates, all of which are beyond our control: - inflation; - slow or stagnant economic growth or recession; - unemployment; - money supply and the monetary policies of the Federal Reserve Board; - international disorders; and - instability in domestic and foreign financial markets. We are vulnerable to an increase in interest rates because our interest-earning assets generally have longer maturities than our interest-bearing liabilities. Under such circumstances, material and prolonged increases in interest rates will negatively affect our net interest income. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. In addition, an increase in the general level of interest rates may adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially and adversely affect our net interest spread, asset quality, loan origination volume, securities portfolio, and overall profitability. Although we attempt to manage our interest rate risk, we cannot assure you that we can minimize our interest rate risk. OUR INVESTMENT PORTFOLIO INCLUDES SECURITIES WHICH ARE SENSITIVE TO INTEREST RATES AND WHICH WE MAY BE REQUIRED TO SELL AT A LOSS TO MEET OUR LIQUIDITY NEEDS. At June 30, 2002, our investment portfolio included $214.0 million of securities, which are sensitive in value to interest rate fluctuations. Our available for sale portfolio totaled $211.6 million at June 30, 2002. The unrealized gains or losses in our available for sale portfolio are reported as a separate component of stockholders' equity until realized upon sale. As a result, future interest rate fluctuations may impact stockholders' equity, causing material fluctuations from quarter to quarter. The risk of us realizing a loss upon a sale in our available for sale portfolio is a function of our liquidity needs and market conditions at the time of sale. Failure to hold our securities until maturity or until market conditions are favorable for a sale could materially and adversely affect our business, financial condition, profitability and prospects. WE INVEST IN INTEREST RATE CONTRACTS WHICH CAN CAUSE LOSSES TO US IN EXCESS OF THE VALUE AT WHICH WE CARRY THESE INVESTMENTS. We invest in interest rate contracts for the purpose of reducing interest rate risk and, to a much more limited extent, to enhance spread income through asset based interest rate swaps. These interest rate contracts may include interest rate swaps, caps and floors and exchange traded futures and options. At June 30, 2002, we had invested in interest rate swaps with an aggregate notional amount of $73.9 million. Although, we have utilized caps, floors and exchange traded futures and options in prior periods, as of June 30, 2002, we did not have any investments in such interest rate contracts. Interest rate contracts can cause losses to us which will be reflected in our statements of earnings, and the maximum potential loss reflected in our statements of earnings may exceed the value at which we carry these instruments. These losses result from changes in the market values of such interest rate contracts. At June 30, 2002, the approximate net market value of our interest rate contracts was $(2.2) million. For additional information see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management." Our interest rate contracts expose us to: - basis or spread risk, which is the risk of loss associated with variations in the spread between the interest rate contract and the hedged item; - credit risk, which is the risk of the insolvency or other inability of another party to the transaction to perform its obligations; - interest rate risk; - volatility risk, which is the risk that the expected uncertainty relating to the price of the underlying asset differs from what is anticipated; and - liquidity risk. If we suffer losses on our interest rate contracts, our business, financial condition and prospects may be negatively affected, and our net income will decline. WE ARE SUBJECT TO EXTENSIVE REGULATION WHICH COULD ADVERSELY AFFECT OUR BUSINESS. Our operations are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. We believe that we are in substantial compliance in all material respects with applicable federal, state and local laws, rules and regulations. Because our business is highly regulated, the laws, rules and regulations applicable to us are subject to regular modification and change. There are currently proposed various laws, rules and regulations that, if adopted, would impact our operations. In addition, the Financial Accounting Standards Board, or FASB, is considering changes to applicable accounting standards which may require, among other things, the expensing of the costs related to the issuance of stock options. If these or any other laws, rules or regulations are adopted in the future, they could make compliance much more difficult or expensive, restrict our ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by us or otherwise materially and adversely affect our business, financial condition, prospects or profitability. OUR CONTINUED PACE OF GROWTH MAY REQUIRE US TO RAISE ADDITIONAL CAPITAL IN THE FUTURE, BUT THAT CAPITAL MAY NOT BE AVAILABLE WHEN IT IS NEEDED. We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. In addition, due to our business strategy which has concentrated on growth and a shift in our lending focus to more commercial lending and the size and character of our available for sale and trading securities portfolio, we have agreed with our federal banking regulator, the Office of Thrift Supervision, or OTS, that we will maintain a total risk-based capital ratio and a leverage capital ratio of at least 11% and 6%, respectively, which is in excess of the OTS' minimum requirements. Management does not believe that Los Padres Bank's agreement with the OTS to maintain increased ratios of total risk-based and leverage capital will limit or restrict our operations. However, to the extent that Los Padres Bank fails to comply with these additional increased capital ratios, the OTS could take such failure to comply into consideration in connection with further requests to have Los Padres Bank pay dividends to us and in additional future branch applications. Los Padres Bank's failure to comply could also impact its overall assessment by the OTS in future regulatory examinations, which, if adverse could also impact its FDIC insurance assessment. See "Capitalization," "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital Resources," and "Regulation - Los Padres Bank - Regulatory Capital Requirements and Prompt Corrective Action." We anticipate that our existing capital resources will satisfy our capital requirements for the foreseeable future. However, we may at some point need to raise additional capital to support continued growth, both internally and through acquisitions. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired. OUR PLAN TO ADD AN ADDITIONAL BRANCH IN KANSAS AND START A DE NOVO BRANCH IN ARIZONA MAY NOT BE SUCCESSFUL, WHICH WOULD NEGATIVELY AFFECT OUR GROWTH STRATEGY AND PROSPECTS. We intend to open a new branch located in the Phoenix/Scottsdale, Arizona metropolitan area in the last quarter of 2002 and a second branch in the Kansas City metropolitan area in mid 2003. Management estimates that it will take approximately 18 months for each of the new branches to be profitable and expects that we will incur average monthly losses of approximately $35,000 for the Phoenix/Scottsdale, Arizona branch and $14,000 for the Kansas City metropolitan area branch until each branch achieves profitability. These estimates are based on our financial model which reflects various assumptions, and we cannot give assurance that we will achieve profitability when estimated or that losses will not be greater than anticipated. While our management has significant experience in the Kansas market, we cannot be sure that our expansion in that market will meet our expectations. In addition, although we have hired experienced personnel who are familiar with the market and although our senior management has extensive knowledge of the area, we are new to the Arizona market and have never conducted any banking business in Arizona before. Accordingly, we may not be successful in these operations and we may not be able to compete in either location successfully. If we are unsuccessful in expanding our business in Kansas and starting our business in Arizona, our growth strategy, financial condition, prospects and profitability may be adversely affected. WE ARE DEPENDENT ON KEY INDIVIDUALS AND OUR ABILITY TO ATTRACT AND RETAIN BANKING PROFESSIONALS WITH SIGNIFICANT EXPERIENCE IN OUR LOCAL MARKETS. We currently depend heavily on Craig J. Cerny, our chief executive officer, and William W. Phillips, Jr., our president. We believe that the prolonged unavailability or the unexpected loss of the services of Messrs. Cerny or Phillips could have a material adverse effect upon us because attracting suitable replacements may involve significant time and/or expense. We do not have employment agreements with Mr. Cerny, Mr. Phillips or any of our other executive officers. We do not currently maintain key man life insurance policies on our executive officers. In order to continue our expansion, we must attract and retain experienced banking professionals. The competition to hire experienced banking professionals is intense. If we are unable to attract qualified banking professionals, our expansion plans could be delayed or curtailed. If we are unable to retain our current banking professionals, our business, financial condition, prospects and profitability may be adversely affected. WE RELY ON THE INVESTMENT ADVICE AND RESEARCH OF AN INDEPENDENT ADVISOR, AND THE LOSS OF SERVICES FROM THAT ADVISOR COULD DISRUPT OUR BUSINESS. Los Padres Bank has entered into an Investment and Interest Rate Advisory Agreement with Smith Breeden Associates, Inc., or Smith Breeden. Under the terms of the agreement, Smith Breeden provides us with investment advice and research related to Los Padres Bank's portfolio of investments and its asset and liability management strategies. Los Padres Bank employs 'option-adjusted pricing analysis' with respect to the purchase and sale of mortgage-backed and related securities for its investment portfolio and relies on Smith Breeden with respect to this analysis as well as the execution of Los Padres Bank's asset and liability management strategies. We believe that there are other investment advisors that could perform the services currently being provided by Smith Breeden; however, there can be no assurance that an alternative investment advisor could be retained on a timely basis if Los Padres Bank's agreement with Smith Breeden was terminated or Smith Breeden was otherwise unable to perform its services to Los Padres Bank. In addition, Smith Breeden provides consulting and investment advice for a number of other financial institutions. Although Smith Breeden has adopted a policy in order to reduce potential conflicts of interest with respect to its financial institution consulting practice, no assurance can be made that a conflict of interest would not arise which conflict could adversely affect Los Padres Bank. Craig J. Cerny, our chief executive officer, was a principal of Smith Breeden until 1996, and persons related to Smith Breeden, other than Mr. Cerny, owned approximately 27% of our common stock outstanding immediately prior to this offering. OUR OWNERSHIP IS CONCENTRATED IN THE HANDS OF OUR DIRECTORS, EXECUTIVE OFFICERS AND PERSONS CONNECTED WITH SMITH BREEDEN, WHO COULD MAKE DECISIONS THAT ARE NOT IN THE BEST INTERESTS OF ALL STOCKHOLDERS. Our directors, executive officers and persons connected with Smith Breeden, our investment advisor, will own approximately 41.5% of our outstanding common stock on an aggregate basis following this offering (39.7% assuming full exercise of the underwriter's over-allotment option). See "Principal and Selling Stockholders." In addition, our directors and executive officers have been granted options to acquire additional shares of our common stock, as described under "Management-1996 Stock Option Plan." Assuming the full exercise of such options, our directors and executive officers would own in the aggregate approximately 51.0% (48.8)% assuming full exercise of the underwriter's over-allotment option). As a result, our directors, executive officers and these other referenced individuals will continue to have the ability to significantly influence the election and removal of our board of directors and management and the outcome of most matters to be decided by a vote of stockholders. The interest of these individuals may not necessarily always be consistent with the interests of all other stockholders. WE FACE STRONG COMPETITION FROM OTHER FINANCIAL INSTITUTIONS, FINANCIAL SERVICE COMPANIES AND OTHER COMPANIES THAT OFFER BANKING SERVICES WHICH CAN HURT OUR BUSINESS. We conduct our banking operations primarily along the central coast of California and, to a lesser extent, in the Kansas City metropolitan area. We intend to open up an office located in the Phoenix/Scottsdale, Arizona metropolitan area in the fourth quarter of 2002 and a second branch office located in the Kansas City metropolitan area in mid 2003. Many competitors offer the banking services that we offer in our service area, and in the areas we intend to expand in. These competitors include other savings associations, national banks, regional banks and other community banks. We also face competition from many other types of financial institutions, including finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, our competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Increased competition in our market areas may result in reduced loans and deposits. Ultimately, we may not be able to compete successfully against current and future competitors. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain deposits, and range and quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances enable more companies to provide financial services. We also face competition from out-of-state financial intermediaries that have opened low-end production offices or that solicit deposits in our market areas. If we are unable to attract and retain banking customers, we may be unable to continue our loan growth and level of deposits and our business, financial condition and prospects may otherwise be negatively affected. WE CONTINUALLY ENCOUNTER TECHNOLOGICAL CHANGE, AND WE MAY HAVE FEWER RESOURCES THAN MANY OF OUR COMPETITORS TO CONTINUE TO INVEST IN TECHNOLOGICAL IMPROVEMENTS. The financial services industry is undergoing rapid technological changes, with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success will depend, in part, upon our ability to address the needs of our clients by using technology to provide products and services that will satisfy client demands for convenience, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. THE STOCK OF LOS PADRES BANK IS PLEDGED UNDER A REVOLVING LINE OF CREDIT, AND IF WE WERE TO DEFAULT ON THE REVOLVING LINE OF CREDIT, THE STOCK COULD BE SOLD AND WE WOULD NO LONGER HAVE ANY BANKING OPERATIONS. We currently have a revolving loan facility with two financial institutions which provide us with a revolving line of credit of up to $25.0 million. At June 30, 2002, we had drawn down $16.6 million under this line of credit. We have pledged the stock of Los Padres Bank as security under the line of credit. The line of credit requires us to maintain compliance with a number of covenants including financial covenants related to our profitability, other indebtedness, capital requirements and loan-to-value ratios. If we were to default under the line of credit, the stock could be foreclosed upon and we could lose all of our banking operations and our common stock would materially diminish in value. See "Business - Source of Funds - Borrowings."

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+RISK FACTORS You should be aware of the risks and uncertainties associated with an investment in our common stock. Specifically, there are risks and uncertainties that could affect our future financial results and that may cause our future earnings and financial condition to be less favorable than our expectations. WE MAY NOT BE ABLE TO MAINTAIN OUR HISTORICAL GROWTH RATE, WHICH MAY ADVERSELY IMPACT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. We have grown substantially in the past few years from $441 million ($630 million after giving effect to acquisitions completed in 1999 accounted for as poolings of interest) in total assets at December 31, 1998 to $1.2 billion in total assets at December 31, 2001. This growth has been achieved through a combination of internal growth and acquisitions. Our future profitability will depend in part on our continued ability to grow. In recent years, we have incurred substantial expenses to centralize our operations, hire additional employees to supplement our management team and upgrade our management information systems to build an infrastructure to support our future growth. We may not be able to sustain our historical rate of growth or may not even be able to grow at all. We may not be able to obtain the financing necessary to fund additional growth and may not be able to find suitable candidates for acquisition. Various factors, such as economic conditions, regulatory and legislative considerations and competition, may impede or prohibit our opening of new branch offices. If we experience a significant decrease in our historical rate of growth, our results of operations and financial condition may be adversely affected due to existing high levels of operating costs in relation to our current asset base. WE MAY BE UNABLE TO COMPLETE ACQUISITIONS, AND ONCE COMPLETE, WE MAY NOT BE ABLE TO INTEGRATE OUR ACQUISITIONS SUCCESSFULLY. Our growth strategy includes our ability to acquire other financial institutions. We may not be able to complete any future acquisitions and, if completed, we may not be able to successfully integrate the operations, management, products and services of the entities we acquire. Following each acquisition, we must expend substantial managerial, operating, financial and other resources to integrate these entities. Our failure to successfully integrate the entities we acquire into our existing operations may adversely affect our results of operations and financial condition. IF OUR ALLOWANCE FOR LOAN LOSSES IS NOT SUFFICIENT TO COVER ACTUAL LOAN LOSSES, OUR EARNINGS WOULD DECREASE. Our loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. We may experience significant loan losses which could have a material adverse effect on our operating results. Management makes various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses in an attempt to cover any loan losses which may occur. In determining the size of the allowance, we rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans, trends in classifications, volume and trends in delinquencies and non-accruals, national and local economic conditions and other pertinent information. If our assumptions are wrong, our current allowance may not be sufficient to cover future loan losses, and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance would materially decrease our net income. Our provisions for loan losses were $7.5 million, $5.0 million and $2.9 million for the years ended December 31, 2001, 2000 and 1999, respectively. In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a negative effect on our operating results. GEOGRAPHIC CONCENTRATION AND LOCAL ECONOMIC CONDITIONS MAY AFFECT OUR PROFITABILITY. Substantially all of The Bank's deposits and assets at December 31, 2001 were derived either from operations in Alabama or from operations in markets in Florida. As of December 31, 2001, approximately 70.9% of total assets and 69.9% of total deposits were derived from operations in Alabama, and 29.1% of total assets and 30.1% of total deposits were derived from operations in Florida. Consequently, our profitability may be negatively affected by factors that have a significant impact on general economic conditions in each of these states. Adverse changes in economic or other conditions in our geographic markets may impair The Bank's ability to collect loans and could otherwise negatively affect our financial condition and results of operations. OUR SIGNIFICANT INCREASE IN CONSTRUCTION AND LAND DEVELOPMENT LENDING ADVERSELY AFFECTED ASSET QUALITY. The Bank's expansion in the Florida market area as well as Birmingham and Huntsville, Alabama has provided us with significant opportunities to increase our loan portfolio, particularly in construction and land development loans. Accordingly, from December 31, 2000 to December 31, 2001, our construction and land development loans increased from $100.4 million to $200.3 million. Although construction and land development loans generally provide for higher interest rates and shorter terms than single-family residential mortgage loans, such loans generally have a relatively higher degree of credit risk. Nonperforming construction and land development loans have increased from $867,000 at December 31, 2000 to $2.9 million at December 31, 2001. OUR SMALL TO MEDIUM-SIZED BUSINESS CUSTOMERS MAY HAVE FEWER FINANCIAL RESOURCES TO WEATHER A DOWNTURN IN THE ECONOMY. One of the primary focal points of our business development and marketing strategy is serving the banking and financial services needs of small to medium-sized businesses. At December 31, 2001, approximately $261.2 million, or 26.1% of our total loan portfolio consisted of commercial and industrial loans, $200.3 million, or 20.0% were construction and land development loans, and $194.5 million, or 19.5% were commercial real estate loans. Small to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions are unfavorable for Alabama or the Florida panhandle, the businesses of our customers and their ability to repay outstanding loans may be negatively affected. As a consequence, our results of operations and financial condition may be adversely affected. FLUCTUATIONS IN INTEREST RATES COULD REDUCE OUR PROFITABILITY. WE REALIZE INCOME PRIMARILY FROM THE DIFFERENCE BETWEEN INTEREST EARNED ON LOANS AND INVESTMENTS AND THE INTEREST PAID ON DEPOSITS AND BORROWINGS. Our earnings are significantly dependent on our net interest income. We expect that we will periodically experience "gaps" in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to our position, this "gap" may work against us, and our earnings may be negatively affected. We are unable to predict fluctuations of market interest rates, which are affected by many factors, including the following: - inflation; - recession; - a rise in unemployment; - tightening money supply; and - domestic and international disorder and instability in domestic and foreign financial markets. Although our asset/liability management strategy is designed to control our risk from changes in market interest rates, we may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Market Risk -- Interest Rate Sensitivity." LOSS OF OUR SENIOR EXECUTIVE OFFICERS OR OTHER KEY EMPLOYEES COULD IMPAIR OUR RELATIONSHIP WITH OUR CUSTOMERS AND ADVERSELY AFFECT OUR BUSINESS. Our success is dependent upon the continued service and skills of James A. Taylor, our Chairman of the Board and Chief Executive Officer, and other senior officers. Loss of the services of any of these key personnel could have a negative impact on our business because of their skills, years of industry experience and the difficulty of promptly finding qualified replacement personnel. OUR BUSINESS IS DEPENDENT ON TECHNOLOGY, AND AN INABILITY TO INVEST IN TECHNOLOGICAL IMPROVEMENTS MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. We have consolidated all of our operations into a centralized data processing network and have recently upgraded our management information systems. Our future success will depend in part upon our ability to create additional efficiencies in our operations, particularly in light of our past and projected growth strategy. Many of our competitors have substantially greater resources to invest in technological improvements. There can be no assurance that our technological improvements will increase our operational efficiency or that we will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. ALTHOUGH PUBLICLY TRADED, OUR COMMON STOCK HAS SUBSTANTIALLY LESS LIQUIDITY THAN THE AVERAGE TRADING MARKET FOR A STOCK QUOTED ON THE NASDAQ NATIONAL MARKET, AND OUR PRICE MAY FLUCTUATE IN THE FUTURE. Although our common stock is listed for trading on the National Market of the Nasdaq Stock Market, the trading market in our common stock has substantially less liquidity than the average trading market for companies quoted on the Nasdaq National Market. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Although we believe that this offering will improve the liquidity of the market for our common stock, no assurance can be given that the offering will increase the volume of trading in our common stock. The market price of our common stock may fluctuate in the future, and these fluctuations may be unrelated to our performance. General market price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. COMPETITION WITH OTHER FINANCIAL INSTITUTIONS COULD ADVERSELY AFFECT OUR PROFITABILITY. We face vigorous competition from banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions. A number of these banks and other financial institutions have substantially greater resources and lending limits, larger branch systems and a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Some of our nonbank competitors are not subject to the same extensive regulations that govern us. This competition may reduce or limit our margins on banking services, reduce our market share and adversely affect our results of operations and financial condition. IF A CHANGE IN CONTROL OR CHANGE IN MANAGEMENT IS DELAYED OR PREVENTED, THE MARKET PRICE OF OUR COMMON STOCK COULD BE NEGATIVELY AFFECTED. Provisions in our corporate documents, as well as certain federal and state regulations, may make it difficult, and expensive, to pursue a tender offer, change in control or takeover attempt that our board of directors opposes. As a result, our stockholders may not have an opportunity to participate in such a transaction, and the trading price of our stock may not rise to the level of other institutions that are more vulnerable to hostile takeovers. Anti-takeover provisions contained in our Restated Certificate of Incorporation also will make it more difficult for an outsider to remove our current board of directors or management. THERE ARE RESTRICTIONS ON THE BANK'S ABILITY TO PAY DIVIDENDS WHICH MAY BE NECESSARY TO FUND OUR OPERATIONS. We conduct our principal business operations through our subsidiaries. We will derive cash available to pay dividends and fund our operations primarily, if not entirely, from dividends paid by our subsidiaries. The Bank is regulated by Alabama laws restricting the declaration and payment of dividends to 90% of annual net income until its surplus funds equal at least 20% of its capital stock. The Bank has surplus in excess of this amount as of December 31, 2001. As a member of the Federal Reserve System, The Bank is also subject to dividend limitations imposed by the Federal Reserve. Federal law further prohibits an insured institution from making any capital distribution, including dividends, if after making the distribution, the institution would not satisfy one or more of its minimum capital requirements. Moreover, the federal bank regulatory agencies also have the general authority to limit dividends paid by insured banks if such payments may be deemed to constitute an unsafe or unsound banking practice. THE AMOUNT OF OUR COMMON STOCK OWNED BY AND OTHER COMPENSATION ARRANGEMENTS WITH OUR OFFICERS AND DIRECTORS MAY IMPEDE POTENTIAL TAKEOVERS. As of December 31, 2001, directors and executive officers owned or controlled approximately 31% of the outstanding shares of our common stock. See "Principal Stockholders." Accordingly, if the directors and executive officers were to act in concert, they would likely have the ability to control the board of directors and therefore, our business and policies. As a result, our management has significant control. In addition, our Executive Incentive Compensation Plan provides that participants will receive a one-time cash bonus equal to 3% of the amount that the total market capitalization (as defined in the plan) on the determination date exceeds the total market capitalization on January 5, 2000. Currently, there is only one participant in this plan. The determination date is the earlier of January 5, 2003 or the date we cease to be a public company. Employment agreements with our senior management also provide for significant payments under certain circumstances following a change in control. These compensation arrangements, common stock ownership of our board and management, along with the potential exercises of stock options, could make it difficult or expensive to obtain majority support for stockholder proposals or potential acquisitions of us that our directors and officers oppose. See "Management -- Employment Agreements" and " -- Incentive Plans" beginning on pages 59 and 61, respectively. THE MARKET PRICE OF OUR SHARES MAY DECLINE AS A RESULT OF SUBSTANTIAL SALES OF OUR COMMON STOCK. Upon completion of this offering, we will have outstanding 17,716,445 shares of common stock. The 3,000,000 shares of common stock sold in this offering and the 470,000 shares that we assume are issuable by us in connection with our acquisition of CF Bancshares will be freely tradeable without restriction or further registration under the federal securities laws unless held by our "affiliates" as that term is defined in Rule 144 under the Securities Act. We and our directors and executive officers have agreed that we will not, for a period of 180 days following the date of this prospectus, without the prior written consent of Sandler O'Neill & Partners, L.P., dispose of or hedge any of our common stock. Following this offering, based on the share ownership of such persons as of December 31, 2001 and assuming no exercise of the underwriters' over-allotment option and assuming that 470,000 shares will be issued by us in connection with our acquisition of CF Bancshares, our directors and officers will in the aggregate hold approximately 23% of our common stock, not including shares issuable upon the exercise of options and warrants. Future sales or the perception that such sales could occur at the expiration of the 180 day period by us or our directors or our executive officers could adversely affect the prevailing market price of our common stock. RECENT TERRORIST ATTACKS IN THE UNITED STATES HAVE AFFECTED THE STOCK MARKET AND THE GENERAL ECONOMY. On September 11, 2001, terrorists carried out attacks that destroyed the World Trade Center in New York and badly damaged the Pentagon outside Washington, D.C. In the wake of these attacks, stock prices broadly declined from the prices that existed prior to the attacks. In addition to affecting the stock markets, the terrorist attacks may affect the national and international economies because of the uncertainties that exist as to how the United States will respond in the future and as to whether additional attacks will be carried out against the United States. These uncertainties contributed to a slowdown in economic activity in the United States in the fourth quarter of 2001. The weakened economy did have and may in the future have the effect of decreasing our loan demand and increasing our loan delinquencies.

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+RISK FACTORS This offering involves a high degree of risk. You should carefully consider the risks described below, together with all of the other information included in this prospectus, before deciding whether to invest in our common stock. If any of the following risks actually occurs, there could be a material adverse effect on our business, financial condition or results of operations. In this case, the trading price of our common stock could decline, and you could lose all or part of your investment. Risks Related to Our Business Because we are dependent on the higher education industry, unfavorable events impacting the higher education market could adversely affect our business, financial condition and results of operations. Substantially all of our clients are colleges and universities. Unfavorable events or economic conditions adversely impacting the higher education market could have a material adverse effect on our business, financial condition and results of operations. For example, a general economic downturn could further intensify the competitive pressures facing colleges and universities that constitute a significant market for our services. Unfavorable events or adverse economic conditions could decrease our pool of potential clients or affect the willingness or financial ability of post-secondary institutions to engage us as a service provider. If our existing clients do not renew or upgrade our services upon expiration of a contract or if we fail to persuade additional post-secondary institutions to use our services, our revenues and results of operations will be adversely affected. Historically, when providing technology management services, we have formed long-term relationships with our clients. A significant portion of our revenues comes from renewals of or upgrades to existing contracts prior to their expiration. If our clients do not renew or upgrade expired contracts, our revenues and results of operations will be adversely affected. Because our services typically cost more than our clients have historically budgeted for such expenses, we must convince clients that our services will generate a sufficient return to justify the additional investment. Our ability to increase revenues will be impaired if we are unsuccessful in persuading additional colleges and universities to use our services. Due to the importance that our potential clients in the higher education market place on referrals and reputation during the selection of vendors, our failure or inability to meet a client's expectations may harm our reputation and adversely affect our business. We believe the higher education market is unique in the importance that colleges and universities place on reputation and trust. We depend on our existing relationships with clients and our reputation for high-quality professional services and integrity to attract and retain clients. Because client referrals are an important component in obtaining new engagements in the higher education market, a failure or inability to meet a client's expectations could seriously damage our reputation and adversely affect our ability to attract new business. A reduction in government funding to our clients could have a negative effect on our revenues. Federal and state governments provide various forms of direct and indirect support for higher education in the form of direct appropriations, subsidies, grants and guaranteed student loan programs. Accordingly, most of the colleges and universities that we serve or intend to serve depend substantially on government funding. The government appropriations process is often slow, unpredictable and subject to economic and political factors outside our control. During 2001, we derived 16% of our revenue from services provided to New Jersey-based community colleges and 16% from services provided to Florida-based community colleges. Curtailments or substantial reductions in government- Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement. funded or sponsored institutions and programs, or termination or renegotiation of government-funded contracts, could have a material adverse impact on or result in the delay or termination of our revenues associated with these programs and contracts. Additionally, certain of our contracts provide that if the client is affected by a reduction in funding, then the amounts owed to us may be reduced, subject to a pro rata reduction in the level of services we provide. If growth in the use of technology in higher education does not continue or continues more slowly than we expect, demand for our services may decrease and our revenues could decline. Our business is dependent upon continued growth in the use of technology in education by our clients and prospective clients. The successful use of new technology in education generally requires that students, faculty and administrators understand and accept the new technology. Institutions that have already invested substantial resources in traditional operations, systems, administration and educational techniques may be reluctant or slow to adopt a new approach if they perceive that the new technology will be rejected by students, faculty or administrators or that it may make some of their existing personnel and infrastructure obsolete. If the growth in the use of technology does not continue or continues more slowly than we expect, demand for our services may decrease and our revenues could decline. Our success is dependent on our ability to attract and retain key personnel in a highly competitive marketplace. Our business involves the delivery of professional and technical services and is labor intensive. Our performance depends on the continued service of our key technical employees and client managers and our ability to continue to attract, train, retain and motivate such personnel. Competition for such personnel is intense, particularly for highly skilled and experienced technology personnel and client managers who also have backgrounds serving higher education. Such technical personnel are in great demand and are likely to remain a limited resource for the foreseeable future. Competitive forces may require us to increase the compensation of our personnel. We may not be able to pass any such increase on to our clients. As a result, we may not be able to attract or retain sufficient numbers of highly skilled employees in the future. The inability to do so could have a material adverse effect upon our business, operating results or financial condition. Our ability to achieve our growth strategy also depends in large part upon the efforts of our senior management. The loss of the services of one or more of our key officers could adversely affect our business and operating results. Our failure to anticipate technological advances or meet evolving industry standards could adversely affect the value of our services to existing and prospective clients and could result in decreased demand for our services. Our success will depend, in part, on our ability to anticipate and develop solutions that keep pace with changes in information technology, evolving industry standards and changing client needs and preferences. To successfully serve our clients, we must stay abreast of new technology initiatives, including administrative systems and academic courseware. In addition, we must anticipate and effectively respond to changes within the higher education industry, especially changes in how our clients deliver education services to students. Our failure to anticipate and address these developments could have a material adverse effect on our business, financial condition or results of operations. In addition, services or technologies developed by third parties may render our services less competitive. Potential liability claims from our services may adversely affect our business. Our services, especially the management of a substantial portion of an institution's technology resources, involve key aspects of computer systems and are typically critical to a client's operations. Failures in a client's system could result in a claim for substantial damages against us, regardless of our If any of the securities being registered on this Form are being offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. actual responsibility or the terms in our client contracts. In addition, although we believe that our services and procedures do not infringe upon the proprietary rights of third parties, we cannot be certain that such a claim would not be asserted against us. Any infringement claim against us could result in costly litigation or a materially adverse settlement, regardless of the merits of such litigation. We maintain general liability insurance coverage, including coverage for errors and omissions and coverage against infringement claims. Our general liability insurance coverage has an aggregate policy limit of $22 million. Our errors and omissions coverage has a policy limit of $10 million. However, such coverage may not continue to be available on acceptable terms, or may not be available in sufficient amounts to cover one or more large claims. The successful assertion of one or more large claims against us that exceed available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could each have a material adverse effect on our business, financial condition and results of operations. Although we attempt to contractually limit our liability, we may be legally prevented from doing so with respect to certain clients. Our failure to accurately estimate the expenses required to complete our contracts may adversely impact our financial condition and results of operations. Substantially all of our revenues are generated under long-term fixed-price contracts that subject us to the risk of cost overruns and inflation. In the future we may not be able to include inflation adjustments in our contracts or to successfully manage our individual project costs. In addition, changes in the scope of services to be provided, estimates of percentage completed or profitability may result in revisions to our revenue. If we fail to accurately estimate the resources and related expenses required for a contract or fail to complete our contractual obligations in a manner consistent with the budget upon which the contract was based, our business, financial condition and results of operations could be adversely impacted. The variability and length of the sales cycle for our services may make our operating results unpredictable and volatile. Approval of our engagement as an institution's technology partner by a college or university may require input from, and the authorization of, several different constituencies, including the institution's administrators, faculty and board of trustees or other governing body. In certain instances the approval of state or local government agencies or regulatory bodies may be required before an engagement can be finalized. As a result, the period between our initial contact with a potential customer and the purchase of our services by that customer typically ranges from three to nine months. Other factors that contribute to our long sales cycle include: the large size and scope of our potential engagement; our need to educate potential clients about the benefits of our services; competitive evaluations by clients; and the client's internal budgeting and approval processes. Our long sales cycle makes it difficult for us to predict if and when a potential engagement will actually occur. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine. Our revenues, operating results and profitability will fluctuate from quarter to quarter, which may result in increased volatility of our share price. Variations in our revenues, operating results and profitability from quarter to quarter have occurred in the past, and are likely to occur in the future. These variations may result from a number of factors, including: the timing, size and scope of new client engagements; the termination of, or failure to renew or upgrade existing client engagements; fluctuations in our reported gross profit due to expenses in excess of budgeted amounts; and general economic conditions. Due to the foregoing factors, it is possible that in some future periods our results of operations will be below the expectations of public market analysts and investors. This may lead to volatility in our share price. Our success is dependent upon our relationships and contracts with certain key clients. We have derived and expect to continue to derive a significant portion of our revenue from a relatively limited number of clients. Our top five clients accounted for approximately 24.3% of our revenue in 2001. For the six months ended June 30, 2002, our top five clients accounted for approximately 28.1% of our revenue. The loss of any one or more of our major clients could have a material adverse effect on our business, financial condition or results of operations. Our continued growth could strain our financial, managerial and human resources, which may harm our business. We continue to experience significant growth, which has placed, and could continue to place, a strain on our financial, managerial and human resources. From December 31, 1997 through June 30, 2002, the number of our full-time employees increased from approximately 290 to over 790. We expect that the number of our employees will continue to increase for the foreseeable future and such increases may occur in large groups as a result of signing large client contracts. Our future performance and profitability will depend on our ability to integrate new employees into our workforce successfully, particularly in light of the decentralized nature of our workforce. To manage our growth, we must continue to implement and improve our managerial controls and procedures along with our operational and financial systems. We may not have made adequate allowances for the costs associated with this expansion, our systems, procedures or controls may be inadequate to support our operations and our management may be unable to successfully offer and expand our services. If we are unable to manage our growth effectively, our business, results of operations and financial condition could be materially adversely affected. We operate in a highly competitive market and increasing competition could result in decreased demand for our services, lower margins and loss of market share. The market for professional and technology management services is competitive, highly fragmented and subject to rapid technological change. Our primary competitive challenge is overcoming the initial resistance to our services from the internal information technology departments of our prospective clients. We compete for clients and experienced personnel with a number of companies having significantly greater financial, technical and marketing resources and revenues than we have. Our competitors include systems consulting and integration services providers, software and professional service organizations and general management consulting firms. Current and potential competitors may make strategic acquisitions or establish cooperative relationships to increase their service offerings to post-secondary institutions. Accordingly, it is possible that new competitors or alliances may emerge and rapidly gain significant market share. Increased competition could result in downward pricing pressures and loss of market share for us. Our failure to successfully integrate any future acquisitions could strain our managerial, operational and financial resources. We may, from time to time, pursue acquisitions of businesses, products or technologies that complement or expand our existing business to meet client and market demands for new services or enhanced skills. Our success in executing our acquisition strategy will depend on our ability to identify potential targets that meet our criteria, including a reputation as a leading service provider with strong client relationships and a complementary culture. Our management has had limited experience in making acquisitions, and we may not be able to complete the acquisitions on acceptable terms or we may not be able to successfully integrate any acquired assets or businesses into our operations. Acquisitions involve a number of risks, including the diversion of management's attention from day-to-day operations to the assimilation of the operations and personnel of the acquired companies and the incorporation of acquired operations, customer lists, products or technologies. In addition, we may require additional debt or equity financing to consummate future acquisitions, which financing may not be available on terms satisfactory to us, if at all. We may issue shares of our common stock as part of the consideration for an acquisition, which may dilute our earnings per share. We cannot assure you that any acquisitions will be successfully completed or that, if one or more acquisitions is completed, the acquired businesses, products or technologies will generate sufficient revenue to offset the associated costs or other adverse effects. Misuse or misappropriation of our proprietary rights could adversely affect our results of operations. Although we do not develop software or systems for license, our performance is in part dependent upon our internal information and communication systems, databases, tools, and the methodologies that we have developed to serve our clients. We have no patents and consequently, we rely on a combination of nondisclosure and other contractual arrangements and copyright, trademark and trade secret laws to protect our proprietary systems, information and procedures. In addition, we enter into and rely upon confidentiality agreements with our employees and clients and limit access to and distribution of our proprietary information. The steps that we take to protect our proprietary rights may not be adequate to prevent the misappropriation of our proprietary rights. In addition, we may not detect unauthorized use or take appropriate steps to enforce our proprietary rights. Ownership of intellectual property created in providing services to our clients is the subject of negotiation and is frequently assigned to the client. We generally retain the right to use any intellectual property that is developed during a client engagement that is of general applicability and is not specific to the client engagement. Issues relating to the ownership of and rights to use intellectual property developed during the course of a client engagement can be complicated, and clients may demand assignment of ownership or restrict the use of the work that we produce in the future. In addition, disputes may arise that affect our ability to resell or reuse such intellectual property. Risks Related to this Offering Because there has been no prior public market for our common stock, we cannot predict the extent of investor interest in our common stock and the market price of the common stock may decline below the initial public offering price. Prior to this offering, there has been no public market for our common stock. We cannot predict the extent to which investor interest in our common stock will lead to the development of an active trading market or how liquid that market might become. The market price of the common stock may decline below the initial public offering price. The initial public offering price for the shares has been determined by negotiations between us and the representatives of the underwriters and may not be indicative of prices that will prevail in the trading market following the completion of this offering. The trading price of our common stock could fluctuate significantly. The stock market has experienced significant price and volume fluctuations that have affected the market prices of companies in recent years. These fluctuations may continue to occur and disproportionately impact our stock price. Factors that could have a significant impact on the market price of our common stock include: actual or anticipated variation in quarterly operating results; failure to achieve, or changes in, financial estimates or recommendations of securities analysts; a downturn in the higher education market generally; additions or departures of key personnel; announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments; reductions in funding for post-secondary institutions; and general market conditions. In particular, the realization of any of the risks described in these "Risk Factors" could have a dramatic and material adverse impact on the market price of our common stock. In the past, following periods of volatility in the market price of a company's securities, securities class-action litigation has often been instituted. This type of litigation could result in substantial costs and a diversion of management's attention and resources, which could materially affect our business, financial condition or results of operations. The future sale of shares of our common stock by existing stockholders may negatively affect our stock price. If our existing stockholders sell substantial amounts of our common stock, including shares issuable upon the exercise of outstanding options in the public market following this offering, the market price of our common stock could fall. These sales also might make it more difficult for us to sell equity securities in the future at a time and price that we deem appropriate. After this offering, we will have outstanding shares of common stock. Of these shares, the shares being offered in this offering will be freely tradable. Our directors, executive officers, existing stockholders and warrant holders and substantially all of our option holders have agreed to the lock-up restrictions described in "Underwriting." After these lock-up agreements expire 180 days from the date of this prospectus, an additional shares will be eligible for sale in the public market. Sales of substantial amounts of common stock (including shares issued in connection with future acquisitions that may be issued with registration rights), or the availability of such shares for sale, may adversely affect the prevailing market price for the common stock and could impair our ability to obtain additional capital through an offering of our equity securities. You will incur immediate and substantial dilution and may experience further dilution. The initial public offering price of our common stock is substantially higher than the pro forma net tangible book value per share of the outstanding common stock immediately after the offering. If you purchase common stock in this offering, you will incur immediate and substantial dilution in the pro forma net tangible book value per share of the common stock from the price you pay for the common stock. To the extent outstanding options and warrants to purchase common stock are exercised, there The information contained in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED AUGUST 8, 2002 Shares Common Stock will be further dilution. Moreover, there can be no assurance that we will not require additional funds to support our working capital requirements or for other purposes, in which case we may seek to raise such additional funds through public or private equity financings or from other sources. Any such financing may result in additional dilution to our stockholders. Control by principal stockholders may delay or prevent a change of control of us, which could adversely affect the market price of our common stock. Upon completion of this offering, certain of our existing shareholders will continue to beneficially own a significant percentage of our outstanding common stock and will have substantial ability to control matters submitted to our stockholders for approval, including the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets, and to control our management and affairs. Accordingly, this concentration of ownership may have the effect of delaying, deferring or preventing a change in control of us, impeding a merger, consolidation, takeover or other business combination involving us or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of us, which in turn could materially adversely affect the market price of our common stock. A third-party could be prevented from acquiring your shares of stock at a premium to the market price because of our anti-takeover provisions in our charter and bylaws and Delaware law. The following provisions of our certificate of incorporation and by-laws may discourage, delay or prevent a merger or acquisition that you may consider favorable, including transactions in which you might otherwise receive a premium for your shares: the ability of our board of directors to issue preferred stock, and determine its terms, without a stockholder vote; our classified board of directors, which effectively prevents stockholders from electing a majority of the directors at any one annual meeting of stockholders; the requirement that any business combination transaction that is not approved by a majority of the directors be approved by the holders of at least 662/3% of our outstanding common stock; the prohibition against stockholder actions by written consent; and the inability of stockholders to call a special meeting of stockholders. In addition, some provisions of Delaware law, particularly the "business combinations" statute in Section 203 of the Delaware General Corporation Law, may also discourage, delay or prevent someone from acquiring us or merging with us. See "Description of Capital Stock" for detailed information on these provisions. We have broad discretion to use the proceeds from this offering, and our use of these proceeds may not yield a favorable return. We have not identified specific uses for a significant portion of the net proceeds of this offering. Accordingly, our management will have significant flexibility in applying the net proceeds of this offering. Although we have no plans, commitments or agreements with respect to any material acquisitions as of the date of this prospectus, we may seek acquisitions of businesses that are complementary to ours, and a portion of the net proceeds may be used for such acquisitions. Because it is unlikely that we will pay dividends, you will only be able to benefit from holding our stock if the stock price appreciates. We have never declared or paid any cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. We presently intend to retain any future earnings for funding growth and, therefore, do not expect to pay any dividends in the foreseeable future. As a result of not collecting a dividend, you will not experience a return on your investment, unless the price of our common stock appreciates and you sell your shares of common stock. Prior to this offering, there has been no public market for our common stock. The initial public offering price of the common stock is expected to be between $ and $ per share. We will apply to have our common stock quoted on The Nasdaq Stock Market's National Market under the symbol "CLGS." We are selling shares of common stock and the selling stockholders are selling an aggregate of shares of common stock. We will not receive any of the proceeds from the shares of common stock sold by the selling stockholders. The underwriters have an option to purchase a maximum of additional shares from certain selling stockholders to cover over-allotments of shares. Investing in our common stock involves risks. See "Risk Factors" on page 7. Price to Public

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+RISK FACTORS You should carefully consider the risks described below before making a decision regarding an investment in our common stock. If any of the following risks actually occur, our business could be harmed, the trading price of our common stock could decline and you may lose all or part of your investment. You should also refer to the other information contained in this prospectus, including our financial statements and the related notes. Our future revenues are unpredictable, our operating results are likely to fluctuate from quarter to quarter, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly. Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside of our control. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance. Some of the factors that could cause our quarterly or annual operating results to fluctuate include market acceptance of our products, ongoing product development and production, competitive pressures and customer retention. It is likely that in some future quarters our operating results may fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock would significantly decline. Because our expense levels are based in large part on estimates of future revenues, an unexpected shortfall in revenue would significantly harm our results of operations. Our expense levels are based largely on our investment plans and estimates of future revenue. RAE may be unable to adjust our spending to compensate for an unexpected shortfall in revenue. Accordingly, any significant shortfall in revenue relative to Our planned expenditures in a particular quarter would harm our results of operations and could cause our stock price to fall sharply, particularly following quarters in which our operating results fail to meet the expectations of securities analysts or investors. Our investment in REnex will cause us to incur losses that we would not otherwise incur. We own approximately 47 percent of, and have management control over, REnex, a wireless systems development company. As such, we are required to consolidate REnex s financial statements. REnex is still in the research and development stage, and to date, REnex has not generated any revenues. If REnex does not begin to generate revenues at the level we anticipate or otherwise incurs greater losses, we could incur greater losses than we anticipate and our results of operations will suffer. Compensation expenses related to past option grants will reduce our earnings over the next four years. Options granted to our employees have historically had exercise prices equal to the fair market value of our common stock on the date of grant, as determined by our board of directors at the time of grant. In connection with our merger with Nettaxi.com, for financial reporting purposes, we reevaluated the fair value of our common stock during the periods in which stock options were granted. In this regard, we recorded aggregate unearned compensation of $1,002,100, of which $333,500 had been recognized as of March 31, 2002, and the remaining $668,600 will be recognized in future periods as non-cash compensation. In addition, there might be further non-cash compensation charges relating to our stock options and such future charges could be significant. These adjustments will have a negative effect on our earnings and results of operations. We may be unable to meet our future capital requirements. any attempts to raise additional capital in the future may cause substantial dilution to our stockholders. We may need to seek additional funding in the future and it is uncertain whether we will be able to obtain additional financing on favorable terms, if at all. Further, if we issue equity securities in connection with Robert I. Chen Chief Executive Officer RAE SYSTEMS INC. 1339 Moffett Park Drive Sunnyvale, California 94089 (408) 752-0723 (Name, address, including zip code, and telephone number, including area code, of agent for service) additional financing, our stockholders may experience dilution and/or the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which could seriously harm our business. Should the benefits of our inventory procurement strategy in Asia not materialize as we anticipate, our results of operations may suffer As part of our overall strategy to increase gross margins and improve operating results, we have devised a strategy to procure a number of our component parts from Asia. Our current strategy involves the purchase of parts in, and delivery of parts from our vendors, to the United States. The parts are then kitted, and shipped to Shanghai, where the subassemblies are made. The proposed strategy involves the procurement of component parts in Asia, where the effective price is much lower. The parts would be shipped directly to Shanghai, thereby reducing the transit time and shipping cost of the inventory. Further, executing the proposed strategy, may have some adverse consequences. Our vendors have to be qualified to ensure that the parts are of acceptable quality and meet the requisite specifications called for by engineering drawings. A significant amount of time and funding may be required to complete the analysis. Should we fail to execute on our proposed procurement strategy in a timely and effective manner, our results of operations may suffer. We depend on our distributors We derive approximately 90% of our revenues via our sales distribution channels, and therefore are dependant on our distributors. Should any of our principal distributors, or a significant group of our distributors, experience financial difficulties or become unwilling to promote and sell our products, our business and results of operations could be materially harmed. We depend on third party suppliers We are dependent on third party suppliers for our component parts, including various sensors, microprocessors and other material components. Should there be any interruption in the supply of these component parts, our business could be adversely affected. If our expansion from a gas detection instrument manufacturer to a wireless systems company is unsuccessful, our business and results of operations will suffer We are in the process of expanding our current business of providing gas detection instruments to include wireless systems for local and remote security monitoring. The pricing of our wireless products and services may be subject to rapid and frequent change. We may be forced for competitive or technical reasons to reduce prices for our wireless products, which would reduce our revenue and could harm our business. Further, the wireless systems market is still evolving, and we have little basis to assess the demand for our wireless products and services or to evaluate whether our wireless products and services will be accepted by the market. If our wireless products and services do not gain broad market acceptance, our business and results of operations will be harmed. The economic downturn in the United States and abroad could have a material adverse impact on our business and results of operations While our business to date has been minimally impacted by the current economic downturn in the United States and abroad, it could eventually succumb to such conditions. Many of our customers have already experienced severe declines in their revenues, which could impact the size and frequency of their purchases of Please send copies of all communications to: Joseph Ng Peter M. Astiz, Esq. Vice President, Business Development and Eric H. Wang, Esq. Chief Financial Officer David B. Leeb, Esq. RAE Systems Inc. Gray Cary Ware & Freidenrich LLP 1339 Moffett Park Drive 400 Hamilton Avenue Sunnyvale, California 94089 Palo Alto, California 94301-1825 (408) 752-0723 (650) 833-2000 Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement. If the only securities being registered on this Form are being offered pursuant to dividend or interest reinvestment plans, please check the following box. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, other than securities offered only in connection with dividend or interest reinvestment plans, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. our products and services. Although we routinely perform credit checks on our customer base to assess their creditworthiness, there can be no assurance that we will be able to collect payments from our customers as they become due. Any decrease in the size or frequency of purchases by our customers, or a failure by us to collect payments as they become due could have a material adverse impact on our business and results of operations. Compliance with safety regulations could delay new product delivery and adversely affect our results of operations Compliance with safety regulations, specifically the need to obtain UL, CUL, ATEX and EEX approvals, could delay the introduction of new products by us. As a result, we may experience delays in realizing revenues from our new products, which could have an adverse effect on our results of operations. A deterioration in trade relations with China could have a material adverse effect on our business and results of operations A significant portion of our products and components are manufactured at our wholly-owned facility in Shanghai, China. Should trade relations between the United States and China deteriorate, our ability to transfer products between China and other regions of the world, including the United States, Asia and Europe, could be significantly impacted. As a result, our business and results of operations would suffer. We are involved in pending legal proceedings On November 21, 2001, we filed a patent infringement claim in the United States District Court of the Northern District of California against Ion Science and its distributors. The suit alleges that Ion Science manufactures, uses, imports into the United States, offers for sale, and sells photo-ionization detectors, including but not limited to the PhoCheck line of photo-ionization detectors. The suit further alleges that Ion Science s photo-ionization detectors, including but not limited to its PhoCheck line of photo-ionization detectors, infringe patents held by us. We intend to pursue the lawsuit vigorously. We expect to incur substantial legal fees and expenses in connection with the litigation, which may also result in the diversion of our internal resources. As a result, our pursuit of this litigation, regardless of its eventual outcome, could be costly and time consuming. The litigation is in the preliminary stage, and we are unable to predict its final outcome. However, an adverse outcome could materially affect our results of operations and financial position. On October 23, 2001, the estate of Virgil Johnson filed a products liability and wrongful death lawsuit against us in the District Court of Harris County, Texas. The plaintiffs allege that our product was defective and unsafe for its intended purposes at the time it left our premises, and that the product was defective in that it failed to conform to the product design and specifications of other gas monitors. Additionally, the plaintiffs allege that the product was defectively designed and marketed so as to render it unreasonably dangerous to the plaintiff. In the event that we do not have adequate insurance coverage for the expenses related to the lawsuit, we may incur substantial legal fees and expenses in connection with the litigation. The litigation may also result in the diversion of our internal resources. Our defense of this litigation, regardless of its eventual outcome, will likely be costly and time consuming. The litigation is in the preliminary stage, and we are unable to predict its final outcome. However, an adverse outcome could materially affect our results of operations and financial position. On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against us in the Superior Court of the State of California for the County of Santa Clara. A similar lawsuit pending in District Court of Harris County, Texas was served on us on March 27, 2002. In these nearly identical lawsuits, Straughan, a distributor of Gastec Gas Detection Devices, claims to have experienced diminished sales to its customers, loss of profits and other damages as a result of the stated allegations, which include claims for interference with present and prospective business relations, false advertising, trade dress infringement, slander and antitrust violations. On April 17, 2002, we removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, we removed the Texas action to the United States District Court for the CALCULATION OF REGISTRATION FEE Southern District of Texas. In the event that we do not have adequate insurance coverage for the expenses related to the lawsuit, we may incur substantial legal fees and expenses in connection with the litigation. The litigation may also result in the diversion of our internal resources. Our defense of this litigation, regardless of its eventual outcome, will likely be costly and time consuming. The litigation is in the preliminary stage, and we are unable to predict its final outcome. However, an adverse outcome could materially affect our results of operations and financial position. In addition to the litigation described above, from time to time we may be subject to various legal proceedings and claims that arise in the ordinary course of business. The market for gas detection monitoring devices is highly competitive, and if we cannot compete effectively, our business may be harmed The market for gas detection monitoring devices is highly competitive. We expect the emerging wireless gas monitoring system market to be equally competitive. Competitors in the gas monitoring industry differentiate themselves on the basis of their technology, quality of product and service offerings, cost and time to market. In the market for gas detection monitoring devices, our primary competitors include Industrial Scientific Corporation, Mine Safety Appliances Company, BW Technologies, PerkinElmer, Inc., Drager Safety Inc., Gastec Corporation, and Bacou-Dalloz. Most of our competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than us. In addition, some of our competitors may be able to: devote greater resources to marketing and promotional campaigns; adopt more aggressive pricing policies; or devote more resources to technology and systems development. In light of these factors, we may be unable to compete successfully. We may not be successful in developing our brand, which could prevent us from remaining competitive We believe that our future success will depend on our ability to maintain and strengthen the RAE Systems brand, which will depend, in turn, largely on the success of our marketing efforts and ability to provide our customers with high-quality products. If we fail to successfully promote and maintain our brand, or incur excessive expenses in attempting to promote and maintain our brand, our business will be harmed. We may not be able to recruit or retain qualified personnel Our future success depends on our ability to attract, retain and motivate highly skilled employees. Despite the recent economic slowdown, competition for qualified employees in the Silicon Valley, particularly management, technical, sales and marketing personnel, is intense. Although we provide compensation packages that include stock options, cash incentives and other employee benefits, we may be unable to retain our key employees or to attract, assimilate and retain other highly qualified employees in the future, which could harm our business. Our business could suffer if we lose the services of any of our executive officers Our future success depends to a significant extent on the continued service of our executive officers, including Robert I. Chen, Joseph Ng, Peter Hsi and Robert Henderson. The loss of the services of any of our executive officers could harm our business. Title of Each Class of Securities to be Registered(1) Amount to be Registered(2) Proposed Maximum Offering Price Per Share(3) Proposed Maximum Aggregate Offering Price(3) Amount of Registration Fee(4) We might not be successful in the development or introduction of new products and services in a timely and effective manner Our revenue growth is dependent on the timely introduction of new products to market. We may be unsuccessful in identifying new product and service opportunities or in developing or marketing new products and services in a timely or cost-effective manner. In addition, product innovations may not achieve the market penetration or price stability necessary for profitability. Our officers, directors and principal stockholders beneficially own approximately 53% of our common stock and, accordingly, may exert substantial influence over the company Our executive officers and directors and principal stockholders, in the aggregate, beneficially own approximately 53% of our common stock. These stockholders acting together have the ability to control all matters requiring approval by our stockholders. These matters include the election and removal of the directors, amendment of our certificate of incorporation, and any merger, consolidation or sale of all or substantially all of our assets. In addition, they may dictate the management of our business and affairs. Furthermore, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination, and may substantially reduce the marketability of our common stock. Future sales of our common stock by existing stockholders could adversely affect our stock price Sales of substantial amounts of our common stock in the public market in connection with this offering could reduce the prevailing market prices for our common stock. We have registered the resale of 44,847,933 shares of common stock on a registration statement on Form S-1, of which this prospectus is a part. Of these shares, approximately 12,412,287 are subject to six month lock-up agreements set to expire on October 9, 2002 and 23,261,326 are subject to one year lock-up agreements set to expire on April 9, 2003. Upon the expiration of the lock-up agreements, these shares will be eligible for resale. Future sales by the holders of such shares could adversely affect the trading price of our common stock. Our facilities and operations are vulnerable to natural disasters and other unexpected losses Our success depends on the efficient and uninterrupted operation of our business. Our facilities in Sunnyvale, California, are in an area that is susceptible to earthquakes. We do not have a backup facility to provide redundant capacity in the event of a natural disaster or other unexpected damage from fire, floods, power loss, telecommunications failures, break-in and similar events. If we seek to replicate our operations at other locations, we will face a number of technical as well as financial challenges, which we may not be able to address successfully. Although we carry property and business interruption insurance, our coverage may not be adequate to compensate us for all losses that may occur. Our business is subject to risks associated with conducting business internationally Our business is subject to risks normally associated with conducting business outside the United States, such as foreign government regulations, nation-specific or region-specific certifications political unrest, disruptions or delays in shipments, fluctuations in foreign currency exchange rates and changes in the economic conditions in the countries in which our raw materials suppliers, service providers, and customers are located. our business may also be adversely affected by the imposition of additional trade restrictions related to imported products, including quotas, duties, taxes and other charges or restrictions. If any of the foregoing factors were to render the conduct of business in a particular country undesirable or impractical, or if our current foreign manufacturing sources were to cease doing business with us for any reason, our business and results of operations could be adversely affected. We may be unable to adequately protect our intellectual property rights We regard our intellectual property as critical to our success. We rely on patent, trademark, copyright and trade secret laws to protect our proprietary rights. Notwithstanding these laws, we may be unsuccessful in protecting our intellectual property rights or in obtaining patents or registered trademarks for which we apply. Our ability to compete is affected by our ability to protect the company s intellectual property rights. We rely on a combination of patents, trade secrets, non-disclosure agreements and confidentiality procedures. Although processes are in place to protect our intellectual property rights, we cannot guarantee that these procedures are adequate to prevent misappropriation of our current technology or that our competitors will not develop technology that is similar to our own. Specifically, we cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties. Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable. Any litigation relating to our intellectual property rights, including the patent infringement claim we have filed against Ion Science described above, could, regardless of the outcome, have a materially adverse impact our business and results of operations. We might face intellectual property infringement claims that might be costly to resolve We may, from time to time, be subject to claims of infringement of other parties proprietary rights or claims that our own trademarks, patents or other intellectual property rights are invalid. Any claims of this type, regardless of merit, could be time-consuming to defend, result in costly litigation, divert management s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business. Any future acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute stockholder value or harm our results of operations We may acquire or make investments in complementary businesses, technologies, services or products if appropriate opportunities arise. The process of integrating any acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired company also may consume much of our management s time and attention that would otherwise be available for ongoing development of our business. Moreover, the anticipated benefits of any acquisition may not be realized. Future acquisitions could result in dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business. Provisions in our charter documents and Delaware law could prevent or delay a change in control of the company, which could reduce the market price of our common stock or discourage potential acquirors from offering a premium over the prevailing trading price of our common stock Provisions in our certificate of incorporation and bylaws could have the effect of delaying or preventing a change of control of the company or changes in our management. In addition, provisions of Delaware law may discourage, delay or prevent a third party from acquiring or merging with us. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions may also have the effect of discouraging or preventing a potential acquiror from offering our stockholders a premium over the prevailing trading price of our common stock.

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+RISK FACTORS You should carefully consider the risks described below, together with all of the other information in this prospectus, before making a decision to invest in our Class A common stock. If any of the following risks actually occur, our business, financial condition and results of operations could suffer. In this case, the trading price of our Class A common stock could decline, and you may lose all or part of your investment in our Class A common stock. Risks Related to Our Business and Industry We are dependent on Ford and GM as our largest customers and on selected vehicle programs. Our sales from Ford and GM represented approximately 52% and 36%, respectively, of our sales in both 2001 and 2000 and approximately 54% and 28%, respectively, of our sales in 1999. The contracts we have entered into with many of our customers provide for supplying the customers requirements for a particular vehicle platform or model, rather than for manufacturing a specific quantity of products. Such contracts range from one year to the life of the platform or model, usually three to seven years, and do not require the purchase by the customer of any minimum number of parts. Therefore, any significant reduction in demand for vehicles manufactured by Ford or GM for which we produce parts or for certain other key models or group of related models sold by any of our major customers could have a material adverse effect on our existing and future sales. Automotive OEMs have historically had significant leverage over their outside suppliers. The automotive component supply industry is fragmented and serves a limited number of automotive OEMs. As a result, OEMs have historically had a significant amount of leverage over their outside suppliers. For example, outside suppliers are subject to substantial continuing pressure from the major OEMs to reduce the cost of their products. If we are unable to generate sufficient production cost savings in the future to offset price reductions, our gross margin and profitability would be adversely affected. In addition, changes in OEMs purchasing policies or payment practices could have an adverse effect on our business. Cyclicality and seasonality in the automotive market could adversely affect us. The automotive market is highly cyclical and is dependent on consumer spending. For example, during the third and fourth quarters of 2000, OEMs reduced production levels in response to a decline in consumer demand. The decline continued throughout 2001. Economic factors adversely affecting automotive production and consumer spending could adversely impact our sales and net income. For example, production cuts by Ford and GM in 2001 adversely affected our sales and net income. Our sales in 2001 declined by approximately $51.3 million, or approximately 9.2%, compared to our sales in 2000. In addition, because we have significant fixed production costs, relatively modest declines in our customers production levels can have a significant adverse impact on our profitability. Our business is also somewhat seasonal. We typically experience decreased sales and operating income during the third calendar quarter of each year due to the impact of scheduled OEM plant shutdowns in July and August for vacations and new model changeovers. We require a significant amount of cash to service our indebtedness, which reduces the cash available to finance organic growth and strategic acquisitions, alliances and partnerships. We have a significant amount of indebtedness. As of March 31, 2002 after giving effect to this offering, our total indebtedness including current maturities would have been $ million. After giving effect to this offering, our required debt service payments under our senior credit facility during 2002, 2003 and 2004 will be $ million, $ million and $ million, respectively. Approximate date of commencement of proposed sale of the securities to the public: As soon as practicable after this Registration Statement becomes effective. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. CALCULATION OF REGISTRATION FEE Table of Contents Our indebtedness could: make us more vulnerable to unfavorable economic conditions; make it more difficult to obtain additional financing in the future for working capital, capital expenditures or other general corporate purposes; make it more difficult to pursue strategic acquisitions, alliances and partnerships; require us to dedicate or reserve a large portion of our cash flow from operations for making payments on our indebtedness, which would prevent us from using it for other purposes; and make us susceptible to fluctuations in market interest rates that affect the cost of our borrowings to the extent that our variable rate indebtedness is not covered by interest rate hedge agreements. Our ability to service our indebtedness will depend on our future performance, which will be affected by prevailing economic conditions and financial, business, regulatory and other factors. Some of these factors are beyond our control. For example, the general slowdown in the U.S. economy that resulted in lower automotive production during 2001 had a negative impact on our operations. We believe that, based upon current levels of operations, we will be able to meet our debt service obligations when due. Significant assumptions underlie this belief including, among other things, that we will continue to be successful in implementing our business strategy and that there will be no material adverse developments in our business, liquidity or capital requirements. If we cannot generate sufficient cash flow from operations to service our indebtedness and to meet our other obligations and commitments, we might be required to refinance our debt or to dispose of assets to obtain funds for such purpose. There is no assurance that refinancings or asset dispositions could be effected on a timely basis or on satisfactory terms, if at all, or would be permitted by the terms of our debt instruments. Restrictions in our debt instruments limit our ability to incur additional debt, make acquisitions and make other investments. Our debt instruments contain covenants that restrict our ability to make distributions to stockholders or other payments unless we satisfy certain financial tests and comply with various financial ratios. If we do not satisfy such tests or comply with such ratios, our creditors could declare a default under our debt instruments, and our indebtedness could be declared immediately due and payable. Our ability to comply with the provisions of our debt instruments may be affected by changes in economic or business conditions beyond our control. If we do not complete this offering or another debt-reducing transaction prior to the end of 2002, it is likely that we will not be in compliance with the total debt/ EBITDA ratio in our senior credit facility as of December 31, 2002. Our debt instruments also contain covenants that limit our ability to incur indebtedness, acquire other businesses, make capital expenditures and impose various other restrictions. These covenants could affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise. Since the April 1999 recapitalization, we have sustained significant net losses and may not achieve profitability in the future. We have experienced significant net losses since our April 1999 recapitalization. We reported net losses of $13.7 million, $9.5 million and $6.9 million in 1999, 2000 and 2001, respectively. Our net losses have resulted primarily from interest costs related to funds borrowed in connection with the recapitalization. In addition, we have incurred additional interest costs associated with borrowings to finance additional acquisitions and capital expenditures. As of March 31, 2002, we had a stockholders deficit of approximately $28.3 million. Lack of profitability would harm our financial condition and adversely impact our business. Table of Contents We are subject to certain risks associated with our foreign operations. We have significant international operations, specifically in Europe as a result of our operations in the UK and Spain. Certain risks are inherent in international operations, including: the difficulty of enforcing agreements and collecting receivables through certain foreign legal systems; foreign customers may have longer payment cycles than customers in the United States; tax rates in certain foreign countries may exceed those in the United States and foreign earnings may be subject to withholding requirements or the imposition of tariffs, exchange controls or other restrictions; general economic and political conditions in countries where we operate may have an adverse effect on their operations in those countries; the difficulties associated with managing a large organization spread throughout various countries; and required compliance with a variety of foreign laws and regulations. As we continue to expand our business globally, our success will be dependent, in part, on our ability to anticipate and effectively manage these and other risks. We cannot assure you that these and other factors will not have a material adverse effect on our international operations or our business as a whole. Currency exchange rate fluctuations could have an adverse effect on our sales and financial results. We generate a significant portion of our sales and incur a significant portion of our expenses in currencies other than U.S. dollars. To the extent that we are unable to match revenues received in foreign currencies with costs paid in the same currency, exchange rate fluctuations in any such currency could have an adverse effect on our financial results. For example, the weakening of European currencies in relation to the U.S. dollar had a negative impact on our sales of $7.2 million in 2000, $3.8 million in 2001 and $0.7 million in the first quarter of 2002. We may be adversely affected as a result of the long lead times for sales. We typically compete for business at the beginning of the development of new components, upon customer redesign of existing components and upon customer decisions to outsource captive component production. For many of our customers, including the automotive and light truck OEMs, new component development generally begins two to five years prior to the marketing of the platform(s) containing such components to the public. As a result of the relatively long lead times required for many of our complex castings, it may be difficult in the short term for us to obtain new sales to replace any unexpected decline in sales of existing components. We may incur significant expense in preparing to meet anticipated customer requirements which may not be recovered. We may not realize all of the sales expected from new program awards. The realization of additional sales from new program awards is inherently subject to a number of important risks and uncertainties, including the number of vehicles that our customers will actually produce as well as the timing of such production. In addition, our customers generally have the right to discontinue a program or replace us with another supplier at any time for a variety of reasons. As a result, all of the approximately $120 million in net new sales, expected to be fully realized by 2005, may not actually result in firm orders from customers. We also incur costs and make capital expenditures for new program awards based upon certain estimates of production volumes for certain vehicles. While we attempt to establish the price of our products for variances in production volumes, if the actual production of certain vehicle models is significantly less than planned, our sales and net income may be adversely Title of Each Class of Proposed Maximum Aggregate Amount of Securities to be Registered Offering Price (1)(2) Registration Fee Table of Contents affected. We cannot predict our customers demands for the products we supply either in the aggregate or for particular reporting periods. Our inability to compete effectively in the highly competitive automotive supply industry could result in the loss of customers, which could have an adverse effect on our sales and operating results. The automotive component supply industry is highly competitive. Some of our competitors are companies, or divisions or subsidiaries of companies, that are larger and have greater financial and other resources than we do. In addition, with respect to certain of our products, we compete with divisions of our OEM customers. Our products may not be able to compete successfully with the products of these other companies, which could result in the loss of customers and, as a result, decreased sales and profitability. In addition, our competitive position in the automotive component supply industry could be adversely affected in the event that we are unsuccessful in making strategic acquisitions or establishing joint ventures that will enable us to continue to expand our global presence. We may be unable to complete additional strategic acquisitions or we may encounter unforeseen difficulties in integrating acquisitions. The automotive component supply industry has undergone, and is likely to continue to experience, consolidation as OEMs seek to reduce costs and reduce their supplier base. We intend to actively pursue acquisition targets that will allow us to continue to expand into new geographic markets, add new customers, and provide new product, manufacturing and service capabilities or increase model penetration with existing customers. There can be no assurance that we will find attractive acquisition candidates or successfully integrate acquired businesses into our existing business. If the expected synergies from such acquisitions do not materialize or we fail to successfully integrate new businesses into our existing businesses, our results of operations could be adversely affected. For example, our operating results in 2000 were adversely affected by greater labor inefficiencies, excess scrap and premium freight costs at facilities we acquired in the Nelson acquisition. To the extent that we may be considered as an acquisition candidate by a third party, certain provisions in our certificate of incorporation and our by-laws may inhibit a change in control. We may be adversely impacted by work stoppages and other labor matters. Many OEMs and their suppliers have unionized work forces. Work stoppages or slow-downs experienced by OEMs or their suppliers could result in slow-downs or closures of assembly plants where our products are included in assembled vehicles. For example, strikes by The International Union, United Automobile, Aerospace and Agricultural Implement Workers of America, or UAW, led to the shut down of most of GM s North American assembly plants in June and July 1998, which had a negative impact on our 1998 sales. The master collective bargaining agreements between each of GM, Ford and DaimlerChrysler and the Canadian Auto Workers and the UAW expire in 2002 and 2003, respectively. In the event that one or more of our customers or their suppliers experience a material work stoppage, such work stoppage could have a material adverse effect on our business. In addition, our Grandville, Michigan facility is party to a collective bargaining agreement with the UAW, which expires in August 2004, and several of our European operations either recognize a union or have employees that are individually members of a union. In total, approximately 5.5% of our employees are subject to a collective bargaining agreement and/or members of a union. We cannot assure you that we will not encounter strikes, further unionization efforts or other types of conflicts with labor unions or our employees. We may be adversely affected by the impact of environmental and safety regulations to which we are subject. We are subject to foreign, federal, state, and local laws and regulations governing the protection of the environment and occupational health and safety, including laws regulating the generation, storage, handling, use and transportation of hazardous materials; the emission and discharge of hazardous materials into the soil, ground or air; and the health and safety of our colleagues. We are also required to obtain *1 .1 Form of Underwriting Agreement. *3 .1 Restated Certificate of Incorporation of J.L. French Automotive Castings, Inc. *3 .2 Restated By-laws of J.L. French Automotive Castings, Inc. 4 .1 Indenture, dated May 28, 1999, by and among J.L. French Automotive Castings, Inc., the Subsidiary Guarantors and U.S. Bank Trust National Association, as trustee, incorporated by reference to Exhibit 4.1 of the Registration Statement on Form S-4 (Registration No. 333-84903) (the S-4 ). 4 .2 Registration Rights Agreement, dated May 28, 1999, by and among J.L. French Automotive Castings, Inc., the Subsidiary Guarantors and the Initial Purchasers, incorporated by reference to Exhibit 4.2 of the S-4. *4 .3 Specimen certificate for Class A common stock of J.L. French Automotive Castings, Inc. *5 .1 Opinion of Kirkland Ellis. 10 .1 Amended and Restated Credit Agreement, dated October 15, 1999, among J.L. French Automotive Castings, Inc., Automotive Components Investments Limited, Morris Ashby Limited, the several banks and other financial institutions from time to time parties to the agreement (the Lenders ), Bank of America NT SA, as syndication agent for the Lenders, Chase Manhattan International Limited, as administrative agent for the English Lenders, and the Chase Manhattan Bank, as administrative agent for the Lenders, incorporated by reference to Exhibit 10.1 of the S-4, as amended pursuant to the First Amendment dated as of November 27, 2000, incorporated by reference to Exhibit 10.1 of the Registrant s Form 8-K filed on December 18, 2000 under the Securities Exchange Act of 1934 (the December 2000 8-K ). 10 .2 Investor Stockholders Agreement, dated April 21, 1999, by and among J.L. French Automotive Castings, Inc., Onex American Holdings LLC, J2R Partners III and the stockholders listed on the signature pages thereto (the Stockholders Agreement ), incorporated by reference to Exhibit 10.2 of the S-4. 10 .3 Registration Agreement, dated April 21, 1999, by and among J.L. French Automotive Castings, Inc. and the investors listed on the signature pages thereto (the Registration Agreement ), incorporated by reference to Exhibit 10.3 of the S-4. 10 .4 Management Agreement, dated April 21, 1999, by and between J.L. French Automotive Castings, Inc. and Hidden Creek Industries, incorporated by reference to Exhibit 10.4 of the S-4. 10 .5 Joinder and Rights Agreement, dated October 15, 1999, by and between J.L. French Automotive Castings, Inc., Onex Advisor LLC and each of the other persons listed on the signature pages thereto, relating to the Stockholders Agreement and the Registration Agreement, incorporated by reference to Exhibit 10.5 of the S-4. 10 .6 Joinder and Rights Agreement, dated October 15, 1999, by and between J.L. French Automotive Castings, Inc. and Tower Automotive, Inc., relating to the Stockholders Agreement and the Registration Agreement, incorporated by reference to Exhibit 10.6 of the S-4. 10 .7 Sublease Agreement, dated March 25, 1998, by and between J.L. French Corporation and American Bumper Mfg. Co., incorporated by reference to Exhibit 10.7 of the S-4. 10 .9 Employment Agreement, dated April 30, 1998, by and between Fundiciones Viuda de Ansola S.A. and Juan Manuel Orbea, incorporated by reference to Exhibit 10.9 of the S-4. 10 .10 Employment Agreement, dated April 30, 1998, by and between Ansola Acquisition Corporation, S.R.L. and Juan Manuel Orbea, incorporated by reference to Exhibit 10.10 of the S-4. 10 .11 Management Stockholders Agreement, dated July 16, 1999, by and between J.L. French Automotive Castings, Inc., Onex American Holdings LLC and the individuals named on Schedule I thereto, incorporated by reference to Exhibit 10.11 of the S-4. Class A Common Stock, par value $0.01 per share $115,000,000 $10,580 Table of Contents permits from governmental authorities for certain operations. We cannot assure you that we have been or will be at all times in complete compliance with such laws, regulations and permits. If we violate or fail to comply with these laws, regulations or permits, we could be fined or otherwise sanctioned by regulators. In some instances, such a fine or sanction could be material. We do not expect that our capital expenditures for environmental control will be material for the current or succeeding fiscal year. We are also subject to laws imposing liability for the cleanup of contaminated property. Under these laws, we could be held liable for costs and damages relating to contamination at our past or present facilities and at third party sites to which these facilities sent waste containing hazardous substances. The amount of such liability could be material. See Business Environmental Matters. Our earnings could decline if we write off goodwill as a result of our various acquisitions or record restructuring charges. As a result of our various acquisitions we have accumulated a substantial amount of goodwill, amounting to $287.2 million as of March 31, 2002. Due to new accounting standards that went into effect on January 1, 2002, goodwill and other intangible assets with indefinite lives are not amortized but rather tested for impairment annually. As a result, we are currently in the process of performing our initial goodwill impairment review under these new accounting standards. We expect to complete this initial review during the second quarter of 2002 and if we determine that significant impairment has occurred, we would be required to write-off the impaired portion of goodwill, which would be recorded as a cumulative adjustment effective as of January 1, 2002. Preliminary indications suggest that we will record a transitional impairment charge in the range of $ million to $ million. However, we are in the process of finalizing the amount of the charge we will take, if any. It is possible that the amount of any charge that we take after completing the formal appraisal process may not fall within the range suggested by our preliminary analysis. See Management s Discussion and Analysis of Financial Condition and Results of Operations Recently Issued Accounting Pronouncements. An important element of our business strategy is to continue to pursue continuous operating improvements. In connection therewith, we continually review the utilization at our facilities and equipment and, when appropriate, make changes to improve our operating efficiency. For example, beginning in 2002 and continuing in 2003 we intend to relocate certain production from higher-cost facilities to our most efficient, low-cost facilities. This relocation or similar changes may require us to incur restructuring costs, which would have a negative impact on our earnings for the period in which we record the charge. Certain stockholders currently control all matters submitted to a stockholder vote. Upon completion of the offering, Onex and its affiliates and the other existing stockholders will beneficially own all of the outstanding shares of Class B common stock. Each share of Class B common stock has ten votes as compared to one vote for each share of Class A common stock, and thus the outstanding Class B common stock will represent % of the combined voting power of the outstanding common stock after the completion of the offering ( % if the underwriters over-allotment option is exercised in full). In addition, all of our existing stockholders have entered into agreements to vote their shares for the election of directors designated by certain of the existing stockholders. As a result of such stock ownership and voting agreements, the existing stockholders will be able to control the vote on all matters submitted to a vote of the holders of common stock, including the election of directors, amendments to our certificate of incorporation and the by-laws and approval of significant corporate transactions. See Description of Capital Stock. Such consolidation of voting power could also have the effect of delaying, deterring or preventing a change in control of the company that might be otherwise beneficial to stockholders. See Principal Stockholders. Table of Contents Risks Relating to this Offering The initial public offering price is significantly higher than the book value of our Class A common stock, and you will experience immediate and substantial dilution in the book value of your investment. Prior investors paid a lower per share price than the price in this offering. The initial public offering price is substantially higher than the net book value per share of the outstanding common stock immediately after this offering. Accordingly, if you purchase Class A common stock in this offering, you will incur immediate and substantial dilution of $ per share. See Dilution. Future sales of our Class A common stock, including the shares purchased in this offering, may depress our stock price. Sales of a substantial number of shares of our common stock in the public market by our stockholders after this offering, or the perception that such sales are likely to occur, could depress the market price of our Class A common stock and could impair our ability to raise capital through the sale of additional equity securities. Upon completion of this offering, we will have outstanding shares of common stock, assuming no exercise of the underwriters over-allotment option. Of these shares, the shares of Class A common stock sold in this offering and an additional shares held by our existing stockholders will be freely tradable, without restriction, in the public market. After the lockup agreements pertaining to this offering expire 180 days from the date of this prospectus, an additional million shares will be eligible for sale in the public market. After the closing of this offering, holders of shares will be entitled to registration rights with respect to the registration of their shares under the Securities Act. See Shares Eligible for Future Sale. An active public market for our Class A common stock may not develop, which could impede your ability to sell your shares and depress our stock price. Before this offering, you could not buy or sell our common stock on the public market. An active public market for our Class A common stock may not develop or be sustained after the offering, which could affect your ability to sell your shares and depress the market price of your shares. The market price of your shares may fall below the initial public offering price. We may be subject to risks as a result of Arthur Andersen LLP serving as our independent auditor. Arthur Andersen LLP, our independent public accountant, provides us with auditing services, including an audit report with respect to the financial statements contained in this prospectus. Arthur Andersen is the subject of litigation and was indicted with respect to its activities in connection with Enron Corp. Arthur Andersen may fail, may merge with or have its assets sold to a third party, may lose critical personnel or may seek protection from creditors. In the event that Arthur Andersen fails, does not otherwise continue in business or seeks protection from creditors, Arthur Andersen may have insufficient assets available to satisfy any claims made by investors or by us with respect to this offering, including claims under Section 11 of the Securities Act for material misstatements or omissions, if any, in the registration statement of which this prospectus forms a part, including the financial statements covered by their report. The SEC has said that it will continue accepting financial statements audited by Arthur Andersen, and interim financial statements reviewed by it, so long as Arthur Andersen is able to make certain representations to their clients. Our access to the capital markets and our ability to make timely SEC filings could be impaired if the SEC ceases accepting financial statements audited by Arthur Andersen, if Arthur Andersen becomes unable to make the required representations to us or if for any other reason Arthur Andersen is unable to perform required audit-related services for us. In such a case, we would be required to engage new independent certified public accountants or take such other actions as may be necessary to enable us to maintain access to the capital markets and comply with our financial reporting and other obligations as a public company in a timely manner. (1) Includes shares that the underwriters have the option to purchase to cover over-allotments, if any. (2) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(o). The registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents Provisions in our charter documents and Delaware law could discourage potential acquisition proposals and could delay, deter or prevent a change in control. Certain provisions of our certificate of incorporation and by-laws, to be effective upon consummation of this offering, may inhibit changes in control of our company not approved by our board of directors. These provisions include: disparate voting rights per share between the Class A common stock and the Class B common stock; a prohibition on stockholder action through written consents; a requirement that special meetings of stockholders be called only by the board of directors; advance notice requirements for stockholder proposals and nominations; limitations on the ability of stockholders to amend, alter or repeal the by-laws; and the authority of the board of directors to issue, without stockholder approval, preferred stock with such terms as the board of directors may determine and additional shares of our common stock. We will also be afforded the protections of Section 203 of the Delaware General Corporation Law, which would prevent us from engaging in a business combination with a person who becomes a 15.0% or greater stockholder for a period of three years from the date such person acquired such status unless certain board or stockholder approvals were obtained. 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+RISK FACTORS YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING FACTORS IN ADDITION TO THE OTHER INFORMATION CONTAINED IN THIS PROSPECTUS BEFORE PURCHASING ANY SHARES OF OUR CLASS A SUBORDINATE VOTING STOCK. If any of the following risks, or any of the risks described in the other documents we file with the SEC and the Canadian securities regulatory authorities, actually occur, our business, financial condition, operating results and prospects could be materially adversely affected. In that case, the trading price of shares of our Class A Subordinate Voting Stock could decline substantially and investors may lose all or part of the value of the shares of our Class A Subordinate Voting Stock held by them. RISKS REGARDING OUR COMPANY WE ARE A RELATIVELY NEW COMPANY WITH A SHORT HISTORY OF RACETRACK OPERATIONS. WE MUST SUCCESSFULLY INTEGRATE RECENT RACETRACK ACQUISITIONS OR OUR OPERATING RESULTS MAY BE ADVERSELY AFFECTED. We were incorporated approximately three years ago and acquired our first racetrack in December 1998. Accordingly, although all our racetracks have been in operation for some time, we have a relatively short history of owning and operating racetracks. The acquisition of Santa Anita Park was completed in December 1998, the acquisition of Gulfstream Park was completed in September 1999, the acquisition of Remington Park and Thistledown was completed in November 1999, the acquisition of Golden Gate Fields was completed in December 1999, the acquisition of Great Lakes Downs was completed in February 2000, the acquisition of Bay Meadows was completed in November 2000, the acquisition of The Meadows was completed in April 2001 and the acquisition of Multnomah Greyhound Park was completed in October 2001. The Portland Meadows facility commenced operations under our management in July 2001. Prior to their respective acquisitions, most of these racetracks had been operated separately under different ownership. Completing the integration of these businesses into our operations will require a significant dedication of management resources and further expansion of our information and other operating systems. If we do not successfully integrate our recent acquisitions and any future acquisitions, or if this integration consumes a significant amount of our management's time, then these acquisitions may materially adversely affect our efficiency and, therefore, significantly harm our business. IF WE DO NOT IDENTIFY, NEGOTIATE AND COMPLETE A SUFFICIENT NUMBER OF STRATEGIC ACQUISITIONS, WE MAY NOT ACHIEVE OUR BUSINESS PLAN AND OUR GROWTH PROSPECTS MAY SUFFER. Our current business plan calls for us to continue to actively pursue strategic acquisitions. Our future profitability will depend to some degree upon the ability of our management to identify, complete and successfully integrate commercially viable acquisitions. If we do not do so for any reason, we may not be able to implement our business plan successfully, or grow as quickly as we anticipate, and this could have a material adverse effect on our future profitability. WE HAVE RECRUITED MOST OF OUR SENIOR EXECUTIVE OFFICERS FROM OUTSIDE THE RACETRACK INDUSTRY. Although our management personnel at our racetracks generally have extensive experience in the racetrack industry, we have recruited most of our senior executive officers from outside the industry. Our chief executive officer, chief operating officer and chief financial officer each joined us during the last two years. This lack of racetrack industry experience may impede the implementation of our strategy and slow our growth. WE MAY NOT BE ABLE TO OBTAIN FINANCING OR MAY BE ABLE TO OBTAIN IT ONLY ON UNFAVORABLE TERMS, WHICH MAY AFFECT THE VIABILITY OF OUR EXPANSION PROJECTS OR MAKE EXPANSION MORE COSTLY. We may require additional financing in order to expand our operations. It is possible that this financing will not be available or, if available, will not be available on terms that are favorable to us. Our controlling stockholder, Magna International, has made a commitment to its shareholders that it will not, before June 1, 2006, make any further debt or equity investments in, or otherwise provide financial assistance to, us or any of our subsidiaries without the prior consent of the holders of a majority of Magna International's subordinate voting shares. If we are unable to obtain financing on favorable terms, or at all, we may not be able to expand our operations, which could have a material adverse effect on our future profitability. OUR RECENT OPERATING INCOME INCLUDES SUBSTANTIAL GAINS FROM THE SALE OF NON-CORE REAL ESTATE, WHICH SALES WILL SOON DECREASE AND MAY CAUSE OUR FUTURE OPERATING INCOME AND CASH FLOW TO DECREASE. Approximately 37% of our pro forma earnings before interest, taxes, depreciation and amortization for the year ended December 31, 2001 resulted from gains from real estate sales. These gains will likely be reduced to zero over the next two years as the balance of our non-core real estate portfolio is sold. Additionally, our short-term and annual operating income and cash flow may decline from the prior year due to decreases in non-core real estate sales. If we do not replace these gains or offset these decreases with additional operating income and cash flow from our racetrack operations, our future operating income and cash flow will decline. OUR BUSINESS IS HEAVILY CONCENTRATED AT CERTAIN OF OUR RACETRACKS. Four of our racetracks, Santa Anita, Gulfstream, Golden Gate Fields and Bay Meadows, accounted for approximately 61% of our pro forma revenue and 83% of our pro forma earnings before interest, taxes, depreciation and amortization for the year ended December 31, 2001. If a business interruption were to occur and continue for a significant length of time at any of these racetracks, it could harm our operating results. Additionally, certain of our other racetrack properties have experienced negative earnings before interest, income taxes, depreciation and amortization over the past two years. These racetrack properties may not improve their operating performance in the future. WE ARE CONTROLLED BY MAGNA INTERNATIONAL AND THEREFORE MAGNA INTERNATIONAL IS ABLE TO PREVENT ANY TAKEOVER OF US BY A THIRD PARTY. Magna International owns all our Class B Stock, which is generally entitled to 20 votes per share, and therefore after this offering will be able to exercise approximately 97% of the total voting power of our outstanding stock. It will therefore continue to be able to elect all our directors and to control us. As a result, Magna International is able to cause or prevent a change in our control. See "Description of Capital Stock--Takeover Protection". OUR RELATIONSHIP WITH MAGNA INTERNATIONAL IS NOT AT "ARM'S LENGTH", AND THEREFORE MAGNA INTERNATIONAL MAY INFLUENCE US TO MAKE DECISIONS THAT ARE NOT IN THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS. Our relationship with Magna International is not at "arm's length". In addition to the ownership of our stock as described in the preceding risk factor, three members of our board of directors are also members of Magna International's board of directors and we have the same chairman. In some cases, the interests of Magna International may not be the same as those of our other stockholders, and conflicts of interest may arise from time to time that may be resolved in a manner detrimental to us or our minority stockholders. Magna International is able to cause us to effect certain corporate transactions without the consent of the holders of our Class A Subordinate Voting Stock, subject to applicable law and the fiduciary duties of our directors and officers. Consequently, transactions effected between us and Magna International may not be on the same terms as could be obtained from independent parties, resulting in the possibility of our minority stockholders' interests being compromised. A DECLINE IN GENERAL ECONOMIC CONDITIONS COULD ADVERSELY AFFECT OUR BUSINESS. Our operations are affected by general economic conditions, and therefore our future success is unpredictable. The demand for entertainment and leisure activities tends to be highly sensitive to consumers' disposable incomes, and thus a decline in general economic conditions may lead to our customers having less discretionary income to wager on horse racing. This would cause a reduction in our revenues and could therefore have a material adverse effect on our operating results. OUR MANAGEMENT HAS BROAD DISCRETION OVER THE USE OF PROCEEDS FROM THIS OFFERING, AND MAY SPEND THE PROCEEDS IN WAYS WITH WHICH YOU DO NOT AGREE. The net proceeds of the offering will be approximately $133.4 million after deducting the underwriting discount and commissions and estimated offering expenses. Our management may retain broad discretion as to the use of those proceeds. Accordingly, you may not have an opportunity to evaluate the specific uses of the net proceeds of this offering and you may not agree with those uses. Our failure to use the proceeds effectively could have an adverse effect on our business, financial condition, operating results and prospects. WE ARE EXPOSED TO CURRENCY EXCHANGE RATE FLUCTUATIONS. Our business outside the United States is generally transacted in currencies other than U.S. dollars. Fluctuations in currencies relative to the U.S. dollar may make it more difficult to perform period-to-period comparisons of our operating results. Moreover, fluctuations in the U.S. dollar relative to currencies in which earnings are generated outside the United States could result in a reduction in our profitability. RISKS RELATING TO OUR GAMING OPERATIONS A DECLINE IN THE POPULARITY OF HORSE RACING COULD ADVERSELY IMPACT OUR BUSINESS. The continued popularity of horse racing is important to our growth plans and our operating results. Our business plan anticipates our attracting new customers to our racetracks, off-track betting facilities and account wagering operations. Even if we are successful in making acquisitions and expanding and improving our current operations, we may not be able to attract a sufficient number of new customers to achieve our business plan. Public tastes are unpredictable and subject to change. Any decline in interest in horse racing or any change in public tastes may adversely affect our revenues and, therefore, our operating results. DECLINING ON-TRACK ATTENDANCE AND INCREASING COMPETITION IN SIMULCASTING MAY MATERIALLY ADVERSELY AFFECT OUR OPERATING RESULTS. There has been a general decline in the number of people attending and wagering at live horse races at North American racetracks due to a number of factors, including increased competition from other forms of gaming, unwillingness of customers to travel a significant distance to racetracks and the increasing availability of off-track wagering. The declining attendance at live horse racing events has prompted racetracks to rely increasingly on revenues from inter-track, off-track and account wagering markets. The industry-wide focus on inter-track, off-track and account wagering markets has increased competition among racetracks for outlets to simulcast their live races. A continued decrease in attendance at live events and in on-track wagering, as well as increased competition in the inter-track, off-track and account wagering markets, could lead to a decrease in the amount wagered at our facilities and on races conducted at our racetracks and may materially adversely affect our business, financial condition, operating results and prospects. OUR GAMING ACTIVITIES ARE DEPENDENT ON GOVERNMENTAL REGULATION AND APPROVALS. AMENDMENTS TO SUCH REGULATION OR THE FAILURE TO OBTAIN SUCH APPROVALS COULD ADVERSELY AFFECT OUR BUSINESS. All our pari-mutuel wagering operations are contingent upon the continued governmental approval of these operations as forms of legalized gaming. All our current gaming operations are subject to extensive governmental regulation and could be subjected at any time to additional or more restrictive regulation, or banned entirely. See "Our Business--Government Regulation" and "--Environmental Matters". We may be unable to obtain, maintain or renew all governmental licenses, registrations, permits and approvals necessary for the operation of our pari-mutuel wagering facilities. Licenses to conduct live horse racing and simulcast wagering must be obtained annually from each state's regulatory authority. The loss or non-renewal of any of our licenses, registrations, permits or approvals may materially limit the number of races we conduct or the form or types of pari-mutuel wagering we offer, and could have a material adverse effect on our business. In addition, we currently devote significant financial and management resources to complying with the various governmental regulations to which our operations are subject. Any significant increase in governmental regulation would increase the amount of our resources devoted to governmental compliance, could substantially restrict our business, and could materially adversely affect our operating results. ANY FUTURE EXPANSION OF OUR GAMING OPERATIONS WILL LIKELY REQUIRE US TO OBTAIN ADDITIONAL GOVERNMENTAL APPROVALS OR, IN SOME CASES, AMENDMENTS TO CURRENT LAWS GOVERNING SUCH ACTIVITIES. The high degree of regulation in the gaming industry is a significant obstacle to our growth strategy, especially with respect to account wagering, including telephone, interactive television and Internet-based wagering. Account wagering may currently be conducted only through hubs or bases located in certain states. Our expansion opportunities in this area will be limited unless more states amend their laws to permit account wagering. The necessary amendments to those laws may not be enacted. In addition, the licensing and legislative amendment processes can be both lengthy and costly, and we may not be successful in obtaining required licenses, registrations, permits and approvals. In the past, certain state attorneys general, district attorneys and other law enforcement officials have expressed concern over the legality of interstate account wagering. In December 2000, legislation was enacted in the United States that amends the Interstate Horseracing Act of 1978. We believe that this amendment clarifies that inter-track simulcasting, off-track betting and account wagering, as currently conducted by the U.S. horse racing industry, are authorized under U.S. federal law. The amendment may not be interpreted in this manner by all concerned, however, and there may be challenges to these activities by both state and federal law enforcement authorities, which could have a material adverse impact on our business, financial condition, operating results and prospects. From time to time, the United States Congress has considered legislation that would inhibit or restrict the use of certain financial instruments, including credit cards, to provide funds for account wagering. For example, in May 2001, the United States Senate Commerce Committee proposed legislation, in the form of the Unlawful Internet Gambling Funding Bill, that would prohibit financial institutions from enforcing credit card debts if they knew the debts were being incurred in order to gamble illegally through the Internet. Further, in July 2001, a bill was reintroduced into the United States House of Representatives that would prohibit any person in a gambling business from knowingly accepting, in connection with the participation of another person in Internet gambling, credit, an electronic funds transfer, a check, a draft or the proceeds of credit or an electronic funds transfer. Legislation of this nature, if enacted, could inhibit account wagering by restricting the use of credit cards and other commonly used financial instruments to fund wagering accounts. This, or any other legislation restricting account wagering, could cause our business and its growth to suffer. IMPLEMENTATION OF SOME OF THE RECOMMENDATIONS OF THE NATIONAL GAMBLING IMPACT STUDY COMMISSION MAY HARM OUR GROWTH PROSPECTS. In August 1996, the United States Congress established the National Gambling Impact Study Commission to conduct a comprehensive study of the social and economic effects of the gambling industry in the United States. This commission reviewed existing federal, state and local policy and practices with respect to the legalization or prohibition of gambling activities with the aim of formulating and proposing changes in these policies and practices and recommending legislation and administrative actions for these proposed changes. On April 28, 1999, the Commission voted to recommend that there be a pause in the expansion of gaming. On June 18, 1999, the Commission issued a report setting out its findings and conclusions, together with recommendations for legislation and administrative actions. Some of the recommendations were: - prohibiting Internet gambling that was not already authorized within the United States or among parties in the United States and any foreign jurisdiction; - limiting the expansion of gambling into homes through such mediums as account wagering; and - banning the introduction of casino-style gambling into pari-mutuel facilities for the primary purpose of saving a pari-mutuel facility that the market has determined no longer serves the community or for the purpose of competing with other forms of gaming. The recommendations made by the National Gambling Impact Study Commission could result in the enactment of new laws and/or the adoption of new regulations in the United States, which would materially adversely impact the gambling industry in the United States in general or our segment in particular and consequently may threaten our growth prospects. WE FACE SIGNIFICANT COMPETITION FROM OTHER RACETRACK OPERATORS WHICH COULD HURT OUR OPERATING RESULTS. We face significant competition in each of the jurisdictions in which we operate racetracks and we expect this competition to intensify as new racetrack operators enter our markets and existing competitors expand their operations and consolidate management of multiple racetracks. In addition, the introduction of legislation enabling slot machines or video lottery terminals to be installed at racetracks in certain states allows those racetracks to increase their purses and compete more effectively with us for horse owners and trainers. One of our competitors, Churchill Downs Inc., has been in operation for a much longer period of time than we have and may have greater name recognition. Competition from existing racetrack operators, as well as the addition of new competitors, may hurt our future performance and operating results. In addition, Florida tax laws have historically discouraged the three Miami-area horse racetracks, Gulfstream Park, Hialeah Park and Calder Race Course, from scheduling concurrent races. A recent tax structure, effective as of July 1, 2001, has eliminated this deterrent. As a result, our Gulfstream Park racetrack may face direct competition from the other Miami-area horse racetracks in the future. This competition could significantly affect the operating results of Gulfstream Park which could reduce our overall profitability. COMPETITION FROM NON-RACETRACK GAMING OPERATORS MAY REDUCE THE AMOUNT WAGERED AT OUR FACILITIES AND MATERIALLY ADVERSELY AFFECT OUR OPERATING RESULTS. We compete for customers with casinos, sports wagering services and other non-racetrack gaming operators, including government-sponsored lotteries, which benefit from numerous distribution channels, including supermarkets and convenience stores, as well as from frequent and extensive advertising campaigns. We do not enjoy the same access to the gaming public or possess the advertising resources that are available to government-sponsored lotteries as well as some of our other non-racetrack competitors, which may adversely affect our ability to effectively compete with them. WE DEPEND ON AGREEMENTS WITH OUR HORSEMEN'S INDUSTRY ASSOCIATIONS TO OPERATE OUR BUSINESS. The U.S. Interstate Horseracing Act of 1978, as well as various state racing laws, require that, in order to simulcast races, we have written agreements with the horsemen at our racetracks, who are represented by industry associations. In some states, if we fail to maintain operative agreements with the industry associations, we may not be permitted to conduct live racing or simulcasting at tracks within those states. In addition, our simulcasting agreements are generally subject to the approval of the industry associations. Should we fail to renew existing agreements with the industry associations on satisfactory terms or fail to obtain approval for new simulcast agreements, we would lose revenues and our operating results would suffer. IF WE ARE UNABLE TO CONTINUE TO NEGOTIATE SATISFACTORY UNION CONTRACTS, SOME OF OUR EMPLOYEES MAY COMMENCE A STRIKE. A STRIKE BY OUR EMPLOYEES OR A WORK STOPPAGE BY BACKSTRETCH PERSONNEL, WHO ARE EMPLOYED BY HORSE OWNERS AND TRAINERS, MAY LEAD TO LOST REVENUES AND COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS. As of December 31, 2001, we employed approximately 4,300 full-time employees, approximately 2,500 of whom were represented by unions. A strike or other work stoppage by our employees could lead to lost revenues and have a material adverse effect on our business, financial condition, operating results and prospects. Recently enacted legislation in California will facilitate the organization of backstretch personnel in that state. A strike by backstretch personnel could, even though they are not our employees, lead to lost revenues and therefore hurt our operating results. WE CURRENTLY FACE SIGNIFICANT COMPETITION FROM INTERNET AND OTHER FORMS OF ACCOUNT WAGERING, WHICH MAY REDUCE OUR PROFITABILITY. Internet and other account wagering gaming services allow their customers to wager on a wide variety of sporting events and casino games from home. The National Gambling Impact Study Commission's June 1999 report estimates that there are over 250 on-line casinos, 64 lotteries, 20 bingo games and 139 sports wagering services offering gambling over the Internet. Amounts wagered in the Internet gaming market are estimated to have doubled from approximately $445 million in 1997 to over $900 million in 1998, according to INTERACTIVE GAMING NEWS, an Internet gaming publication. Although many on-line wagering services are operating from offshore locations in violation of U.S. law by accepting wagers from U.S. residents, they may divert wagering dollars from legitimate wagering venues such as our racetracks and account wagering operations. Moreover, our racetrack operations may require greater ongoing capital expenditures in order to expand our business than the capital expenditures required by Internet and other account wagering gaming operators. Currently, we cannot offer the diverse gaming options offered by many Internet and other account wagering gaming operators and may face significantly greater costs in operating our business. Our inability to compete successfully with these operators could hurt our business. In addition, the market for account wagering is affected by changing technology. Our ability to anticipate such changes and to develop and introduce new and enhanced services on a timely basis will be a significant factor in our ability to expand, remain competitive and attract new customers. EXPANSION OF GAMING CONDUCTED BY NATIVE AMERICAN GROUPS MAY LEAD TO INCREASED COMPETITION IN OUR INDUSTRY, WHICH MAY NEGATIVELY IMPACT OUR GROWTH AND PROFITABILITY. In March 2000, the California state constitution was amended, resulting in the expansion of gaming activities permitted to be conducted by Native American groups in California. This may lead to increased competition and may have an adverse effect on the profitability of Santa Anita Park, Golden Gate Fields, Bay Meadows and our future growth in California. It may also affect the purses that those tracks are able to offer and therefore adversely affect our ability to attract top horses. Several Native American groups in Florida have recently expressed interest in opening or expanding existing casinos in southern Florida, which could compete with Gulfstream Park and reduce its profitability. Moreover, other Native American groups may open or expand casinos in other regions of the country where we currently operate, or plan to operate, racetracks or other gaming operations. Any such competition from Native American groups could adversely affect our growth and profitability. SOME JURISDICTIONS VIEW OUR OPERATIONS PRIMARILY AS A MEANS OF RAISING TAXES, AND THEREFORE WE ARE PARTICULARLY VULNERABLE TO ADDITIONAL OR INCREASED TAXES AND FEES. We believe that the prospect of raising significant additional revenue through taxes and fees is one of the primary reasons that certain jurisdictions permit legalized gaming. As a result, gaming companies are typically subject to significant taxes and fees in addition to the normal federal, state, provincial and local income taxes, and such taxes and fees may be increased at any time. From time to time, legislators and officials have proposed changes in tax laws, or in the administration of such laws, affecting the gaming industry. For instance, U.S. legislators have proposed the imposition of a U.S. federal tax on gross gaming revenues. It is not possible to determine with certainty the likelihood of any such changes in tax laws or their administration; however, if enacted, such changes could have a material adverse effect on our business. OUR OPERATING RESULTS FLUCTUATE SEASONALLY AND MAY BE IMPACTED BY A REDUCTION IN LIVE RACING DATES DUE TO REGULATORY FACTORS. We experience significant fluctuations in quarterly operating results due to the seasonality associated with the racing schedules at our racetracks. Generally, our revenues from racetrack operations are greater in the first quarter of the calendar year than in any other quarter. We have a limited number of live racing dates at each of our racetracks and the number of live racing dates varies somewhat from year to year. The allocation of live racing dates in most of the states in which we operate is subject to regulatory approval from year to year and, in any given year, we may not receive the same or more racing dates than we have had in prior years. Recently, the regulatory agencies in California have announced their intention to reduce live racing dates. We are also faced with the prospect that competing racetracks may seek to have some of our historical dates allocated to them. A significant decrease in the number of our live racing dates would reduce our revenues and cause our business to suffer. UNFAVORABLE WEATHER CONDITIONS MAY RESULT IN A REDUCTION IN THE NUMBER OF RACES WE HOLD. Since horse racing is conducted outdoors, unfavorable weather conditions, including extremely high or low temperatures, excessive precipitation, storms or hurricanes, may cause races to be cancelled or may reduce attendance and wagering. Since a substantial portion of our operating expenses is fixed, a reduction in the number of races held or the number of horses racing due to unfavorable weather would reduce our revenues and cause our business to suffer. THE CURRENT LEASE OF THE BAY MEADOWS PROPERTY EXPIRES IN LESS THAN ONE YEAR AND MAY NOT BE RENEWED. The Bay Meadows site lease expires on December 31, 2002 (subject to extension through March 31, 2003 if we are holding a race meet). Although we are exploring various alternative venues for the conduct of the racing dates currently held at Bay Meadows, there is a risk that we will be unable to obtain the necessary regulatory approvals to transfer these racing dates to another racetrack operated by us in northern California, which could cause a reduction in our revenues and, therefore, materially adversely affect our operating results. THE PROFITABILITY OF OUR RACETRACKS IS PARTIALLY DEPENDENT UPON THE SIZE OF THE LOCAL HORSE POPULATION IN THE AREAS IN WHICH OUR RACETRACKS ARE LOCATED. Horse population is a factor in a racetrack's profitability because it generally affects the average number of horses (i.e., the average "field size") that run in races. Larger field sizes generally mean increased wagering and higher wagering revenues due to a number of factors, including the availability of exotic bets (such as "exacta" and "trifecta" wagers). Various factors have led to declines in the horse population in certain areas of the country, including competition from racetracks in other areas, increased costs and changing economic returns for owners and breeders, and Mare Reproductive Loss Syndrome, which last year caused a large number of mares in Kentucky to sustain late term abortions or early embryonic loss. If we are unable to attract horse owners to stable and race their horses at our tracks by offering a competitive environment, including improved facilities, well-maintained racetracks, better living conditions for backstretch personnel involved in the care and training of horses stabled at our tracks, and a competitive purse structure, our profitability could decrease. AN EARTHQUAKE IN CALIFORNIA COULD INTERRUPT OUR OPERATIONS AT SANTA ANITA PARK, GOLDEN GATE FIELDS AND BAY MEADOWS, WHICH WOULD ADVERSELY IMPACT OUR CASH FLOW FROM THESE RACETRACKS. Three of our largest racetracks, Santa Anita Park, Golden Gate Fields and Bay Meadows, are located in California and are therefore subject to earthquake risks. We do not maintain significant earthquake insurance on the structures at our California racetracks. We maintain fire insurance for fire risks, including those resulting from earthquakes, subject to policy limits and deductibles. There can be no assurance that earthquakes or the fires often caused by earthquakes will not seriously damage our California racetracks and related properties or that the recoverable amount of insurance proceeds will be sufficient to fully cover reconstruction costs and other losses. If an uninsured or underinsured loss occurs, we could lose anticipated revenue and cash flow from our California racetracks. OUR BUSINESS DEPENDS ON PROVIDERS OF TOTALISATOR SERVICES. In purchasing and selling our pari-mutuel wagering products, our customers depend on information provided by two of the three main totalisator companies operating in North America. These totalisator companies provide the computer systems that accumulate wagers, record sales, calculate payoffs and display wagering data. The loss of any of the totalisator companies as a provider of these critical services would decrease competition in the market for those services and could result in an increase in the cost to obtain them. Additionally, the failure of the totalisator companies to keep their technology current could limit our ability to serve customers effectively or develop new forms of wagering. Because of the highly specialized nature of these services, replicating these totalisator services would be expensive. REAL ESTATE OWNERSHIP AND DEVELOPMENT RISKS OUR OWNERSHIP AND DEVELOPMENT OF REAL ESTATE IS SUBJECT TO RISKS AND MAY INVOLVE SIGNIFICANT ONGOING EXPENDITURES OR LOSSES THAT COULD ADVERSELY AFFECT OUR OPERATING RESULTS. All real estate investments are subject to risks including: general economic conditions, such as the availability and cost of financing; local real estate conditions, such as an oversupply of residential, office, retail or warehousing space, or a reduction in demand for real estate in the area; governmental regulation, including taxation of property and environmental legislation; and the attractiveness of properties to potential purchasers or tenants. The real estate industry is also capital intensive and sensitive to interest rates. Further, significant expenditures, including property taxes, mortgage payments, maintenance costs, insurance costs and related charges, must be made throughout the period of ownership of real property, which expenditures may negatively impact our operating results. WE MAY NOT BE ABLE TO SELL SOME OF OUR NON-CORE REAL ESTATE WHEN WE NEED TO OR AT THE PRICE WE WANT, WHICH MAY MATERIALLY ADVERSELY AFFECT OUR FINANCIAL CONDITION. At times, it may be difficult for us to dispose of some of our non-core real estate. The costs of holding real estate may be high and, during a recession, we may be faced with ongoing expenditures with little prospect of earning revenue on our non-core real estate properties. If we have inadequate cash reserves, we may have to dispose of properties at prices that are substantially below the prices we desire, and in some cases, below the prices we originally paid for the properties, which may materially adversely affect our financial condition and our growth plans. WE REQUIRE GOVERNMENTAL APPROVALS FOR SOME OF OUR PROPERTIES WHICH MAY TAKE A LONG TIME TO OBTAIN OR WHICH MAY NOT BE GRANTED, EITHER OF WHICH COULD MATERIALLY ADVERSELY AFFECT OUR EXISTING BUSINESS OR OUR GROWTH. Some of our properties will require zoning and other approvals from local government agencies. The process of obtaining these approvals may take many months and we might not obtain the necessary approvals. Furthermore, in the case of certain land to be held by us in Aurora, Ontario, the transfer of this land to us from Magna International is conditional on our obtaining permission to sever the land from adjoining properties and other approvals. If we do not obtain these approvals, we may not ultimately acquire this land. Holding costs, while regulatory approvals are being sought, and delays may render a project economically unfeasible. If we do not obtain all of our necessary approvals, our plans, growth and profitability could be materially adversely affected. WE MAY NOT BE ABLE TO COMPLETE EXPANSION PROJECTS SUCCESSFULLY AND ON TIME, WHICH WOULD MATERIALLY ADVERSELY AFFECT OUR GROWTH AND OUR OPERATING RESULTS. We intend to further develop our racetracks and expand our gaming activities. Numerous factors, including regulatory and financial constraints, could cause us to alter, delay or abandon our existing plans. If we proceed to develop new facilities or enhance our existing facilities, we face numerous risks that could require substantial changes to our plans. These risks include the inability to secure all required permits and the failure to resolve potential land use issues, as well as risks typically associated with any construction project, including possible shortages of materials or skilled labor, unforeseen engineering or environmental problems, delays and work stoppages, weather interference and unanticipated cost overruns. For example, Santa Anita Park completed certain upgrades to its facilities in 1999. The disruption caused by these upgrades was greater than anticipated and reduced the total amount wagered at Santa Anita Park's simulcast wagering facilities and attendance at The Oak Tree Meet in 1999. Even if completed in a timely manner, our expansion projects may not be successful, which would affect our growth and could have a material adverse effect on our future profitability. We intend to commence a major redevelopment of Gulfstream Park in May 2002. Although we have scheduled the redevelopment so as to minimize any interference with Gulfstream Park's racing season, there is a risk that the redevelopment will not be completed according to schedule, in which case it could cause us to disrupt a racing season and result in a reduction in the revenues and earnings generated at Gulfstream Park during that season. See "Our Business -- Our Properties -- Gulfstream Park". WE FACE STRICT ENVIRONMENTAL REGULATION AND MAY BE SUBJECT TO LIABILITY FOR ENVIRONMENTAL DAMAGE, WHICH COULD MATERIALLY ADVERSELY AFFECT OUR FINANCIAL RESULTS. We are subject to a wide range of requirements under environmental laws and regulations relating to waste water discharge, waste management and storage of hazardous substances. Compliance with environmental laws and regulations can, in some circumstances, require significant capital expenditures. Moreover, violations can result in significant penalties and, in some cases, interruption or cessation of operations. We have been involved in a dispute with the United States Environmental Protection Agency involving the Portland Meadows racetrack, which we currently lease and operate, which dispute caused us to postpone the planned September 1, 2001 opening of that facility. See "Prospectus Summary--Recent Developments" and "Our Business--Environmental Matters." Furthermore, we may not have all required environmental permits and we may not otherwise be in compliance with all applicable environmental requirements. Where we do not have an environmental permit but one may be required, we will determine if one is in fact required and, if so, will seek to obtain one and address any related compliance issues, which may require significant capital expenditures. Various environmental laws and regulations in the United States, Canada and Europe impose liability on us as a current or previous owner and manager of real property, for the cost of maintenance, removal and remediation of hazardous substances released or deposited on or in properties now or previously owned or managed by us or disposed of in other locations. Our ability to sell properties with hazardous substance contamination or to borrow money using that property as collateral may also be uncertain. Changes to environmental laws and regulations, resulting in more stringent terms of compliance, or the enactment of new environmental legislation, could expose us to additional liabilities and ongoing expenses. Any of these environmental issues could have a material adverse effect on our business. RISKS RELATING TO OUR CLASS A SUBORDINATE VOTING STOCK OUR STOCK PRICE MAY BE VOLATILE, AND FUTURE ISSUANCES OR SALES OF OUR STOCK MAY DECREASE OUR STOCK PRICE. The trading price of our Class A Subordinate Voting Stock has experienced, and may continue to experience, substantial volatility. The following factors have had, and may continue to have, a significant effect on the market price of our Class A Subordinate Voting Stock: - our historical and anticipated operating results; - the announcement of new wagering and gaming opportunities by us or our competitors; - the passage of legislation affecting horse racing or gaming; - developments affecting the horse racing or gaming industries generally; - sales or other issuances or the perception of potential sales or issuances, including in connection with our past and future acquisitions, of substantial amounts of our shares; - sales or the expectation of sales by Magna International of a portion of our shares held by it, as a result of its previously stated intention to reduce its majority equity position in us over time, or by our other significant stockholders; and - a shift in investor interest away from the gaming industry, in general. These factors could have a material adverse effect on the market price of our Class A Subordinate Voting Stock, regardless of our financial condition and operating results. CERTAIN CANADIAN SHAREHOLDERS OF MAGNA INTERNATIONAL, WHO RECEIVED EXCHANGEABLE SHARES AS A DISTRIBUTION FROM MAGNA INTERNATIONAL, MAY SELL THE SHARES OF OUR CLASS A SUBORDINATE STOCK THAT THEY RECEIVE UPON THE EXCHANGE OF EXCHANGEABLE SHARES, WHICH SALES MAY REDUCE THE TRADING PRICE OF OUR CLASS A SUBORDINATE VOTING STOCK. Certain Canadian shareholders of Magna International received exchangeable shares of our Canadian subsidiary that are exchangeable on a one-for-one basis for shares of our Class A Subordinate Voting Stock as a distribution from Magna International. As of December 31, 2001, 2,263,372 exchangeable shares were outstanding, excluding those held by us. As certain Canadian shareholders are subject to restrictions on the amount of stock of a non-Canadian company that they may own, after these exchangeable shares are exchanged for shares of our Class A Subordinate Voting Stock, these shareholders may sell the shares of Class A Subordinate Voting Stock that they receive in exchange for the exchangeable shares. This may have a material adverse effect on the market price of our Class A Subordinate Voting Stock, regardless of our financial condition and operating results. See "Description of Capital Stock--Capital Stock". THE TRADING PRICE OF OUR CLASS A SUBORDINATE VOTING STOCK COULD DECREASE AS A RESULT OF OUR ISSUING ADDITIONAL SHARES AS CONSIDERATION FOR FUTURE ACQUISITIONS. We may issue our Class A Subordinate Voting Stock as full or partial consideration in connection with future acquisitions. To the extent that we do so, the percentage of our common equity and voting stock that our existing stockholders own will decrease and, particularly if such acquisitions do not contribute proportionately to our profitability, the trading price of our shares may also decrease. SALES OF OUR CLASS A SUBORDINATE VOTING STOCK BY MAGNA INTERNATIONAL OR BY CERTAIN OTHER OF OUR SIGNIFICANT STOCKHOLDERS UNDER OUR SHELF REGISTRATION STATEMENT COULD DEPRESS OUR STOCK PRICE. As of the date of this prospectus, Magna International owns 4,362,328 shares of our Class A Subordinate Voting Stock and 58,466,056 shares of our Class B Stock (which are convertible into shares of our Class A Subordinate Voting Stock on a one-for-one basis). Magna International has announced its intention at an undetermined point in the future to convert some shares of our Class B Stock to shares of our Class A Subordinate Voting Stock and dispose of these shares of our Class A Subordinate Voting Stock when market conditions for doing so are favorable, with the ultimate intention of retaining only a minority equity position but continuing to retain control of us. In addition, we have an effective shelf registration statement that permits the secondary sale of shares of our Class A Subordinate Voting Stock by some of our stockholders who received those shares in connection with our past acquisitions. Up to 881,126 shares covered by that shelf registration statement remain unsold. Sales of a substantial number of shares of our Class A Subordinate Voting Stock, either by Magna International or under our shelf registration statement, could depress the prevailing market prices of our Class A Subordinate Voting Stock. WE DO NOT PLAN TO PAY DIVIDENDS UNTIL 2004, IF AT ALL. We have not paid any dividends to date on our Class A Subordinate Voting Stock, we do not plan to pay any dividends until 2004 and we may not pay dividends then, or ever. See "Corporate Constitution--Required Allocations--Dividends".

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+RISK FACTORS You should carefully consider the risks and uncertainties described below before making an investment decision. Our business, financial condition and operating results could be adversely affected by any of the factors listed below, which could cause the trading price of our common stock to decline, and you could lose all or part of your investment. Decreased transaction volume could continue to reduce our revenues. Our revenues depend on the volume of securities transactions that we handle for our customers. Transaction volume in the securities industry can fluctuate widely both in markets where prices are rising and also in markets where prices are falling. Our securities transaction volume decreased approximately 16% during 2001 compared to 2000 and our order execution transaction volume decreased approximately 20% during the same periods. Further decreases in the volume of transactions could result in reduced revenues and adversely affect our profitability. Our revenues could be reduced significantly due to market price fluctuations. Our order execution services involve the purchase and sale of securities predominantly as principal, instead of buying and selling securities as an agent for our customers. As a result, we own securities or are required to buy securities to complete customer transactions. During the period that we own the securities, market prices could fluctuate significantly which could result in lost revenues to us and adversely affect our profitability. A reduction in our commission rates could adversely affect our revenues and profitability. Intense competition from existing and new brokerage services may harm our business. The market for online brokerage services is relatively new, rapidly evolving, intensely competitive and has few barriers to entry. We expect competition to continue and intensify in the future. Discount brokerage firms may continue to reduce their commission rates in an effort to offer the lowest transaction costs to investors. Because many of our competitors have significantly greater financial, technical, marketing and other resources, offer a wider range of products and services and have more extensive client bases than we do, they may be able to respond more quickly to new or changing opportunities, technologies and client requirements than us. They may also be able to undertake more extensive promotional activities, offer more attractive terms to clients and adopt more aggressive pricing policies than us. Moreover, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties or may consolidate to enhance their services and products. Many of these firms have greater transaction volume and offer a wider range of services than we do, which allows them to compensate for lower commission rates. Our current commission fees for online trading start at $5.00 per trade. Our independent registered representatives could leave or affiliate with a competitor. The independent registered representatives can terminate their relationship with us on little or no notice and could associate with another broker dealer. The independent registered representatives can transfer their client accounts which could adversely affect our revenues. A reduction in order flow payments could negatively impact revenues. We have arrangements with various investment banking and securities brokerage firms under which we pay them to send their trade orders to us for execution. This is known as paying for order flow. To attract order flow, we must be competitive on: o providing enhanced liquidity to our customers; o the speed of our order execution; o payment for order flow; o the sophistication of our trading technology; and o the quality of our customer service. Loss of the ability to have orders routed to us in this manner could reduce our transaction volume and therefore reduce our revenues and adversely affect our profitability. We are subject to securities regulation and failure to comply could subject us to penalties or sanctions that could harm our business. Our business is subject to federal and state laws regulating the securities industry. In addition, the Securities and Exchange Commission, or the SEC, the National Association of Securities Dealers, Inc., or the NASD, and other self-regulatory organizations, as well as the various stock exchanges and state securities commissions, require strict compliance with their rules and regulations. Broker dealers are subject to regulations covering all aspects of the securities business, including sales methods, trade practices among broker dealers, use and safekeeping of clients' funds and securities, capital structure, record keeping and the conduct of directors, officers and employees. Errors in performing clearing functions and failure to comply with related regulatory requirements could create liabilities to affected customers and lead to civil penalties imposed by the SEC or the NASD. Clearing services include the confirmation, receipt, settlement and delivery functions involved in securities transactions. Clearing securities firms are subject to substantially more regulatory control and examination than non-clearing firms because clearing operations involve substantial risks of liability to customers due to clerical errors related to the handling of customer funds and securities. We are also required to maintain cash or qualified securities in a special reserve bank account for the exclusive benefit of our customers. Failure to comply and disputes concerning compliance with any of these laws, rules or regulations could result in substantial expenses for us as well as censure, fines, the issuance of cease and desist orders or suspension or expulsion as a broker dealer. Potential governmental regulation of the Internet and online commerce could harm our business. Our business could be harmed by future legislation or regulation, the application of laws and regulations from jurisdictions whose laws do not currently apply to our business or the application of existing laws and regulations to the Internet and other online services. The adoption of any additional laws or regulations may decrease the growth of the Internet or other online services, which could, in turn, decrease the demand for our trading systems and services and increase our cost of doing business. Failure to comply with net capital requirements could subject us to suspension or revocation of our broker dealer registration by the SEC or expulsion by the NASD. We are subject to stringent rules promulgated by the SEC, the NASD and various other regulatory agencies with respect to the maintenance of specific levels of net capital by securities brokers. Failure to maintain the required net capital may subject us to suspension or revocation of registration by the SEC and suspension or expulsion by the NASD or other regulatory bodies and ultimately could require our liquidation. In addition, a change in the net capital rules, the imposition of new rules or any unusually large charge against our net capital could limit our operations that require the intensive use of capital, such as the financing of client account balances. Failure to qualify as a foreign corporation could result in the imposition of taxes and penalties that would increase our costs. Our subsidiaries Advantage Trading Group, Inc. and Empire Financial Group, Inc. are both currently registered as broker dealers in all 50 states as well as Puerto Rico, but are qualified to do business as a foreign corporation in only a few states. Because our services are available over the Internet and we have customers in many states, we and/or any of our subsidiaries may be required to qualify as a foreign corporation. If we fail to qualify as a foreign corporation in states that may require such qualifications, we may be penalized. Employee misconduct could result in regulatory sanctions and unanticipated costs. Because our business involves handling cash and marketable securities on behalf of our customers, employee misconduct could result in unknown and unmanaged risks or losses. Misconduct by employees could also include binding us to transactions that exceed authorized limits or present unacceptable risks or hiding from us unauthorized or unsuccessful activities. If our retail customers do not repay us for credit we extend to them, our financial condition could be negatively impacted. Periods of volatile markets increase the risks inherent in extending credit to the extent that we permit our retail customers to purchase securities on a margin basis. Under such circumstances the value of the collateral held by us could fall below the amount borrowed by the customer. We may then be required to sell or buy securities at prevailing market prices and incur losses to satisfy customer obligations. As of December 31, 2001, we had extended approximately $8,775,000 in credit to our retail customers, accounting for approximately 50% of our total assets. We may be required to sell or buy securities at prevailing market prices and incur losses to satisfy customer obligations which could have a substantial negative impact on our financial condition. If we are unable to keep up with rapid technological changes in a cost-effective manner, we may lose business. Our future success will depend, in part, on our ability to develop and use new technologies, respond to technological advances, enhance our existing services and products, and develop new services and products in a timely and cost-effective manner. The market for brokerage services and, particularly, electronic brokerage services over the Internet, is characterized by rapid technological change, changing client requirements, frequent service and product enhancements and introductions, and emerging industry standards. The introduction of services or products embodying new technologies and the emergence of new industry standards can render existing services or products obsolete and unmarketable. Interruption or loss of content provided by third parties could cause us to lose customers, harming our business. We rely on third-party content providers for much of the financial information we offer through our website and are therefore dependent on the ability of third-party content providers to deliver content in a timely and consistent manner. Interruption or termination of our existing third-party content supply would require us to seek content from other third parties. Delays in obtaining replacement content could cause us to lose customers. Disruption of our computer systems and/or those of our vendors and systems failures could cause our revenues to decline and our business reputation to suffer. We rely heavily on various electronic media. We receive trade orders using the Internet and telephone. In addition, we process trade orders through our own systems and those of Bear Stearns Securities Corp., ABN Amro Incorporated, The Vantra Group, Inc. and Automated Data Processing, Inc. These methods of trading are heavily dependent on the integrity of the electronic systems supporting them. Heavy system traffic during peak trading times could cause our systems to operate at unacceptably low speeds or fail altogether. Any significant degradation or failure of our computer systems, those of our vendors, or any other systems in the trading process (e.g., online service providers, record keeping and data processing functions performed by third parties and third-party software such as Internet browsers) could cause clients to suffer delays in trading. These delays could cause substantial losses for our clients and could subject us to claims from clients for losses, including litigation claiming fraud or negligence. Our computer systems are also vulnerable to damage or interruption from human error, natural disasters, power loss, sabotage or computer viruses. If our systems security is compromised, our reputation may suffer and we may lose business. Any compromise of our systems' security could harm our business. The secure transmission of confidential information over public networks is a critical element of our operations. We and our vendors rely on encryption and authentication technology to provide the security and authentication necessary to effect secure transmission of confidential information over the Internet. However, advances in computer capabilities, new discoveries in the field of cryptography or other events or developments may result in a compromise of our systems' security. Claims of infringement may increase our costs and disrupt our business. Other parties may claim that we infringe on their intellectual property rights. Regardless of whether any such claims are valid, claims of infringement could be time-consuming and expensive to defend, could divert our resources and our management's attention. If we are forced to stop using any software, systems or processes that are important to run our operations, our business may be disrupted and our costs significantly increased. If we are unable to obtain additional capital when we need it, we may not be able to effectively compete in the marketplace. We currently anticipate that our available cash resources, combined with the net proceeds from the offering, will be sufficient to meet our presently anticipated working capital and capital expenditure requirements for at least the next 12 months. In the future, however, we may need to raise additional funds in order to support further expansion, develop new or enhanced services and products, respond to competitive pressures, acquire complementary businesses or technologies or respond to unanticipated requirements. We cannot assure you that additional financing will be available when needed on terms favorable to us or on terms that will not result in dilution to our existing shareholders. Our lines of credit are subject to annual renewal in May of each year. As of December 31, 2001 we had an outstanding balance of $1,032,000 under these lines of credit. We cannot assure you that our line of credit will be renewed and if it not renewed it may affect our ability to operate. Disagreements between our co-chief executive officers could hinder our growth. Our management team is currently headed by our co-chairmen, co-chief executive officers and co-presidents, Kevin M. Gagne and Richard L. Goble. Messrs. Gagne and Goble may disagree in the future regarding business decisions. Our bylaws provide that disagreements between our co-chairmen, co-chief executive officers and co-presidents will be decided by our board of directors. Nevertheless, our business could suffer if we frequently have to resort to this dispute resolution procedure. Since Kevin M. Gagne and Richard L. Goble own most of our common stock and control us, minority shareholders will have little say in the direction of the company. Upon completion of this offering, our co-chairmen, co-chief executive officers and co-presidents, Kevin M. Gagne and Richard L. Goble, will beneficially own approximately 80% of our common stock. Accordingly, following completion of this offering, these two individuals will control us and have the power to, among other matters, to elect all directors, increase our authorized capital stock or cause us to dissolve, merge or sell our assets. Messrs. Gagne and Goble have also entered into a voting agreement under which they have agreed that corporate actions requiring their vote as shareholders will require the approval of both of them, so that neither of them can act unilaterally, thus strengthening their collective control of us. The voting agreement provides that, if Messrs. Gagne and Goble are unable to agree as to a particular proposal to be voted upon by our shareholders, they each agree to abstain from voting, which may have the effect of preventing the other shareholders from approving the proposal. Messrs. Gagne and Goble also have entered into a shareholder agreement pursuant to which each of them has granted to the other a right of first refusal (except in limited circumstances) to purchase any shares of our common stock owned by them, thus further strengthening their collective control of us. Each of Messrs. Gagne and Goble also has entered into an employment agreement with us for an initial term expiring on December 31, 2005. As a result, they have the right to control our business and operations as our most senior officers. Additional discussion of these employment agreements is found at "Directors and Executive Officers--Employment Agreements" at page 40 of this prospectus. We rely on relatively few key personnel to provide critical management functions. If one or more of such individuals leave the Company, our ability to manage our operations may be impeded and our business could be adversely impacted. Investors will experience immediate and substantial dilution. This offering involves an immediate and substantial dilution of $5.67 (80.9%) per share between the net tangible book value per share after the offering and the initial public offering price per share, assuming an initial public offering price of $7.00. There has been no prior public market for our common stock and our stock price may be volatile. Prior to this offering, there has been no public market for our common stock. We have applied for listing of our common stock on The American Stock Exchange. The initial public offering price will be determined by negotiations between us and Keefe, Bruyette & Woods., the representative of the underwriters, and may not be indicative of the actual value of the common stock and may bear no relationship to the price at which the common stock will trade after completion of this offering. The market price of our common stock may be subject to wide fluctuations in response to variations in operating results, general trends in our industry, actions taken by competitors, the overall performance of the stock market and financial services and brokerage stocks in particular as well as other factors. There are many shares eligible for future sale and sales of those shares could reduce the market price. The 1,000,000 shares of common stock offered hereby will be freely tradable without restriction or further registration under the Securities Act of 1933 by persons other than "affiliates" within the meaning of Rule 144 under the Securities Act. The holders of the remaining 4,000,000 shares of common stock generally are entitled to sell these shares without registration under the Securities Act to the extent permitted by Rule 144 under the Securities Act, which substantially limits sales by control persons. In addition, the holders of these restricted shares have agreed not to sell or dispose of those shares for a period of 180 days from the date of this prospectus without the written consent of Keefe, Bruyette & Woods, Inc. Future sales of a substantial amount of our common stock in the public market, or the perception that future sales may occur, could reduce the market price of our common stock. We may issue preferred stock with preferential rights that may adversely affect your rights. The rights of the holders of our common stock will be subject to, and may be adversely affected by, the rights of holders of any preferred stock that we may issue in the future. Preferred stock could be issued to discourage, delay or prevent a change in our control. Our articles of incorporation authorize our board of directors to issue 1,000,000 shares of preferred stock and to fix the rights, preferences, privileges and restrictions, including voting rights of these shares without further shareholder approval. The holders of preferred stock will have a preference on the receipt of dividends and payment upon liquidation compared to the holders of our common stock. Certain provisions of Florida law may discourage, delay or prevent a change of control which might otherwise be beneficial to our shareholders. Certain provisions of the Florida Business Corporation Act could delay, defer or impede the removal of incumbent directors and could make more difficult a merger, tender offer or proxy contest involving us, even if these events could be beneficial to our shareholders. These provisions could also limit the price that certain investors might be willing to pay in the future for our common stock. In addition, Florida has certain laws that may deter or frustrate takeovers of Florida corporations, although we have at the present time opted out of these statutes. CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS This prospectus contains statements about future events and expectatations which are, "forward looking statements". Any statement in this prospectus that is not a statement of historical fact may be deemed to be a forward looking statement. Forward-looking statements represent our judgment about the future and are not based on historical facts. These statements include: forecasts for growth in the number of customers using our service, statements regarding our anticipated revenues, expense levels, liquidity & capital resources and other statements including statements containing such words as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate," "continue" or "plan" and similar expressions or variations. Certain important factors may affect our actual results and could cause those results to differ materially from any forward-looking statements made in this prospectus or that are otherwise made by us or on our behalf. Investing in our common stock is risky. You should carefully consider the risks and uncertainties identified in this prospectus, including the factors described in the preceding risk factors, and our financial statements and the related notes before making an investment decision. Our business, operating results and financial condition could be adversely affected by any of the preceding risks. The trading price of our common stock could decline due to any of these risks, and you could lose all or part of your investment.

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+The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act or until this registration statement shall become effective on such date as the Commission, acting pursuant to Section 8(a), may determine. (in millions) Losses related to discontinued operations, net of income tax benefit $ 5.0 $ 8.3 $61.8 $13.2 Amortization expense on intangible assets 30.4 32.7 32.9 10.5 Interest expense 26.0 25.6 25.5 9.8 Net losses 30.1 18.2 96.5 24.7 We expect to incur a net loss in 2002, may incur net losses in the future and may never achieve profitability. We also face the risk of future charges that could be material. Beyond the charges that are expected to be incurred in connection with and upon the consummation of this offering, potential charges are: an estimated $1.0 million prepayment fee and a charge of $3.8 million for the remaining write-off of deferred financing fees in connection with prepayment of indebtedness under our existing credit facility, after giving effect to the pro-rata write-off, upon entering into a new credit facility or issuing debt instruments following this offering; an additional estimated fee of $1.0 million in the event that our leverage covenant in our credit facility is not met on December 31, 2002; a goodwill and other intangible asset write-down resulting from impairment; continued SARs expense until all SARs are either cashed-out or exchanged for options or stock; and government regulation affecting our Specialized Benefits Services segment that may result in restructuring charges (e.g., severance, lease termination and leasehold write-offs). If we are unable to achieve profitability, the value of our common stock could be negatively impacted. (a) Assumes an interest rate of 9% which was an approximate average interest on our debt over the last several years; the interest rates on most of our indebtedness are variable and it is not possible to accurately predict future interest rates. We believe that cash and cash equivalents on hand of $16.6 million as of June 30, 2002, together with cash flow generated from operations, should be sufficient to fund our estimated $18.0 million in debt principal repayments, $7.7 million in capital expenditures and working capital needs through December 31, 2002. Our liquidity thereafter will depend on our financial results and future available sources of additional equity or debt funding, which include public debt offerings, private placements of debt under Rule 144A of the Securities Act, syndicated loans, bank debt and additional public equity offerings. If we are unable to access these forms of capital on terms attractive to us or at all, we will consider raising funds from private equity sources or explore other strategic alternatives. Table of Contents The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion Preliminary Prospectus dated October 17, 2002 PROSPECTUS 9,000,000 Shares U.S.I. Holdings Corporation Common Stock Table of Contents Our high level of debt could have important consequences for you, including the following: we may have difficulty borrowing money in the future to finance working capital, capital expenditures and acquisitions, to implement our business strategy and to refinance our other debt; we will need to use cash generated by our subsidiaries to pay principal and interest on our existing credit facility and our other debt shown in the tables above, which will reduce the amount of money available to us to finance our operations and other business activities; as of June 30, 2002, the $165.0 million outstanding under our existing credit facility had a weighted average variable interest rate of 6.4%, which exposes us to the risk of increased interest rates; and all debt under our existing credit facility is secured by substantially all of our assets, including all of our equity interests in our subsidiaries, and therefore, if we default under the facility, some of our assets may be sold by our creditors. Our high level of indebtedness may put us at a competitive disadvantage relative to insurance brokers and other distributors of financial products and services. As of June 30, 2002, our total indebtedness of $229.2 million and our total indebtedness measured as a percentage of our total capitalization of 68.5% were higher than those of brokers that we consider to be generally comparable to us, including Arthur J. Gallagher, Brown & Brown and Hilb, Rogal and Hamilton. As a result, we are likely to be less able to compete effectively with our peers when acquiring other brokerage operations that are seeking cash purchase consideration versus stock purchase consideration. Additionally, with a lower level of indebtedness, our peers are likely to have greater flexibility to direct cash flow from operations toward capital expenditures, hiring additional sales professionals and other forms of reinvestment in their businesses than we have currently. Restrictive covenants in our existing credit facility make it difficult to implement our business plan, and refinance our other debt. Our existing credit facility contains, and our future debt instruments may contain, restrictive covenants. These restrictions limit: our ability to incur additional debt; the amount of capital expenditures we may make; and our ability to make acquisitions. If we are unable to obtain waivers of these restrictions, it will be difficult to implement our business strategy and to refinance our other debt. Failure to comply with financial covenants in our existing credit facility could cause all or a portion of our debt to become immediately due and payable. Under our existing credit facility, we must comply with financial covenants, which limit our flexibility in responding to changing business and economic conditions. Liabilities Premiums payable to insurance companies $ 5,376 $ 7,361 Accrued expenses 14,268 7,981 Current portion of long-term debt 4,732 4,052 Other This is our initial public offering. We are selling all of the shares. We expect the public offering price of the shares to be between $10.00 and $11.00 per share. Currently, no public market exists for our shares. Our common stock has been approved for listing on the New York Stock Exchange under the symbol USH, subject to official notice of issuance. Investing in our common stock involves risks that are described in the Risk Factors section beginning on page 8 of this prospectus. (a) Adjusted Pro Forma EBITDA as defined in the existing credit facility means the EBITDA for such period adjusted for the EBITDA of any business acquired during such period, adjusted to reflect changes in continuing revenues and expenses in connection with the acquisition and excluding from the calculation the revenues, other income items and expenses and other charges attributable to each subsidiary of ours that ceased to be wholly owned by us during such period, in each case as though such acquisition or sale had been consummated on the first day of such period. EBITDA as defined in the existing credit facility means the consolidated net income for the period plus the aggregate amount of (1) charges for consolidated interest and financing fees and costs and other interest charges accrued in or for the period, (2) charges for consolidated income taxes accrued in or for the period by us, (3) charges for consolidated amortization and depreciation, (4) compensation expense accrued in respect of SARs, minus cash payments made in the period to honor, redeem or discharge SARs, and (5) other adjustments. (b) Stockholders Equity as defined in the existing credit facility means the total of our stockholders equity and the total of our redeemable securities. In addition, under the provisions of our existing credit facility, we are generally prohibited from repurchasing shares of our capital stock, with the limited exception of repurchasing shares held by terminated employees in an amount up to $3.0 million per year. As a result, if the rights described below under Our liquidity could be reduced if a substantial number of our employee stockholders or two former employee stockholders require us to repurchase their stock and Description of Put Rights are exercised, we may be required to repurchase the related shares in excess of the monetary thresholds provided for under our existing credit facility. If the lenders under our existing credit facility do not waive the applicable limitations and we fail to repurchase the shares, we may be in default under our obligations to repurchase the shares put to us and could be sued for breach of the contract governing the put. However, if we repurchase the shares, we would be in default under our existing credit facility, which could result in the acceleration of our indebtedness under that facility and our other debt. Amounts due under our existing credit facility and under future debt instruments could become immediately due and payable as a result of our failure to comply with the restrictive covenants they contain, which, in turn, could cause all or a portion of our other debt to become immediately due and payable. Our ability to comply with these provisions in existing or future debt instruments may be affected by events beyond our control. Since 1999, we have had to amend the financial covenants in our existing credit facility five times to avoid being in default under this facility. We may be required to seek similar amendments to this facility or any replacement facility in the future and, if we need to make such amendments, we may not be able to obtain them on terms acceptable to us or at all. Our continued growth is partly based on our ability to acquire and integrate operations successfully, and our failure to do so may negatively affect our financial results. Competition to acquire traditional insurance brokerage agencies is intense. As part of our business strategy, we may seek to acquire such agencies and may experience heightened price competition from our peers. Per Share Table of Contents We also seek to acquire agencies in the core benefits, benefits enrollment and communication, and executive and professional benefits areas. Due in part to the decentralized nature of our operations, as well as the variety of types of businesses we seek to acquire, we may have difficulty integrating the operations, systems and management of our acquired companies and may lose key employees of acquired companies. Also, we may be required to obtain additional financing to pursue our acquisition strategy; however, our ability to do so is limited by the terms of our existing credit facility, which contains covenants that, among other things, require lender approval of most acquisitions that we propose to make as well as restrictions on our ability to incur additional debt. We may also be similarly limited by our future debt instruments. Government regulation relating to the supplemental executive benefits plans we design and implement could negatively affect our financial results. The Executive and Professional Benefits division of our Specialized Benefits Services segment designs and implements supplemental executive retirement plans that use split dollar life insurance as a funding source. Split dollar life insurance policies are arrangements in which premiums, ownership rights, and death benefits are generally split between an employer and an employee. The employer pays either the entire premium or the portion of each year s premium that at least equals the increase in cash value of the policy. Split dollar life insurance has traditionally been used because of its federal tax law advantages. However, in recent years, the Internal Revenue Service has proposed regulations relating to the tax treatment of some types of these life insurance arrangements. The Internal Revenue Service recently proposed regulations that treat premiums paid by an employer in connection with split dollar life insurance arrangements as loans for tax purposes under the Internal Revenue Code. In addition, the recently enacted Sarbanes-Oxley Act of 2002 may affect these arrangements. Specifically, the Sarbanes-Oxley Act includes a provision that prohibits most loans from a public company to its directors and/or executives. Because a split dollar life insurance arrangement between a public company and its directors and/or executives could be viewed as a personal loan, we may face a reduction in sales of split dollar life insurance policies to some of our clients. Moreover, members of Congress have proposed, from time to time, other laws reducing the tax incentive or otherwise impacting these arrangements. As a result, these plans as presently structured are likely to become less attractive to some of our customers. This could result in lower revenues to us in which case, we may have to restructure our Executive and Professional Benefits division. This could result in severance, lease termination, leasehold write-offs, impairment charges to intangible assets and other similar charges, as well as a reduction in future revenues. Our Executive and Professional Benefits division is one of our highest margin operations and, in 2001, represented approximately $10 million, or 3%, of our revenues and contributed $1.2 million pre-tax income toward our loss from continuing operations before income taxes of $39.3 million. We expect that in 2002 the Executive and Professional Benefits division will contribute approximately the same amount toward our consolidated financial results. If we are required to write down goodwill and other intangible assets, our financial condition and results would be negatively affected. When we acquire a business, a substantial portion of the purchase price of the acquisition is allocated to goodwill and other identifiable intangible assets. The amount of the purchase price which is allocated to goodwill and other intangible assets is determined by the excess of the purchase price over the net identifiable assets acquired. At June 30, 2002, goodwill represented $184.0 million, or 249.6% of our total stockholders equity, net of accumulated amortization of $40.2 million. At June 30, 2002, other intangible assets, including expiration rights, covenants not-to-compete and other assets, represented $102.6 million, or 139.3% of our total stockholders equity, net of accumulated amortization of $118.8 million. On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets, which addresses the financial accounting and reporting standards for the acquisition of intangible assets outside of a business combination and for goodwill and other intangible assets subsequent to their acquisition. This accounting standard requires that goodwill no longer be amortized but tested for impairment at least annually. Intangible assets deemed to have indefinite lives are no longer amortized but are subject to impairment tests at Total Table of Contents least annually. Other intangible assets will continue to be amortized over their useful lives. SFAS No. 142 also requires the completion of a transitional impairment test within six months of adoption. In May 2002, we completed the transitional impairment test, which indicated that there was no goodwill impairment as of January 1, 2002. We have no intangible assets with indefinite lives. Under current accounting standards, if we determine goodwill or intangible assets are impaired, we will be required to write down the value of such assets. Because goodwill and intangible assets comprise such a large percentage of our stockholders equity, any such writedown would have a significant negative effect on our stockholders equity and financial results. Our liquidity could be reduced if a substantial number of our employee stockholders or two former employee stockholders require us to repurchase their stock. Substantially all of our employees who hold our preferred stock from prior acquisitions may put to us that number of shares owned by them having a fair market value equal to the employee s original investment in those shares upon termination of employment by us without cause, the employee s resignation for good reason or the death or disability of the employee. As of June 30, 2002, the value of the largest individual employee stockholder s put was $1.8 million and the aggregate value of all employee stockholders puts was $17.3 million. In addition, our retired chairman of the board and one of our other former employees have rights to require us to repurchase some of the preferred stock owned by them at fair market value at the time of such repurchase, up to the amount of their original investment. Our retired chairman may require us to repurchase $1.0 million of the preferred stock owned by him during the period between December 31, 2002 and January 30, 2003. The other former employee may require us to repurchase $3.0 million of the preferred stock owned by him during a 60-day period beginning November 30, 2004. Our requirement to repurchase significant amounts of our stock is conditioned on our ability to fund the repurchase from operations or obtain other financing. If we are required to make such repurchase and have or obtain adequate cash to make the repurchase, the cash utilized to make the repurchase would be unavailable for other corporate purposes. Such circumstances would reduce our liquidity. If we are unable to fund or finance a purchase at the time the preferred stock is put to us by a stockholder, then we will be permitted to delay the purchase for a period of up to 120 days. If we are not able to fund or finance the purchase within the 120-day period, then the stockholder may withdraw the put and will again have the right to put the preferred stock to us. If the stockholder later exercises his or her put right, we would be subject to the same liquidity risks described above. Under the provisions of our existing credit facility, we are generally prohibited from repurchasing shares of our capital stock, with the limited exception of repurchasing shares held by terminated employees in an amount up to $3.0 million per year. As a result, if the put rights are exercised, we may be required to repurchase the related shares in excess of the monetary thresholds provided for under our existing credit facility. If the lenders under our existing credit facility do not waive the applicable limitations, we may be in default under our obligations to repurchase the shares put to us and could be sued for breach of the contract governing the put. However, if we effected the repurchase, we may be in default under our existing credit facility, which could result in the acceleration of our indebtedness under that facility and our other debt. Please read Description of Put Rights for additional information about these put rights. SARs remaining after the consummation of this offering could negatively affect our financial results. Until recently, we issued stock appreciation rights, or SARs, as compensation to our employees and consultants. As of June 30, 2002, there were 2,912,674 SARs held by employees and consultants and 472,656 Public offering price $ $ Underwriting discount $ $ Proceeds, before expenses, to U.S.I. Holdings Corporation $ $ The underwriters may also purchase up to an additional 1,350,000 shares from us at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus to cover overallotments. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The shares will be ready for delivery on or about , 2002. Table of Contents SARs held by former employees. Within 60 days following the consummation of this offering, we will exercise our right to cash out all of the SARs deemed exercised because they are held by former employees who have no continuing relationship with us. We estimate and currently reflect this liability to be approximately $0.8 million, which we expect to fund through cash flows from operations or additional borrowings under our existing credit facility. Soon after the completion of this offering, we intend to make an offer to exchange outstanding SARs that are held by current employees and consultants for stock options or stock under the 2002 Equity Incentive Plan. The historical accounting treatment of SARs (which is described in Note 6 Stockholders Equity, to our annual financial statements included elsewhere in this prospectus) will continue until the exchange is finalized and the SARs tendered in the exchange are canceled; that is, the difference between the reference price of the SARs (the estimated fair value of our common stock on the date the SARs were granted) and the market value of our common stock would continue to be recorded on our income statement as an expense and would, therefore, continue to affect our financial results. If fewer than all of the SARs are exchanged, the difference between the reference price of the outstanding SARs and the market value of our common stock would continue to be recorded on our income statement as an expense and would, therefore, continue to affect our financial results. Our decentralized operating strategy and structure make it difficult to respond quickly to operational or financial problems, which could negatively affect our financial results. We operate through decentralized units that report their results to corporate headquarters monthly. If there is a delay in informing corporate headquarters of a negative business development such as the possible loss of an important client or insurance carrier relationship or a threatened professional liability claim, corporate headquarters may not be able to take action to remedy the situation on a timely basis. This in turn could have a negative effect on our financial results. In addition, if one of our operating units were to report inaccurate financial information, we might not learn of the inaccuracies on a timely basis and be able to take corrective measures promptly. During the past two years, we have taken steps to minimize the impact of untimely reporting of negative business developments within our operations. For example, we reduced the number of units reporting into corporate headquarters, thereby concentrating oversight among fewer regional executive officers and reducing the number of regions requiring monitoring by corporate headquarters. Furthermore, we have instituted new operating policies and procedures to improve corporate headquarters monitoring of our nationwide operations. Specifically, our chief executive officer and chief financial officer conduct monthly calls with regional executive officers to discuss results and material operational concerns. However, if these measures are unsuccessful in reducing the occurrence or minimizing the impact of untimely and/or inaccurate reporting, our financial results could be negatively affected. The geographic concentration of our businesses could leave us vulnerable to an economic downturn or regulatory changes in those areas, resulting in a decrease in our revenues. For the years ended December 31, 1999, 2000 and 2001 and for the six months ended June 30, 2002, our California- and New York-based businesses constituted approximately 27%, 26%, 28% and 30%, respectively, of our consolidated revenues. Because our business is concentrated in these two states, the occurrence of adverse economic conditions or an adverse regulatory climate in either California or New York could negatively affect our financial results more than would be the case if our business was more geographically diversified. Currently, we are not experiencing adverse economic conditions or an adverse regulatory climate in either of these two states. The cyclical nature of P&C premium rates may make our financial results volatile and unpredictable. Commissions from the brokering of insurance products represent a majority of our revenues. Commissions are typically determined as a percentage of premium rates. We have no control over the insurance premium rates on which these commissions are calculated. For example, from 1987 through 1999, the P&C Merrill Lynch & Co. JPMorgan Table of Contents insurance industry experienced a period of flat to declining premium rates, which negatively affected commissions earned by insurance brokers. Years of underwriting losses for insurance companies combined with the downward turn in the equity markets caused insurers to increase premium rates starting in mid- to late 2000. Additionally, the insurance industry was affected by the events of September 11, 2001, which resulted in the largest insurance loss in America s history and accelerated increases in premium rates for particular lines of P&C insurance. However, the longevity of this cycle cannot be accurately predicted. Accordingly, the cyclical nature of premium rates may make our financial results volatile and unpredictable. Contingent commissions are more profitable, but less predictable, than our other revenues, which makes it difficult to forecast revenues; and decreases in these commissions may negatively impact our financial results. Many insurance companies pay us contingent commissions for achieving specified premium volume goals set by them and/or the loss experience of the insurance we place with them. We generally receive these commissions in the first and second quarters of each year. However, we have no control over the ability of insurance companies to estimate loss reserves, which affects the amount of contingent commissions that we will receive. In addition, because no significant incremental operating costs are incurred when contingent commissions are realized, a significant decrease in these commissions can cause a disproportionate increase in loss from continuing operations before income taxes. We derived approximately 3%, 4% and 4% of our consolidated revenues from contingent commissions for each of the years ended December 31, 1999, 2000 and 2001, respectively. Contingent commissions for each six month period ended June 30, 2001 and 2002 approximated 6% of our consolidated revenues, or $9.4 million. Any decrease in the contingent commissions we receive would reduce our revenues and, to a greater degree, increase our loss from continuing operations net of incoming taxes, on a percentage basis. For example, a $3.1 million reduction in contingent commissions would have reduced 2001 revenues by approximately 1% but would have increased loss from continuing operations before income taxes by approximately 8% in the same period. A significant decrease in contingent commissions would consequently have a negative impact on our financial results and limit our ability to incur and service debt and comply with financial covenants in our existing credit facility. Competition in our industry is intense and, if we are unable to compete effectively, we may lose clients and our financial results may be negatively affected. We face competition in both our Insurance Brokerage and Specialized Benefits Services segments. We compete for clients on the basis of reputation, client service, program and product offerings, and the ability to tailor our products and services to the specific needs of a client. We currently have approximately 60,000 small and mid-sized business clients. Revenues generated by our ten largest clients accounted for 5.5% of our commissions and fees in 2001, while no single client in this group represented more than 1.0% of our commissions and fees in 2001. Our client base fluctuates over time as a result of competition in our industry as well as other factors. If we lose one or more of our larger clients and are not able to replace them or otherwise mitigate our loss sufficiently, our financial results could be negatively affected. In our Insurance Brokerage segment, competition is intense in all our business lines and in every insurance market. We believe that most of our competition is from numerous local and regional brokerage firms that focus primarily on middle-market businesses and, to a lesser extent, from larger domestic brokerage firms. We believe our most significant competitors will be brokers that pursue an acquisition or consolidation strategy similar to ours, which include Arthur J. Gallagher, Brown & Brown and Hilb, Rogal and Hamilton. In addition, insurance companies compete with us by directly soliciting clients without the assistance of an independent broker or agent. Weak economic growth, as experienced in the past few years, as well as rising P&C insurance Credit Suisse First Boston Credit Lyonnais Securities (USA) Inc. Fox-Pitt, Kelton Table of Contents rates, exacerbate these various competitive pressures as some of our customers have chosen to cut back or eliminate various types of coverage. These conditions have not negatively affected our revenues to date, but they may in the future. Additionally, as P&C insurance rates continue to rise, some of our customers may seek alternatives to traditional coverage options and other mechanisms for funding their risks. Additional competitive pressures arise from the entry of new market participants, such as banks, securities firms, accounting firms and other institutions that offer insurance-related products and services. Our Specialized Benefits Services segment competes with consulting firms, brokers, third-party administrators, producer groups and insurance companies. A number of our competitors offer attractive alternative programs. We believe that most of our competition is from large, diversified financial services organizations that are willing to expend significant resources to enter our markets and from larger competitors that pursue an acquisition or consolidation strategy similar to ours. The loss of key personnel could negatively affect our financial results and impair our ability to implement our business strategy. Our success substantially depends on our ability to attract and retain senior management and the individual sales professionals and teams that service our clients and maintain client relationships. The ten highest revenue producing sales professionals during 2001 represented 9.7% of our commissions and fees for the year. In addition, each of our regional and product line reporting unit chief executive officers are responsible for significant segments of our business. If key sales professionals and senior managers were to end their employment with us, it could disrupt our client relationships and have a corresponding negative effect on our financial results, marketing and other objectives and impair our ability to implement our strategy. Our senior managers and substantially all of our sales professionals are subject to employment agreements containing confidentiality and non-solicitation provisions. We have no reason to believe any of these senior managers and key sales professionals will leave us in the foreseeable future. However, if any of them were to leave and litigate to be released from these agreements, some courts may not enforce these agreements. Our business, financial condition and/or results may be negatively affected by errors and omissions claims. We have extensive operations and are subject to claims and litigation in the ordinary course of business resulting from alleged errors and omissions in placing insurance and handling claims. The placement of insurance and the handling of claims involve substantial amounts of money. Since errors and omissions claims against us may allege our potential liability for all or part of the amounts in question, claimants may seek large damage awards and these claims can involve significant defense costs. Errors and omissions could include, for example, our employees or sub-agents failing, whether negligently or intentionally, to place coverage or file claims on behalf of clients, to provide insurance carriers with complete and accurate information relating to the risks being insured or to appropriately apply funds that we hold for our clients on a fiduciary basis. It is not always possible to prevent or detect errors and omissions, and the precautions we take may not be effective in all cases. We have primary errors and omissions insurance coverage providing limits of $5.0 million per claim and $10.0 million annual aggregate coverage. We also carry $25.0 million per claim excess coverage and $60.0 million aggregate excess coverage. Our deductible on these policies is $500,000 per claim. The coverage limits and the amount of related deductibles are established annually based upon our assessment of our errors and omissions exposure, loss experience and the availability and pricing within the marketplace. During our recent renewal, our premiums and deductibles associated with the purchase of errors and omission coverages were higher than in prior years because of adverse market conditions for buyers of these coverages. Recently, prices have increased and coverage terms have become far more restrictive because of reduced insurer capacity in the The date of this prospectus is , 2002. Table of Contents marketplace. While we endeavor to purchase coverage that is appropriate to our assessment of our risk, we are unable to predict with certainty the frequency, nature or magnitude of claims for direct or consequential damages. Our business, financial condition and/or results may be negatively affected if in the future our insurance proves to be inadequate or unavailable. In addition, errors and omissions claims may harm our reputation or divert management resources away from operating our business. Failure to comply with regulations applicable to us could restrict our ability to conduct our business. We conduct business in a number of states and are subject to comprehensive regulation and supervision by government agencies in many of the states in which we do business. State laws grant supervisory agencies broad administrative powers. Our ability to conduct our business in the states in which we currently operate depends on our compliance with the rules and regulations established by the regulatory authorities in each of these states. State insurance regulators and the National Association of Insurance Commissioners continually re-examine existing laws and regulations, some of which affect us, including those relating to the licensing of insurance brokers and agents, premium rates, regulating unfair trade and claims practices, and the regulation of the handling and investment of insurance carrier funds held in a fiduciary capacity. These examinations may result in the enactment of insurance-related laws and regulations, or the issuance of interpretations of existing laws and regulations, that adversely affect our business. More restrictive laws, rules or regulations may be adopted in the future that could make compliance more difficult and/or expensive. Specifically, recently adopted federal financial services modernization legislation addressing privacy issues, among other matters, is expected to lead to additional federal regulation of the insurance industry in the coming years, which could result in increased expenses or restrictions on our operations. In response to perceived excessive cost or inadequacy of available insurance, states have also from time to time created state insurance funds and assigned risk pools, which compete directly, on a subsidized basis, with private insurance providers. We act as agents and brokers for state insurance funds such as those in California, New York and other states in which we operate. These state funds could choose to reduce the sales or brokerage commissions we receive. In addition, these states could enact legislation to reform existing P&C and individual and group health care insurance regulations. If these reductions in commissions or changes in legislation occurred in a state in which we have substantial operations, such as California or New York, they could substantially affect the profitability of our operations in that state or cause us to change our marketing focus. Proposed tort reform legislation could decrease demand for liability insurance, thereby reducing our commission and fee revenues. Legislation concerning tort reform has been considered, from time to time, in the United States Congress and in several states. Among the provisions considered for inclusion in proposed legislation have been limitations on damage awards, including punitive damages, and various restrictions applicable to class action lawsuits. Enactment of these or similar provisions by Congress or by states in which we sell insurance could result in a reduction in the demand for liability insurance policies or a decrease in limits on policies we sell, thereby reducing our commission and fee revenues. Risks Related to our Common Stock Investors in this offering will suffer immediate and substantial dilution. The initial public offering price of our common stock will be substantially higher than the net tangible book value per share of our common stock. Purchasers of our common stock in this offering will experience immediate and substantial dilution in the net tangible book value of $13.40 per share of the common stock, Net Cash Provided By Operating Activities 11,614 9,924 Investing Activities Purchases of property and equipment (3,020 ) (3,772 ) Proceeds from sale of assets 18,254 Cash paid for businesses acquired and related costs (3,556 ) (4,920 ) Cash obtained from businesses acquired, primarily fiduciary funds 444 Other Table of Contents USI s National Distribution System Table of Contents assuming an initial public offering price of $10.50 per share. Our issuance of options and the exercise of our existing warrants will cause investors to experience further dilution if the market price of our common stock exceeds the exercise price of these securities. The market price of our common stock could be negatively affected by sales of substantial amounts of our common stock in the public markets. Sales by us or our stockholders of a substantial number of shares of our common stock in the public markets following this offering, or the perception that these sales might occur, could cause the market price of our common stock to decline or could impair our ability to obtain capital through an offering of equity securities. Upon the consummation of this offering, there will be 44,113,696 shares of our common stock outstanding. There will be 45,463,696 shares outstanding if the underwriters exercise their overallotment option in full. Of these shares, the shares of our common stock sold in this offering will be freely transferable, except for any shares sold to our affiliates, as that term is defined in Rule 144 under the Securities Act. The remaining shares will be restricted securities subject to the volume limitations and the other conditions of Rule 144. We, our directors, officers and all existing stockholders have agreed, with limited exceptions, for a period of 180 days after the date of this prospectus, that we and they will not, without the prior written consent of the representatives on behalf of the underwriters, directly or indirectly, offer to sell, sell or otherwise dispose of any shares of our common stock. Upon the consummation of this offering, all existing stockholders and their transferees will have the right to require us to register their shares of our common stock under the Securities Act for sale into the public markets, subject to the 180-day lock-up agreements. Upon the effectiveness of that registration statement, all shares covered by the registration statement will be freely transferable. In addition, following the consummation of this offering, we intend to file a registration statement on Form S-8 under the Securities Act to register an aggregate of 11,869,515 shares of our common stock reserved for issuance under our 2002 Equity Incentive Plan and our Employee Stock Purchase Plan. Subject to the exercise of issued and outstanding options, shares registered under the registration statement on Form S-8 will be available for sale into the public markets after the expiration of 180-day lock-up agreements. Possible volatility in our stock price could negatively affect us and our stockholders. The trading price of our common stock may be volatile in response to a number of factors, many of which are beyond our control, including actual or anticipated variations in quarterly financial results, changes in financial estimates by securities analysts and announcements by our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments. In addition, our financial results may be below the expectations of securities analysts and investors. If this were to occur, the market price of our common stock could decrease, perhaps significantly. In addition, the U.S. securities markets have experienced significant price and volume fluctuations. These fluctuations often have been unrelated to the operating performance of companies in these markets. Broad market and industry factors may negatively affect the price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of an individual company s securities, securities class action litigation often has been instituted against that company. The institution of similar litigation against us could result in substantial costs and a diversion of our management s attention and resources, which could negatively affect our financial results. Our common stock may not trade actively, which may cause our common stock to trade at a discount and make it difficult for you to sell your stock. This is our initial public offering, which means that our common stock currently does not trade in any market. Upon the consummation of this offering our common stock may not trade actively. In addition, since only 20.4% of our common stock will be sold to the public in this offering, the market for our stock may be Table of Contents TABLE OF CONTENTS Page Table of Contents illiquid. An illiquid market for our common stock may result in price volatility and poor execution of buy and sell orders for investors. Our initial public offering price may bear no relationship to the price at which the common stock will trade after this offering. Our principal stockholders interests in our business may be different than yours and therefore may make decisions that are adverse to your interests. After this offering, Capital Z will beneficially own 19.4% of our outstanding voting common stock. Capital Z s ownership, combined with the ownership of entities controlled by Zurich, JPMorgan Chase, CNA, UnumProvident and Ceridian, which are all unaffiliated with each other, will comprise together 52.4% of our outstanding voting common stock. As a result, Capital Z, both independently and voting together with these stockholders, will have the ability to significantly influence matters requiring stockholder approval, including, without limitation, the election of directors and mergers, consolidations and sales of all or substantially all of our assets. They also may have interests that differ from yours and may vote in a way with which you disagree and which may be adverse to your interests. In addition, this concentration of ownership may have the effect of preventing, discouraging or deferring a change of control, which could depress the market price of our common stock. Provisions of Delaware law could delay or prevent a change in control of our company, which could adversely impact the value of our common stock. Delaware law imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. This provision in Delaware law could delay or prevent a change in control of our company, which could adversely affect the price of our common stock. We have no plans to pay and are currently precluded from paying dividends on our common stock. We have never declared or paid cash dividends on our common stock and do not anticipate paying any cash dividends on our common stock in the foreseeable future. We currently intend to retain future earnings, if any, to finance our business. In addition, under our existing credit facility we are currently prohibited from paying dividends on or repurchasing shares of our capital stock, with the limited exception of repurchasing shares held by terminated employees in an amount up to $3.0 million per year. It is likely that future debt we incur will similarly restrict dividend payments and/or share repurchases. Table of Contents

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+RISK FACTORS An investment in our common stock involves a high degree of risk. You should consider carefully the following information about these risks, together with the other information contained in this prospectus, before you decide whether to buy our common stock. If any of the following risks actually occur, our business and prospects could suffer significantly. In any of these cases, the market price of our common stock could decline, and you could lose all or part of your investment in our common stock. WE ARE IN EARLY STAGES OF DEVELOPMENT AND MAY NEVER ACHIEVE PROFITABILITY. We have not yet completed the development, including obtaining regulatory approvals, of our current product candidates and, consequently, have not generated any revenues from the sale of these product candidates. Even if we succeed in developing, obtaining FDA approval for and commercializing one or more of our product candidates, we may never achieve significant sales revenue. Our ability to achieve profitability will depend, among other things, on our successfully completing development of our product candidates, obtaining regulatory approvals, contracting for the manufacture of our product candidates on favorable terms, establishing marketing and sales capabilities, achieving market acceptance for our product candidates and maintaining sufficient funds to finance our activities. We expect to encounter risks, costs and difficulties frequently encountered by companies in an early stage of development. Many of these risks are unknown, but they include those associated with managing our growth, the uncertain cycle of developing commercial pharmaceutical products and the marketing and distribution of our product candidates in a competitive market. Our failure to identify and successfully address these risks would harm our business and prospects. WE HAVE A HISTORY OF LOSSES AND EXPECT SUCH LOSSES TO CONTINUE IN THE FORESEEABLE FUTURE. Our company was formed in 1994 and has incurred significant operating expenses but has not generated significant revenues to date. We need to generate significant revenue to achieve and maintain profitability. We may not be able to generate sufficient revenue and we may never be able to achieve or maintain profitability. As of December 31, 2001, we had an accumulated deficit of $36.1 million, funded primarily by issuing preferred stock. For the fiscal years ended December 31, 1999, 2000 and 2001, we had operating losses of approximately $1.0 million, $1.3 million and $12.9 million, respectively, resulting principally from research and development efforts and other costs of operations, and we expect to incur operating losses for the foreseeable future. We expect to continue to incur significant operating expenses and anticipate that our expenses will increase substantially in the foreseeable future as we: - conduct clinical trials; - conduct research and development on existing and new product candidates; - seek regulatory approvals for our product candidates; - build a marketing and sales infrastructure to commercialize our product candidates; - hire additional clinical, scientific and management personnel; and - add operational, financial and management information systems and personnel. WE MAY NOT RECEIVE REGULATORY APPROVALS FOR OUR PRODUCT CANDIDATES OR APPROVALS MAY BE DELAYED, EITHER OF WHICH COULD PREVENT US FROM MARKETING OUR PRODUCT CANDIDATES. None of our product candidates is currently approved for sale by the FDA or by any other regulatory agency in the world, and our product candidates may never be approved for sale or become commercially viable. If we fail to obtain regulatory approval for a product candidate that we intend to market, such failure could have a material adverse effect on our business, results of operations, and financial condition. We cannot assure you that we will obtain such approval. For example, the results of our Phase III efficacy study for Enjuvia at the 0.3 mg dosage strength did not meet the FDA's threshold for showing a statistically significant reduction in the frequency and severity of vasomotor symptoms at all monitoring points during the study, and this may hinder our ability to obtain FDA approval at this dosage strength. We are seeking FDA approval of our 0.45 mg dosage strength based on data correlating the 0.45 mg dosage strength to the 0.3 and 0.625 mg dosage strengths. The FDA may require us to perform additional studies evaluating the level of the product candidate in the blood after dosing to prove the correlation of dosage strengths. If we are unable to gain approval of the 0.3 mg dosage strength, we will be unable to gain approval of the 0.45 mg dosage strength for the vasomotor indication unless we conduct an additional trial. We cannot assure you that, if we conduct the trial, the FDA will approve the 0.45 mg dosage strength for the vasomotor indication. In addition, we currently do not plan to conduct any separate efficacy studies for the treatment of vasomotor symptoms and prevention of osteoporosis for Projuvia. As a result, if we fail to obtain approval for any of the indications for which we are seeking approval with respect to Enjuvia, such failure also would adversely affect our efforts to obtain approval of Projuvia. Any failure by us to comply with current or future laws, regulations and procedures that apply to our product candidates could result in civil, criminal and punitive liability, and such liability could have a material adverse effect on our business, results of operations and financial condition. Before the marketing or commercial sale of a pharmaceutical product, we must obtain regulatory approval generally based upon: - pre-clinical and clinical testing, studies and trials establishing the safety and efficacy of the product for each target indication; and - chemistry, manufacturing, and controls data. The drug approval process is generally time consuming, expensive and subject to unexpected delays. Despite the expenditure of time, human resources and capital by us, we cannot assure you when, if at all, any of our product candidates will gain approval from the FDA and comparable foreign entities. Even after submitting applications to the appropriate regulatory agencies, any number of factors could delay the approval process, including the need to generate and submit additional data, or adverse changes in approval requirements. Delays or rejections may be encountered during any stage of the regulatory approval process based upon the failure of clinical data to demonstrate compliance with, or upon the failure of the product candidate to meet, regulatory requirements for such factors as quality, safety and efficacy. The FDA and comparable foreign entities may change the approval requirements for our product candidates or may require demonstration of clinical endpoints that we may not be able to establish. Any change in approval requirements or the establishment of unanticipated clinical endpoints could increase the cost of our product candidates' clinical development beyond our ability to pursue such study or product candidates, and may significantly change the time to approval for one or more of such product candidates. In particular, we believe that a sexual dysfunction indication for Juviand involves a high degree of risk since the FDA has yet to establish the criteria for effectiveness in treating female sexual dysfunction. Moreover, even if the FDA does establish such criteria, it may do so without sufficient specificity. Either event could make it difficult or impossible to design clinical trials to show that Juviand is safe and effective for female sexual dysfunction or obtain FDA approval for other therapeutic uses. Any such delay or increase in cost due to an adverse decision by the FDA with respect to approval requirements, clinical endpoints or effectiveness criteria would have a material adverse effect on our business, results of operations and financial condition. WE ARE DEPENDENT ON THE SUCCESSFUL OUTCOME OF CLINICAL TRIALS FOR OUR PRODUCT CANDIDATES. Before obtaining regulatory approval for the sale of our product candidates, they must be subjected to extensive pre-clinical and clinical testing to demonstrate their safety and efficacy for humans. Our success will depend on the success of our currently ongoing clinical trials and subsequent clinical trials that have not yet begun. There are a number of difficulties and risks associated with clinical trials. The possibility exists that: - trial patient recruitment may be slower than expected; - patients may drop out of our clinical trials; - results may not be statistically significant or predictive of results that will be obtained from large-scale, advanced clinical trials; - we may discover that a product candidate does not exhibit the expected therapeutic results in humans; - we may discover that a product candidate may cause harmful or undesirable side effects; or - we or the FDA may suspend the clinical trials of our product candidates. To date, patient recruitment for our clinical trials has been slower than we originally expected. Although patients have dropped out of our trials, the dropout rate has not been greater than we anticipated. We have not experienced any of the other potential difficulties or risks described above. The results from pre-clinical studies and early clinical trials may not accurately predict the results that will be obtained in large-scale testing. If the results of the large-scale testing vary significantly from the pre-clinical studies and early clinical trials, we will have allocated resources to a product candidate that ultimately may fail to obtain regulatory approval, which would have a material adverse effect on our business, results of operations and financial condition. In addition, we depend on independent clinical investigators and contract research organizations to conduct our clinical trials. If independent investigators fail to devote sufficient resources to the development of our product candidates, or if their performance is substandard, it will delay the approval and commercialization of our product candidates. If our independent clinical investigators and contract research organizations fail to comply with the FDA's standards for good clinical practice, the results of our clinical trials could be called into question and the clinical development of our product candidates could be delayed. EVEN IF WE OBTAIN REGULATORY APPROVAL, WE WILL BE SUBJECT TO ONGOING REGULATION, AND ANY FAILURE BY US TO COMPLY WITH SUCH REGULATION COULD SUSPEND OR ELIMINATE OUR ABILITY TO SELL OUR PRODUCTS. We have submitted an application for regulatory approval of Enjuvia for the treatment of vasomotor symptoms, and we intend to seek regulatory approval of our other product candidates and of Enjuvia for other indications. Even if we obtain regulatory approvals, failure to comply with post-marketing requirements, such as maintenance of current Good Manufacturing Practices, or safety surveillance of such product candidates or lack of compliance with other regulations could result in suspension or limitation of approvals or other enforcement actions. Current Good Manufacturing Practices are FDA regulations that define the minimum standards that must be met when manufacturing pharmaceuticals and apply to all drugs for human use including those to be used in clinical trials as well as those produced for general sale after approval of an application. These regulations define requirements for personnel, buildings and facilities, equipment, control of raw materials and packaging components, production and process controls, packaging and label controls, handling and distribution, laboratory controls, and recordkeeping. Furthermore, the terms of any product candidate approval, including the labeling content and advertising restrictions, may be so restrictive that they could adversely affect the marketability of our product candidates. Any such failure to comply or the application of such restrictions could limit our ability to market our product candidates and have a material adverse effect on our business, results of operations and financial condition. WE MAY EXPERIENCE DIFFICULTY RAISING NEEDED CAPITAL IN THE FUTURE. We have expended, and will continue to expend, substantial funds to complete the research, development, clinical testing, manufacturing and commercialization of our product candidates. To date we have used, rather than generated, cash from operations and we expect this to continue until we are able to generate significant revenue from the sale of our product candidates. We expect the proceeds of this offering to fund our operations through the initial launch period for Enjuvia. We anticipate that cash flow from operations and short-term borrowings will fund the launches of Projuvia and Juviand. If any of our product candidates' anticipated launch dates are delayed or if our launches are more costly than we anticipate, we may require additional financing. In addition, one of our strategies is to acquire products or product candidates. Any such acquisition, depending on size and scope, may require additional financing. If we seek to raise additional funds through equity or debt financings, collaborative arrangements or other sources, this may dilute your ownership in us. Additional financing may not be available on acceptable terms, if at all. If our operations require more funds than we anticipate or our sources of financing do not produce adequate funds, we may have to delay, reduce the scope of, or eliminate one or more of our product development, approval and commercialization programs by delaying the timing of certain clinical studies and development activities, which would materially curtail our business and growth and harm our prospects. WE SOURCE MANY OF THE PRINCIPAL COMPONENTS OF OUR PRODUCT CANDIDATES FROM SINGLE OR LIMITED SOURCE SUPPLIERS AND THE FAILURE OF SUCH SUPPLIERS TO CONTINUE TO SUPPLY SUCH COMPONENTS ON TERMS OR OF QUALITY ACCEPTABLE TO US COULD MATERIALLY IMPACT OUR ABILITY TO PRODUCE OUR PRODUCT CANDIDATES. Many of the principal components of our product candidates are available only from single or limited source suppliers. Berlex Laboratories, Inc., or Berlex, has agreed to supply, through Berlichem, Inc., or Berlichem, our requirements for delta(8),(9) dehydroestrone. We have contracted with Organics/LaGrange, Inc. to incorporate this compound into our complex estrogens mixture as delta(8),(9) dehydroestrone sulfate, or delta(8),(9). We believe multiple manufacturers will be able to synthesize this compound and incorporate it into our complex estrogens mixture. In addition, the androgen we intend to use in Juviand is only currently available from one supplier and through a proprietary process we have developed. In the event we cannot maintain good relationships with our suppliers or that we are unable to find suitable replacements if the relationships with any of our existing suppliers are terminated, our competitive advantage and results of operations could suffer. We have not experienced delays in our one clinical trial conducted to date due to reliance on these suppliers. Regulatory authorities, such as the FDA, require that we contract only with manufacturers that comply with current Good Manufacturing Practices, as defined and prescribed by applicable regulations, and other applicable laws. Other than by attempting to enforce contractual obligations to us mandating compliance by our suppliers, we have no control over whether our third-party suppliers will be able to supply our product candidate components in conformity with such requirements. A failure by such suppliers to comply with regulatory requirements could result in an interruption of the availability of our product candidates. In addition, any failure by us or a third-party provider to meet orders could damage our reputation and have a material adverse effect on our business, results of operations and financial condition. Since the marketing approval process requires manufacturers to indicate their proposed suppliers of active pharmaceutical ingredients and certain packaging materials in their applications to the FDA, regulatory approval of any new supplier would be required if active pharmaceutical ingredients or such packaging materials were no longer available from the specified supplier. The qualification of a new supplier could delay our development and marketing efforts and materially adversely affect our company. WE FACE SIGNIFICANT COMPETITION, INCLUDING THE RISK THAT PRODUCTS OF COMPETITORS WILL MAKE OUR PRODUCT CANDIDATES OBSOLETE. Many companies currently market products which will compete directly with our product candidates, assuming they are approved, including Wyeth (Premarin(R) family of products), Novartis (Vivelle(R)), Pharmacia (Activella(R)), Berlex (Climara(R)), Solvay (Estratest(R)), Monarch Pharmaceuticals (Menest(R), Ortho Prefest(R)), Warner Chilcott (Estrace(R)) and Barr Laboratories, Inc. (Cenestin(R)). All of these companies' products are FDA-approved and actively marketed. These, as well as other competitors such as Procter & Gamble (estradiol-testosterone patch), may have products in development that also will directly compete with our product candidates. Our competitors may have relationships with managed care providers that may make it difficult for us to penetrate the hormone replacement therapy market. In addition, these competitors possess far greater financial, technical and human resources than we do. Many of these companies also possess greater experience and resources in handling the FDA testing and approval process and marketing pharmaceutical products. According to IMS Health, the Premarin(R) family of products accounted for approximately 67% of all hormone replacement therapy prescriptions in 2001. Premarin(R)'s significant market share may make it difficult to compete with Premarin(R) or command a meaningful portion of the hormone replacement therapy market not accounted for by Premarin(R). Our ability to compete with the Premarin(R) family of hormone replacement therapy products, or with other currently marketed hormone replacement therapy products, will be significantly affected by whether our product candidates are as safe and effective as, more safe and effective than, or comparable or superior in other respects compared with, such competing products by reason of the combination, doses, and regimens of the hormones in our product candidates, the source and nature of the hormones we use, and the absence of biological impurities in our product candidates. We cannot claim that our product candidates have equivalent or superior qualities unless such equivalence or superiority is shown in comparative studies. We currently do not intend to conduct such studies. Even if we were to do so, we do not know if such studies would be successful or that the FDA would agree that they are sufficient to enable us to make equivalence or superiority claims in our marketplace promotion of our product candidates. If such studies are not conducted or are unsuccessful, or if the FDA does not permit us to make relevant claims about the equivalent or superior qualities of our product candidates, our ability to compete effectively with the Premarin(R) family of products, or other hormone replacement therapy products, will be adversely affected. Moreover, rapid improvements and technological advances characterize the pharmaceutical and biotechnology industries. Even if we manage to successfully develop our product candidates, obtain FDA approval, and effectively market our product candidates, other companies may develop technologies and products that are more effective or achieve greater market acceptance than those developed by us. Such products could render our product candidates and technologies less competitive or obsolete. OUR PRODUCT CANDIDATES MAY CARRY CERTAIN HEALTH RISKS WHICH MAY HINDER OUR ABILITY TO MARKET THESE PRODUCTS. The class of products we currently are developing is known to carry certain health risks, including an increased risk of certain types of cancer. If our product candidates are approved by the FDA, we expect the labeling of each of our approved product candidates to contain a warning regarding the possible health risks associated with taking the product candidate. If a warning label required by the FDA adversely affects the market acceptance of our product candidates or if our product candidates are otherwise unable to effectively compete in the market for this class of drugs, such inability to compete would have a material adverse effect on our business, results of operations and financial condition. In addition, there are current studies that question the potential collateral benefits of hormone replacement therapy such as protecting against coronary heart disease, preventing memory loss, slowing the progression of Alzheimer's disease and improving the symptoms of depression. These studies are discussed in a recent position paper financed by the National Institutes of Health, or NIH, and the private Giovanni Loren Zini Medical Science Foundation of Italy. This paper, in which 28 doctors and scientists review the results of existing studies, questions certain of the claimed collateral benefits of hormone replacement therapy. We do not know if these studies or the NIH paper will adversely affect the market for hormone replacement therapy products and the commercialization of our product candidates. IF THERE IS LITTLE OR NO MARKET ACCEPTANCE OF OUR PRODUCT CANDIDATES, OUR REVENUES WILL BE REDUCED. Even if our product candidates obtain FDA approval, they may not gain market acceptance among physicians, patients, third-party payors and the medical community. The degree of market acceptance of any of our product candidates will depend on a number of factors, including: - demonstration of their clinical efficacy and safety; - their cost-effectiveness; - their potential advantage over alternative existing and newly developed treatment methods; - the marketing and distribution support they receive; and - reimbursement policies of government and third-party payors. Our product candidates, if successfully developed and approved by the FDA, will compete with a number of drugs and therapies currently manufactured and marketed by major pharmaceutical and other specialty pharmaceutical companies. The Premarin(R) family accounted for approximately 67% of all hormone replacement therapy prescriptions in 2001. We may not be able to successfully compete with the Premarin(R) family of products or command a meaningful portion of the hormone replacement therapy market not accounted for by the Premarin(R) family of products. Furthermore, there currently does not exist an established market for female sexual dysfunction products, and thus our Juviand product candidate will face the challenges associated with entering an unestablished product market. Our product candidates also may compete with new products currently under development by others or with products that may cost less than our product candidates. Physicians, patients, third-party payors and the medical community may not accept or utilize our product candidates. If our product candidates do not achieve significant market acceptance, there will be a material adverse effect on our business, results of operation and financial condition. IF WE ARE UNABLE TO CREATE MARKETING AND SALES CAPABILITIES, OR ENTER INTO AGREEMENTS WITH THIRD PARTIES TO PERFORM THESE FUNCTIONS, WE WILL NOT BE ABLE TO COMMERCIALIZE OUR PRODUCT CANDIDATES. We do not have the marketing or sales capabilities to support the launch of our product candidates. To commercialize our product candidates we must acquire or internally develop marketing and sales capabilities or make arrangements with third parties to perform these services for us. We initially intend to rely on the services of a contract sales organization to market our first product candidate if it receives FDA approval. If we obtain FDA approval for our other product candidates, we intend to internalize our sales function and/or to rely on relationships with one or more pharmaceutical companies or other third parties with established distribution systems and direct sales forces to market our product candidates. If we decide to market any of our product candidates directly and are not able to hire sales representatives from contract sales organizations, we must either acquire or internally develop a sales force. The acquisition or development of a sales infrastructure would require significant costs and management involvement, which may divert the attention of our management and key personnel. To the extent we enter into co-promotion or other licensing agreements for our product candidates, our product revenues may be lower than if we directly marketed and sold our product candidates, and a portion of the revenue we receive will depend upon the efforts of third parties, which may not be successful. CHANGES IN THE REIMBURSEMENT RATES OF THIRD-PARTY PAYORS OR CURRENT LAWS REGARDING SUCH RATES MAY REDUCE OUR ABILITY TO MAKE A REASONABLE RETURN ON INVESTMENT AND INVESTORS MAY BE ADVERSELY AFFECTED. Our success will depend in part on the extent to which reimbursement for the costs of therapeutic products and related treatments will be available from third-party payors, such as government health administration authorities, private health insurers, managed care programs and other organizations. We cannot assure you that our product candidates will be included in certain key formularies of such third-party payors. If generic versions of the Premarin(R) family of products enter the hormone replacement therapy market, third-party payors would likely tailor reimbursement policies to encourage patients to use these generic products to the extent they are less expensive than other alternatives, such as our product candidates. The FDA may approve a generic version of Premarin(R) at any time. Over the past decade, as the cost of healthcare has risen significantly, legislators, regulators and third-party healthcare payors have attempted to curb these costs by limiting the amount of reimbursement for certain products. In the future, federal and state legislatures may pass laws limiting the amount of reimbursement for certain pharmaceutical products, including our product candidates. In addition, third-party insurance payors also may reduce the amount they are willing to reimburse for certain pharmaceutical products. Any such actions by state or federal legislatures or by third-party payors could hinder our ability to realize a significant return on investment in product development and our business, results of operations, and financial condition would be adversely affected. Further, the threat of cost control measures might materially adversely affect our stock price. WE MAY NOT BE ABLE TO PROTECT, THROUGH PATENTS, THE PROPRIETARY TECHNOLOGIES AND PROCESSES WE PLAN TO UTILIZE TO DEVELOP COMMERCIALLY VIABLE HORMONE-BASED PRODUCT CANDIDATES. To a large extent, our future success will depend on our ability to use our proprietary technologies and processes to develop commercially viable hormone-based product candidates for the hormone replacement therapy and other therapeutic markets. We currently have two approved patents and twelve pending patent applications in the United States. Of the two approved patents, one expires on July 15, 2016 and the other expires on August 1, 2016. Neither of these approved patents is applicable to our current product candidates. We do not license patents from any third parties. Many of our pending patents are applicable to more than one of our product candidates. Up to five of the pending patents relate to Enjuvia, up to six of the pending patents relate to Projuvia and up to five of the pending patents relate to Juviand. Two of our patent applications, which include claims directed to either the composition of matter or the synthesis of the complex estrogens that we use in our product candidates, are pending, and under review with the United States Patent and Trademark Office. Obtaining patents for pharmaceuticals is often difficult and sometimes requires an appeal within the Patent and Trademark Office. Many patent applications initially receive "office actions" denying the grant of a patent and there can be no guarantee a patent will issue once an application receives an office action. We have received such an office action for our composition of matter patent application, and no final determination has been made by the Patent and Trademark Office examiners regarding either our composition of matter or our synthesis patent applications. It is likely that an appeal within the Patent and Trademark Office will be required with respect to our composition of matter application. If either of such patents is not issued, any potential patent exclusivity period relative to that technology will not be available, and if neither of such patents issues, we will have no patent protection for our complex estrogens mixture used in our first three product candidates. In addition, such pending patent rights, if granted, may not prevent competitors from commercializing products that are similar or functionally equivalent to our product candidates, or using technologies or processes for formulating or manufacturing such similar or functionally equivalent products. More specifically, we do not know: - if and when our pending patents will issue; - the degree of protection any patents we obtain will afford us against competitors with similar technologies or processes; - whether or not others will obtain patents claiming properties similar to those covered by our patent applications; - the extent to which patents granted to others will affect our patent applications and the use of our technologies or processes; or - the cost of potential patent litigation. Furthermore, the validity of any patent rights granted to us may be successfully challenged in the future and third parties may claim that one or more of our product candidates, technologies or processes infringe upon their patent rights. In addition, our competitors may be able to avoid our patent rights through design innovation. It is also possible that third parties will obtain patent or other proprietary rights that might be necessary or useful for the development, manufacture or sale of our product candidates. In cases where third parties are the first to invent a particular product or technology, it is possible that those parties will obtain patent rights that will be sufficiently broad to prevent us from developing, manufacturing or selling our product candidates. We may need to obtain licenses for intellectual property rights from others to develop, manufacture and market commercially viable product candidates. Such licenses may not be obtainable on commercially reasonable terms, if at all, and any licensed patents or proprietary rights we obtain may not be valid and enforceable. Failure to obtain or maintain patent protection over our proprietary technologies or processes, for any reason, would have a material adverse effect on our business, results of operations and financial condition. OUR NON-PATENTED, PROPRIETARY TECHNOLOGIES AND PROCESSES MAY NOT BE ADEQUATELY PROTECTED FROM UNAUTHORIZED DISCLOSURE, AND UNAUTHORIZED DISCLOSURE MAY HAVE A MATERIAL ADVERSE EFFECT ON US. In addition to patent protection we have or propose to obtain, we also rely on confidentiality and non-disclosure agreements with our employees, consultants, advisers and collaborators to protect certain trade secrets and proprietary information relating to our technologies and processes. These agreements may not effectively prevent disclosure of our confidential information and may not provide us with an adequate remedy in the event of unauthorized disclosure of such information. Failure to obtain or maintain trade secret protection, for any reason, would have a material adverse effect on our business, results of operations and financial condition. WE MAY NOT BE ABLE TO ESTABLISH OWNERSHIP OF TECHNOLOGIES AND PROCESSES DEVELOPED BY EMPLOYEES, CONSULTANTS AND SERVICE PROVIDERS, WHICH COULD DIMINISH OUR COMPETITIVE POSITION AND HAVE A MATERIAL ADVERSE EFFECT ON US. We use our employees, consultants and service providers to develop our technologies and processes, and disputes may arise about the ownership of proprietary rights to those technologies and processes. To maintain the confidentiality of trade secrets and proprietary information, we maintain a policy of requiring employees, scientific advisors, consultants and collaborators to execute confidentiality and invention assignment agreements upon commencement of a relationship with us. Nonetheless, we may be unable to prove or establish proprietary rights to such technologies and processes. Protracted and costly litigation could be necessary to enforce and determine the scope of our proprietary rights. Failure to prove or establish such proprietary rights, or the failure to do so in a cost effective manner, could have a material adverse effect on our business, results of operations and financial condition. WE RELY ON THIRD PARTIES FOR RESEARCH, DEVELOPMENT AND MANUFACTURING NEEDS, AND ANY FAILURE OF SUCH THIRD PARTIES TO PROVIDE APPROPRIATE SERVICES TO US WILL HAVE A MATERIAL ADVERSE EFFECT ON US. We currently rely on third parties to provide almost all our research, development and manufacturing resources. Our current research and development vendors include aaiPharma, Inc., or aaiPharma, Pharmaceutical Products Development Inc., Pharmaceutics International Inc., or Pharmaceutics International, ProClinical Inc., Quality Chemical Laboratories Inc., PRACS Institute, Ltd. and MDS Pharma Services. aaiPharma and Pharmaceutics International have manufactured small quantities of our product candidates for clinical purposes. Upon expiration of the term, or upon earlier termination, of any third-party agreement or arrangement, we may not be able to renew or extend any such agreement with the third party, or obtain an alternative, for the necessary goods or services on commercially viable terms, if at all. In addition, third-party manufacturers may not be able to meet the demand for our product candidates and any such failure may adversely affect our business, results of operations and financial condition. WE DEPEND ON CERTAIN KEY PERSONNEL AND CANNOT ASSURE YOU THAT SUCH PERSONNEL WILL CONTINUE TO SERVE OUR COMPANY IN THE FUTURE OR THAT WE WILL BE ABLE TO RECRUIT AND RETAIN OTHER NEEDED PERSONNEL. We are dependent on the members of our senior management team. In particular, we rely on the services of R. Forrest Waldon, our President and CEO, and Thomas W. Leonard, Ph.D., our Vice President, Chief Science Officer. We do not carry key man life insurance on the lives of any of our key personnel. The loss of service of any of these individuals would disrupt our operations. In addition, we may need to hire certain additional key officers and staff, including a medical director and regional marketing and sales managers. We may not be able to hire or retain capable personnel to fill these positions. Many of the companies with whom we compete for employees have greater financial resources than we do. We may not be able to compete successfully with these companies for qualified personnel and officers. WE ARE SUBJECT TO REGULATION BY THE DRUG ENFORCEMENT ADMINISTRATION. Since our Juviand product candidate will contain an androgen, which is an anabolic steroid, the Drug Enforcement Administration will require facility licenses, tracking records, secured storage and disposal capabilities in facilities developing or manufacturing this product candidate. Since all manufacturing, packaging, analytical testing and storage of the active androgen chemical and Juviand is not conducted by us, we are not required to register with the Drug Enforcement Agency. Our vendors, suppliers and contractors that handle the androgen for us, and that are required to register with the Drug Enforcement Administration, are to the best of our knowledge currently registered. Failure to comply with the Drug Enforcement Administration's facilities requirements for this type of compound, or failure to comply with the Drug Enforcement Administration's requirements for tracking, storing, or disposing of this compound, could result in revocation or suspension of the facility license necessary to continue developing or manufacturing the compound. Such suspension or revocation of the required Drug Enforcement Administration license to develop or manufacture the Juviand product in a facility we use could have a material adverse effect on our business, results of operations, and financial condition. In addition, we may develop other product candidates that fall under Drug Enforcement Administration jurisdiction and thus subject us to the same types of risks. WE FACE POTENTIAL LIABILITIES RELATING TO THE DEVELOPMENT AND SALE OF DRUGS AND THE STORAGE OF POTENTIALLY HARMFUL MATERIALS. We are developing pharmaceutical product candidates which currently involve human consumption in clinical trials and, if approved by the FDA, will ultimately involve human consumption in the marketplace. Such consumption exposes us to the risk of liability for personal injury or death to the persons using our product candidates. Risks relating to use of hormone replacement therapy products include, but are not limited to, an increase in the incidence of breast cancer in women after extended estrogen dosing, an increased risk of endometrial cancer for women on long term estrogen therapy who have not had a hysterectomy if no progestin is co-administered, and an increase in the risk of abnormal blood clotting. We have obtained clinical trial insurance at a level that we consider appropriate for our current stage of development. Maintaining such insurance coverage costs us approximately $50,000 per year. We do not maintain comprehensive product liability insurance. Our liability may exceed the limitations of our present insurance coverage. As we commercialize our product candidates, we will need to obtain more extensive insurance coverage. Such insurance may not be available at an acceptable cost, if at all, and such coverage may not be sufficient to shield us from liability. A successful product liability claim that exceeds our insurance coverage could have a materially adverse effect on our business, results of operations and financial condition. Occupational exposure to estrogens without adequate protection may result in breast pain or tenderness in women and an increase in breast size in men. Occupational exposure to large amounts of progestins may have a negative impact on fertility or menstrual irregularities in female workers. Occupational exposure to large amounts of androgens could cause development of some male characteristics in female workers. Currently, we do not own adequate facilities to handle the hormone materials which comprise our product candidates, and rely on third parties for the processing, storage and destruction of such materials. Although we believe that our service providers utilize adequate safety procedures for handling and disposing of such materials that comply with the standards prescribed by such laws and regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any damages that result and any such liability could have a material adverse effect on our company. In addition, we may be held liable in the event of third-party claims against our manufacturers, suppliers, contract sales organizations, and third-party research and development providers relating to our product candidates. IF WE DECIDE TO ENTER THE GLOBAL PHARMACEUTICAL MARKET, WE WOULD CONFRONT MANY RISKS ASSOCIATED WITH DOING BUSINESS IN MARKETS OUTSIDE THE UNITED STATES. Because the pharmaceutical and biotechnology industries are increasingly competing in global markets, we may eventually market our product candidates outside the United States. Doing business outside the United States involves various risks and expenses. Non-U.S. regulatory agencies often require different tests and applications than those required by the FDA. If we decide to do business outside the United States, we may need to expend significant resources to obtain non-U.S. regulatory approval. We cannot assure you that such expenditures, if made, would result in regulatory approval. In addition, even if we obtain regulatory approval outside the United States, successfully operating in non-U.S. markets may prove difficult especially in light of many factors that may be beyond our control. International operations may be limited or disrupted by, among other things, imposition of government controls, export license requirements, political or economic instability, trade restrictions and changes in tariffs, restrictions on repatriating profits, taxation, difficulties in staffing and managing international operations, and fluctuations in currency exchange rates. CERTAIN PROVISIONS IN OUR RESTATED CERTIFICATE OF INCORPORATION AND RESTATED BYLAWS AND DELAWARE STATE LAW MAY BE USED TO RESIST ACQUISITIONS AND COMBINATIONS INVOLVING US THAT MIGHT OTHERWISE BENEFIT OUR STOCKHOLDERS. Provisions of our restated certificate of incorporation and restated bylaws and Section 203 of the Delaware General Corporation Law give our board of directors broad discretion in resisting or delaying proposed acquisitions of our company. These provisions, in addition to the existence of several large stockholders, may discourage possible acquisitions or combinations of our company, even if such acquisitions or combinations would otherwise benefit our stockholders. For more information, see "Description of Capital Stock." WE RETAIN BROAD DISCRETION AS TO THE USE OF PROCEEDS AND AN INEFFECTIVE USE OF PROCEEDS WOULD BE DETRIMENTAL TO OUR COMPANY. We retain significant flexibility in applying the net proceeds of this offering. If we fail to effectively use the net proceeds of this offering, our business, results of operations and financial condition could be materially adversely affected. WE MAY NOT SUCCESSFULLY MANAGE OUR GROWTH. Our success will depend upon the expansion of our operations and the effective management of growth, which will place significant strains on our management and on our administrative, operational and financial resources. To manage our growth, we must expand our facilities, augment our operational, financial and management systems and hire and train additional qualified personnel. If we cannot manage our growth effectively, our business will be harmed. THE MARKET PRICE OF OUR COMMON STOCK AFTER THIS OFFERING MAY FLUCTUATE WIDELY AND RAPIDLY. There is currently no public market for our common stock, and an active trading market may not develop or be sustained after this offering. We and the underwriters' representatives will negotiate an initial public offering price that may not be indicative of the market price for our common stock after this offering. As a result, the market price of our stock could fall below the initial public offering price. The market price of our common stock could fluctuate significantly as a result of many factors including: - the receipt and timing of FDA approval of our product candidates, if granted; - our financial performance; - failure to meet analysts' or investors' expectations; - economic and stock market conditions; - changes in evaluation and recommendation by securities analysts who follow our stock or our industry; - earnings and other announcements by, and changes in market evaluations of, other companies in our industry; - changes in business or regulatory conditions; - announcements or implementation by us or our competitors of technological innovations or new products; - the trading volume of our common stock; or - other factors unrelated to our company or industry. The securities of many technology and pharmaceutical companies have experienced extreme price and trading volume fluctuations in recent years, often unrelated or disproportionate to the companies' operating performances. Following periods of volatility in the market price of a company's securities, stockholders often have instituted securities class action litigation against that company. If we become involved in a class action suit, it could divert the attention of management, and, if adversely determined, could have a material adverse impact on our financial condition. SUBSTANTIAL SALES OF OUR COMMON STOCK AFTER THE OFFERING COULD CAUSE OUR STOCK PRICE TO FALL. Our sale or the resale by our stockholders of shares of our common stock after this offering could cause the market price of our common stock to decline. After this offering, we will have shares of common stock outstanding. Of these shares, the shares sold in this offering will be freely transferable without restriction. As of May , 2002, options to purchase shares of our common stock were outstanding. These options are subject to vesting that generally occurs over a period of up to three years following the date of grant. In addition, we have established a new stock option plan, under which shares will be available for option grants. We intend to file a registration statement following this offering to register the shares underlying all such options. In addition, as of May , 2002, warrants to purchase shares of our common stock were outstanding and were fully vested with respect to of such shares. The shares received upon exercise of these warrants may become freely tradable at various points over the next few years, depending upon the method of exercise. Certain of our stockholders, optionholders and warrantholders signed lock-up agreements before the commencement of this offering. Under these lock-up agreements, these stockholders, optionholders and warrantholders have agreed, subject to limited exceptions, not to sell any shares owned by them as of the date of this prospectus for a period of 180 days thereafter, unless they first obtain the written consent of Banc of America Securities LLC and Bear, Stearns & Co. Inc. At the end of 180 days, unless earlier waived by Banc of America Securities LLC and Bear, Stearns & Co. Inc., the lock-up restrictions will end and the stockholders, optionholders and warrantholders will be able to sell such shares. YOU WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION. If you purchase common stock in this offering, you will pay more for your shares than the amounts paid by existing stockholders for their shares. As a result, you will experience immediate and substantial dilution of approximately $ per share, representing the difference between our net tangible book value per share after giving effect to this offering and the initial public offering price. Stated another way, investors in this offering will contribute % of the total equity capital raised by our company to date but will own only % of our outstanding common shares and this amount will be reduced further upon the exercise of options and warrants. For more information, see "Dilution."

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+RISK FACTORS An investment in our common stock involves significant risks. You should carefully consider the following risk factors before you decide to buy our common stock. Risks Related To Our Company We have no product revenues and may need to raise additional capital to operate our business. We are a development-stage company focused on product development and have not generated any product revenues to date. Until, and if, we receive approval from the FDA and other regulatory authorities for our product candidates, we cannot sell our drugs and will not have product revenues. Therefore, for the foreseeable future, we will have to fund all of our operations and capital expenditures from the net proceeds of this offering, cash on hand and grants. We expect that the assumed net proceeds of $43.9 million from this offering and cash on hand will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. However, our actual capital requirements will depend on many factors. If we experience unanticipated cash requirements, we may need to seek additional sources of financing, which may not be available on favorable terms, if at all. If we do not succeed in raising additional funds on acceptable terms, we may be unable to complete planned preclinical studies and clinical trials or obtain approval of our product candidates from the FDA and other regulatory authorities. In addition, we could be forced to discontinue product development, reduce or forego sales and marketing efforts and attractive business opportunities or discontinue operations. We have a history of losses and we may never achieve or sustain profitability. We have incurred substantial losses since our inception, and we may not achieve profitability for the foreseeable future, if at all. We incurred a net loss attributable to our common stockholders of approximately $470,000 for the period from February 23, 1998 (inception) to December 31, 1998, $1.2 million in 1999, $23.0 million in 2000 and $11.6 million in 2001. As of December 31, 2001, we had an accumulated net loss attributable to our common stockholders of $36.3 million. Even if we succeed in developing and commercializing one or more of our product candidates, we expect to incur substantial net losses and negative cash flows for the foreseeable future due in part to increasing research and development expenses, including clinical trials, and increasing expenses from leasing additional facilities and hiring additional personnel. As a result, we will need to generate significant revenues in order to achieve and maintain profitability. We may not be able to generate these revenues or achieve profitability in the future. Even if we do achieve profitability, we may not be able to sustain or increase profitability. We have a limited operating history upon which to base an investment decision. We commenced operations in 1998. Our limited operating history may limit your ability to evaluate our prospects due to our limited historical financial data and our unproven potential to generate profits. You should evaluate the likelihood of financial and operational success in light of the risks, uncertainties, expenses and difficulties associated with an early-stage business, many of which may be beyond our control, including: o our potential inability to continue to undertake preclinical studies and clinical trials, o our potential inability to obtain regulatory approvals, and o our potential inability to manufacture, sell and market our products. Our operations have been limited to organizing and staffing our company, acquiring, developing and securing our proprietary technology and undertaking preclinical studies and clinical trials of our principal product candidates. These operations provide a limited basis for you to assess our ability to commercialize our product candidates and the advisability of investing in our common stock. If we fail to obtain or maintain necessary regulatory approvals for our products, or if approvals are delayed or withdrawn, we will be unable to commercialize our product candidates. Government regulation in the United States and other countries has a significant impact on our business and affects the research and development, manufacture and marketing of our products. In the United States, the FDA has broad authority to regulate the distribution, manufacture and sale of drugs. Foreign sales of drugs are subject to foreign governmental regulation and restrictions, which vary from country to country. In order to obtain FDA approval of any of our product candidates, we must submit to the FDA a New Drug Application, or NDA, demonstrating that the product candidate is safe for humans and effective for its intended use. This demonstration requires significant research and animal tests, which are referred to as preclinical studies, as well as human tests, which are referred to as clinical trials. The process of obtaining FDA and other regulatory clearances and approvals is lengthy and expensive. We may not be able to obtain or maintain necessary approvals for clinical trials or for the manufacturing or marketing of our products. Failure to comply with applicable regulatory approvals can, among other things, result in fines, suspension or withdrawal of regulatory approvals, product recalls, operating restrictions, and criminal prosecution. In addition, governmental regulations may be established which could prevent, delay, modify or rescind regulatory approval of our products. Any of these actions by the FDA, or any changes in FDA regulations, would adversely impact our business and financial condition. Our product candidates are in early stages of clinical testing. Our three principal product candidates, intranasal ketamine, intranasal morphine and intravenous diclofenac, are still in the early- to mid-stages of clinical testing on a limited number of patients. We will need to commit substantial time and additional resources to conducting further preclinical studies and clinical trials before we can submit an NDA with respect to any of these product candidates. Our other product candidate, intranasal fentanyl, is at a much earlier stage of development and may require extensive preclinical testing before we can proceed to clinical trials. In addition, before we can commence clinical trials in the United States on intravenous diclofenac and intranasal fentanyl, we will have to submit an IND to the FDA. We cannot predict with any certainty if or when we might submit an NDA for regulatory approval of any of our product candidates. If the clinical trials of our product candidates fail, we will not be able to market our product candidates. To receive the regulatory approvals necessary for the sale of our product candidates, we must demonstrate through human clinical trials that each product candidate is safe and effective. Positive results from preclinical studies and early clinical trials do not ensure positive results in clinical trials designed to permit application for regulatory approval. We may suffer significant setbacks in clinical trials, even after earlier clinical trials show promising results. Any of our product candidates may produce undesirable side effects in humans that could cause us or regulatory authorities to interrupt, delay or halt clinical trials of a product candidate. We, the FDA and foreign or other regulatory authorities may suspend our clinical trials at any time if we or they believe the trial participants face unacceptable health risks or if the FDA finds deficiencies in our IND submissions. Even if we obtain FDA approval to market our product candidates, they may not be accepted by physicians and patients. Our drugs will not be commercially accepted products unless physicians and patients determine that our drugs are clinically useful, cost-effective and safe. Acceptance and use of our drugs will also depend upon a number of factors including: o the cost of our drugs as compared to competing products, o the availability of adequate coverage and reimbursement levels from government health administration authorities, private or other health insurers and other organizations, and o the effectiveness of our and our licensees' marketing and distribution efforts. Because we expect sales of our current product candidates, if approved, to generate substantially all of our product revenues for the foreseeable future, the failure of any of these drugs to find market acceptance would harm our business and could require us to seek additional financing. Our product candidates contain controlled substances, the supply of which may be limited by U.S. government policy and the use of which may generate public controversy. The active ingredients in our current product candidates, including morphine, ketamine and fentanyl, are listed by the U.S. Drug Enforcement Agency, or DEA, as Schedule II or III substances under the Controlled Substances Act of 1970. The DEA regulates chemical compounds as Schedule I, II, III, IV or V substances, with Schedule I substances considered to present the highest risk of substance abuse and Schedule V substances the lowest risk. These product candidates are subject to DEA regulations relating to manufacturing, storage, distribution and physician prescription procedures. For example, all regular Schedule III drug prescriptions must be signed by a physician and may not be refilled. Furthermore, the amount of Schedule III substances we can obtain for clinical trials and commercial distribution is limited by the DEA and our quota may not be sufficient to complete clinical trials or meet commercial demand, if any. Products containing controlled substances may generate public controversy. Opponents of these products may seek restrictions on marketing and withdrawal of any regulatory approvals. In addition, these opponents may seek to generate negative publicity in an effort to persuade the medical community to reject these products. Political pressures and adverse publicity could lead to delays in, and increased expenses for, and limit or restrict the introduction and marketing of our product candidates. The FDA may require us to develop a comprehensive risk management program to reduce the inappropriate use of our products and product candidates, including the manner in which they are marketed and sold, so as to reduce the risk of improper patient selection and diversion or abuse of the product. Developing such a program in consultation with the FDA may be a time-consuming process and could delay approval of any of our product candidates. Such a program or delays of any approval from the FDA could limit market acceptance of the product. International commercialization of our product candidates faces significant obstacles. We may plan to commercialize some of our products internationally through collaborative relationships with foreign partners. We have limited foreign regulatory, clinical and commercial resources. Future partners are critical to our international success. We may not be able to enter into collaboration agreements with appropriate partners for important foreign markets on acceptable terms, or at all. Future collaborations with foreign partners may not be effective or profitable for us. We will need to obtain approvals from the appropriate regulatory, pricing and reimbursement authorities to market any of our proposed products internationally, and we may be unable to obtain foreign regulatory approvals. Pursuing foreign regulatory approvals will be time-consuming and expensive. The regulations can vary among countries and foreign regulatory authorities may require different or additional clinical trials than we conducted to obtain FDA approval for our product candidates. In addition, adverse clinical trial results, such as death or injury due to side effects, could jeopardize not only foreign regulatory approval, but may also lead to marketing restrictions in the United States. Our product candidates may also face foreign regulatory requirements applicable to controlled substances. Our preclinical studies and clinical trials depend upon third-party researchers who are outside our control. We depend upon third parties, such as independent investigators, collaborators and medical institutions, to conduct our preclinical studies and clinical trials under agreements with us. These third parties are not our employees and we cannot control the amount of time or resources that they devote to our programs. These investigators may not assign as great a priority to our programs or pursue them as diligently as we would if we were undertaking such programs ourselves. If outside collaborators, including West Pharmaceutical Services, Inc. with respect to preclinical development of Fentonyl, fail to devote sufficient time and resources to our preclinical studies and clinical trials, or if their performance is substandard, the approval of our FDA applications, if any, and our introduction of new drugs, if any, will be delayed. These collaborators may also have relationships with other commercial entities, some of whom may compete with us. If our collaborators assist our competitors at our expense, our competitive position would be harmed. We rely exclusively on one party to formulate some of our product candidates and the loss of this party could harm our business. We currently rely on a single formulator, West Pharmaceutical, to formulate intranasal morphine for our clinical trials. Our agreement with West Pharmaceutical will expire on September 21, 2002. The parties meet regularly to discuss the status of the development programs and we submit to West Pharmaceutical biannual revised product plans, the scope and detail of which we believe are consistent with industry standards. In addition, West Pharmaceutical currrently supplies us intranasal morphine for use in our clinical trials. Although we believe that we can obtain morphine from alternative suppliers, we may be unable to obtain it on favorable terms, or at all. If we are unable to obtain sufficient supplies of morphine, our business would be seriously harmed. If any of our product candidates receives FDA approval, we expect to rely on one or more third-party contractors to supply our drugs. If our current or future third-party suppliers cease to supply the drugs in the quantity and quality we need to manufacture our drug candidates or if they are unable to comply with good manufacturing practice and other government regulations, the qualification of additional or replacement suppliers could be a lengthy process and there may not be adequate alternatives to meet our needs, which would negatively affect our business. We may not be able to obtain the necessary drugs used in our products in the future on a timely basis, if at all. If our sole supplier of chitosan fails to provide us sufficient quantities, we may not be able to obtain an alternative supply on a timely or acceptable basis. We currently rely on a sole source for our supply of chitosan, a principal component of our intranasal morphine product candidate. Under our agreement with West Pharmaceutical, which will expire on September 21, 2002, we are required to purchase from West Pharmaceutical all of the chitosan required for use in our intranasal morphine clinical trials, subject to West Pharmaceutical's ability to supply the full amount we require. There are relatively few alternative sources of supply for chitosan and we may not be able to obtain a sufficient supply of chitosan from West Pharmaceutical or other suppliers, or at all. We may also not be able to find alternative suppliers in a timely manner that would provide chitosan at acceptable quantities and prices. Any interruption in the supply of chitosan would disrupt our ability to manufacture intranasal morphine and could have a material adverse effect on our business. We have no experience selling, marketing or distributing products and no internal capability to do so. We currently have no sales, marketing or distribution capabilities. In order to commercialize our products, if any are approved, we intend to develop internal sales, marketing and distribution capabilities to target particular markets for our products, as well as make arrangements with third parties to perform these services for us with respect to other markets for our products. We may not be able to establish these capabilities internally or hire marketing and sales personnel with appropriate expertise to market and sell our products, if approved. In addition, even if we are able to identify one or more acceptable collaborators to perform these services for us, we may not be able to enter into any collaborative arrangements on favorable terms, or at all. If we enter into any collaborative arrangements for the marketing or sale of our products, our product revenues are likely to be lower than if we marketed and sold our products ourselves. In addition, any revenues we receive would depend upon the efforts of our collaborators, which may not be adequate due to lack of attention or resource commitments, management turnover, change of strategic focus, business combinations, their inability to comply with regulatory requirements or other factors outside of our control. Depending upon the terms of our collaboration, the remedies we have against an under- performing collaborator may be limited. If we were to terminate a relationship, it may be difficult or impossible to find a replacement collaborator on acceptable terms, if at all. We are faced with intense competition and rapid technological change, which may make it more difficult for us to achieve significant market penetration. If we cannot compete successfully for market share against other drug companies, we may not achieve sufficient product revenues and our business will suffer. The market for our product candidates is characterized by intense competition and rapid technological advances. If our product candidates receive FDA approval, they will compete with a number of existing and future drugs and therapies developed, manufactured and marketed by others which use opioids and NSAIDs as pain management. If our competitors' existing products or new products are more effective than or considered superior to our future products, the commercial opportunity for our product candidates will be reduced or eliminated. Existing or future competing products may provide greater therapeutic convenience or clinical or other benefits for a specific indication than our products, or may offer comparable performance at a lower cost. We face competition from fully integrated pharmaceutical companies and smaller companies that are collaborating with larger pharmaceutical companies, academic institutions, government agencies and other public and private research organizations. If we are successful in penetrating the market for pain treatment with our product candidates, other companies may be attracted to the market. Many of our competitors have opioid or NSAID painkillers already approved or in development. In addition, many of these competitors, either alone or together with their collaborative partners, are larger than we are and have substantially greater financial, technical, research, marketing, sales, distribution and other resources than we do. Our competitors may develop or market products that are more effective or commercially attractive than any that we are developing or marketing. Our competitors may obtain regulatory approvals, and introduce and commercialize products before we do. These developments could have a significant negative effect on our financial condition. Even if we are able to compete successfully, we may not be able to do so in a profitable manner. If we fail to adequately protect or enforce our intellectual property rights or secure rights to patents of others, we may be unable to compete effectively. Our success, competitive position and future revenues will depend in part on our ability and the abilities of our third-party licensors to obtain and maintain patent protection for our products, methods, processes and other technologies and to preserve our trade secrets. To date, we have licenses to certain patent rights, including rights under U.S. patents and U.S. patent applications and under foreign patents and patent applications, related to our product candidates. We anticipate filing additional patent applications both in the United States and in other countries, as appropriate. The procedures for obtaining an issued patent in the United States and in most foreign countries are complex. These procedures require an analysis of the scientific technology related to the invention and many legal issues. Accordingly, we expect that the examination of our patent applications will be complex and time consuming. We do not know when, or if, we will obtain additional issued patents for our technologies. We cannot predict whether or not: o any additional patents will issue and the degree and range of protection they will afford us against competitors, o others will obtain patents claiming aspects similar to those covered by our patents and patent applications, o we will need to initiate litigation or administrative proceedings regarding our patents, which may be costly whether we win or lose or o third parties will find ways to challenge, invalidate or otherwise circumvent our patent rights that we currently hold or license. The degree and range of protection afforded by any of our licensed patents, as with all patents, is defined by the breadth of the claims of the patent. As the components of our product candidates are commercially available to third parties, it is possible that competitors may design formulations, propose dosages, or develop methods or routes of administration with respect to these components that would be outside the scope of the claims of one or more, or of all, of our licensed patents. This would enable their products to effectively compete with our product candidates. We may have to institute costly legal action to protect our intellectual property rights. We may not be able to afford the costs of enforcing our intellectual property rights. Consequently, we do not know how much, if any, protection our patents will provide. A third party might request a court to rule that our patents are invalid or unenforceable. In such a case, even if the validity and enforceability of our patents were upheld, a court might hold that the third party's actions do not infringe our patent. The laws of some countries may not protect our intellectual property rights to the same extent as U.S. laws. For example, methods of treating humans are not patentable subject matter in many countries outside of the United States. It may be necessary or useful for us to participate in proceedings to determine the validity of our foreign patents or those of our competitors, which could result in substantial cost and divert our efforts and attention from other aspects of our business. These and other issues may limit the patent protection we will be able to secure outside of the United States. Our success also depends upon the skills, knowledge and experience of our scientific and technical personnel, our consultants and advisors as well as our licensors and contractors. To help protect our proprietary know-how and our inventions, we also rely on trade secret protection and confidentiality agreements, in addition to patents. However, trade secrets are difficult to protect. To this end, we require all of our employees, consultants, advisors and contractors to enter into agreements that prohibit the disclosure of our trade secrets and other confidential information and, where applicable, require disclosure and assignment to us of the ideas, developments, discoveries and inventions important to our business. These agreements may not provide adequate protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use or disclosure or the lawful development by others of such information. If any of our trade secrets, know-how or other proprietary information is disclosed, or if third parties independently discover our trade secrets or proprietary information, the value of our trade secrets, know-how and other proprietary rights would be significantly impaired and our business and competitive position would suffer. Technology licensed to us by others, or in-licensed technology, is important to our business. We may not control the patent prosecution, maintenance or enforcement of some of our in-licensed technology. Accordingly, we may be unable to exercise the same degree of control over this intellectual property as we would over our internally developed technologies. Moreover, our rights to in-licensed technology could be terminated under the terms of our license agreements, including upon a default by us. If such a default were to occur under any of these agreements, we could lose our rights to the in-licensed technologies or other products that are the subject of that agreement, including our rights to continue to develop that technology. The loss of these technologies, products or rights could harm our business. A dispute regarding the infringement or misappropriation of our proprietary rights or the proprietary rights of others could be costly and result in delays in our research and development activities. Our success, competitive position and future revenues will also depend in part on our ability to operate without infringing on or misappropriating the proprietary rights of others. Since our product candidates contain components that are well known and that have been in use by other companies, our product candidates could infringe the proprietary rights of third parties. We are aware of one third party who could allege that certain uses of our product candidates infringe its proprietary rights. We do not intend to market our products for such uses, nor are we aware of any such uses currently in practice, but we may not be able to avoid claims or liability with respect thereto because we cannot prevent others from using our products for such uses in the future. Many of our employees and consultants were, and many of our consultants may currently be, parties to confidentiality agreements with other companies. While our confidentiality agreements with these employees and consultants require that they do not bring to us, or use without proper authorization, any third party's proprietary technology, if they violate their agreements, we could suffer claims or liabilities. If our products, methods, processes and other technologies infringe the proprietary rights of other parties, we could incur substantial costs and we may have to: o obtain licenses, which may not be available on commercially reasonable terms, if at all, o redesign our products or processes to avoid infringement, o stop using the subject matter claimed in the patents held by others, o pay damages or o defend litigation or administrative proceedings which may be costly whether we win or lose, and which could result in a substantial diversion of our valuable management resources. We may not successfully manage our growth. Our success will depend upon the expansion of our operations and the effective management of our growth. We expect to experience significant growth in the scope of our operations and the number of our employees. If we grow significantly, such growth will place a significant strain on our management and on our administrative, operational and financial resources. To manage this growth, we must expand our facilities, augment our operational, financial and management systems, internal controls and infrastructure and hire and train additional qualified personnel. Our future success is heavily dependent upon growth and acceptance of our future products. If we are unable to scale our business appropriately or otherwise adapt to anticipated growth and new product introduction, our business and financial condition will be harmed. We depend upon Paramount Capital Investments, LLC for all of our current infrastructure-related administrative services and office support and equipment. Paramount Capital Investments, LLC, an affiliate of one of our principal stockholders, currently provides all of our office space, some members of our management and employees and certain administrative and legal assistance at no cost to us. Paramount also provides us with computer hardware and software and services related to the development, management and maintenance of our internal data and file storage, as well as office equipment. The estimated fair value of the assistance provided by Paramount to us totaled $481,299 for the twelve months ended December 31, 2001, which has been reflected in the accompanying financial statements as an expense in that period with a corresponding deemed capital contribution. We currently do not have an agreement in place with Paramount governing all aspects of this relationship. We do, however, have an agreement in place with Paramount under which Paramount has waived any claim for reimbursement for such assistance, and will continue to waive any claim for reimbursement for any assistance provided to us through the end of the third quarter of 2002. If Paramount fails to provide assistance to us, we will need to obtain similar services from a third party or develop an internal infrastructure for similar services in order to operate our business. We also have an agreement with Paramount under which Paramount assigned to us all rights in all proprietary technology and information developed with the assistance of Paramount. In addition, we have an agreement stating that Paramount will maintain our proprietary information in confidence for a period of ten years from the date they receive such proprietary information. Due to the existing arrangements, Paramount may be able to exert influence over our business and affairs. We currently have no permanent facilities. We currently share office space with Paramount Capital Investments on a rent-free and informal basis. We do not have any contractual rights to continue that arrangement. We currently have an agreement in place with Paramount under which Paramount has waived any claim for reimbursement for any payments regarding this arrangement, and will continue to waive any claim for reimbursement for any similar payments through the end of the third quarter of 2002. In order to succeed, we will need to lease our own facilities at some point in the future. If we are unable to acquire these facilities on acceptable terms, or at all, our business will be harmed. We may be exposed to liability claims associated with the use of hazardous materials and chemicals. Our research and development activities involve the controlled use of hazardous materials and chemicals. Although we believe that our safety procedures for using, storing, handling and disposing of these materials comply with federal, state and local laws and regulations, we cannot completely eliminate the risk of accidental injury or contamination from these materials. In the event of such an accident, we could be held liable for any resulting damages and any liability could materially adversely affect our business, financial condition and results of operations. In addition, the federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous or radioactive materials and waste products may require us to incur substantial compliance costs that could materially adversely effect our business and financial condition. We rely on key executive officers and scientific and medical advisors, and their knowledge of our business and technical expertise would be difficult to replace. We are highly dependent on Dr. Leonard Firestone, our Chief Executive Officer and Chief Medical Officer, as well as other executive officers, including Douglas A. Hamilton, our Chief Operating Officer and Chief Financial Officer, Dr. Fred Mermelstein, our President, and Dr. Randi Albin, our Chief Scientific Officer. We have entered into an employment agreement with Dr. Firestone that will become effective upon the closing of this offering. In addition, Dr. Mermelstein devotes only approximately 48% of his business time to us and the remainder to Paramount Capital Investments. We do not have "key person" life insurance policies for any of our officers. The loss of the technical knowledge and management and industry expertise of any of our key personnel could result in delays in product development, loss of customers and sales, if any, and diversion of management resources, which could adversely affect our operating results. In addition, we rely on members of our scientific advisory board and clinical advisors to assist us in formulating our research and development strategy. All of the members of our scientific advisory board and our clinical advisors have other jobs and commitments that may limit their availability to work with us. If we are unable to hire additional qualified personnel, our ability to grow our business may be harmed. We will need to hire additional qualified personnel with expertise in preclinical studies, clinical research and trials, government regulation, formulation and manufacturing and sales and marketing. We compete for qualified individuals with numerous biopharmaceutical companies, universities and other research institutions. Competition for such individuals, particularly in the New York City area, is intense, and we may not be able to hire sufficient personnel to support our efforts. We may incur substantial liabilities and may be required to limit commercialization of our products in response to product liability lawsuits. The testing and marketing of medical products entail an inherent risk of product liability. Although side effects from our clinical trials thus far have been limited to symptoms known to be associated with these medications, such as dysphoria, which is a feeling of malaise, and nausea, we may be held liable if any more serious adverse reactions from the use of our product candidates occurs. Our product candidates involve a new method of delivery for potent drugs that require greater precautions to prevent unintended use, especially since they are designed for patients' self-use rather than being administered by medical professionals. For example, the FDA may require us to develop a comprehensive risk management program for our product candidates to reduce the risk of improper patient selection, diversion and abuse. The failure of these measures could result in harmful side effects or death. As a result, consumers, regulatory agencies, pharmaceutical companies or others might make claims against us. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Our inability to obtain sufficient product liability insurance at an acceptable cost to protect against potential product liability claims could prevent or inhibit the commercialization of pharmaceutical products we develop, alone or with corporate collaborators. We currently carry clinical trial insurance but do not carry product liability insurance. We, or any corporate collaborators, may not be able to obtain insurance at a reasonable cost, if at all. Even if our agreements with any future corporate collaborators entitle us to indemnification against losses, such indemnification may not be available or adequate if any claim arises. Risks Related To The Offering Our stock price could be volatile and the value of your investment could decline. After this offering, you may not be able to resell your shares at or above the initial public offering price. The trading price for our common stock is likely to be highly volatile and could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including: o publicity regarding actual or potential clinical results relating to products under development by our competitors or us, o delay or failure in initiating, completing or analyzing preclinical studies or clinical trials or unsatisfactory design or results of these tests, o achievement or rejection of regulatory approvals by our manufacturers, suppliers, distributors, competitors or us, o announcements of technological innovations or new commercial products by our competitors or us, o developments concerning proprietary rights, including patents, o developments concerning our collaborations, o regulatory developments in the United States and foreign countries, o economic or other crises and other external factors, o period-to-period fluctuations in our revenue and other results of operations, o changes in financial estimates by securities analysts, and o sales of our common stock. We will not be able to control many of these factors, and we believe that period-to-period comparisons of our financial results will not necessarily be indicative of our future performance. If our revenues, if any, in any particular period do not meet expectations, we may not be able to adjust our expenditures in that period, which could cause our operating results to suffer further. If our operating results in any future period fall below the expectations of securities analysts or investors, our stock price may fall by a significant amount. In addition, the stock market in general, and the Nasdaq National Market and the market for biotechnology companies in particular, has experienced extreme price and volume fluctuations that may have been unrelated or disproportionate to the operating performance of individual companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. We are at risk of securities class action litigation due to our expected stock price volatility. In the past, securities class action litigation has often been brought against companies following periods of volatility in the market price of their securities. Due to the expected volatility of our stock price, we may be the target of securities litigation in the future. Securities litigation could result in substantial costs and divert management's attention and resources from our business. An active trading market for our common stock may not develop. Before this offering, there was no public market for our common stock. An active public market for our common stock may not develop or be sustained after this offering. We will determine the initial public offering price of our common stock based on negotiations between the representatives of the underwriters and our management concerning the valuation of our common stock, and this price may not be indicative of future market prices. The public market may not agree with or accept this valuation. The factors to be considered in determining the initial public offering price of our common stock, in addition to prevailing market conditions, include: o estimates of our business potential and earnings prospects, o an assessment of our management, and o the consideration of these factors in relation to market valuations of companies in related businesses. Because our directors, management and affiliates will retain significant control over us after this offering, they could control our actions in a manner that conflicts with our interests and the interests of our stockholders. We anticipate that our officers, directors and individuals or entities affiliated with our directors, including our largest stockholder, will beneficially own approximately 39.9% of our outstanding common stock as a group after this offering closes. Acting together, these stockholders would be able to exercise significant influence over all matters that our stockholders vote upon, including the election of directors and the approval of significant corporate transactions. This concentration of ownership may also delay, deter or prevent a change in our control and may make some transactions more difficult or impossible to complete without the support of the stockholders. We will be subject to the anti-takeover provisions of the Delaware General Corporation Law, which regulates corporate acquisitions and we have other anti-takeover provisions that may make it difficult for a third party to acquire us. Delaware law will prevent us from engaging, without the approval of our board of directors, or two-thirds of our stockholders, in transactions with any stockholder that controls, together with its affiliates, 15% or more of our outstanding common stock for three years following the date on which the stockholder first acquired 15% or more of our outstanding common stock. The anti-takeover provisions of our charter documents, including, among other things, division of our board into three classes serving staggered terms and our board's ability to issue up to 5,000,000 shares of preferred stock, and of the Delaware General Corporation Law are likely to discourage potential acquisition proposals and delay or prevent a transaction resulting in a change in control. If a large number of shares of our common stock are sold after this offering, the market price of our common stock could decline. If our stockholders sell substantial amounts of common stock in the public market, including shares that we may issue upon the exercise of outstanding options and warrants, the market price of our common stock could decline. This could also impair our ability to raise additional capital through the sale of our equity securities. After this offering, we will have 20,645,327 shares of common stock outstanding or, if the underwriters exercise their over-allotment option in full, 21,485,327 shares of common stock outstanding. Of these shares, the shares sold in this offering will be freely tradeable. The remaining 15,045,327 shares are "restricted shares" and will become eligible for sale in the public market at various times after 180 days after the date of this prospectus, subject to the limitations and other conditions of Rule 144 under the Securities Act. In addition, after this offering, the holders of approximately 6,646,635 shares of common stock and warrants to purchase approximately 635,090 shares of common stock will have registration rights with respect to these shares, allowing these stockholders to sell these shares in the market simultaneously with any further public offerings by us of our equity securities. You will suffer immediate and substantial dilution because the net tangible book value of shares purchased in this offering will be substantially lower than the initial public offering price. The initial public offering price of the shares of common stock in this offering will significantly exceed the pro forma as adjusted net tangible book value per share of our common stock. Any shares of common stock that investors purchase in this offering will have a pro forma as adjusted net tangible book value per share of $6.50 per share less than the initial public offering price paid, assuming an initial public offering price per share of $9.00. Accordingly, if you purchase common stock in this offering, you will incur immediate and substantial dilution of your investment. You may suffer additional dilution if current options or warrants are exercised. We have issued options and warrants to acquire our common stock at prices significantly below the initial public offering price of our common stock in this offering. When any of these options or warrants are exercised, you will incur additional dilution. Upon the completion of certain milestones and upon mutual agreement of the parties, Dr. Stuart Weg, one of our licensors, and West Pharmaceutical may receive a cash or stock payment from us. If West Pharmaceutical receives our stock, we will be required to issue the stock at its then fair market value. If Dr. Weg receives our stock, we will be required to issue the stock at the average closing price for our shares of common stock for the ten consecutive trading days immediately preceding the achievement of such milestones. In addition, upon the completion of certain milestones, Shimoda Biotech (Proprietary) Ltd. and Farmarc Netherlands B.V. (Registration No. 2807216) may elect to receive a cash or stock payment from us. If Shimoda and Farmarc receive our stock, we will be required to issue the stock at the initial public offering price. If any of these stock payments occur, you will incur additional dilution. To the extent we raise additional capital by issuing equity securities in the future, you and our other stockholders may experience dilution and future investors may be granted rights superior to those of our current stockholders.

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+RISK FACTORS You should carefully consider the following risk factors and all other information contained in this prospectus before purchasing our common stock. Investing in our common stock involves a high degree of risk. If any of the following risks actually occurs, we may be unable to conduct our business as currently planned, and our financial condition and operating results could be seriously harmed. In addition, the trading price of our common stock could decline due to the occurrence of any of these risks, and you may lose all or part of your investment. Please read "Forward-Looking Statements." Risks Related to Our Business Our bioinformatics-based discovery strategy is unproven, and we do not know whether we will be able to discover any genes or proteins of commercial value. We do not know whether we can successfully implement our bioinformatics- based therapeutic protein discovery strategy because we are in the early stages of development. For most of our corporate existence, we relied on exploratory biology to study particular diseases and medical conditions and to find potential treatments. We shifted our emphasis to bioinformatics-based discovery relatively recently. Bioinformatics is the use of high-powered computers, software and analytical tools to interpret DNA sequence data and to assist in identifying those genes and proteins that are likely to play a meaningful role in human health. We use bioinformatics to discover genes and their corresponding proteins in genomic databases, with the goal of developing therapeutic protein-based products based on these discoveries. We have not begun clinical trials of any product candidates discovered through our bioinformatics-based efforts, and we are not aware of any other company that has successfully commercialized products derived from bioinformatics-based research. Our bioinformatics-based strategy may not result in the development or commercialization of any products. We depend heavily on bioinformatics technology, which may prove to be ineffective in the discovery of therapeutic proteins. Our bioinformatics capabilities may prove ineffective in discovering genes and proteins and may not be adequate to handle the daily flow of DNA sequence data. Other technologies for analyzing genomic data and discovering genes may enable other parties to discover novel genes or proteins that our technologies fail to identify or may enable other parties to discover them before we do. Any inadequacies of our bioinformatics technologies may prevent us from discovering genes or proteins with therapeutic potential or from obtaining patent priority relating to these genes or proteins. The availability of novel genomic data may decrease in the future, which may adversely affect our ability to discover novel therapeutic proteins. We rely on the continuing availability of existing genomic data and the continuous generation of new genomic data for the discovery of genes and proteins. Because many companies and government or public agencies are analyzing the genomic data that is currently publicly available, it has become increasingly difficult for us to be the first to discover novel genes through the analysis of this data. Companies and government or public agencies have already mapped and made available significant portions of the human genome, and the flow of novel genetic sequence data will likely decrease significantly in the future. This expected decrease in the rate of generation of novel sequence data could impair our ability to discover novel therapeutic proteins. We may not be able to develop commercially viable products from the key protein categories on which we focus. We may not be able to discover any new therapeutic proteins of commercial value in the key therapeutic protein categories we target in our discovery and development efforts. Prior successes of other companies in commercializing protein-based products derived from these categories provide no indication that we will be able to discover any therapeutic proteins within these categories beyond those that we have already discovered. Also, we may not be able to successfully commercialize any novel therapeutic proteins we have discovered or may discover in the future. In addition, some of the protein categories we concentrate on have not yielded any successful therapeutic protein products or late-stage clinical trial candidates. Discovery and development efforts we expend on these categories may prove ineffective and may detract from our efforts to discover and develop therapeutic proteins within those categories that have shown more promise. Also, by focusing on specific categories of proteins, we may overlook other therapeutic proteins not contained in these categories that ultimately will be successfully commercialized by others. In addition, other classes of drugs may prove to have superior therapeutic benefits or be easier and more cost-effective to produce than therapeutic proteins. Our patent applications may not result in issued patents, and our competitors may commercialize the discoveries we attempt to patent. Our pending patent applications covering genes and their corresponding proteins may not result in the issuance of any patents. These applications may not be sufficient to meet the statutory requirements for patentability, and therefore we may be unable to obtain enforceable patents covering the related therapeutic protein-based product candidates we may want to commercialize. In addition, other parties have filed or may file patent applications that cover genes, proteins or related discoveries or technologies similar or identical to those covered in our patent applications. Because patent applications in the United States historically have been maintained in secrecy until a patent issues, other parties may have filed patent applications on genes or their corresponding proteins before we filed applications covering the same genes or proteins, and we may not be the first to discover these genes or proteins. Any patent applications filed by third parties may prevail over our patent applications or may result in patents that issue alongside patents issued to us, leading to uncertainty over the scope of the patents or the freedom to practice the claimed inventions. Third parties may infringe our patents or challenge their validity or enforceability. Third parties may infringe our patents or may initiate proceedings challenging the validity or enforceability of our patents. The issuance of a patent is not conclusive as to its validity or enforceability. Challenges raised in patent infringement litigation we initiate or in proceedings initiated by third parties may result in determinations that our patents have not been infringed or that they are invalid, unenforceable or otherwise subject to limitations. In the event of any such determinations, third parties may be able to use the discoveries or technologies claimed in our patents without paying licensing fees or royalties to us, which could significantly diminish the value of our intellectual property. Also, as a result of such determinations, we may be enjoined from commercializing potential products or may be required to obtain licenses, if available, to third-party patents or develop or obtain alternative technology. In addition, enforcing our patents against third parties may require significant expenditures regardless of the outcome of such efforts. For example, we are currently in discussions with a biopharmaceutical company regarding a possible license to one of our families of patents. In the event that these discussions are unsuccessful, any proceedings that may arise relating to these patents may require significant expenditures, regardless of their outcome. Furthermore, third parties may independently develop intellectual property similar to our patented intellectual property, which could result in, among other things, interference proceedings in the United States Patent and Trademark Office to determine priority of discovery or invention. Interference proceedings could result in the loss of or significant limitations on patent protection for our discoveries or technologies. Responding to interference proceedings or other challenges initiated by third parties may require significant expenditures and divert the attention of our management and key personnel from other business concerns. We may be subject to patent infringement claims, which could result in substantial costs and liability and prevent us from commercializing our potential products. Third parties may claim that our potential products or related technologies infringe their patents. Patent litigation is very common in the biopharmaceutical industry, and the risk of infringement claims is likely to increase as the industry expands and as other companies obtain more patents and increase their efforts to discover genes through automated means and to develop proteins. Any patent infringement claims or similar legal impediments that might be brought against us may cause us to incur significant expenses, divert the attention of our management and key personnel from other business concerns and, if successfully asserted against us, require us to pay substantial damages. In addition, as a result of a patent infringement suit, we may be forced to stop or delay developing, manufacturing or selling potential products that are claimed to infringe a patent covering a third party's intellectual property unless that party grants us rights to use its intellectual property. We may be unable to obtain these rights on terms acceptable to us, if at all. Even if we are able to obtain rights to a third party's patented intellectual property, these rights may be non-exclusive, and therefore our competitors may obtain access to the same intellectual property. Ultimately, we may be unable to commercialize our potential products or may have to cease some of our business operations as a result of patent infringement claims, which could severely harm our business. Issued patents may not provide us with any competitive advantage or provide meaningful protection against competitors. Issued patents may not provide us with any competitive advantage. Although we have a number of issued patents, the discoveries or technologies covered by these patents may not have any value. In addition, issued patents may not provide commercially meaningful protection against competitors. Other parties may be able to design around our issued patents or independently develop products having effects similar or identical to our patented product candidates. Some companies are currently attempting to develop therapeutic protein-based products substantially equivalent to products patented by other parties by altering the amino acid sequence within the therapeutic protein- based product and declaring the altered product a new product. It may be easier to develop substantially equivalent versions of therapeutic protein-based products such as monoclonal antibodies and soluble receptors than it is to develop substantially equivalent versions of the proteins with which they interact because there is often more than one antibody or receptor that has the same therapeutic effect. Consequently, any existing or future patents we have that cover monoclonal antibodies or soluble receptors may not provide any meaningful protection against competitors. In addition, the scope of our patents is subject to considerable uncertainty and competitors or other parties may obtain similar patents of uncertain scope. For example, other parties may discover uses for genes or proteins different from the uses covered in our patents, and these other uses may be separately patentable. If another party holds a patent on the use of a gene or protein, then even if we hold the patent covering the composition of matter of the gene or protein itself, that other party could prevent us from selling any product directed to such use. Also, other parties may have patents covering the composition of matter of genes or proteins for which we have patents covering only methods of use of these genes or proteins. Furthermore, the patents we hold relating to recombinant human proteins, such as our patents covering rh Factor XIII or rh Thrombin, may not prevent competitors from developing, manufacturing or selling other versions of these proteins. Moreover, although we hold patents relating to the manufacture of recombinant human thrombin, we have no composition of matter patent protection covering thrombin. Accordingly, we may not be able to prevent other parties from commercializing competing forms of recombinant human thrombin. If other parties publish information about the genes or proteins we discover before we apply for patent protection, we may be unable to obtain patent protection. Public disclosures of genetic sequence information may limit the scope of our patent claims or result in the denial of subsequent patent applications that we file on genes and their corresponding proteins. Washington University has identified genes through partial sequencing funded by Merck & Co., Inc. and has deposited these partial sequences in a public database. Also, in January 1997, The Institute for Genomic Research disclosed more than 35,000 full-length DNA sequences that were assembled from partial gene sequences available in publicly accessible databases or sequenced at the Institute. In addition, the Human Genome Project and Celera Genomics Corporation completed an initial sequencing of the human genome and published papers on this sequencing in February 2001. We may be unable to obtain patent protection for sequences published in these disclosures if they represent prior art. The patent field relating to therapeutic protein-based products is subject to a great deal of uncertainty, and if patent laws or the interpretation of patent laws change, our competitors may be able to develop and commercialize products based on proteins that we discovered. The patent protection available for genes and therapeutic protein-based products is highly uncertain and involves complex legal and factual questions that determine who has the right to develop a particular product. No clear policy has emerged regarding the breadth of patents in this area. There have been, and continue to be, intensive discussions concerning the scope of patent protection for partial gene sequences, full-length genes and their corresponding proteins. Social and political opposition to patents on genes may lead to narrower patent protection for genes and their corresponding proteins. Patent protection relating to genes and therapeutic protein-based products is also subject to a great deal of uncertainty outside the United States, and patent laws are currently undergoing review and revision in many countries. Changes in, or different interpretations of, patent laws in the United States and other countries may result in our inability to obtain patents covering the genes or proteins we discover or to enforce patents that have been issued to us, and may allow others to use our discoveries to develop and commercialize therapeutic protein-based products. Our analysis of how often we were the first party to file patent applications for therapeutic proteins was based on numerous assumptions that may prove to be incorrect. As a means of evaluating the success of our bioinformatics efforts, we conducted an analysis of how often, during certain time periods analyzed, we were the first party to file patent applications covering proteins within the therapeutic protein categories we target in our discovery and development efforts. Our analysis, which was based on a review of the Derwent database of DNA and protein sequences contained in European patents and patent applications, does not imply that we will be successful in the future in being the first to file patent applications on novel proteins, that we will be able to obtain patent protection for any of the proteins covered by our pending patent applications, or that we will be able to successfully commercialize any therapeutic protein-based products discovered through our bioinformatics efforts. The methodology and results of our analysis have not been independently tested or verified. In addition, our analysis was based on numerous factual assumptions that may prove to be incorrect and numerous methodological assumptions that may prove to be flawed, including, but not limited to, the following: . Our analysis gave discovery credit regarding a particular protein within the protein categories only to the party that was first to file a published patent application on the full-length gene sequence. The date of filing of a patent application may have been significantly later than the date of discovery of the gene sequence, and therefore may not indicate the party that actually first discovered the novel gene sequence. . Our analysis only considered DNA and protein sequence information included in the Derwent database as of November 2001. Due to the delay in the publishing of patent applications, our analysis may not have included patents filed for up to 18 months preceding the date of our analysis. It is possible that our performance in filing patent applications first may have declined or the performance of our competitors may have improved during this period of time. . Our analysis included only patent applications filed in Europe. Any discoveries claimed in United States patent applications would not have been covered in the analysis unless corresponding patent applications covering such discoveries were also filed in Europe during the periods analyzed. . Our analysis only considered DNA and protein sequences included in the Derwent database. Delays in the timing of the publication of European patent applications and delays in the inclusion in the Derwent database of sequences contained within those applications may have led to incorrect conclusions in our analysis. Furthermore, any errors that may have occurred in the publishing of gene sequence information could have led to incorrect conclusions in our analysis. . In reviewing the gene sequence data contained in the patent applications underlying our analysis, we may have incorrectly identified partial gene sequences as full-length gene sequences, and vice versa, leading to erroneous conclusions about the sequences, or may have otherwise incorrectly analyzed or interpreted the data in the patent applications. . Our analysis included only patent applications containing sequences for proteins that we have classified within our designated protein categories, and others may not agree with how we defined these categories or may not agree that a particular protein that is the subject of one or more patent applications belongs in one of these categories. . We may have inadvertently excluded from our analysis patent applications covering newly discovered proteins that are actually members of the protein categories we target because we failed to recognize structural or sequence similarities between these proteins and other known members in these categories, or otherwise failed to recognize these proteins as members of the protein categories. We expect to incur significant expenses in applying for patent protection and prosecuting our patent applications. We may fail to secure meaningful patent protection relating to any of our existing or future product candidates, discoveries or technologies despite the expenditure of considerable resources. Our success depends significantly on the establishment of patent protection for the genes, proteins and related technologies we discover or invent. Consequently, we intend to continue our substantial efforts in applying for patent protection and prosecuting pending and future patent applications. These efforts have historically required the expenditure of considerable time and money, and we expect that they will continue to require significant expenditures. If future changes in United States or foreign patent laws complicate or hinder our efforts to obtain patent protection, the costs associated with patent prosecution may increase significantly. We may be unable to protect our proprietary technology and information. In addition to our patented intellectual property, we also rely on unpatented technology, trade secrets and confidential information, including our ASIDE software program, our genetic sequence database and our bioinformatics algorithms. We may not be able to effectively protect our rights to this technology or information. Other parties may independently develop equivalent technologies or independently gain access to and disclose substantially equivalent information. Disputes may arise about inventorship and corresponding rights to know-how and inventions resulting from the joint creation or use of intellectual property by us and our corporate partners, licensees, scientific and academic collaborators and consultants. In addition, confidentiality agreements and material transfer agreements we have entered into with these parties and with employees and advisors may not provide effective protection of our technology or information or, in the event of unauthorized use or disclosure, may not provide adequate remedies. We have limited experience in developing products. We have not yet developed or commercialized any products on our own. Our contributions to the discovery or development of certain therapeutic proteins currently on the market do not indicate that we will be able to successfully develop products alone. Our work relating to these marketed products did not include clinical trials, manufacturing, marketing or other late-stage development or commercialization activities. We have limited experience with product development activities and may not be successful in developing or commercializing any products. Any failure or delay in commencing or completing clinical trials for product candidates could severely harm our business. The successful commercialization of any product candidates will depend on regulatory approval in each market in which we, our collaborators or our licensees intend to market the product candidates. Each of our product candidates must undergo extensive preclinical studies and clinical trials as a condition to regulatory approval. Preclinical studies and clinical trials are time-consuming and expensive and together take several years to complete, and to date we have not completed any clinical trials on our own. The commencement and completion of clinical trials for our product candidates may be delayed by many factors, including: . our inability or the inability of our collaborators or licensees to manufacture or obtain from third parties materials sufficient for use in preclinical studies and clinical trials; . delays in patient enrollment and variability in the number and types of patients available for clinical trials; . difficulty in maintaining contact with patients after treatment, resulting in incomplete data; . poor effectiveness of product candidates during the clinical trials; . unforeseen safety issues or side effects; and . governmental or regulatory delays. It is possible that none of our product candidates, whether developed on our own, with collaborators or by licensees, will enter or complete clinical trials in any of the markets in which we, our collaborators or licensees intend to sell those product candidates. Accordingly, we, our collaborators or licensees may not receive the regulatory approvals needed to market our product candidates in any markets. Any failure or delay in commencing or completing clinical trials or obtaining regulatory approvals for our product candidates could severely harm our business. Clinical trials may fail to demonstrate the safety and effectiveness of our product candidates, which could prevent or significantly delay their regulatory approval. Clinical trials involving our product candidates may reveal that those candidates are ineffective, are unacceptably toxic or have other unacceptable side effects. In addition, data obtained from tests are susceptible to varying interpretations, which may delay, limit or prevent regulatory approval. Likewise, the results of preliminary studies do not predict clinical success, and larger and later-stage clinical trials may not produce the same results as earlier-stage trials. Frequently, product candidates that have shown promising results in early clinical trials have subsequently suffered significant setbacks in later clinical trials. For example, in 1998, Amgen Inc. halted Phase III clinical trials in the United States relating to our product candidate Thrombopoietin in the treatment of chemotherapy-induced thrombocytopenia after reports of the development of neutralizing antibodies in both cancer patients and volunteer donors in platelet donation trials. In addition, clinical trials of potential products often reveal that it is not practical or feasible to continue development efforts for these product candidates. For example, in 2001, Celltech Group plc discontinued development of platelet-derived growth factor receptor antibody, a product candidate that Celltech licensed from us and designated as CDP 860, for the treatment of restenosis. Celltech concluded that the Phase II clinical trial results did not justify further development of CDP 860 as a restenosis therapy. We may be unable to satisfy the rigorous government regulations relating to the development and commercialization of our product candidates. Any failure to receive the regulatory approvals necessary to commercialize our product candidates could severely harm our business. Our product candidates are subject to extensive and rigorous government regulation. The United States Food and Drug Administration, or FDA, regulates, among other things, the collection, testing, manufacturing, safety, efficacy, potency, labeling, storage, record keeping, advertising, promotion, sale and distribution of therapeutic products. If our potential products are marketed abroad, they will also be subject to extensive regulation by foreign governments. None of our product candidates has been approved for sale in the United States or any foreign market, and we have only limited experience in filing and pursuing applications necessary to gain regulatory approvals. The regulatory review and approval process, which includes preclinical studies and clinical trials of each product candidate, is lengthy, expensive and uncertain. Securing FDA approval requires the submission of extensive preclinical and clinical data and supporting information to the FDA for each indication to establish the product candidate's safety and effectiveness. The approval process typically takes many years to complete and may involve ongoing requirements for post-marketing studies. Any FDA or other regulatory approval of our product candidates, once obtained, may be withdrawn. In addition, government regulation may result in: . prohibitions or significant delays in the marketing of potential products; . discontinuation of marketing of potential products; and . limitations of the indicated uses for which potential products may be marketed. If we fail to comply with the laws and regulations pertaining to our business, we may be subject to sanctions, including the temporary or permanent suspension of operations, product recalls, marketing restrictions and civil and criminal penalties. We may encounter difficulties developing or commercializing our product candidate rh Factor XIII. We may encounter difficulties developing or commercializing our product candidate rh Factor XIII due to regulatory impediments and intellectual property challenges. The FDA placed our initial investigational new drug application for rh Factor XIII on hold in 1993, citing insufficient information to assess its risks to subjects. Although we intend to submit a new investigational new drug application for rh Factor XIII to the FDA, the FDA may raise additional questions or require additional data, which could delay or prevent the initiation of clinical trials. In addition, rh Factor XIII is currently the subject of a patent interference proceeding with Aventis Behring L.L.C. Although we have entered into a cross-licensing agreement with Aventis Behring with respect to rh Factor XIII, the interference proceeding could result in the loss of or significant limitations on our patent protection for this product candidate. Furthermore, under the cross-licensing agreement, Aventis Behring retains the ability to market recombinant products that may compete with rh Factor XIII. Our plan to use collaborations to leverage our capabilities may not be successful. As part of our business strategy, we have entered into collaboration arrangements with strategic partners to develop product candidates and will continue to evaluate similar opportunities. For our collaboration efforts to be successful, we must identify partners whose competencies complement ours. We must also successfully enter into collaboration agreements with them on terms attractive to us and integrate and coordinate their resources and capabilities with our own. We may be unsuccessful in entering into collaboration agreements with acceptable partners or negotiating favorable terms in these agreements. Also, we may be unsuccessful in integrating the resources or capabilities of these collaborators. In addition, our collaborators may prove difficult to work with or less skilled than we originally expected. If we are unsuccessful in our collaborative efforts, our ability to develop and market product candidates could be severely limited. We may not be able to generate any revenue from product candidates developed by collaborators or licensees if they are unable to successfully develop those candidates. We may be unable to derive any value from product candidates developed by collaborators or licensees. Our ability to generate revenues from existing or future collaborations and license arrangements is subject to numerous risks, including: . the possibility that our collaborators or licensees lack sufficient financial, technical or other capabilities to develop these product candidates; . the length of time that it takes for our collaborators or licensees to achieve various clinical development and regulatory approval milestones; . the inability of collaborators or licensees to successfully address any regulatory or technical challenges they may encounter; and . the possibility that these product candidates may not be effective or may prove to have undesirable side effects, unacceptable toxicities or other characteristics that preclude regulatory approval or prevent or limit commercial use. Novo Nordisk has substantial rights to license proteins we discover, which may limit our ability to pursue other collaboration or licensing arrangements or benefit from our discoveries. As part of our separation from Novo Nordisk, we granted Novo Nordisk options to license certain rights to several of our potential therapeutic proteins under an option agreement. Although we generally retain North American rights to the proteins licensed by Novo Nordisk pursuant to this agreement, Novo Nordisk has rights to these proteins in the rest of the world. In addition, under this agreement Novo Nordisk has worldwide rights, including rights in North America, to any licensed proteins that act to generate, expand or prevent the death of insulin-producing beta cells. Novo Nordisk has already exercised options to license three proteins, and it may license other proteins in the future pursuant to this agreement. Our agreement with Novo Nordisk may: . preclude or delay opportunities to seek other collaborators for our product candidates, due to the fact that we cannot explore other collaboration opportunities relating to proteins subject to the agreement until after Novo Nordisk has decided not to exercise an option with respect to the protein, which decision Novo Nordisk may decide not to make until well into the product development cycle; . limit the financial benefits we may derive from product candidates by allowing Novo Nordisk to license proteins in exchange for pre-determined payments and royalties and with pre-determined cost- sharing arrangements, which payments and royalty rates may be less than, and which cost-sharing arrangements may be less favorable to us than, terms we might otherwise obtain in collaborative or licensing arrangements with other parties; . result in Novo Nordisk licensing proteins with the most therapeutic and commercial potential, leaving us with fewer or less desirable product candidates to develop on our own or with other potential collaborators; and . prevent us from collaborating with or licensing a product candidate to another company that, by virtue of its particular skills and capabilities, may be a more desirable collaborator or licensing partner for that particular product candidate than Novo Nordisk. Because we currently do not have the capability to manufacture materials for clinical trials or for commercial sale, we will have to rely on third parties to manufacture our potential products, and we may be unable to obtain required quantities in a timely manner or on acceptable terms, if at all. We currently do not have the manufacturing facilities necessary to produce materials for clinical trials or commercial sale, and we have only limited capabilities to produce materials for preclinical studies. We intend to rely on collaborators and third-party contract manufacturers to produce the quantities of drug materials needed for preclinical studies, clinical trials and commercialization of our potential products. We will have to rely on these manufacturers to deliver materials on a timely basis and to comply with regulatory requirements, including current Good Manufacturing Practices regulations enforced by the FDA through its facilities inspection program. These manufacturers may not be able to meet our needs with respect to timing, quantity or quality of materials, and may fail to satisfy applicable regulatory requirements with respect to the manufacturing of these materials. If we are unable to contract for a sufficient supply of needed materials on acceptable terms, or if we encounter delays in the delivery of materials from, or difficulties in our relationships with, manufacturers, our preclinical studies and clinical trials may be delayed. Delays in preclinical studies could postpone the filing of investigational new drug applications or the initiation of clinical trials, and delays in clinical trials could postpone the subsequent submission of product candidates for regulatory approval and market introduction. We may not be successful in developing internal manufacturing capabilities or complying with applicable manufacturing regulations. We may be unable to establish the internal manufacturing capabilities necessary to develop our potential products. Therapeutic proteins are often more difficult and expensive to manufacture than other classes of drugs, and the manufacture of therapeutic proteins may not be commercially feasible. Also, we will be required to adhere to rigorous Good Manufacturing Practices regulations in the manufacture of therapeutic proteins. Although we intend to develop limited manufacturing facilities internally, construction of an initial pilot manufacturing plant will take at least three years and require substantial expenditures. In addition, we will need to hire and train employees to staff this facility if we are able to complete construction. We do not anticipate that this initial pilot manufacturing plant will provide us with the capability to produce drug materials for commercial sale. To develop this capability we would need to further expand our manufacturing facilities. If any of our future facilities cannot pass a pre-approval plant inspection, the FDA pre-market approval of our product candidates may not be granted. In complying with these regulations and any applicable foreign regulatory requirements, we will be obligated to expend time, money and effort in production, record-keeping and quality control to assure that our potential products meet applicable specifications and other requirements. Any failure to comply with these requirements may subject us to regulatory sanctions and delay or interrupt our development and commercialization efforts. In addition, some of the inventions licensed to us were initially developed at universities or other not-for-profit institutions with funding support from an agency of the United States government. In accordance with federal law, we or our licensees may be required to manufacture products covered by patents in those inventions in the United States, unless we can obtain a waiver from the government on the basis that such domestic manufacture is not commercially feasible. We have not attempted to secure any such waivers from the government, and do not know if they would be available if sought. If we are not able to obtain such waivers on a timely basis, we might be forced to seek manufacturing arrangements at higher prices, or on otherwise less favorable terms, than might be available to us in the absence of this domestic manufacturing requirement. Because we will depend on third parties to conduct laboratory tests and clinical trials, we may encounter delays in or lose some control over our efforts to develop product candidates. We will rely on third parties to design and conduct laboratory tests and clinical trials for us. If we are unable to obtain these services on acceptable terms, we may not be able to complete our product development efforts in a timely manner. Also, because we will rely on third parties for laboratory tests and clinical trials, we may lose some control over these activities or be unable to manage them appropriately, or may become too dependent on these parties. These third parties may not complete the tests or trials on schedule or when we request, and the tests or trials may be methodologically flawed or otherwise defective. Any delays or difficulties associated with third-party laboratory tests or clinical trials may delay the development of our product candidates. Because we currently have no sales or marketing capabilities, we may be unable to successfully commercialize our potential products. We currently have no direct sales capabilities or marketing capabilities. We expect that in the future we will rely on collaborators or other third parties to market any products that we may develop. These third parties may not be successful in marketing our potential products, and we will have little or no control over their marketing efforts. In addition, we may co-promote our potential products or retain marketing rights in North America to these products. If we decide to market products directly, we will need to incur significant additional expenses and commit significant additional management resources to develop effective sales and marketing capabilities. We may not be able to establish these capabilities despite these additional expenditures. In addition, co-promotion or other marketing arrangements with third parties to commercialize potential products could significantly limit the revenues we derive from these products. Environmental and health and safety laws may result in liabilities, expenses and restrictions on our operations. State and federal laws regarding environmental protection, hazardous substances and human health and safety may adversely affect our business. The use of hazardous substances in our operations exposes us to the risk of accidental releases. If our operations result in contamination of the environment or expose individuals to hazardous substances, we could be liable for damages and fines. Future changes to environmental and health and safety laws could cause us to incur additional expenses or restrict our operations. In addition, the site where our principal headquarters and facilities are located has been listed as a contaminated property by the State of Washington due to its previous use by the City of Seattle as an electricity generating plant. We purchased this property from the City of Seattle. The City of Seattle has agreed to defend us against and indemnify us for any claims that arise from this pre-existing contamination, except to the extent that we caused the claim through our negligence or intentional fault, or to the extent that we contributed to the contamination that is the subject of the claim, caused an increase in the clean-up costs or failed to comply with our obligations under our agreement with the City of Seattle. This indemnity may be insufficient and we may be subject to environmental liabilities or be prohibited from using or occupying some or all of the property as a result of environmental claims. Financial and Market Risks We anticipate incurring additional losses and may not achieve profitability. As of September 30, 2001, we had an accumulated deficit of $99.9 million. We expect to continue to incur increasing losses over the next several years, and we may never become profitable. We are in the early stages of development as an independent company, and it will be a number of years, if ever, before we generate any revenues from our own product sales. Our revenues from existing collaborative and licensing arrangements are insufficient to cover our operating expenses, and we may never generate revenues from these or any future arrangements sufficient to cover these expenses. In addition, we will continue to incur substantial expenses relating to our discovery and development efforts. We anticipate that these expenses will increase as we focus on the laboratory tests and clinical trials required to obtain the regulatory approvals necessary for the sale of any products. The development of our product candidates will require significant further research, development, testing and regulatory approvals. We may not be able to complete such development or succeed in developing products that will generate revenues in excess of the costs of development. Our operating results are subject to fluctuations that may cause our stock price to decline. Our operating results have fluctuated in the past and are likely to continue to do so in the future. Our revenues are unpredictable and may fluctuate due to the timing of licensing fees or the achievement of milestones under new or existing licensing and collaborative arrangements, including our option agreement with Novo Nordisk. In addition, our expenses may fluctuate from quarter to quarter due to the timing of expenses, including payments owed by us under collaborative or licensing arrangements. We believe that period-to-period comparisons of our past operating results are not good indicators of our future performance and should not be relied on to predict our future operating results. For example, for periods prior to 2000, most of our revenues represented payments received from Novo Nordisk for research and development activities we conducted on their behalf. This arrangement terminated in 2000 in connection with our separation from Novo Nordisk. It is possible that in the future our operating results in a particular quarter or quarters will not meet the expectations of securities analysts or investors, causing the market price of our common stock to decline. If we do not obtain substantial additional funding on acceptable terms, we may not be able to continue to grow our business or generate enough revenue to recover our investment in research and development. Our business does not currently generate the cash needed to finance our operations. We anticipate that we will continue to expend substantial funds on our discovery and development programs. We expect that these expenditures will increase significantly over the next several years as we hire additional employees, expand our preclinical development activities and begin internal clinical trials. We will need to seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative and licensing arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements sooner than we expect. However, financing may be unavailable when we need it or may not be available on acceptable terms. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our existing shareholders will be diluted, and these securities may have rights superior to those of our common stock. If we are unable to raise additional funds when we need them, we may be required to delay, scale back or eliminate expenditures for some of our discovery or development programs. We may also be required to grant rights to third parties to develop and market product candidates that we would prefer to develop and market internally, and such rights may be granted on terms that are not favorable to us. If we are required to grant such rights, the ultimate value of these product candidates to us would be reduced. Risks Related to Our Industry Negative public opinion and increased regulatory scrutiny of genetic and clinical research may limit our ability to conduct our business. Ethical, social and legal concerns about genetic and clinical research could result in additional regulations restricting or prohibiting some of our activities or the activities of our suppliers and collaborators. In recent years, federal and state agencies, congressional committees and foreign governments have expressed interest in further regulating the biotechnology industry. More restrictive regulations could delay preclinical studies or future clinical trials, or prevent us from obtaining regulatory approvals or commercializing any products. In addition, animal rights activists may protest our use of animals in research and development and may attempt to disrupt our operations, which could cause us to incur significant expenses and distract our management's attention from other business concerns. Many of our competitors have substantially greater capabilities and resources than we do and may be able to develop and commercialize products before we do. We may be unable to compete successfully against our current or future competitors. We expect that competition in our field will continue to be intense. We face competition from other entities using high-speed gene sequencers and other sophisticated bioinformatics technologies to discover genes, including Celera Genomics Corporation, Curagen, Inc., Genentech, Inc., Human Genome Sciences, Inc., Incyte Genomics, Inc. and Millennium Pharmaceuticals, Inc. We also face competition from entities using more traditional methods to discover genes related to particular diseases, including other large biotechnology and pharmaceutical companies. In addition, we face competition from other parties that conduct research to identify genes and conduct human genome research similar to or competing with our focus on gene discovery, including biotechnology and pharmaceutical companies; privately or publicly financed research institutes or programs, such as those sponsored by the United States government and the governments of France, Germany, Japan and the United Kingdom; and laboratories associated with universities or other not- for-profit organizations. Furthermore, our potential products, if approved and commercialized, may compete against well-established existing therapeutic protein-based products, many of which may be currently reimbursed by government health administration authorities, private health insurers and health maintenance organizations. Also, healthcare professionals and consumers may prefer existing or newly developed products to any product we develop. Many of our existing and potential competitors have substantially greater research and product development capabilities and financial, scientific, marketing and human resources than we do. As a result, these competitors may: . succeed in identifying genes or proteins, or developing therapeutic protein-based products, earlier than we do; . obtain approvals for products from the FDA or other regulatory agencies more rapidly than we do; . obtain patents that block or otherwise inhibit our ability to develop and commercialize our product candidates; . develop treatments or cures that are safer or more effective than those we propose to develop; . devote greater resources to marketing or selling their products; . introduce or adapt more quickly to new technologies or scientific advances, which could render our bioinformatics technologies obsolete; . introduce products that make the continued development of our potential products uneconomical; . withstand price competition more successfully than we can; . more effectively negotiate third-party collaborative or licensing arrangements; and . take advantage of acquisition or other opportunities more readily than we can. The failure to attract or retain key management or other personnel could decrease our ability to discover, develop and commercialize potential products. We depend on our senior executive officers as well as key scientific and other personnel. Only a few of our key personnel are bound by employment agreements, and those with employment agreements are bound only for a limited period of time. Further, we have not purchased key-person life insurance policies for any of our executive officers or key personnel. Competition for scientists and other qualified employees is intense among pharmaceutical and biotechnology companies, and the loss of qualified employees, or an inability to attract, retain and motivate the additional highly skilled employees required for the expansion of our activities, could hinder our ability to discover, develop and commercialize potential products. If the health care system or reimbursement policies change, the prices of our potential products may fall or our potential sales may decline. In recent years, officials have made numerous proposals to change the health care system in the United States. These proposals include measures that would limit or prohibit payments for certain medical procedures and treatments or subject the pricing of pharmaceuticals to government control. Government and other third-party payors increasingly have attempted to contain health care costs by limiting both coverage and the level of reimbursement of newly approved health care products. They may also refuse to provide any coverage of uses of approved products for medical indications other than those for which the FDA has granted marketing approval. Governments may adopt future legislative proposals and federal, state or private payors for health care goods and services may take further action to limit payments for health care products and services. In addition, in certain foreign countries, particularly the countries of the European Union, the pricing of prescription pharmaceuticals is subject to governmental control. Any of these factors could limit our ability to successfully commercialize our potential products. We may be required to defend lawsuits or pay damages in connection with the alleged or actual harm caused by our product candidates. We face an inherent business risk of exposure to product liability claims in the event that the use of our product candidates is alleged to have resulted in harm to others. This risk exists in clinical trials as well as in commercial distribution. In addition, the pharmaceutical and biotechnology industries in general have been subject to significant medical malpractice litigation. We may incur significant expenses if product liability or malpractice lawsuits against us are successful. Although we may obtain product liability insurance, any coverage we obtain may not be adequate to cover such claims. Risks Related to This Offering Our stock price may be volatile, and you may be unable to sell your shares at or above the offering price. There previously has been no public market for our common stock. An active public market for our common stock may not develop or be sustained after this offering. The initial public offering price for our shares will be determined by negotiations between us and representatives of the underwriters and may not be indicative of prices that will prevail in the trading market. The market price of our common stock may fluctuate significantly in response to many factors beyond our control, including: . changes in the recommendations of securities analysts or changes in their financial estimates of our operating results; . failures in meeting performance expectations of securities analysts or investors; . fluctuations in the valuations of companies perceived by securities analysts or investors to be comparable to us; and . share price and volume fluctuations attributable to inconsistent trading volume levels of our shares. Furthermore, the stock markets have experienced extreme price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many companies. In particular, there have been high levels of volatility in the market prices of securities of biotechnology companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These market and industry fluctuations, as well as general economic, political and market conditions such as recessions, interest rate changes or international currency fluctuations, may negatively impact the market price of our common stock. In the past, companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management's attention from other business concerns, which could seriously harm our business. Our existing shareholders have significant control of our management and affairs, which they could exercise against your best interests. Following the completion of this offering, Novo Nordisk, together with Warburg, Pincus Equity Partners, L.P. and entities affiliated with Patricof & Co. Ventures, Inc. will beneficially own an aggregate of approximately 66% of our outstanding common stock. Novo Nordisk will beneficially own 100% of our outstanding non-voting common stock. In addition, Novo Nordisk and Warburg, Pincus Equity Partners will retain rights to designate director nominees to our board of directors after the completion of this offering. These shareholders, acting together, will be able to control our management and affairs and matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets. Consequently, these shareholders, acting together, will be able to cause a change in control, as well as to delay or prevent a change in control. They may also discourage a potential acquirer from making a tender offer or otherwise attempting to effect a change in control, even if such a change in control would benefit our other shareholders. New shareholders will incur immediate and substantial dilution as a result of this offering. The initial public offering price will be substantially higher than the net tangible book value per share of our common stock based on the total value of our tangible assets less our total liabilities immediately following this offering. Therefore, if you purchase common stock in this offering, you will experience immediate and substantial dilution of approximately $6.19 per share in the price you pay for our common stock as compared to its net tangible book value, based on an assumed initial public offering price of $13.00 per share. Furthermore, investors purchasing common stock in this offering will own only 22% of our aggregate outstanding shares of common stock and non-voting common stock even though they will have contributed 46% of the total consideration received by us in connection with our sales of common stock and non-voting common stock. To the extent options to purchase common stock are exercised, there will be further dilution to investors in this offering. Following this offering, a substantial number of our shares of common stock will become available for sale in the public market, which may cause the market price of our common stock to decline. Sales of substantial amounts of our common stock in the public market following this offering could cause the market price of our common stock to fall and could impair our ability to raise funds in additional offerings of securities. Upon completion of this offering, we will have 36,501,279 shares of common stock outstanding and 9,100,800 shares of non-voting common stock outstanding, assuming no exercise of the underwriters' over-allotment option, no exercise of options after September 30, 2001 and the conversion of all shares of outstanding preferred stock into common stock and non-voting common stock. Of these shares, the 10,000,000 shares of common stock sold through the underwriters in this offering will be freely tradable without restriction under the Securities Act, assuming they are not held by our affiliates. The remaining shares of common stock outstanding after this offering will be available for sale in the public market as follows: . 10,000,000 shares of common stock upon completion of this offering; . 34,163,872 shares of common stock beginning 180 days after the date of this prospectus, assuming the conversion of all shares of non-voting common stock into common stock upon the sale of the non-voting common stock by Novo Nordisk to entities unaffiliated with Novo Nordisk; and . 1,438,207 shares of common stock periodically thereafter upon the expiration of one-year holding periods. In addition, we intend to file a registration statement under the Securities Act as promptly as possible after the completion of this offering to register shares to be issued pursuant to our Amended and Restated 2000 Stock Incentive Plan and our 2001 Stock Incentive Plan. We expect this registration statement to become effective immediately upon filing. Our management has broad discretion in the use of net proceeds from this offering and may not use these net proceeds effectively. As of the date of this prospectus, we cannot specify with certainty the amounts we will spend on particular uses from the net proceeds we will receive from this offering. Although our management currently expects to use the net proceeds as described in "Use of Proceeds," they will have broad discretion in the application of these proceeds. The failure by our management to apply these funds effectively could adversely affect our ability to develop and commercialize our product candidates. Provisions in our charter documents could prevent or frustrate any attempts to replace our current management by shareholders. Our articles of incorporation and bylaws contain provisions, such as undesignated preferred stock and prohibitions on cumulative voting in the election of directors, which could make it more difficult for a third party to acquire us without the consent of our board of directors. Also, our board of directors has approved amendments to our articles of incorporation, which, subject to shareholder approval, would provide for a staggered board, removal of directors only for cause and certain requirements for calling special shareholder meetings. In addition, our board of directors has approved amendments to our bylaws to require advance notice of shareholder proposals and nominations and to impose restrictions on the persons who may call special shareholder meetings. These provisions may have the effect of preventing or hindering any attempts by our shareholders to replace our current management. See "Description of Our Capital Stock."

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+RISK FACTORS An investment in our securities involves a high degree of risk. You should consider carefully the risks described below together with the other information contained in this prospectus before making a decision to invest in our units. We are a development stage company with no current funds and will be unable to continue our existence if we do not raise funds in this offering We are a recently incorporated development stage company with no significant operating results to date. Therefore, our ability to begin operations is dependent upon obtaining financing through a public offering of our securities. You should carefully review and consider our financial statements in their entirety before investing in our common stock. We have disclosed in our financial statements that substantial doubt exists as to our ability to continue as a going concern. Through March 31, 2002, we have incurred net losses of approximately $419,000. We depleted our funding received through the sale of common stock to our existing stockholders to operate our business in early June 2001. Since June 2001, Mr. Richard Frost has contributed an aggregate of $69,500 to us ($66,000 of which was used to pay for our operating expenses and $3,500 of which was equal to the value of services Mr. Frost performed on our behalf). We treated such amounts as a capital contribution to us. Other than the funds Mr. Frost provided as a capital contribution to us (of which approximately $5,000 remains available), we have no other funds or sources of funds to operate our business until the consummation of this offering. In the event we do not have sufficient funds to complete a business combination before we exhaust our proceeds to operate, we will attempt to obtain financing, which would accrue interest, from Mr. Frost or any of our existing stockholders or officers, a bank or other financial institution. No party is required to provide us with any such financing. We also cannot assure you that to the extent we do not have sufficient funds from the proceeds not placed in trust to conduct our business in the future, Mr. Frost or our other existing stockholders or officers, or a bank or other financial institution will loan us such funds or that such financing or any future financing would be available on acceptable terms, if at all. See "Use of Proceeds." We have limited resources and managerial experience which could result in a material adverse effect on the development and growth of a target business Since we do not have a meaningful operating history, you will have a limited basis upon which to evaluate our ability to achieve our business objective. We have limited resources and have not generated any revenues. In addition, we will not achieve any revenues (other than interest on the proceeds of this offering) until, and only if, we combine with another business. Even if we are able to complete a business combination, we may not be able to generate significant revenues or operate on a profitable basis and the combined business may not be successful. Our success in attaining our business objective of combining with a business with significant growth potential will largely be based on the abilities of our officers and directors in identifying, evaluating and selecting a prospective business and structuring and completing a business combination. Our officers have limited operational and managerial experience. One of our officers has been a principal of four companies that have executed business plans similar to our business plan. These transactions represent substantially all of our officers' experience in the identification, evaluation, selection and structuring of prospective business combinations. We cannot assure you that our assessment of the skills, qualifications or abilities of the management of a prospective target business will prove to be correct, especially in light of the inexperience of our officers in evaluating many types of businesses. In addition, we cannot assure you that, despite a positive assessment by our officers, the management of a prospective target business will have the necessary skills, qualifications or abilities to manage a public company intending to embark on a program of business development. If management of a target business is not qualified, it could result in a material adverse effect on the development and growth of the target business. See "Proposed Business--Effecting a Business Combination--Limited Ability to Evaluate the Target Business' Management." Our Chairman and President has been involved with four similar companies, three of which have filed for bankruptcy within a year and a half to four years after completion of their offering, and investors who held shares at that time lost their investment Our Chairman and President, Richard Frost, has been a principal of companies that have completed four offerings similar to this offering and executed business plans similar to our business plan. All four of these companies acquired an operating business, but in two of the four cases, the companies filed for bankruptcy within 18 months after completing their acquisitions. In one of the other two cases, the entity into which the company was subsequently merged filed for bankruptcy four years after the initial business combination. Equity holders in a company that files for bankruptcy generally lose their entire investment. You will not acquire any interest in these companies by investing in our common stock. You should also not conclude that we will be able to complete a business combination within a time period comparable to these other four companies (or at all), or that we will complete a business combination with companies in similar lines of business. Moreover, you may lose your entire investment if we are unsuccessful in our business and are compelled to file for bankruptcy. The limited experience of our Chairman and President, the sole principal in this company, in evaluating business combinations may adversely impact our ability to attain our objectives In the four completed offerings similar to this offering, Mr. Richard Frost was one of several principals. Such principals had significant experience in evaluating business transactions and played a significant role in identifying and evaluating prospective businesses and structuring and completing the business combinations completed by the respective companies. Mr. Frost is the sole principal of this company. His primary experience with companies of this nature is comprised of his experience in the four offerings referred to above. We cannot assure you to what extent Mr. Frost as the sole principal in this offering will impact our ability to attain our business objectives. We may not have sufficient resources to identify a suitable business and complete a business combination The terms of this offering anticipate that we will have up to 24 months, or 30 months under certain circumstances, to consummate a business combination. However, upon completion of this offering, we will only have approximately $92,000 available cash (after the payment of $10,000 in accounts payable for accounting services unrelated to this offering) to fund our operations until the consummation of a business combination (including approximately $5,000 currently on hand), which is insufficient to fund our operations for the full 24 or 30 months. We anticipate that our expenses for the first twelve months of operations will be approximately $75,000, which should cover anticipated due diligence expenses associated with one or two possible target businesses, expenses related to consummating a business combination and complying with securities requirements and other customary operating expenses. However, due diligence expenses can vary drastically depending on many factors including on the type of the business, the operational history, and the organization and experience of the business target. We have budgeted an aggregate of $30,000 for due diligence expenses related to two possible business combinations, which assumes due diligence expenses of $15,000 related to each possible business combination. Since it is difficult to predict the actual cost of any due diligence, we can not assure you that due diligence expenses will not be higher than budgeted or that the amount budgeted for a possible business combination will be sufficient to conduct a thorough due diligence examination of a possible target business. If we do not complete a business combination with the first possible target business, we may not have sufficient funds to conduct a thorough due diligence examination of a second possible target business. Therefore, if our initial due diligence reviews do not result in any successful business combination, we will have insufficient funds to continue to look for a suitable business. In addition, if we are unable to identify a suitable business or we are unable to consummate a business combination within twelve months from the completion of the offering, we will not have sufficient funds to continue operating our business. In the event we do not complete a business combination before we exhaust our proceeds to operate, we will attempt to obtain financing, which would accrue interest, from Mr. Frost or any of our existing stockholders or officers, a bank or other financial institution. No party is required to provide us with any such financing. We cannot assure you that such financing would be available on acceptable terms, if at all. If we are unable to identify, due diligence and consummate a business transaction in the first twelve months and cannot obtain additional financing we will cease operations. If we are forced to liquidate before a business combination, our public stockholders will receive less than $6.00 per share upon distribution of the trust fund and our remaining assets If we are unable to complete a business combination and are forced to liquidate our assets, the per-share liquidation distribution will be less than $6.00 because of the expenses of this offering and anticipated costs of seeking a business combination. We intend to use the net proceeds not placed in trust to identify and evaluate prospective businesses for a business combination and to structure a business combination. We must make these expenditures, which will likely be significant, whether or not we complete a business combination with the prospective businesses we consider. These proceeds will also be used to pay our general and administrative expenses, including accountable and non-accountable expenses. Furthermore, there will be no distribution from the trust fund with respect to our outstanding warrants and, accordingly, the warrants will expire worthless in the event we liquidate before the completion of a business combination. See "Proposed Business--Effecting a Business Combination--Liquidation If No Business Combination." A third party claim could reduce the proceeds held in trust Our placing of funds in trust will not protect those funds from third party claims against us. The proceeds held in trust could be subject to such claims which could take priority over the claims of the public stockholders. We cannot assure you that the per share liquidation price will not be less than $5.00 (or $1.00 less than the per unit offering price of $6.00, which are the proceeds required to be deposited in the trust fund), plus interest, due to claims of creditors. If we liquidate before the completion of a business combination, Mr. Richard Frost will be personally liable under certain circumstances to ensure that the proceeds in the trust fund are not reduced by any claims of our creditors. However, we cannot assure you that Mr. Frost could satisfy such obligations. See "Proposed Business--Effecting a Business Combination--Liquidation If No Business Combination." You will not be entitled to protections, such as the return of your investment after 18 months upon failure to complete a business combination, normally afforded to investors of blank check companies Since the net proceeds of this offering are intended to be used to complete a business combination with a target business that has not been identified, we may be deemed to be a blank check company. However, we are exempt from rules promulgated by the SEC to protect investors of blank check companies since we will have net tangible assets in excess of $5,000,000 upon the successful completion of this offering and our common stock is being offered at an initial price equal to $6.00 per share in this offering. These rules, among other things, prevent a blank check company from holding investors' funds for more than 18 months from the investment date upon failure to complete a business combination as opposed to this offering in which we generally may hold investors' funds for up to 30 months. Accordingly, investors will not be afforded the benefits or protections of such rules. See "Proposed Business--Comparison to Rule 419." If our common stock becomes subject to the SEC's penny stock rules because we have net tangible assets of $5,000,000 or less or our common stock is trading at a price per share of less than $5.00, broker-dealers may experience difficulty in completing customer transactions and trading activity in our common stock which may have an adverse effect on the market price of our common stock If at any time we have net tangible assets (i.e., total assets less intangible assets and liabilities) of $5,000,000 or less or our common stock is trading at a price per share of less than $5.00, transactions in our common stock may be subject to certain rules under the Securities Exchange Act of 1934. Under such rules, broker-dealers who recommend such securities to persons other than institutional accredited investors (generally institutions with assets in excess of $5,000,000): . must make a special written suitability determination for the purchaser; . receive the purchaser's written agreement to a transaction prior to sale; . provide the purchaser with risk disclosure documents which identify certain risks associated with investing in "penny stocks" and which describes the market for these "penny stocks" as well as a purchaser's legal remedies; and . obtain a signed and dated acknowledgment from the purchaser demonstrating that the purchaser has actually received the required risk disclosure document before a transaction in a "penny stock" can be completed. Currently, our net tangible assets upon consummation of this offering is anticipated to be $5,092,788. We, therefore, can incur net losses of no more than $92,788 in connection with our business operations before we may be deemed a "penny stock" company. We believe that we will be able to operate for approximately a twelve-month period prior to incurring net losses in excess of this amount. We may, however, incur additional expenses within such time period, such as attorneys' and accountants' fees, due diligence expenses and other such expenses related to consummating a business combination and complying with securities requirements and filings. If we incur additional expenses and are unable to offset these additional expenses with either revenue or increases in our capital, then our net losses may exceed $92,788 in less than twelve months. Since we may need to operate for a period of 24 months, or 30 months under certain circumstances, before we consummate a business combination, our paying or accruing such expenses may result in our net tangible assets falling below $5,000,000 within such time period. Since September 2001, our officers have contributed and in the future will contribute the value of their services, if any, to us as additional paid-in capital. Our officers and the directors also have agreed to contribute their reimbursable out-of-pocket expenses to us as additional paid-in capital after completion of the offering if paying or accruing their expenses would reduce our net tangible assets below $5,000,000. We cannot assure you that this contribution will be sufficient to maintain our net tangible assets above $5,000,000 or that our common stock will be trading at a price of $5.00 per share or above following completion of this offering. Accordingly, if the price of our common stock is trading at a price per share of less than $5.00 following completion of this offering or our net tangible assets fall below $5,000,000, we may be subject to the "penny stock" rules. If our common stock becomes subject to these rules, broker-dealers may find it difficult to effectuate customer transactions and trading activity in our common stock. As a result, the market price of our common stock may be depressed, and you may find it difficult to dispose of our common stock. Due to the possibility that we may be deemed a "penny stock" company if our net tangible assets fall below $5,000,000 or the price per share of our common stock falls below $5.00, our officers and directors will likely be motivated to complete a business combination promptly. Such a business combination may be less advantageous to us than a business combination which may have occurred at a later date if our officers and directors had not been motivated by the "penny stock" rules to complete a business combination at an earlier date. See "Plan of Operations." It is probable that we will only be able to complete one business combination which will cause us to be solely dependent on a single business and a limited number of products or services, subjecting us to adverse economic, competitive and regulatory developments, including the inability to diversify our operations or benefit from the possible spreading of risks or offsetting of losses Our initial business combination must be with a business with a fair market value of at least 80% of our net assets at the time of such acquisition. Consequently, it is probable that we will have the ability to complete only a single business combination. Accordingly, the prospects for our success may be . solely dependent upon the performance of a single business, or . dependent upon the development or market acceptance of a single or limited number of products, processes or services. In this case, we will not be able to diversify our operations or benefit from the possible spreading of risks or offsetting of losses which is experienced by other entities which may have the resources to complete several business combinations in different industries or different areas of a single industry. A lack of diversification may subject us to numerous economic, competitive and regulatory developments, any or all of which may have a substantial adverse impact upon the particular industry in which we may operate subsequent to a business combination. Therefore, we cannot assure you that the target business will prove to be commercially viable. See "Proposed Business--Effecting a Business Combination--Probable Lack of Business Diversification" and "-- Competition." Since we have not currently selected a particular industry or any target business with which to complete a business combination, both you and we are unable to ascertain the merits or risks of the industry or business in which we may ultimately operate We have not selected any particular industry or any target business on which to concentrate our search for a business combination. Accordingly, there is no current basis for prospective investors to evaluate the possible merits or risks of the particular industry or the target business in which we may ultimately operate. To the extent we complete a business combination with a financially unstable company or an entity in its development stage, we may be affected by numerous risks inherent in the business operations of such entities. If we complete a business combination with an entity in an industry characterized by a high level of risk, we may be affected by the currently unascertainable risks of that industry. Although our management will endeavor to evaluate the risks inherent in a particular industry or target business, we cannot assure you that we will properly ascertain or assess all such significant risk factors. We also cannot assure you that an investment in our units will not ultimately prove to be less favorable to investors in this offering than a direct investment, if such opportunity were available, in a target business. See "Proposed Business--Effecting a Business Combination--We Have Not Identified a Target Business or Target Industry." We may issue shares of our common stock and/or preferred stock to complete a business combination, which would reduce the equity interest of our stockholders, likely cause a change of control of ownership of us, and could adversely affect prevailing market prices for our common stock and our ability to raise additional capital through the sale of our securities Our Certificate of Incorporation authorizes the issuance of 100,000,000 shares of common stock, par value $.0001 per share. Upon completion of this offering, there will be 98,026,783 authorized but unissued shares of our common stock available for issuance (after appropriate reservation for the issuance of shares upon full exercise of the underwriters' option). Although we have no commitments as of the date of this offering to issue our securities, we will, in all likelihood, issue a substantial number of additional shares of our common stock or preferred stock, or a combination of common and preferred stock, to complete a business combination. The issuance of additional shares of our common stock or any number of shares of our preferred stock may: . significantly reduce the equity interest of our stockholders; . likely cause a change in control if a substantial number of our shares of common stock are issued which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and most likely also result in the resignation or removal of our present officers and directors; accordingly our investors will be relying on the abilities of the management and directors of the target business who are unidentifiable as of the date of this offering; . adversely affect prevailing market prices for our common stock; and . impair our ability to raise additional capital through the sale of our equity securities. In the event we issue a substantial number of additional shares of our common stock and/or preferred stock, you will in all likelihood experience a substantial reduction in your interest as a stockholder, a change in control and the effects of the other factors listed above. We may also issue additional shares of our common stock, preferred stock or options to purchase shares of common stock to professionals in connection with the consummation of a business combination which may result in an additional reduction in your interest. Additionally, to the extent we issue shares of common stock to complete a business combination, the potential for the issuance of substantial numbers of additional shares upon exercise of our warrants could increase our cost of the target business in terms of number of shares required to be issued. We may be unable to obtain additional financing, if required, to complete a business combination or to fund the operations and growth of the target business, which could compel us to restructure the transaction or abandon a particular business combination We may seek additional financing to complete a business combination or to fund the operations and growth of a target business, which may include assuming or refinancing the indebtedness of the target business. We cannot assure you that such financing would be available on acceptable terms, if at all. To the extent that such additional financing proves to be unavailable when needed to complete a particular business combination, we would, in all likelihood, be compelled to restructure the transaction or abandon that particular business combination and seek an alternative candidate. In addition, our failure to secure additional financing could have a material adverse effect on the continued development or growth of the target business. We may be adversely impacted if we are unable to receive debt financing to complete a business combination or operate the acquired business and if we receive debt financing, we may be subject to interest rate fluctuations and not generate sufficient funds to pay principal and interest on such debt The amount and nature of any borrowings by us will depend on numerous considerations, including our capital requirements, our perceived ability to meet debt service requirements and the prevailing conditions in the financial markets and general economic conditions. Debt financing may not be available to us on terms deemed to be commercially acceptable and in our best interests. Our inability to borrow funds required to complete or facilitate a business combination, or to provide funds for an additional infusion of capital into an acquired business, may have a material adverse effect on our financial condition and future prospects. Additionally, if debt financing is available, any borrowings may subject us to various risks traditionally associated with incurring of indebtedness. These risks include the risks of interest rate fluctuations and insufficiency of cash flow to pay principal and interest. We may assume similar risks to the extent that any business with which we combine has outstanding indebtedness. Since our officers and directors may allocate their time to other businesses, a conflict of interest may arise as to which business they present a viable business opportunity, which could cause us a delay in or prevent us from completing a business combination Mr. Richard Frost, our Chairman and President, and Ms. Grout, our Secretary and Treasurer, intend to only devote as much time as may be necessary to our affairs. As of March 2002, Ms. Grout has served as a part-time residential realtor for Coldwell Banker Residential Real Estate, Inc. Our officers and directors are not required to commit their full time to our affairs, which may result in a conflict of interest in allocating their time between our operations and other businesses. Certain of these persons may in the future become affiliated with entities, including other "blank check" companies, engaged in business activities similar to those intended to be conducted by us. Our officers and directors may become aware of business opportunities which may be appropriate for presentation to us as well as the other entities with which they may be affiliated. Such persons may have conflicts of interest in determining to which entity a particular business opportunity should be presented. Such conflict may cause a delay in or prevent us from completing a business combination and may not be in the best interest of our stockholders. See "Management--Conflicts of Interest." All of our directors and officers and certain members of our Advisory Committee own shares of our common stock which are held in escrow until after we complete a business combination and therefore may have a conflict of interest in determining whether a particular business is appropriate to complete a business combination, which may not be in the best interests of our stockholders All of our directors and officers and two of our members of our Advisory Committee, whose role is to advise our directors and officers on and recommend potential business combinations, own stock in our company which will be held in escrow until after we complete a business combination. The personal and financial interests of our directors, officers and members of our Advisory Committee may influence their motivation in identifying and selecting a target business, completing a business combination timely and securing the release of their stock from escrow. In the event we do not have sufficient funds to operate our business which will likely be the case if we do not consummate a business combination within twelve months from the date of this offering, our directors and officers would likely be motivated to complete a business combination promptly. Consequently, our directors' and officers' discretion in identifying and selecting a suitable target business may result in a conflict of interest when determining whether the terms, conditions and timing of a particular business combination are appropriate and in our stockholders' best interest. See "Management--Conflicts of Interest." As a blank check company, our management will have broad discretion with respect to the use of the proceeds of your investment As a blank check company, substantially all of the net proceeds of this offering are intended to be generally applied toward completing a business combination; however, such proceeds are not otherwise being designated for any more specific purposes. Our management, therefore, will have broad discretion with respect to the proceeds which are disbursed from the trust fund after a business combination is completed and the specific application of the net proceeds of this offering not placed in trust. Our existing stockholders, including our officers, directors and members of our Advisory Committee, control a substantial interest in us and our operations and thus may influence certain actions requiring stockholder vote Following this offering, our officers and directors will own at least 11.1% of us and our existing stockholders, including our officers, directors and members of our Advisory Committee, will own at least 30% of us. Although our existing stockholders, including our directors and the members of our Advisory Committee, must vote in accordance with the vote of the public stockholders owning a majority of the shares of our outstanding common stock to complete a business combination, such existing stockholders may vote other issues as they see fit and, accordingly, have the ability to influence any actions requiring stockholder vote. For example, we may determine to seek the approval of a majority of our then outstanding shares to continue our existence if we do not complete a business combination within 24 months after completion of this offering, or within 30 months under certain circumstances. Our existing stockholders can influence the vote to continue our existence which may result in a conflict of interest. Even though there is no current intention, our existing stockholders, officers, directors and members of our Advisory Committee may purchase units in this offering and/or units, shares and warrants following this offering in the open market. In the event they purchase any additional shares in this offering or following this offering in the open market, such existing stockholders may vote such additional shares as they determine in their sole discretion, resulting in an ability to influence all actions requiring stockholder vote. If holders of a majority of shares of our common stock do not approve a business combination or holders of 20% or more of the shares exercise their conversion rights, we will not be able to complete a business combination even if management believes such a combination would be in the best interests of the stockholders We will seek stockholder approval before we complete any business combination. We will not complete a business combination if: . public stockholders purchasing shares in this offering or in the open market following this offering, who own at least a majority of such shares, vote against the transaction; or . public stockholders owning more than 20% of the shares sold in this offering exercise their conversion rights. In connection with the vote required for any business combination, all of our existing stockholders, including all of our officers and directors, have agreed to vote the shares of common stock owned by them immediately before this offering in accordance with the vote of the public stockholders owning a majority of the shares of our outstanding common stock. Even though management may believe such business combination may be in our best interests, they will be unable to complete the business combination unless the above requirements are met. Our existing stockholders paid a nominal amount for their shares and, accordingly, you will experience immediate and substantial dilution from the purchase of our common stock The difference between the public offering price per share of our common stock and the pro forma net tangible book value per share of our common stock after this offering constitutes the dilution to you and the other investors in this offering. The fact that our existing stockholders acquired their shares of common stock at a nominal price (ranging from $.22 to $1.33 per share after giving effect to both a merger effective on April 4, 2001 where each issued and outstanding share of Frost Capital Group, Inc., a Florida corporation, was converted into approximately .6723 shares of our common stock and an approximately ..6696-for-one reverse split of our common stock effectuated on October 4, 2001) has significantly contributed to this dilution. Assuming the offering is completed, you and the other new investors will incur an immediate and substantial dilution of approximately $2.68 per share (the difference between the pro forma net tangible book value per share of $3.32, and the initial offering price of $6.00 per share), or 44.7%, allocable to each share of common stock (in each case assuming no exercise of the option granted to any underwriters). You and the other investors may also incur dilution upon the exercise of certain warrants. See "Dilution."

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+RISK FACTORS An investment in our common stock involves a high degree of risk, the occurrence of the events underlying which could materially harm our business. You should consider carefully the risks and uncertainties described below, and all other information contained in this prospectus, before you decide whether to purchase our common stock. The trading price of our common stock could decline due to any of the risks and uncertainties facing our business, and you may lose part or all of your investment. We have limited operating experience, are not currently profitable and may never achieve or maintain profitability. If we cannot achieve and maintain profitability, our stock price could decline. We were incorporated in August 1998 and are an early stage company. We have a limited operating history which makes it difficult to forecast our future operating results. You should consider and evaluate our prospects in light of the risks and uncertainty frequently encountered by early stage companies in rapidly evolving markets. Although our revenue has increased substantially in recent quarters, we have not been profitable in any quarter since inception, and we may not realize sufficient revenue to achieve profitability. As of March 31, 2002, we had an accumulated deficit of $25.3 million. We anticipate that our operating expenses will increase substantially in the foreseeable future as we continue to develop our technology, products and services, expand our distribution channels and increase our sales and marketing activities, including expanding our United States and international field sales forces. These efforts may prove more expensive than we currently anticipate and we may not succeed in increasing our revenue sufficiently to offset these higher expenses. Any failure to increase our revenue as we implement initiatives to grow our business could prevent us from achieving profitability and, as a result, our stock price could decline. If we do achieve profitability in any period, we cannot be certain that we will be able to sustain or increase it on a quarterly or annual basis. Our quarterly operating results are difficult to predict, and if we do not meet quarterly financial expectations, our stock price is likely to decline. Our quarterly revenue and operating results are difficult to predict and may fluctuate from quarter to quarter. It is possible that our operating results in some quarters will be below market expectations. If this happens, the market price of our common stock is likely to decline. As a result, we believe that quarter-to-quarter comparisons of our financial results are not necessarily meaningful, and you should not rely on them as an indication of our future performance. Fluctuations in our future quarterly operating results may be caused by many factors, including: . changes in demand for our products; . the size, timing and contractual terms of orders for our products; . any downturn in our customers and potential customers' businesses, the domestic economy or international economies where our customers and potential customers do business; . the timing of product releases or upgrades by us or by our competitors; and . changes in the mix of revenue attributable to higher-margin software products as opposed to substantially lower-margin services. A majority of our software revenue in any quarter depends on orders booked and shipped in the last month, weeks or days of that quarter. Many of our customers are large businesses, and if an order from one of these large customers does not occur or is deferred, our revenue in that quarter could be substantially reduced, and we may be unable to proportionately reduce our operating expenses during a quarter in which this occurs. Our operating expenses are based on our expectations of future revenue and are relatively fixed in the short term. We plan to increase our operating expenses. If our revenue does not increase commensurate with those expenses, net income in a given quarter could be less than expected. If Microsoft successfully expands its systems management software offerings that compete with our products or if the Microsoft technologies upon which our products are dependent become incompatible with our products or lose market share, the demand for our products would suffer. We expect Microsoft to expand its offerings in the systems management software market that compete with our products. Microsoft has substantially greater financial, technical and marketing resources, a larger customer base, a longer operating history, greater name recognition and more established relationships in the industry than we do. If Microsoft gains significant market share in the systems management market with competing products, our ability to achieve sufficient market penetration to grow our business may be impaired and the demand for our products would suffer. In addition, the perception among our customers and potential customers that Microsoft is going to expand its systems management software offerings that compete with our products may delay their buying decisions and limit our ability to increase market penetration and grow our business. In addition, many of our products are designed specifically for the Windows platform and designed to use current standard Microsoft technologies, protocols and application programming interfaces. Although some of our products work on other platforms, such as UNIX, we believe that the integration between our products and Microsoft's products is one of our key competitive advantages. If Microsoft decides to promote technologies and standards, protocols and application programming interfaces that are incompatible with our technology, or promote and support existing or future products launched by our competitors, the demand for our products would suffer. In addition, our business would be harmed if Microsoft loses market share for its Windows products. We expect our products to be dependent on the Windows market for the foreseeable future. If the market for Windows systems declines or develops more slowly than we anticipate, our ability to increase revenue could be limited. Although the market for Windows systems has grown rapidly, this growth may not continue at the same rate, or at all. We believe that our success has depended in large part, and will continue to depend for the foreseeable future, on our ability to continue as a complementary software provider for Microsoft's systems management server, or SMS, and operations manager products. Because we do not have any long-term arrangements with Microsoft, we cannot be certain that our relationship with Microsoft will continue or expand. Any deterioration of our relationship with Microsoft could harm our business and affect our ability to develop, market and sell our products. If the market for IT lifecycle management software does not continue to develop as we anticipate, the demand for our products might be adversely affected. As their needs have become more complex, many companies have been addressing their IT lifecycle management needs for systems and applications internally and only recently have become aware of the benefits of third-party software products such as ours. Our future financial performance will depend in large part on the continued growth in the number of businesses adopting third-party IT lifecycle management software products and their deployment of these products on an enterprise-wide basis. Any deterioration of our relationships with Compaq could adversely affect our ability to develop, market and sell our products and impair or eliminate a substantial revenue source. An important part of our operating results depends on our relationships with Compaq Computer Corporation, or Compaq. We have generated a substantial portion of our revenue as a result of our relationships with Compaq. Compaq accounted for approximately 24% of our revenue in 2001 and approximately 32% of our revenue in the first quarter of 2002. We have a license and distribution agreement with Compaq under which Compaq distributes our products to customers directly or through Compaq's distributors and resellers. We also have an agreement with Compaq to develop and market an integrated product combining our server deployment and provisioning technology with a new Compaq line of servers. If either of these agreements were terminated, our business would be harmed. Any deterioration in our relationships with Compaq could harm our business and adversely affect our ability to develop, market and sell our products. On September 3, 2001, Compaq and Hewlett-Packard Company, or HP, announced that they had entered into an agreement to merge Compaq into HP. This merger could disrupt our relationships with Compaq, which would harm our business. The loss of significant revenue from Compaq could negatively impact our results of operations. We expect that we will continue to be dependent on Compaq for a significant portion of our revenue in future periods. We face strong competitors that have greater market share than we do and pre-existing relationships with our potential customers, and if we are unable to compete effectively, we might not be able to achieve sufficient market penetration to achieve or sustain profitability. The market for IT lifecycle management products and services is rapidly evolving and highly competitive, and we expect competition in this market to persist and intensify. We may not have the resources or expertise to compete successfully in the future. Many of our competitors have substantially greater financial, customer support, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. If our competitors maintain significant market share, we might not be able to achieve sufficient market penetration to grow our business, and our operating results could be harmed. We believe that there is likely to be consolidation in our markets, which could lead to increased price competition and other forms of competition. Established companies may not only develop their own systems management software, but may also acquire or establish cooperative relationships with our current competitors. In addition, we may face competition in the future from large established companies, as well as from emerging companies that have not previously entered the market for IT lifecycle management software or that currently do not have products that directly compete with our products. For example, Microsoft, which has a significantly larger installed base of customers and substantially greater financial, distribution, marketing and technical resources than we do, could decide to expand its existing products and offer new products that are competitive with ours. It is also possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We may not be able to compete successfully against current or future competitors, and this would impact our revenue adversely and cause our business to suffer. In addition, existing and potential competitors could elect to bundle their products with, or incorporate systems management software into, products developed by themselves or others. Developers of software products with which our products must be compatible to operate could change their products so that they will no longer be compatible with our products. If our competitors were to bundle their products in this manner or make their products non-compatible with ours, this could harm our ability to sell our products and could lead to price reductions for our products, which would likely reduce our profit margins. If we do not expand our distribution channels, we will have to rely more heavily on our direct sales force to develop our business, which could limit our ability to increase revenue and grow our business. Our ability to sell our products into new markets and to increase our penetration into existing markets will be impaired if we fail to expand our distribution channels and sales force. Our direct sales force generated approximately 50% of our revenue in each of 1999, 2000 and 2001 and approximately 35% of our revenue in the first quarter of 2002. Our sales strategy requires that we establish multiple indirect marketing channels in the United States and internationally through computer manufacturers, original equipment manufacturers, or OEMs, VARs, systems integrators and distributors, and that we increase the number of customers licensing our products through these channels. Our ability to establish relationships with additional computer manufacturers will be adversely affected to the extent that computer manufacturers decide not to enter into relationships with us because of our existing relationships with computer manufacturers with which they compete. In addition, the establishment or expansion of our relationships with computer manufacturers may cause other computer manufacturers with which we have relationships to reduce the level of business they conduct with us or even terminate their relationships with us, either of which would adversely affect our ability to increase our revenue and grow our business. Moreover, our channel partners must market our products effectively and be qualified to provide timely and cost-effective customer support and service, which requires us to provide proper training and technical support. If our channel partners do not effectively market and sell our products or choose to place greater emphasis on products offered by our competitors, our ability to grow our business and sell our products will be negatively affected. We are planning to expand our sales efforts worldwide and are investing, and plan to continue to invest, substantial resources toward this expansion. Despite these efforts, we may experience difficulty in recruiting and retaining qualified sales personnel. Because we rely heavily on our sales organizations, any failure to expand these organizations could limit our ability to sell our products. If our existing customers do not purchase additional licenses or renew annual upgrade protection, our sources of revenue might be limited to new customers and our ability to grow our business might be impaired. Historically, we have derived, and expect to continue to derive, a significant portion of our total revenue from existing customers who purchase additional products and renew annual upgrade protection, or AUP. Sales to existing customers represented 30% of our revenue in 1999, 39% of our revenue in 2000, 53% of our revenue in 2001 and 58% of our revenue in the first quarter of 2002. If our customers do not purchase additional products or renew AUP, our ability to increase or maintain revenue levels could be limited. Most of our current customers initially license a limited number of our products for use in a division of their enterprises. We actively market to these customers to have them license additional products from us and increase their use of our products on an enterprise-wide basis. Our customers may not license additional products and may not expand their use of our products throughout their enterprises. In addition, as we deploy new versions of our products or introduce new products, our current customers may not require or desire the functionality of our new products and may not ultimately license these products. We also depend on our installed customer base for future revenue from AUP renewal fees. The terms of our standard license arrangements provide for a one-time license fee and a prepayment for one year of AUP. AUP is renewable annually at the option of our customers and there are no minimum payment obligations or obligations to license additional software. Our product sales cycle for large enterprise-wide sales often lasts in excess of three months and is unpredictable, making it difficult to plan our expenses and forecast our results of operations for any given period. Increasingly, we are focusing more of our selling effort on large enterprises. The sales cycle for sales to large businesses is typically significantly longer than the sales cycle to small businesses. We have traditionally focused sales of our products to the workgroups and divisions of a customer, resulting in a sales cycle ranging between 30 and 90 days or even longer. If we do not correctly predict the timing of our sales, the amount of revenue we recognize in that quarter could be negatively impacted, which could negatively affect our operating results. In addition, the failure to complete sales, especially large, enterprise-wide sales, in a particular quarter or calendar year could significantly reduce revenue in that quarter, as well as in subsequent quarters over which revenue for the sale would likely be recognized. The sales cycle associated with the purchase of our products is subject to a number of significant risks over which we have little or no control, including: . customers' budgetary constraints and internal acceptance procedures; . concerns about the introduction or announcement of our competitors' new products; . announcements by Microsoft relating to Windows; and . potential downturns in the IT market and in economic conditions generally. Future acquisitions could require significant management attention and prove difficult to integrate with our business, which could distract our management, disrupt our business, dilute stockholder value and adversely affect our operating results. We recently acquired and integrated technologies from Compaq, Computing Edge and Tekworks. As part of our strategy, we intend to continue to make investments in complementary companies, products or technologies. If we fail to integrate successfully any future acquisitions, or the technologies associated with such acquisitions, into our company, the revenue and operating results of the combined company could decline. Any integration process will require significant time and resources, and we may not be able to manage the process successfully. If our customers are uncertain about our ability to operate on a combined basis, they could delay or cancel orders for our products. We may not be able successfully to evaluate or utilize the acquired technology and accurately forecast the financial impact of an acquisition transaction, including accounting charges. Acquisitions involve a number of difficulties and risks to our business, including the following: . potential adverse effects on our operating results; . integration of acquired technologies with our existing products and technologies; . integration of management information systems, personnel, research and development and marketing, sales and support operations; . potential loss of key employees from the acquired company; and . diversion of management's attention from other business concerns. Further, we may have to incur debt or issue equity securities to pay for any future acquisition, either of which could affect the market price of our common stock. The sale of additional equity or convertible debt could result in dilution to our stockholders. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. If we fail to manage effectively the recent, significant growth in our business, our infrastructure, management and resources might be strained and our ability to manage our business could be diminished. Our historical growth has placed, and any further growth is likely to continue to place, a significant strain on our resources. We have grown from 26 employees at December 31, 1998, to 321 employees at March 31, 2002. We currently are implementing new financial and accounting systems in our foreign offices. We also need to expand our other infrastructure systems, including implementing additional management information systems, customer relationship and support systems, and improve our operating and administrative systems and controls. As part of this implementation, we need to train new employees and maintain close coordination among our executive, engineering, accounting, finance, marketing, sales, operations and customer support organizations. In addition, our growth has resulted, and any future growth will result, in increased responsibilities of management personnel. Managing this growth will require substantial resources that we may not have or otherwise be able to obtain. If we experience delays in developing our products, our ability to deliver product releases in a timely manner and meet customer expectations will be impaired. We have experienced delays in developing new versions and updating releases in the past and may experience similar or more significant product delays in the future. To date, none of these delays has materially harmed our business. If we are unable, for technological or other reasons, to develop and introduce new and improved products or enhanced versions of our existing products in a timely manner, our business and operating results could be harmed. Difficulties in product development could delay or prevent the successful introduction, marketing and delivery of new or improved products to our customers, damage our reputation in the marketplace and limit our growth. If we do not develop and maintain productive relationships with systems integrators, our ability to generate sales leads and increase our revenue sources will be limited. We expect to develop and rely on additional relationships with a number of computing and systems integration firms to enhance our sales, support, service and marketing efforts, particularly with respect to the implementation and support of our products, as well as to help generate sales leads and assist in the sales process. Many such firms have similar, and often more established, relationships with our competitors. These systems integrators may not be able to provide the level and quality of service required to meet the needs of our customers. If we are unable to develop and maintain effective relationships with systems integrators, or if they fail to meet the needs of our customers, our business could be harmed. Errors in our products or product liability claims asserted against us could result in decreases in customers and revenue, unexpected expenses and loss of competitive market share. Because our software products are complex, they may contain errors or "bugs" that can be detected at any point in a product's lifecycle. While we continually test our products for errors and work with customers through our customer support services to identify and correct bugs, errors in our products may be found in the future even after our products have been commercially introduced. Detection of any significant errors may result in, among other things, loss of, or delay in, market acceptance and sales of our products, diversion of development resources, injury to our reputation, or increased service and warranty costs. In the past, we have discovered errors in our products and have experienced delays in the shipment of our products during the period required to correct these errors. Product errors could harm our business and have a material adverse effect on our results of operations. Moreover, because our products primarily support other systems and applications, such as Windows, any software errors or bugs in the operating systems or applications may result in errors in the performance of our software, and it may be difficult or impossible to determine where the error resides. In addition, we may be subject to claims for damages related to product errors in the future. While we carry insurance policies covering this type of liability, these policies may not provide sufficient protection should a claim be asserted. A material product liability claim could harm our business, result in unexpected expenses and damage our reputation. Our license agreements with our customers typically contain provisions designed to limit exposure to potential product liability claims. Our standard software licenses provide that if our products fail to meet the designated standard, we will correct or replace such products. Our standard license also provides that we shall not be liable for indirect or consequential damages caused by the failure of our products. However, such limitation of liability provisions may not be effective under the laws of certain jurisdictions to the extent local laws treat certain warranty exclusions or similar limitations of liability as unenforceable. Although we have not experienced any product liability claims to date, the sale and support of our products entails the risk of such claims. Our industry changes rapidly due to evolving technological standards, and our future success will depend on our ability to continue to meet the sophisticated and changing needs of our customers. Our future success will depend on our ability to address the increasingly sophisticated needs of our customers by supporting existing and emerging technologies, including technologies related to the development of Windows and other operating systems generally. If we do not enhance our products to meet these evolving needs, we may not remain competitive and be able to grow our business. We will have to develop and introduce enhancements to our existing products and any new products on a timely basis to keep pace with technological developments, evolving industry standards, changing customer requirements and competitive products that may render existing products and services obsolete. In addition, because our products are dependent upon Windows and other operating systems, we will need to continue to respond to technological advances in these operating systems, including major revisions. Our position in the market for IT lifecycle management software for Windows and other systems and applications could be eroded rapidly by our competitors' product advances. Consequently, the lifecycles of our products are difficult to estimate. We expect that our product development efforts will continue to require substantial investments, and we may lack the necessary resources to make these investments on a timely basis. We are subject to risks inherent in doing business internationally that could impair our ability to expand into foreign markets. Sales to international customers represented approximately 16% of our revenue in 2001 and approximately 26% of our revenue in the first quarter of 2002. Our international revenue is attributable principally to sales to customers in Europe. Our international operations are, and any expanded international operations will be, subject to a variety of risks associated with conducting business internationally that could harm our business, including the following: . longer payment cycles and problems in collecting accounts receivable; . seasonal reductions in business activity during the summer months in Europe and certain other parts of the world; . increases in tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries; . limited or unfavorable intellectual property protection; . fluctuations in currency exchange rates; . the possible lack of financial and political stability in foreign countries that prevent overseas sales and growth; . restrictions against repatriation of earnings from our international operations; . potential adverse tax consequences; and . difficulties in staffing and managing international operations. Recent unfavorable economic conditions and reductions in IT spending could limit our ability to grow our business. Our business and operating results are subject to the effects of changes in general economic conditions. There has been a rapid and severe downturn in the worldwide economy during the past 18 months. We expect this downturn to continue, but are uncertain as to its future severity and duration. This uncertainty has increased because of the potential long-term impact of terrorist attacks, such as the attacks on the United States on September 11, 2001, and the resulting military actions against terrorism. In the future, fears of global recession, war and additional acts of terrorism in the aftermath of the September 11, 2001 attack may continue to impact global economies negatively. We believe that these conditions, as well as the decline in worldwide economic conditions, have led our current and potential customers to reduce their IT spending. If these conditions worsen, demand for our products and services may be reduced as a result of even further reduced spending on IT products such as ours. We rely heavily on our intellectual property rights, and our inability to protect these rights could impair our competitive advantage, divert management attention, require additional development time and resources or cause us to incur substantial expense to enforce our rights, which could harm our ability to compete and generate revenue. Our success is heavily dependent upon protecting our proprietary technology. We rely primarily on a combination of copyright, patent, trade secret and trademark laws, as well as confidentiality procedures and contractual provisions to protect our proprietary rights. These laws, procedures and provisions provide only limited protection. We have been issued three patents and have two patent applications pending. However, our patents may not provide sufficiently broad protection or they may not prove to be enforceable in actions against alleged infringers. In addition, patents may not be issued on our current or future technologies. Despite precautions that we take, it may be possible for unauthorized third parties to copy aspects of our current or future products or to obtain and use information that we regard as proprietary. In particular, we may provide our licensees with access to proprietary information underlying our licensed applications which they may improperly appropriate. Additionally, our competitors may independently design around patents and other proprietary rights we hold. Policing unauthorized use of software is difficult and some foreign laws do not protect our proprietary rights to the same extent as United States laws. Litigation may be necessary in the future to enforce our intellectual property rights, protect our trade secrets or determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of resources and management attention. If third parties assert that our products or technologies infringe their intellectual property rights, our reputation and ability to license or sell our products could be harmed. In addition, these types of claims could be costly to defend and result in our loss of significant intellectual property rights. We expect that software product developers, such as ourselves, will increasingly be subject to infringement claims as the number of products and competitors in the software industry segment grows and the functionality of products in different industry segments overlaps. If third parties assert that our current or future products infringe their proprietary rights, there could be costs associated with defending these claims, whether the claims have merit or not, which could harm our business. Any future claims could harm our relationships with existing customers and may deter future customers from licensing our products. Any such claims, with or without merit, could be time consuming, result in costly litigation, including costs related to any damages we may owe resulting from such litigation, cause product shipment delays or result in loss of intellectual property rights which would require us to obtain licenses which may not be available on acceptable terms or at all. Failure to host or participate in the SMS user training conference could negatively affect our reputation and eliminate a valuable marketing opportunity. In the past, we have hosted a systems management server, or SMS, user conference in which we provide training on and promote the integration between Microsoft's SMS products and our products. We and Microsoft, with assistance from NetIQ and Compaq, hosted a successor conference, called the Microsoft Management Summit, during the week of April 29, 2002. In 2001, our hosting of the SMS user conference generated $1.9 million or 14% of our services revenue and a significant number of product sales. In the event we do not continue to host this conference or we are unable to participate in this conference in the future, our revenue could be reduced and our ability to grow our business and sell our products could be negatively affected. If we cannot continually attract and retain sufficient and qualified management, technical and other personnel, our ability to manage our business successfully and commercially introduce products could be negatively affected. Our future success will also depend on our ability to attract and retain experienced, highly qualified management, technical, research and development, and sales and marketing personnel. The development and sales of our products could be impacted negatively if we do not attract and retain such personnel. Competition for such personnel in the computer software industry is intense, and in the past we have experienced difficulty in recruiting qualified personnel, especially technical and sales personnel. Moreover, we intend to expand the scope of our international operations and these plans will require us to attract experienced management, sales, marketing and customer support personnel for our international offices. We expect competition for qualified personnel to remain intense, and we may not succeed in attracting or retaining such personnel. In addition, new employees generally require substantial training in the use of our products, which will require substantial resources and management attention. If we are unable to retain key personnel, our ability to manage our business effectively and continue our growth could be negatively impacted. Our future success will depend to a significant extent on the continued service of our executive officers and certain other key employees. Of particular importance to our continued operations are our President and Chief Executive Officer, Greg Butterfield, and our Chief Technology Officer, Dwain Kinghorn. None of our executive officers and key employees are bound by an employment agreement. If we lose the services of one or more of our executive officers or key employees, or if one or more of them decide to join a competitor or otherwise compete directly or indirectly with us, our business could be harmed. Searching for replacements for our key personnel could divert management's time and result in increased operating expenses. Future changes in accounting standards, particularly changes affecting revenue recognition, could cause unexpected revenue fluctuations. Future changes in accounting standards, particularly those affecting revenue recognition, could require us to change our accounting policies. These changes could cause deferment of revenue recognized in current periods to subsequent periods or accelerate recognition of deferred revenue to current periods, each of which could cause shortfalls in meeting securities analysts and investors' expectations. Any of these shortfalls could cause a decline in our stock price. You will be relying on our management's judgment, with which you may disagree, regarding the use of proceeds from this offering. If our management does not use the proceeds in a manner that increases our operating results or market value, our business could suffer. We do not have a definite, quantified plan with respect to the use of the net proceeds from this offering and have not committed the substantial majority of these proceeds to any particular purpose, as more fully described in the section entitled "Use of Proceeds." Accordingly, our management will have broad discretion as to the use of the net proceeds from this offering. Investors will be relying on the judgment of our management regarding the application of these proceeds, and we may not be able to invest these proceeds to yield a significant return. We have made only preliminary determinations as to the amount of net proceeds to be used based on our current expectations regarding our financial performance and business needs over a foreseeable future. These expectations may prove to be inaccurate, as our financial performance may differ from our current expectations or our business needs may change as our business and the industry we address evolve. As a result, the proceeds we receive in this offering may be used in a manner significantly different from our current allocation plans. Our principal stockholders can exercise a controlling influence over our business affairs and may make business decisions with which you disagree and which may adversely affect the value of your investment. Our principal stockholders, The Canopy Group, Inc., or Canopy, and two entities affiliated with Technology Crossover Ventures, or TCV, will beneficially own approximately 57% of our common stock after this offering and are likely to be able to exercise control over most matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in control of our company or discouraging others from making tender offers for our shares, which could prevent our stockholders from receiving a premium for their shares. These actions may be taken even if they are opposed by the other stockholders, including those investors who purchase shares of our common stock in this offering. Provisions in our charter documents, Delaware law and our agreements with Compaq may inhibit potential acquisition bids for Altiris and prevent changes in our management. Certain provisions of our charter documents could discourage potential acquisition proposals and could delay or prevent a change in control transaction. In addition, our agreements with Compaq contain provisions which in the event of a change of control allow Compaq to terminate the agreements. These provisions of our charter documents and agreements with Compaq could have the effect of discouraging others from making tender offers for our shares, and as a result, these provisions may prevent the market price of our common stock from reflecting the effects of actual or rumored takeover attempts. These provisions may also prevent changes in our management. See the section entitled "Description of Capital Stock--Antitakeover Effects of Provisions of Our Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws and Delaware Law," for a more complete description of these provisions. The market price for our common stock may be volatile, and you may not be able to resell your shares at or above the initial public offering price. The initial public offering price of our common stock may vary from the market price of our common stock following this offering. The market price of our common stock may fluctuate in response to various factors, some of which are beyond our control. These factors include the following: . changes in market valuations of our competitors or other technology companies; . actual or anticipated fluctuations in our operating results; . technological advances or introduction of new products by us or our competitors; . loss of key personnel; . sale of significant amounts of our common stock or other securities in the open market; and . intellectual property or litigation developments. General economic conditions, such as recession or interest rate or currency rate fluctuations in the United States or abroad, could negatively affect the market price of our common stock. In addition, our operating results may be below the expectations of public market analysts and investors. If this were to occur, the market price of our common stock would likely significantly decrease. Finally, there has not been a public market for our common stock. We cannot predict the extent to which investor interest in our company will lead to the development of an active, liquid trading market. Our stock price may decline significantly because of stock market fluctuations that affect the prices of technology stocks. A decline in our stock price could result in securities class action litigation against us, which could divert management's attention and harm our business. The stock markets have experienced significant price and trading volume fluctuations, and the market prices of technology companies in particular have been extremely volatile, and technology companies also often experience trading volume changes in the first days and weeks after the securities are released for public trading. Prior to the offering, there has been no public market for our common stock, and following this offering, the market price for our common stock may experience a substantial decline. Investors may not be able to resell their shares at or above the initial public offering price. In the past, following periods of volatility in the market price of a public company's securities, securities class action litigation has often been instituted against that company. Such litigation could result in substantial cost and a diversion of management's attention and resources. Fluctuations in the value of foreign currencies could result in currency transaction losses. As we expand our international operations, we expect that our international business will increasingly be conducted in foreign currencies. Fluctuations in the value of foreign currencies relative to the United States Dollar have caused, and we expect such fluctuation to increasingly cause, currency transaction gains and losses. We cannot predict the effect of exchange rate fluctuations upon future quarterly and annual operating results. We may experience currency losses in the future. To date, we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations. Sales of shares of our common stock in the public market following this offering could depress our stock price and make it more difficult for us to sell securities in the future. The number of shares of our common stock available for sale in the public market is limited by restrictions under federal securities law and the 180-day lock-up agreements described in "Underwriting." As restrictions on resale end, our stock price could drop significantly if the holders of these restricted shares sell them or are perceived by the market as intending to sell them. The sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Upon completion of this offering, and assuming no exercise of the underwriters' over-allotment option, we will have outstanding 19,795,933 shares of common stock, including 258,064 shares of Class B non-voting common stock. Of these shares, 14,795,933 shares are "restricted shares" subject to restrictions on resale under federal securities laws, and 14,782,496 of these shares are subject to the 180-day lock-up agreements described in "Underwriting." Other than the 5,000,000 shares offered hereby, 13,437 shares will be eligible for immediate sale following completion of this offering. Subject to the lock-up agreements, restricted shares may be sold in the public markets only if registered or if they qualify for an exemption from registration under Rule 144 or Rule 701 promulgated under the Securities Act. For summaries of federal securities law restrictions under Rule 144 or Rule 701, see "Shares Eligible For Future Sale." The following table indicates approximately when these 14,795,933 restricted shares will be eligible for sale into the public market: Eligibility of Restricted Shares for Sale in Public Market <TABLE> <CAPTION> Shares Eligible Days after Date of this Prospectus for Sale Comment ---------------------------------- --------------- ---------------------------------------------------- <S> <C> <C> Upon completion of offering.... 13,437 shares that become saleable under Rule 144(k). 180 days....................... 9,034,108 shares that become saleable under Rule 144 or 144(k) upon expiration of 180-day lock-up. Thereafter..................... 5,748,388 shares held for one year or less. </TABLE> Many of the restricted shares that will become eligible for sale 180 days after the date of this prospectus or afterward will be subject to certain volume limitations because they are held by our affiliates. Additionally, of the shares issuable upon exercise of options to purchase our common stock outstanding as of May 2, 2002, approximately 1,668,532 shares, will have vested and be eligible for sale 180 days following the completion of this offering. In addition, 180 days following completion of this offering, holders of 5,516,953 shares of our common stock will have rights to require us to register their shares, subject to certain limitations and conditions. For more information on these registration rights, see "Description of Capital Stock--Registration Rights." If holders of these registration rights request that we register their shares, and if the registration is effected, these shares will be freely tradeable without restrictions under the Securities Act. Any sales of shares by these stockholders could have a material adverse effect on the trading price of our common stock. As a new investor, you will incur immediate and substantial dilution as a result of this offering and future equity issuances. The initial public offering price is substantially higher than the pro forma book value per share of our common stock. As a result, investors purchasing common stock in this offering will incur immediate dilution of $7.71 in net tangible book value per share of common stock, assuming an initial public offering price of $11.00 per share. This dilution is due in large part to earlier investors in our company having paid less than the initial public offering price when they purchased their shares. Investors will incur additional dilution upon the exercise of outstanding stock options.

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+RISK FACTORS Investing in preferred securities involves a number of risks. Some of these risks relate to the preferred securities and others relate to us and the financial services industry, generally. We urge you to read all of the information contained in this prospectus. In addition, we urge you to consider carefully the following factors in evaluating an investment in the trust before you purchase the preferred securities. Because the trust will rely on the payments it receives on the debentures to fund all payments on the preferred securities, and because the trust may distribute the debentures in exchange for the preferred securities, purchasers of the preferred securities are making an investment decision that relates to the debentures being issued by MB Financial, Inc. as well as the preferred securities. Purchasers should carefully review the information in this prospectus about the preferred securities, the debentures and the guarantee. Risks Related to an Investment in MB Financial, Inc. Our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio. Lending money is a substantial part of our business. However, every loan we make carries a certain risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things: cash flow of the borrower and/or the project being financed; in the case of a collateralized loan, the changes and uncertainties as to the future value of the collateral; the credit history of a particular borrower; changes in economic and industry conditions; and the duration of the loan. We maintain an allowance for loan losses which we believe is appropriate to provide for any probable losses in our loan portfolio. The amount of this allowance is determined by management through a periodic review and consideration of several factors, including: an ongoing review of the quality, size and diversity of our loan portfolio; evaluation of non-performing loans; historical loan loss experience; and the amount and quality of collateral, including guarantees, securing the loans. At March 31, 2002, our allowance for probable loan losses as a percentage of total loans was 1.19%, and as a percentage of total non-performing loans was 144.34%. If our loan losses exceed our allowance for probable loan losses, our business, financial condition and profitability may suffer. Total Our commercial real estate loans involve higher principal amounts than other loans, and repayment of these loans may be dependent on factors outside our control or the control of our borrowers. At March 31, 2002, commercial real estate loans totaled $856.1 million, or 37.1%, of our total loan portfolio. Commercial real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on the successful operation of the property securing the loan or the business conducted on the property securing the loan. These loans may therefore be more adversely affected by conditions in the real estate markets or in the economy generally. For example, if the cash flow from the borrower's project is reduced due to leases not being obtained or renewed, the borrower's ability to repay the loan may be impaired. In addition, many commercial real estate loans are not fully amortized over the loan period, but have balloon payments due at maturity. A borrower's ability to make a balloon payment typically will depend on being able to either refinance the loan or completing a timely sale of the underlying property. Repayment of our commercial loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value. At March 31, 2002, commercial loans totaled $492.1 million, or 21.3%, of our total loan portfolio. We make our commercial loans primarily based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral is accounts receivable, equipment or real estate. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists. As a result, in the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The collateral securing commercial loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Our lease loans entail some of the same risks as our commercial loans, and we may not be able to realize our entire investment in the equipment we lease. At March 31, 2002, lease loans totaled $290.5 million, or 12.6%, of our total loan portfolio. These loans are generally non-recourse to the leasing company, and, consequently, our recourse is limited to the lessee and the leased equipment. Our lease loans are generally secured not only by the assignment of the lease payments, but also by the equipment being leased. As with commercial loans secured by equipment, the equipment securing our lease loans may depreciate over time, may be difficult to appraise and may fluctuate in value. We rely on the lessee's continuing financial stability, rather than the value of the leased equipment, for the repayment of all required amounts under lease loans. In the event of default, it is unlikely that the proceeds from the sale of the leased equipment will be sufficient to satisfy the outstanding unpaid amounts under the terms of the lease loan. As part of our lease banking operations, we also invest directly in equipment that we lease to other companies. At March 31, 2002, we had $46.6 million invested directly in leased equipment. We retain a residual interest in these operating leased assets. At March 31, 2002, the aggregate residual value of the equipment leased under our operating leases totaled $12.4 million. Our profitability depends, to some degree, upon our ability to realize these residual values. Realization of residual values depends on many factors, several of which are outside our control, including general market conditions at the time of expiration of the lease, whether there has been technological or economic obsolescence or unusual wear and tear on, or use of, the equipment and the cost of comparable equipment. If, upon the expiration of a lease, we sell the Public offering price $ 25.00 $ 52,000,000 Proceeds to the trust $ 25.00 $ 52,000,000 This is a firm commitment underwriting. We will pay underwriting commissions of $ per preferred security, or a total of $ , to the underwriters for arranging the investment in our debentures. The underwriters have been granted a 30-day option to purchase up to an additional 312,000 preferred securities to cover over-allotments, if any. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense. Stifel, Nicolaus & Company Incorporated Legg Mason Wood Walker Incorporated Howe Barnes Investments, Inc. Sandler O'Neill & Partners, L.P. , 2002 equipment and the amount realized is less than the recorded value of the residual interest in the equipment, we will recognize a loss reflecting the difference. If we fail to realize our aggregate recorded residual values, our financial condition and profitability could be adversely affected. As of March 31, 2002, we had approximately $9.9 million in performing lease loans under which K-Mart Corporation was the lessee. Approximately $5.8 million of these loans were direct financing leases included in our lease loan portfolio pursuant to which we invested in the equipment leased. K-Mart filed for bankruptcy protection on January 22, 2002. The K-Mart lease loans are secured by revenue producing equipment with an original cost of $10.2 million that was purchased and installed during the second half of 2001. Subsequent to filing for bankruptcy protection, K-Mart closed a number of its retail stores, including some in which this equipment was located. K-Mart informed us that all of our equipment located in closed stores has been moved to stores that will remain open. While the K-Mart lease loans are currently performing in accordance with their terms, no assurance can be given that this will continue to be the case and such performance may depend on the terms of the reorganization plan for K-Mart. No assurances can be made that a loss related to these loans will not be incurred. Our concentration of residential real estate loans may result in lower yields and profitability. At March 31, 2002, residential real estate loans comprised $347.7 million, or 15.1%, of our total loan portfolio. Relative to our other categories of loans, residential real estate loans result in lower yields and lower profitability for us. Our installment and other consumer loans generally have a higher risk of default than our other loans. At March 31, 2002, installment and other consumer loans totaled $165.5 million, or 7.2%, of our total loan portfolio. Consumer loans typically have shorter terms and lower balances with higher yields as compared to one- to four-family residential mortgage loans, but generally carry higher risks of default. Consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on these loans. Our construction loans are based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. At March 31, 2002, construction loans totaled $153.9 million, or 6.7%, of our total loan portfolio. Construction lending involves additional risks because funds are advanced upon the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. MB FINANCIAL, INC. [Map depicting locations of MB's banking facilities and main bank office.] Changes in interest rates may reduce our net interest income. Like other financial institutions, our operating results are largely dependent on our net interest income. Net interest income is the difference between interest earned on loans and investments and interest expense incurred on deposits and other borrowings. Our net interest income is impacted by changes in market rates of interest, the interest rate sensitivity of our assets and liabilities, prepayments on our loans and investments and limits on increases in the rates of interest charged on our loans. Our interest-earning assets and our interest-bearing liabilities may react in different degrees to changes in market interest rates. Interest rates on some types of assets and liabilities may fluctuate prior to changes in broader market interest rates, while rates on other types may lag behind. We continually take measures intended to manage the risks from changes in market interest rates. Changes in market rates of interest are beyond our control. We cannot control or accurately predict changes in market rates of interest. The following factors may affect market interest rates: inflation; slow or stagnant economic growth or recession; unemployment; money supply and the monetary policies of the Federal Reserve Board; international disorders; instability in domestic and foreign financial markets; and other factors beyond our control. Market rates of interest will impact the amounts earned on our assets such as loans and securities and the amounts paid on our liabilities such as deposits and borrowings. We pursue acquisitions to supplement internal growth. We pursue a strategy of supplementing internal growth by acquiring other financial institutions and related entities in order to achieve certain size objectives that we believe are necessary to compete effectively with our larger competitors. There are risks associated with this strategy, however, including the following: With the overall strength of the banking industry, numerous potential acquirors exist for most acquisition candidates, creating intense competition, particularly with respect to price. In many cases, this competition involves organizations with significantly greater resources than we have available; We may be exposed to potential asset quality issues or unknown or contingent liabilities of the banks or businesses we acquire. If these issues or liabilities exceed our estimates, our earnings and financial condition may be adversely affected; Prices at which acquisitions can be made fluctuate with market conditions. We have experienced times during which acquisitions could not be made in specific markets at prices our management considered acceptable and expect that we will experience this condition in the future in one or more markets; The acquisition of other entities generally requires integration of systems, procedures and personnel of the acquired entity in order to make the transaction economically feasible. This integration process is complicated and time consuming to us, and it can also be disruptive to the customers of the acquired business. If the integration process is not conducted successfully and with minimal effect on the acquired business and its customers, we may not realize the anticipated economic benefits of particular acquisitions within the expected time frame, and we may lose customers or employees of the acquired business; We may borrow additional funds to finance an acquisition, thereby increasing our leverage and diminishing our liquidity; and We have completed various acquisitions and opened additional banking offices in the past few years that enhanced our rate of growth. We may not be able to continue to sustain our past rate of growth or to grow at all in the future. Our continued pace of growth may require us to raise additional capital in the future, but that capital may not be available when it is needed. We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. In addition, our bylaws currently require us to maintain capital ratios in excess of those mandated by the regulatory authorities. We anticipate that our existing capital resources will satisfy our capital requirements for the foreseeable future. We may at some point need to raise additional capital to support continued growth, both internally and through acquisitions. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired. Since our business is concentrated in the Chicago, Oklahoma City and Dallas metropolitan areas, a downturn in the economy of any of these areas may adversely affect our business. Except for our lease banking activities, which are nationwide, our lending and deposit gathering activities are concentrated primarily in the Chicago metropolitan area, and, to a lesser extent, the Oklahoma City and Dallas metropolitan areas. Our success depends on the general economic conditions of these metropolitan areas and their surrounding areas. A majority of the loans in our portfolio are secured by real estate. Most of these loans are secured by properties located in the Chicago metropolitan area, with the remainder located in Texas and Oklahoma. Negative conditions in the real estate markets where collateral for a mortgage loan is located could adversely affect the borrower's ability to repay the loan and the value of the collateral securing the loan. Real estate values are affected by various other factors, including changes in general or regional economic conditions, governmental rules or policies and natural disasters such as tornados. Adverse changes in the regional and general economy could reduce our growth rate, impair our ability to collect loans and generally have a negative effect on our financial condition and results of operations. The loss of certain key personnel could adversely affect our operations. Our success depends in large part on the retention of a limited number of key management, lending and other banking personnel. We could undergo a difficult transition period if we lose the services of any of these individuals. Our success also depends on the experience of our banking facilities' managers and lending officers and on their relationships with the customers and communities they serve. The loss of these key persons could negatively impact the affected banking operations. We may not be able to retain our current key personnel or attract additional qualified key persons as needed. Our future success is dependent on our ability to compete effectively in the highly competitive banking industry. We face substantial competition in all phases of our operations from a variety of different competitors. Our future growth and success will depend on our ability to compete effectively in this highly competitive environment. To date, we have grown our business successfully by focusing on our geographic markets and emphasizing the high level of service and responsiveness desired by our customers. We compete for loans, deposits and other financial services with other commercial banks, thrifts, credit unions, brokerage houses, mutual funds, insurance companies and specialized finance companies. Many of our competitors offer products and services which we do not offer, and many have substantially greater resources and lending limits, name recognition and market presence that benefit them in attracting business. In addition, larger competitors may be able to price loans and deposits more aggressively than we do, and smaller newer competitors may also be more aggressive in terms of pricing loan and deposit products than us in order to obtain a share of the market. Some of the financial institutions and financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on bank holding companies, federally insured state-chartered banks and national banks and federal savings banks. As a result, these nonbank competitors have certain advantages over us in accessing funding and in providing various services. We continually encounter technological change, and we may have fewer resources than many of our competitors to continue to invest in technological improvements. The financial services industry is undergoing rapid technological changes, with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success will depend, in part, upon our ability to address the needs of our clients by using technology to provide products and services that will satisfy client demands for convenience, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Our business may be adversely affected by the highly regulated environment in which we operate. We are subject to extensive federal and state legislation, regulation, examination and supervision. Recently enacted, proposed and future legislation and regulations have had, will continue to have, or may have a material adverse effect on our business and operations. Our success depends on our continued ability to maintain compliance with these laws and regulations, including those pertaining to the Community Reinvestment Act. In addition, many banking regulations are primarily intended to protect depositors and the Federal Deposit Insurance Corporation, not our other creditors or shareholders. Some of these regulations may increase our costs and thus place other financial institutions in stronger, more favorable competitive positions. We cannot predict what restrictions may be imposed upon us by future legislation. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes or interpretations could be materially adverse to us. Recent events may adversely affect financial markets and us. On September 11, 2001, the United States was subjected to multiple terrorist attacks, resulting in the loss of many lives and massive property damage and destruction in New York City, Washington, D.C. and Pennsylvania. Since that date, various persons have received letters infected with anthrax bacteria and other terrorist threats have been made. Such terrorist activities have resulted in military responses by the United States and other countries, as well as disruptions in air travel, substantial losses by various companies including airlines, insurance providers and aircraft makers, the need for heightened security across the country and decreases in consumer confidence that could cause a general slowdown in economic growth. These disruptions and uncertainties could adversely affect U.S. and world financial markets, as well as our financial condition and results of operations. Risks Related to an Investment in the Preferred Securities If we do not make interest payments under the debentures, the trust will be unable to pay distributions and liquidation amounts. The guarantee will not apply because the guarantee covers payments only if the trust has funds available. The trust will depend solely on our payments on the debentures to pay amounts due to you on the preferred securities. If we default on our obligation to pay the principal or interest on the debentures, the trust will not have sufficient funds to pay distributions or the liquidation amount on the preferred securities. In that case, you will not be able to rely on the guarantee for payment of these amounts because the guarantee only applies if the trust has sufficient funds to make distributions on or to pay the liquidation amount of the preferred securities. Instead, you or the property trustee will have to institute a direct action against us to enforce the property trustee's rights under the indenture relating to the debentures. To the extent we must rely on dividends from our subsidiaries to make interest payments on the debentures to the trust, our available cash flow may be restricted and distributions may be deferred. We are a holding company and substantially all of our assets are held by our direct and indirect subsidiaries. Our ability to make payments on the debentures when due will depend primarily on available cash resources at the bank holding company and dividends from our direct and indirect subsidiaries. Dividend payments or extensions of credit from our bank subsidiaries are subject to regulatory limitations, generally based on capital levels and current and retained earnings, imposed by the various regulatory agencies with authority over such subsidiaries. The ability of our banks to pay dividends also is subject to their profitability, financial condition, capital expenditures and other cash flow requirements and the ability of certain of their subsidiaries to pay dividends to them. In addition, our bylaws effectively limit the amount of dividends our banks may pay to us by currently requiring each bank to maintain regulatory capital ratios in excess of those required for "well capitalized" status. As of March 31, 2002, our banks had the ability to pay, in the aggregate, $43.8 million in dividends to us and still maintain the minimum capital ratios currently required by our bylaws. We cannot assure you that our banks will be able to pay dividends to us in the future. The debentures and the guarantee rank lower than most of our other indebtedness and our holding company structure effectively subordinates any claims against us to those of our subsidiaries' creditors. Our obligations under the debentures and the guarantee are unsecured and will rank junior in priority of payment to our existing and future senior and subordinated indebtedness, which totaled $24.0 million in outstanding principal amount at March 31, 2002. The securities that we are offering do not impose limits on our ability or the ability of our subsidiaries to incur additional indebtedness, except that in connection with any future issuance of trust preferred or similar securities, the related indebtedness and guarantee must rank equally with or junior in priority of right of payment to the debentures and to our guarantee of the preferred securities. Because we are a holding company, the creditors of our subsidiaries, including depositors, also will have priority over you in any distribution of our subsidiaries' assets in liquidation, reorganization or otherwise. Accordingly, the debentures and the guarantee will be effectively subordinated to all existing and future liabilities of our direct and indirect subsidiaries, and you should look only to our assets for payments on the preferred securities and the debentures. We may defer interest payments on the debentures for substantial periods, which could have adverse consequences for you. We may, at one or more times, defer interest payments on the debentures for up to 20 consecutive quarters ending no later than September 30, 2032. If we defer interest payments on the debentures, the trust will defer distributions on the preferred securities during any deferral period. During a deferral period, you will be required to recognize as income for federal income tax purposes the amount approximately equal to the interest that accrues on your proportionate share of the debentures held by the trust in the tax year in which that interest accrues, even though you will not receive these amounts until a later date. You will also not receive the cash related to any accrued and unpaid interest from the trust if you sell the preferred securities before the end of any deferral period. During a deferral period, accrued but unpaid distributions will increase your tax basis in the preferred securities. If you sell the preferred securities during a deferral period, your increased tax basis will decrease the amount of any capital gain or increase the amount of any capital loss that you may have otherwise realized on the sale. A capital loss, except in certain limited circumstances, cannot be applied to offset ordinary income. As a result, deferral of distributions could result in ordinary income, and a related tax liability for the holder, and a capital loss that may only be used to offset a capital gain. We do not currently intend to exercise our right to defer interest payments on the debentures. In the event of a deferral period, however, the market price of the preferred securities would likely be adversely affected. The preferred securities may trade at a price that does not fully reflect the value of accrued but unpaid interest on the debentures. If you sell the preferred securities during a deferral period, you may not receive the same return on investment as someone who continues to hold the preferred securities. Due to our right to defer interest payments, the market price of the preferred securities may be more volatile than the market prices of other securities without the deferral feature. The following table provides information regarding each of our bank and thrift merger and acquisition transactions since 1999. Institution Regulators may preclude us from making distributions on the debentures in the event our regulatory capital, liquidity or financial performance deteriorates. We and our bank subsidiaries are subject to extensive federal and state law, regulation and supervision. Our regulators monitor our financial condition on a periodic basis and may impose limitations on our operations and business activities under various circumstances. In response to any perceived deficiencies in liquidity or regulatory capital levels, our regulators may require us to obtain their consent prior to paying dividends on our capital stock or interest on the debentures. In the event our regulators withheld their consent to our payment of interest on the debentures, we would exercise our right to defer interest payments on the debentures, and the trust would not have funds available to make distributions on the preferred securities during the deferral period. This action by our regulators may or may not be taken in conjunction with similar restrictions on the ability of our subsidiaries to pay dividends to us. The commencement of a deferral period with respect to interest on the debentures and, accordingly, distributions on the preferred securities, would likely cause the market price of the preferred securities to decline. We have made only limited covenants in the indenture and the trust agreement, which may not protect your investment in the event we experience significant adverse changes in our financial condition or results of operations. The indenture governing the debentures and the trust agreement governing the trust do not require us to maintain any credit rating on the securities offered or any financial ratios or specified levels of net worth, revenues, income, cash flow or liquidity. In addition, they do not protect holders of the debentures or the preferred securities if we are involved in a highly leveraged transaction and therefore do not protect holders of the debentures or the preferred securities in the event we experience adverse changes in our financial condition or results of operations. The indenture prevents us and any of our subsidiaries from incurring, in connection with the issuance of any trust preferred securities or any similar securities, indebtedness that is senior in right of payment to the debentures or our guarantee with respect to the preferred securities, but not indebtedness that is equal in priority or junior in priority in right of payment. Except as described above, neither the indenture nor the trust agreement limits our ability or the ability of any of our subsidiaries to incur other additional indebtedness that is senior in right of payment to the debentures. Therefore, you should not consider the provisions of these governing instruments as a significant factor in evaluating whether we will be able to comply with our obligations under the debentures or the guarantee. In the event we redeem the debentures before September 30, 2032, you may not be able to reinvest your principal at the same or a higher rate of return. Under the following circumstances, we may redeem the debentures before their stated maturity: We may redeem the debentures, in whole or in part, at any time on or after September 30, 2007. We may redeem the debentures in whole, but not in part, within 180 days after certain occurrences at any time during the life of the trust. These occurrences include adverse tax, investment company or bank regulatory developments. You should assume that we will exercise our redemption option if we are able to obtain capital at a lower cost than we must pay on the debentures or if it is otherwise in our interest to redeem the debentures. If the debentures are redeemed, the trust must redeem preferred securities having an Consummation Date aggregate liquidation amount equal to the aggregate principal amount of debentures redeemed, and you may be required to reinvest your principal at a time when you may not be able to earn a return that is as high as you were earning on the preferred securities. We can distribute the debentures to you, which may have adverse tax consequences for you and which may adversely affect the market price of the preferred securities prior to such distribution. The trust may be dissolved at any time before maturity of the debentures on September 30, 2032. As a result, and subject to the terms of the trust agreement, the trustees may distribute the debentures to you. We cannot predict the market prices for the debentures that may be distributed in exchange for preferred securities upon liquidation of the trust. The preferred securities, or the debentures that you may receive if the trust is liquidated, may trade at a discount to the price that you paid to purchase the preferred securities. Because you may receive debentures, your investment decision with regard to the preferred securities will also be an investment decision with regard to the debentures. You should carefully review all of the information contained in this prospectus regarding the debentures. If the debentures are distributed by the trust, we will use our best efforts to list the debentures for trading on a national securities exchange or in a comparable automated quotation system. However, we may not be able to achieve that listing and a market for the debentures may not develop. Under current interpretations of United States federal income tax laws supporting classification of the trust as a grantor trust for tax purposes, a distribution of the debentures to you upon the dissolution of the trust would not be a taxable event to you. Nevertheless, if the trust is classified for United States federal income tax purposes as an association taxable as a corporation at the time it is dissolved, the distribution of the debentures would be a taxable event to you. In addition, if there is a change in law, a distribution of debentures upon the dissolution of the trust could be a taxable event to you. Trading characteristics of the preferred securities may create adverse tax consequences for you. The preferred securities may trade at a price that does not reflect the value of accrued but unpaid interest on the underlying debentures. If you dispose of your preferred securities between record dates for payments on the trust preferred securities, you may have adverse tax consequences. Under these circumstances, you will be required to include accrued but unpaid interest on the debentures allocable to the preferred securities through the date of disposition in your income as ordinary income if you use the accrual method of accounting or if this interest represents original issue discount. If interest on the debentures is included in income under the original issue discount provisions, you would add this amount to your adjusted tax basis in your share of the underlying debentures deemed disposed. If your selling price is less than your adjusted tax basis, which will include all accrued but unpaid original issue discount interest included in your income, you could recognize a capital loss which, subject to limited exceptions, cannot be applied to offset ordinary income for federal income tax purposes. Total Assets at Consummation There is no current public market for the preferred securities and their market price may decline after you invest. There is currently no public market for the preferred securities. Although the trust has applied to list the preferred securities on the Nasdaq National Market there is no guarantee that an active or liquid trading market will develop for the preferred securities or that the Nasdaq National Market will approve the listing of the preferred securities. If an active trading market does not develop, the market price and liquidity of the preferred securities will be adversely affected. Even if an active public market does develop, there is no guarantee that the market price for the preferred securities will equal or exceed the price you pay for the preferred securities. Future trading prices of the preferred securities may be subject to significant fluctuations in response to prevailing interest rates, our future operating results and financial condition, the market for similar securities and regional and general economic and market conditions. The initial public offering price of the preferred securities has been set at the liquidation amount of the preferred securities and may be greater than the market price following the offering. The market price for the preferred securities, or the debentures that you may receive in a distribution, is also likely to decline during any period that we are deferring interest payments on the debentures. You must rely on the property trustee to enforce your rights if there is an event of default under the indenture. You may not be able to directly enforce your rights against us if an event of default under the indenture occurs. If an event of default under the indenture occurs and is continuing, this event will also be an event of default under the trust agreement. In that case, you must rely on the enforcement by the property trustee of its rights as holder of the debentures against us. The holders of a majority in liquidation amount of the preferred securities will have the right to direct the property trustee to enforce its rights. If the property trustee does not enforce its rights following an event of default and a request by the record holders to do so, any record holder may, to the extent permitted by applicable law, take action directly against us to enforce the property trustee's rights. If an event of default occurs under the trust agreement that is attributable to our failure to pay interest or principal on the debentures, or if we default under the guarantee, you may proceed directly against us. You will not be able to exercise directly any other remedies available to the holders of the debentures unless the property trustee fails to do so. As a holder of preferred securities you have limited voting rights, and we can amend the trust agreement to change the terms and conditions of the administration, operation and management of the trust without your consent. Holders of preferred securities have limited voting rights. We can, without your consent, make certain amendments to the trust agreement. Your voting rights pertain primarily to certain amendments to the trust agreement and not to the administration, operation or management of the trust. In general, only we can replace or remove any of the trustees. However, if an event of default under the trust agreement occurs and is continuing, the holders of at least a majority in aggregate liquidation amount of the preferred securities may replace the property trustee and the Delaware trustee. In certain circumstances, with the consent of the holders of a majority in the aggregate liquidation amount of the preferred securities, we may amend the trust agreement to ensure that the trust remains classified for federal income tax purposes as a grantor trust and to ensure that the trust retains its exemption from Total Deal Value at Consummation status as an "investment company" under the Investment Company Act, even if such amendment adversely affects your rights as a holder of preferred securities. You are subject to repayment risk because possible tax law changes could result in a redemption of the trust preferred securities. Future legislation may be enacted that could adversely affect our ability to deduct our interest payments on the debentures for federal income tax purposes, making redemption of the debentures likely and resulting in a redemption of the preferred securities. From time to time, Congress has proposed federal income tax law changes that would, among other things, generally deny interest deductions to a corporate issuer if the debt instrument has a term exceeding 15 years and if the debt instrument is not reflected as indebtedness on the issuer's consolidated balance sheet. Other proposed tax law changes would have denied interest deductions if the debt instrument had a term exceeding 20 years. These proposals were not enacted into law. Although it is impossible to predict whether future proposals of this nature will be introduced and enacted with application to already issued and outstanding securities, in the future we could be precluded from deducting interest on the debentures in this event. Enactment of this type of proposal might in turn give rise to a tax event enabling us to redeem the debentures prior to September 30, 2032. In addition, the IRS could challenge the deductibility of interest paid on the debentures. If such a challenge were litigated to a conclusion in which the IRS's position on this matter were sustained, this judicial determination could constitute a tax event that could result in an early redemption of the preferred securities.

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+RISK FACTORS We have summarized below material risks you will face as a holder of our Voting Common Stock. You should carefully consider these risks and other information in this Prospectus. The Company is targeted by animal rights activists who have a stated goal of closing the Company. If they succeed you could lose the value of your entire investment. The Company is targeted by extreme animal rights activists who oppose all testing on animals, for whatever purpose, including the Company's animal testing activities in support of its safety and efficacy testing for clients. These groups, which include Stop Huntingdon Animal Cruelty (SHAC) and the Animal Liberation Front (ALF), among others, have publicly stated that the goal of their campaign is to "shut Huntingdon". If they were to succeed in closing the Company or significantly adversely affecting the Company's business, you could lose all or substantially all of the value of your investment in the Company's Voting Common Stock. The animal rights activists may target you individually for harassment if they learn of your ownership of Voting Common Stock. As part of their campaign against the Company, animal rights activists have targeted holders of the Company's stock, among others, for harassment, which has included home and office protests. On at least two occasions, activists have physically assaulted Company employees and allegedly have committed arson, assault and destruction of physical property against their targets. If activists learn of your ownership of Voting Common Stock, they may target you for harassment. This Prospectus lists the names of the registered owners of Voting Common Stock under "Selling Stockholders". The animal rights activists have targeted, and may continue to target, the US financial community that trades in LSR Voting Common Stock, which has caused and may continue to cause illiquidity and a lower market price of the Voting Common Stock. The animal rights activists have in the past harassed the financial community that trades in LSR shares, including market makers and stockbrokers. As a result, LSR has had difficulty identifying market makers to make a market in the Voting Common Stock, which has greatly reduced liquidity in those shares. The liquidity and market price of the shares of LSR Voting Common Stock could be adversely affected in the future by such actions. Activist pressure has in the past led large stockholders to announce the sale of their shares, which may continue to occur in the future and could adversely affect the market price of the Voting Common Stock. In the past, pressure from animal rights activists has led several large stockholders to announce the sale of their shares. For example, in October 2001 Oracle Partners LP announced they were in the process of selling all of their Huntingdon shares, in January 2002 Stephens Group announced that they had entered into an agreement to sell all of their shares in Huntingdon as well as all of their debt interests and in February 2002, Quilcap Corp. made a filing with the SEC indicating that it no longer owned shares of Huntingdon. If activists continue to pressure other large stockholders of LSR, that could lead those stockholders to also announce the sale of their shares, which could adversely affect the market price of the Voting Common Stock. Because the anonymity of LSR stockholders is not guaranteed, you may be exposed to threats from and hostile actions taken by extremist animal rights activists who object to our commercial activities. Although an important goal in structuring and launching the LSR exchange offer to redomicile Huntingdon to the US was to enable our stockholders to preserve their anonymity, by complying with the Maryland General Corporation Law ("MGCL"), extremist animal rights activists may be able to obtain copies of our stockholder lists and employ their intimidation tactics against our stockholders. Under the MGCL, any person or group of persons who together are the holders of record of 5 percent or more of our Voting Common Stock and have been such holders for at least six months will be entitled to inspect and copy our stock ledger. Our stock ledger will include the names of beneficial owners who have not registered their share ownership in a nominee name. In addition, in accordance with US securities laws, beneficial owners of more than 5 percent of any class of voting equity securities registered with the SEC must file reports that describe their identity. If the animal rights activists discover your identity, either by acquiring a copy of our stock ledger or checking publicly available filings with the SEC, they may target you in future hostile campaigns. Our amended and restated charter and bylaws contain provisions that could delay or prevent an acquisition of LSR or substantially impede your ability to change our management. The existence of these provisions may depress the price of our Voting Common Stock and reduce the likelihood that a bidder will seek to acquire LSR at a premium over market price. Our amended and restated charter and bylaws contain provisions that might enable our management to resist a proposed takeover of LSR, which could limit the price that investors might be willing to pay in the future for shares of our Voting Common Stock. These provisions include, but are not limited to: o The prohibition on removing our directors without cause; o The exclusive right of our board of directors to amend our bylaws; and o Advance notice provisions for director nominations and new business proposals. The MGCL contains provisions that could discourage, defer or prevent an acquisition of LSR, which could lower the price of our Voting Common Stock and reduce the likelihood that a bidder will seek to acquire LSR at a premium over market price. As a corporation incorporated under Maryland law, we are governed by the MGCL. The MGCL contains provisions that could deter or prevent changes in control of LSR or prevent transactions between LSR and its large stockholders, thereby decreasing the price that acquirors might be willing to pay in the future for shares of our Voting Common Stock, including a business combination statute, which basically prohibits "business combinations" between a Maryland corporation and an "interested stockholder" for a period of five years after the most recent date on which the stockholder becomes an interested stockholder. For this purpose, the term "business combinations" includes mergers, consolidations, share exchanges, asset transfers and certain issuances or reclassifications of equity securities. An "interested stockholder" is defined for this purpose as: (1) any person who beneficially owns ten percent or more of the voting power of the corporation's shares or (2) an affiliate or associate of the corporation who, at any time within the two-year period prior to the date in question, was the beneficial owner of ten percent or more of the voting power of the then outstanding voting shares of the corporation. After the five-year prohibition, any business combination between the corporation and the interested stockholder generally must be recommended by the board of directors of the corporation and approved by two supermajority stockholder votes. None of these provisions of the Maryland Business Combination Act will apply, however, to business combinations that are approved or exempted by the board of directors of the corporation prior to the time that the interested stockholder becomes an interested stockholder. The Business Combination Act may discourage others from trying to acquire control of the Company and increase the difficulty of consummating any offer. Maryland also has a Control Share Acquisition Act, which provides that control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter, excluding all shares as to which the acquirer or any officer or employee-director of the Company may exercise or direct the exercise of the voting power. "Control shares" are voting shares which, if aggregated with all other shares owned by the acquirer or with respect to which the acquirer has the right to vote, would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of voting powers: o One-tenth or more but less than one-third; o One-third or more but less than a majority; or o A majority or more of all voting power. Control shares do not include shares the acquiring person is then entitled to vote as a result of having previously obtained shareholder approval. Except as otherwise specified in the statute, a "control share acquisition" means the acquisition of control shares. As permitted by the MGCL, we have provided in our bylaws that the Control Share Acquisition Act will not apply to transactions involving our company, but the board of directors retains the discretion to change this provision in the future. If the Bylaw provision is revoked or amended, the Control Share Acquisition Act may discourage others from trying to acquire control of the Company and increase the difficulty of consummating any offer. LSR has significant debt leverage and debt service obligations; if LSR is unable to service these debt obligations, its business, operating results and financial condition could be materially adversely impacted. LSR currently has outstanding $50 million in Convertible Capital Bonds due September 25, 2006 (the "Capital Bonds"), as well as an outstanding credit facility of approximately $33 million, which is fully drawn and comes due on June 30, 2006. The degree to which LSR may be leveraged could materially and adversely affect its ability to obtain financing for working capital, acquisitions or other purposes and could make LSR more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependent upon future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control. We will require substantial amounts of cash to fund scheduled payments of principal and interest on outstanding indebtedness. If we are unable to meet our cash requirements out of cash flow from operations, there can be no assurance that we will be able to obtain alternative financing, that any such financing would be on favorable terms, or that we will be permitted to do so under the terms of existing financing arrangements, or financing arrangements in effect in the future. In the absence of such financing, our ability to respond to changing business and economic conditions, to make future acquisitions, to respond to adverse operating results or to fund required capital expenditures or increased working capital requirements may be adversely affected. We have a history of losses. We have sustained both operating and net losses in each of the past five years. We cannot predict with any degree of certainty when those operating and net losses will cease and the Company will begin to realize operating and net profits. If such losses continue, the Company's market price could be adversely affected. LSR's non-US locations account for a majority of its revenues, making LSR exposed to risks associated with operating internationally. Approximately two-thirds of our revenues are generated by our facilities outside the United States. As a result of our foreign sales and facilities, our operations are subject to a variety of risks unique to international operations, including the following: o adverse changes in value of foreign currencies against the US dollar in which results are reported; o import and export duties and value-added taxes; o import and export regulation changes that could erode profit margins or restrict exports; o potential restrictions on the transfer of funds; and o the burden and cost of complying with foreign laws. LSR is exposed to exchange rate fluctuations and exchange controls. Interest on the Bonds is payable half-yearly (in March and September) in US dollars and the impact of fluctuations in the exchange rate between sterling and US dollars is offset by US dollar denominated revenues receivable by LSR. Although historical reported results have been affected partially by conversion into sterling of the Bonds on consolidation and there may be an impact in the future, management has decided not to hedge against this exposure. Such a hedge might impact upon LSR's cash flow compared with movements on the Bonds which do not affect cash flow in the medium term. LSR's current treasury policy does not include any hedging or derivative activity. LSR operates on a worldwide basis and generally invoices its clients in the currency of the country in which it operates. Thus, for the most part, exposure to exchange rate fluctuations is limited as sales are denominated in the same currency as costs. Trading exposures to currency fluctuations do occur as a result of certain sales contracts, performed in the UK for US clients, which are denominated in US dollars and contribute approximately 11% of total revenues. Secondly, exchange rate fluctuations have an impact on the relative price competitiveness of LSR vis a vis competitors who trade in currencies other than sterling or dollars. As LSR operates on an international basis, movements in exchange rates, particularly against sterling, can have a significant impact on its price competitiveness. Exchange rates for translating US dollars into sterling were as follows: YEAR ENDED DECEMBER 31 AT DECEMBER 31 AVERAGE RATE (1) 1997 0.6075 0.6104 1998 0.6010 0.6034 1999 0.6205 0.6181 2000 0.6694 0.6596 2001 0.6871 0.6943 (1) Based on the average of the exchange rates on the last day of each month during the period. On July 10, 2002 the noon buying rate for sterling was $1.00 = (pound)0.6461. LSR faces competition from its CRO competitors, some of which are larger and better financed than the Company. Competition in both the pharmaceutical and non-pharmaceutical market segments ranges from in-house research and development divisions of large pharmaceutical, agrochemical and industrial chemical companies, who perform their own safety assessments, to contract research organizations like LSR who provide a full range of services to the industries and niche suppliers focusing on specific services or industries. This competition could have a material adverse effect on LSR's net revenues and net income, either through in-house research and development divisions doing more work internally to utilize capacity or through the loss of studies to other competitors. Pharmaceutical industry consolidation may negatively impact revenues. The process of consolidation within the pharmaceutical industry should accelerate the move towards outsourcing work to contract research organizations such as LSR in the longer term as resources are increasingly invested in in-house facilities for discovery and lead optimization, rather than development and regulatory safety evaluation. However, in the short term, there is a negative impact with development pipelines being rationalized and a focus on integration rather than development. This can have a material adverse impact on LSR's net revenues and net income. LSR is subject to interest rate risks and fluctuations. The Company's exposure to market risk for changes in interest rates relates primarily to the company's debt obligations. The Company has a cash flow exposure on its bank loans due to its variable LIBOR pricing. Failure to comply with applicable governmental regulations could harm LSR's business. As a company in the CRO industry, LSR is subject to a variety of governmental regulations, both in the US and the UK, relating to animal welfare and the conduct of its business. Failure by it to comply with such laws and regulations could result in material liabilities, the suspension of licenses or a material adverse effect on its business or financial condition. In addition, these laws and regulations could significantly restrict LSR's ability to expand its facilities or require it to acquire costly equipment or incur other material costs to comply with regulations. We do not expect to pay cash dividends on our Voting Common Stock for the foreseeable future. We have never declared or paid cash dividends on our Voting Common Stock or on the Huntingdon ordinary shares and do not expect to do so for the foreseeable future. We may experience future dilution from the exercise of outstanding options, warrants and convertible securities. We have granted options to acquire an aggregate of 1,142,000 shares of Voting Common Stock to our employees and directors. All of such options are exercisable at $1.50 per share. Options to acquire 571,000 shares are currently exercisable and options to acquire an additional 571,000 shares of Voting Common Stock will become exercisable on March 1, 2003. LSR also granted in October 2001 warrants to acquire 704,425 shares of Voting Common Stock to Stephens Inc. (the "LSR Warrants"). Those warrants were subsequently transferred to several third parties unaffiliated with either Stephens or LSR. In addition, LSR stockholders approved at the June 11, 2002 Annual Meeting of Stockholders a grant of warrants to purchase 410,914 shares of Voting Common Stock to Focused Healthcare Partners LLC (the "FHP Warrants") a firm which is controlled by Andrew Baker, LSR's Chairman and Chief Executive. The LSR Warrants and FHP Warrants each have an exercise price of $1.50 per share. Finally, the Bonds are convertible into shares of Voting Common Stock, although the conversion price is well in excess of the Company's current market price. These instruments may cause future dilution of the Company's equity. Such dilution could adversely affect the market price of the Company's stock. We depend on our senior management team, and the loss of any member may adversely affect our business. We believe our success will depend on the continued employment of our senior management team, especially Andrew Baker (Chairman and CEO) and Brian Cass (President and Managing Director). If one or more members of our senior management team were unable or unwilling to continue in their present positions, those persons could be difficult to replace and our business could be harmed. If any of our key employees were to join a competitor or to form a competing company, some of our clients might choose to use the services of that competitor or new company instead of our own. Furthermore, clients or other companies seeking to develop in-house capabilities may hire away some of our senior management or key employees. The loss of one or more of these key employees could adversely affect our business. We must recruit and retain qualified personnel. Because of the specialized scientific nature of our business, we are highly dependent upon qualified scientific, technical and managerial personnel. There is intense competition for qualified personnel in the pharmaceutical and biotechnology fields. Therefore, although traditionally we have experienced a relatively low turnover in our staff, in the future we may not be able to attract and retain the qualified personnel necessary for the conduct and further development of our business. Moreover, activities of the animal rights groups against LSR may make it difficult to attract new employees and may increase turnover of current employees. The loss of the services of existing personnel, as well as the failure to recruit additional key scientific, technical and managerial personnel in a timely manner, could have a material adverse effect on our ability to expand our businesses and remain competitive in the industries in which we participate. Our contracts are generally terminable on little or no notice. Termination of a large contract for services or multiple contracts for services could adversely affect our revenue and profitability. In general, our clients may terminate the agreements that they enter into with us or reduce the scope of services under these contracts upon little or no notice. Contracts may be terminated for various reasons, including: - unexpected or undesired study results; - production problems resulting in shortages of the drug being tested; - adverse reactions to the drug being tested; - regulatory restrictions placed on the drug or compound being tested; or - the client's decision to forego or terminate a particular study. In most instances, if a client terminates its contract with us we are generally entitled under the terms of the contract to receive revenue earned to date as well as certain other costs. Cancellation of multiple or large contracts could materially adversely affect our business, financial condition and operating results. Because most of our pre-clinical revenue is from fixed-price contracts, we may be subject to under-pricing and cost overruns. The majority of our contracts with our pre-clinical clients are fixed price contracts creating the risk of cost overruns under these contracts. If the costs of completing these projects exceed the fixed fees for these projects, for example if we underprice these contracts or if there are significant cost overruns under these contracts, our business, financial condition and operating results could be adversely affected. We typically have some flexibility under these contracts to adjust the price to be charged under these contracts if we are asked to provide additional services. If we did have to bear significant costs of underpricing or cost-overruns under our pre-clinical contracts, our business, financial condition and operating results could be adversely affected. Our clients retain us on an engagement-by-engagement basis, which reduces the predictability of our revenues and our profitability. Our clients retain us on an engagement-by-engagement basis. Costs of switching drug development services companies are relatively low when compared with other industries and after we complete a project for a client we have no assurance that the same client will retain us in the future for additional projects or that they will have additional studies in the near term. A client that accounts for a significant portion of our revenues in a given period may not generate a similar amount of revenues, if any, in subsequent periods. This makes it difficult for us to predict revenues and operating results. Since our operating expenses are relatively fixed and cannot be reduced on short notice to compensate for unanticipated variations in the number or size of engagements in progress, we may continue to incur costs and expenses based on our expectations of future revenues. This could have an adverse effect on our business, financial condition and operating results. Our backlog is subject to reduction and cancellation. For our internal purposes, we periodically calculate backlog. Backlog represents the aggregate price of services that our clients have committed to purchase by signed contract, signed letter of intent or other written evidence of commitment. Our backlog is subject to fluctuations and is not necessarily indicative of future backlog or sales. Delayed or cancelled contracts are removed from backlog. Our failure to replace items of backlog that have been completed, delayed or cancelled could result in lower revenues. We compete in a highly competitive market. We primarily compete with in-house departments of pharmaceutical companies, other drug development services organizations, universities and teaching hospitals. We believe we are one of the largest providers of pre-clinical safety evaluation services in the world, based on net service revenue. Our primary pre-clinical competitor globally is Covance, although we also face competition from publicly traded companies such as Charles River Laboratories, Inveresk and MDS Pharma, as well as from a number of privately-held companies. Providers of outsourced drug development services compete on the basis of many factors, including the following: - reputation for on-time quality performance; - expertise, experience and stability; - scope of service offerings; - how well services are integrated; - strength in various geographic markets; - technological expertise and efficient drug development processes; and - ability to acquire, process, analyze and report data in a time-saving, accurate manner. We have traditionally competed effectively in the above areas, but there can be no assurance that we will be able to continue to do so. If we fail to compete successfully, our business could be seriously harmed. Health care industry reform could reduce or eliminate our business opportunities. The health care industry is subject to changing political, economic and regulatory influences that may affect the pharmaceutical and biotechnology industries. In recent years, several comprehensive health care reform proposals were introduced in the United States Congress. The intent of the proposals was, generally, to expand health care coverage for the uninsured and reduce the growth of total health care expenditures. While none of the proposals were adopted, the United States Congress may again address health care reform. In addition, foreign governments may also undertake health care reforms in their respective countries. Business opportunities available to us could decrease if the implementation of government health care reform adversely affects research and development expenditures by pharmaceutical and biotechnology companies. The sale of a substantial number of our shares of Voting Common Stock in the public market could adversely affect the market price of our shares, which in turn could negatively impact your investment in us. Future sales of substantial amounts of our shares of Voting Common Stock in the public market (or the perception that such sales may occur) could adversely affect market prices of our Voting Common Stock prevailing from time to time and could impair our ability to raise capital through future sales of our equity securities. Upon completion of this offering, we will have nearly doubled the number of shares of Voting Common Stock issued and outstanding that are registered for public sale under the Securities Act. All of the shares we are selling in this offering will be freely tradable without restriction under the Securities Act of 1933, unless purchased or owned by our affiliates. In addition, we intend in the future to file one or more registration statements under the Securities Act of 1933 covering all of our shares of Voting Common Stock reserved for issuance under our stock option plans and our 401(k) profit sharing plan. Shares registered under these registration statements would be available for sale in the open market, unless these shares are subject to vesting restrictions contained in the applicable award agreement, if any. We also may issue our shares of common stock from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of shares that we may issue may in turn be significant. In addition, we may also grant registration rights covering those shares in connection with any such acquisitions and investments. In addition, 704,425 shares of Voting Common Stock are issuable upon exercise of the LSR Warrants and 410,914 shares of Voting Common Stock are issuable upon exercise of the FHP Warrants. We were previously de-listed from OTCBB. Following completion of the Exchange Offer, the Company's Voting Common Stock was initially listed on the OTCBB. However, when our market maker resigned following pressure from animal rights activists and our stock failed to trade on OTCBB for five consecutive days, we were de-listed from OTCBB and began trading on the Other OTC Market. OTCBB may provide brokers and others with better access to the better or more liquid bid and ask prices than Other OTC. Stockholders may find it more difficult to buy, sell and obtain pricing information about our Voting Common Stock on the Other OTC Market. Effective July 10, 2002 we are now again listed on the OTCBB. No assurances can be made regarding future changes in trading markets. In addition, because our securities do not trade on a national securities exchange and are not qualified for trading in the National Market System, they do not qualify as a "margin security" as defined by the Federal Reserve Board, and no credit may be extended to you by broker dealers in order to purchase our Voting Common Stock. Our stock price is volatile and could drop unexpectedly. The high and low closing bid prices for our Voting Common Stock between April 8 and July 10, 2002, was $2.25 and $0.50, respectively. The high and low sales price for Huntingdon ordinary shares were (pound)0.045 and (pound)0.0325 respectively in 2002 and (pound)0.05 and (pound)0.0225, respectively in 2001. The high and low sales prices for Huntingdon ADS's in 2002 were $1.63 and $1.35 respectively and in 2001 were $3.13 and $0.50, respectively. LSR's stock price may be volatile due to factors outside of its control. LSR's stock price could fluctuate due to the following factors outside of our control, among others: o announcements of operating results and business conditions by its customers; o announcements by its competitors relating to new customers, technological innovation or new services; o economic developments in the healthcare industry as a whole; o political and economic developments in countries where it has operations; and o general market conditions. SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS You should carefully consider the risk factors set forth above, as well as the other information contained in this Prospectus. This Prospectus contains forward-looking statements regarding events, conditions, and financial trends that may affect our plan of operation, business strategy, operating results, and financial position. Generally, the words "will", "may", "should", "believes", "expects", "intends" or similar expressions identify forward-looking statements. You are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties. Actual results may differ materially from those included within the forward-looking statements as a result of various factors. Cautionary statements in the risk factors section and elsewhere in this Prospectus identify important risks and uncertainties affecting our future, which could cause actual results to differ materially from the forward-looking statements made in this Prospectus. We do not undertake any obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.

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+RISK FACTORS You should carefully consider the following factors in addition to the other information in this Registration Statement before investing in the notes. Risks Related to Our Debt Our high level of debt may limit our ability to successfully operate our business. We have a substantial amount of debt. On September 30, 2001, we had $312.9 million of outstanding debt, excluding letters of credit and guarantees, including $12.9 million of senior indebtedness. Of such total debt, $300 million would have consisted of the notes, and $12.9 million would have consisted of capitalized lease obligations and other debt, resulting in a pro forma percentage of debt-to-total capitalization of 49.1%. For the year ended June 30, 2001, on a pro forma basis, earnings were insufficient to cover fixed charges by $5.3 million. For the three months ended September 30, 2001, on a pro forma basis, the ratio of earnings to fixed charges was 1.16. Subject to the restrictions in the indenture and the 2001 senior secured credit facility, we and our subsidiaries may be able to incur substantial additional indebtedness in the future. The 2001 senior secured credit facility permits revolving borrowings and letters of credit of up to $125 million in the aggregate outstanding at any one time, all of which would be senior to the notes and the subsidiary guarantees, and we may borrow substantial additional indebtedness in the future, some or all of which would also be senior to the notes and the subsidiary guarantees. Our substantial indebtedness could have important consequences to you. For example, it could: o make it more difficult for us to satisfy our obligations with respect to the notes; o increase our vulnerability to general adverse economic, market and industry conditions and limit our flexibility in planning for, or reacting to, these conditions; o increase our vulnerability to interest rate fluctuations because much of our debt may be at variable interest rates; o limit our ability to obtain additional financing to fund future acquisitions and working capital, capital expenditures or other needs; and o limit our ability to compete with others who are not as highly-leveraged. Our ability to make scheduled payments of principal and interest or to satisfy our other debt obligations, to refinance our indebtedness, including the notes, or to fund capital expenditures will depend on our future performance. Prevailing economic conditions and financial, business and other factors, many of which are beyond our control, will also affect our ability to meet these needs. We may not be able to generate sufficient cash flow from operations or realize anticipated revenue growth or operating improvements, or obtain future borrowings in an amount sufficient to enable us to pay our debt, including the notes, or to fund our other liquidity needs. We may need to refinance all or a portion of our debt, including the notes, on or before maturity. We may not be able to refinance any of our debt, including our 2001 senior secured credit facility and the notes, when needed on commercially reasonable terms or at all. Operating and financial restrictions in our debt agreements will limit our operational and financial flexibility. Restrictions and covenants in our existing debt agreements, as well as the 2001 senior secured credit facility and the indenture, and any future financing agreements, may adversely affect our ability to finance future operations or capital needs or to engage in other business activities. Specifically, our debt agreements restrict our ability to: o declare dividends or redeem or repurchase capital stock; o prepay, redeem or repurchase debt, including the notes; o incur liens; o make loans and investments; o incur additional indebtedness; o amend or otherwise change debt and other material agreements; o make capital expenditures; o engage in mergers, acquisitions and asset sales; o enter into transactions with affiliates; and o change our primary business. Although it is difficult for us to predict future liquidity requirements with certainty, we believe that the net proceeds from the offering of the old notes, together with our current cash and cash equivalents, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Our acquisition program requires substantial capital resources, and the operations of our existing hospitals and newly acquired hospitals require ongoing capital expenditures for renovation, expansion and the addition of medical equipment and technology. More specifically, we are currently, and may in the future be, contractually obligated to make significant capital expenditures relating to the facilities we acquire. Our debt agreements may restrict our ability to incur additional indebtedness to fund these expenditures. Also, our 2001 senior secured credit facility requires us to comply with the financial ratios included in that facility. If we fail to comply with the requirements of the 2001 senior secured credit facility, the lenders can declare the entire amount owed thereunder immediately due and payable and prohibit us from making payments of interest and principal on the notes until the default is cured or all such debt is paid or otherwise satisfied in full. If we are unable to repay such borrowings, such lenders could proceed against the collateral securing the 2001 senior secured credit facility. A breach of any of the restrictions or covenants in our debt agreements could cause a default under our 2001 senior secured credit facility, other debt or the notes. A significant portion of our indebtedness then may become immediately due and payable. We are not certain whether we would have, or be able to obtain, sufficient funds to make these accelerated payments, including payments on the notes. If any senior debt is accelerated, our assets may not be sufficient to repay in full such indebtedness and our other indebtedness, including the notes, in which event the interests of the senior debt lenders may conflict with the interests of the holders of the notes. Risks Related to this Offering Subordination: Your rights to receive payment on the notes will be junior to our senior debt. The obligations under the notes will be subordinated to substantially all of our existing and future senior debt, in particular our 2001 senior secured credit facility, meaning that, in bankruptcy or insolvency, you will receive payment on the notes only after the senior debt is paid in full. Any subsidiary guarantee will be subordinated in right of payment to all senior indebtedness of the relevant guarantor subsidiary including its guarantee of the 2001 senior secured credit facility. The notes will also be effectively subordinated to all of our secured debt to the extent of the assets securing such secured indebtedness, and to the obligations of any subsidiary that is not a guarantor to the extent of its assets. As of September 30, 2001, we had $12.9 million of senior debt, excluding letters of credit and guarantees, with an additional $125 million of revolving loans available under the 2001 senior secured credit facility. Our indenture allows us to incur additional indebtedness, which may be senior indebtedness, based on, among other things, our ability to meet an interest coverage ratio. See "Description of the Notes - Covenants - Limitation on Indebtedness" for a description of the additional indebtedness we are allowed to incur under the indenture. Our ability to incur additional indebtedness is also currently limited by the terms of our 2001 senior secured credit facility, even if such debt would be permitted under our indenture. However, the limitations on indebtedness in our 2001 senior secured credit facility are subject to a number of exceptions which permit us to incur debt including, among others, purchase money obligations and capitalized leases and, with the lending commitment of one or more lenders under that facility or new lenders and subject to financial tests, up to $250 million of additional term loans, all of which would be senior indebtedness. In a bankruptcy, liquidation, reorganization or dissolution relating to us, our assets will be available to pay the notes and the subsidiary guarantees only after all payments have been made on our senior indebtedness. In addition, all payments on the notes and the subsidiary guarantees will be blocked in the event of a payment default on our senior debt and may be blocked for up to 179 of 360 consecutive days in the event of certain non-payment defaults on our senior debt. Holders of the notes will participate in the assets remaining after we and our guarantor subsidiaries have paid all of the debt senior to the notes with all other holders of our and our guarantor subsidiaries' indebtedness which is deemed to be of the same class as the notes. However, because the indenture requires that amounts otherwise payable to holders of the notes in a bankruptcy or similar proceeding be paid to holders of debt senior to the notes under the bankruptcy laws instead, holders of the notes may receive less, ratably, than holders of trade payables in any such proceeding, even if such trade payables are not senior debt. In any of these cases, we and our guarantor subsidiaries may not have sufficient funds to pay all of our creditors, and holders of notes may receive less, ratably, than the holders of other debt. We conduct most of our operations through, and depend on funds from, our subsidiaries, and funds we receive from our subsidiaries may be insufficient to make payments on the notes. We are a holding company with no material assets except for the stock of our direct subsidiaries. As a holding company, we conduct substantially all of our operations through our direct and indirect subsidiaries. Moreover, we are dependent on dividends or other intercompany transfers of funds from our subsidiaries to meet our debt service and other obligations, including payment of principal and interest on the notes. The ability of our subsidiaries to pay dividends or make other payments or advances to us will depend on their operating results and will be subject to applicable laws and restrictions contained in agreements governing the debt of such subsidiaries. Initially, certain of our subsidiaries were not required to provide a guarantee of the notes. In the future, the lenders under our 2001 senior secured credit facility may agree that other subsidiaries need not provide guarantees thereunder, in which case such subsidiaries will not be required to provide guarantees of the notes. Thus, the assets of these subsidiaries would be available for payment on the notes and other liabilities of Vanguard (or of any subsidiary guarantor holding such non-guarantor subsidiary's stock) only after satisfaction of all of such non-guarantor subsidiary's liabilities. We may be unable to raise the funds necessary to repurchase the notes upon a change of control. In the event of a change of control, we are required to make an offer for cash to repurchase the notes at 101% of the principal amount of the notes, plus accrued and unpaid interest, if any, thereon to the repurchase date. However, our 2001 senior secured credit facility requires that we repay all indebtedness thereunder or obtain the consent of the lenders prior to such repurchase of outstanding notes, and any exercise by the holders of the notes of their right to require us to repurchase the notes may cause an event of default under the 2001 senior secured credit facility. If a change of control occurs at a time when we are required to pay outstanding amounts under the 2001 senior secured credit facility or obtain such consents, and if we do not refinance such borrowings or obtain such consents, we will remain prohibited from repurchasing the notes, which would constitute an event of default under the indenture which would, in turn, constitute an event of default under our 2001 senior secured credit facility and under our other senior indebtedness. If we fail to comply with the requirements of the 2001 senior secured credit facility, the lenders can declare the entire amount owed thereunder immediately due and payable and prohibit us from making payments of interest and principal on the notes until all such debt is paid or otherwise satisfied in full, and can also enforce their security interests against our assets. On September 30, 2001, we had $12.9 million of senior indebtedness, in addition to the $5.6 million of undrawn letters of credit under the 2001 senior secured credit facility. In addition, we do not now, and would not expect to, have the financial resources sufficient to repurchase all of the notes if all our obligations to purchase or repay indebtedness occurred simultaneously upon a change of control. See "Description of the Notes - Repurchase of Notes Upon a Change of Control" for a more detailed description of the change of control provision. In the event that our subsidiary guarantees are deemed to be fraudulent conveyances, your claim against a guarantor could be lost or limited. Certain of our current and future domestic restricted subsidiaries will guarantee the notes. The issuance of these guarantees could be subject to review under applicable fraudulent transfer or conveyance laws in a bankruptcy or other similar proceeding. Under these laws, the issuance of a guarantee will generally be a fraudulent conveyance if either (1) the guarantor issued the guarantee with the intent of hindering, delaying or defrauding its creditors or (2) the guarantor received less than reasonably equivalent value or fair consideration in return for the guarantee and any of the following is true: o the guarantor was insolvent or became insolvent when it issued the guarantee; o the guarantor was left with an unreasonably small amount of capital after issuing the guarantee; or o the guarantor intended to incur, or believed that it would incur, debts beyond its ability to pay as they matured. Since our subsidiary guarantors issued the guarantees for our benefit and only indirectly for their own benefit, the guarantees could be subject to a claim that they were given for less than reasonably equivalent value or fair consideration. Although the definition of "insolvency" differs among jurisdictions, in general, the guarantor would be considered insolvent when it issued the guarantee if: o its liabilities exceeded the fair value of its assets; or o the present market value of its assets is less than the amount it would need to pay its total existing debts and liabilities as they mature (including those contingent liabilities which are likely to become certain). We cannot predict which standard a court would apply when determining whether a guarantor was insolvent when the notes were issued or how the court would decide this issue regardless of the standard. Even if a court determined that the guarantor was not insolvent when the notes were issued, you should be aware that payments under the guarantees may constitute fraudulent transfers on other grounds. In addition, the liability of each guarantor under its guarantee is limited to the amount that will not constitute a fraudulent conveyance or improper corporate distribution under applicable laws. We cannot predict which standard a court would apply when determining the maximum liability of each guarantor. To the extent that the note guarantee of any guarantor is voided as a fraudulent conveyance or otherwise held to be unenforceable, your claim against that guarantor could be lost or limited. Risks Related to Our Business We may be unable to achieve our acquisition and growth strategy and we may have difficulty acquiring not-for-profit hospitals due to regulatory scrutiny. An important element of our business strategy is expansion by acquiring hospitals in our existing and in new urban and suburban markets and by entering into partnerships or affiliations with other health care service providers. The competition to acquire hospitals is significant, including competition from health care companies with greater financial resources than us, and we may not be able to make suitable acquisitions on favorable terms, and we may have difficulty obtaining financing, if necessary, for such acquisitions on satisfactory terms. In addition, we may not be able to effectively integrate any acquired facilities with our operations. Even if we continue to acquire additional facilities and/or enter into partnerships or affiliations with other health care service providers, Federal and state regulatory agencies may constrain our ability to grow. Additionally, many states, including some where we have hospitals and others where we may in the future attempt to acquire hospitals, have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the not-for-profit seller. These review and approval processes can add time to the consummation of an acquisition of a not-for-profit hospital, and future actions on the state level could seriously delay or even prevent future acquisitions of not-for-profit hospitals. Furthermore, as a condition to approving an acquisition, the attorney general of the state in which the hospital is located may require us to maintain specific services, such as emergency departments, or to continue to provide specific levels of charity care, which may affect our decision to acquire or the terms of an acquisition of these hospitals. Difficulties with integrating our acquisitions may disrupt our ongoing operations. We may not be able to profitably or effectively integrate the operations of, or otherwise achieve the intended benefits from, any acquisitions we make or partnerships or affiliations we may form. The process of integrating acquired hospitals may require a disproportionate amount of management's time and attention, potentially distracting management from its day-to-day responsibilities. This process may be even more difficult in the case of hospitals we may acquire out of bankruptcy or otherwise in financial distress. In addition, poor integration of acquired facilities could cause interruptions to our business activities, including those of the acquired facilities. As a result, we may incur significant costs related to acquiring or integrating these facilities and may not realize the anticipated benefits. Moreover, acquired businesses may have unknown or contingent liabilities, including liabilities for failure to comply with health care laws and regulations. Although our policy is to conform the practices of acquired facilities to our standards, and generally to obtain indemnification from sellers covering these matters, we could in the future become liable for past activities of acquired businesses and such liabilities could be material. If we are unable to enter into favorable contracts with managed care plans, our operating revenues may be reduced. Our ability to negotiate favorable contracts with health maintenance organizations, preferred provider organizations and other managed care plans significantly affects the revenue and operating results of our hospitals. Revenues derived from health maintenance organizations, preferred provider organizations and other managed care plans accounted for approximately 65% and 61% of our patient revenues for the year ended June 30, 2001 and the three months ended September 30, 2001, respectively. Managed care organizations offering prepaid and discounted medical services packages represent an increasing portion of our admissions, a general trend in the industry which has limited hospital revenue growth nationwide. In addition, private payers are increasingly attempting to control health care costs through direct contracting with hospitals to provide services on a discounted basis, increased utilization review, including the use of hospitalists, and greater enrollment in managed care programs such as health maintenance organizations and preferred provider organizations. Our future success will depend, in part, on our ability to renew existing managed care contracts and enter into new managed care contracts on terms favorable to us. Other health care companies, including some with greater financial resources, greater geographic coverage or a wider range of services, may compete with us for these opportunities. If we are unable to contain costs through increased operational efficiencies or to obtain higher reimbursements and payments from managed care or government payers, our results of operations and cash flow will be adversely affected. As of September 30, 2001, West Anaheim Medical Center in Anaheim, California receives payments under a long term "take-or-pay" contract with a managed care payer which generated approximately $22.9 million, or 3.4%, of our revenues for the year ended June 30, 2001 and $5.5 million, or 2.7%, of our revenues for the three months ended September 30, 2001. Under this "take or pay" arrangement the payer has agreed to purchase in each contractual year a fixed amount of patient days at a fixed rate per day primarily from West Anaheim Medical Center, except that a portion of such patient days can also be purchased, at the option of the payer, at our Huntington Beach Hospital in Huntington Beach, California or at our two ambulatory surgery centers in Orange County, California. The rate is adjusted annually to reflect any increases in the consumer price index and may also be adjusted pursuant to a contractual formula if the level of care for the patients which the payer directs to our facilities increases. Under this contract, the payer is obligated to purchase from our facilities patient days which will cost the payer an aggregate of $22,932,000 for the contract year ending March 31, 2002. If annual patient days costing less than $22,932,000 are purchased during the contract year ended March 31, 2002, then the payer must reimburse the West Anaheim Medical Center for the difference between $22,932,000 and the total amount of patient days purchased even though no additional patient days are provided. The managed care payer of this contract has given us notice that it intends to terminate this contract, effective May 18, 2005. We do not know at this time whether we will be able to extend or renew this contract beyond May 18, 2005, even if we agreed to reduce our health care charges to such payer, or replace these revenues with other new business. If we are unable to renew or replace this contract, our earnings will be adversely impacted. Changes in governmental programs may significantly reduce our revenues. Government health care programs, principally Medicare and Medicaid, accounted for approximately 20% and 28% of our revenues for the year ended June 30, 2001 and the three months ended September 30, 2001, respectively. Recent legislative changes, including those enacted as part of the Balanced Budget Act of 1997, have resulted in limitations on and, in some cases, reductions in levels of, payments to health care providers for certain services under many of these government programs. Many changes imposed by the Balanced Budget Act of 1997 are being phased in over a period of years. Certain rate reductions resulting from the Balanced Budget Act of 1997 are being mitigated by the Balanced Budget Refinement Act of 1999 and will be further mitigated by the Benefits Improvement Protection Act of 2000. Nonetheless, the Balanced Budget Act of 1997 significantly reduced the level of payment under the Medicare and Medicaid programs. These changes have resulted, and we expect will continue to result, in significant reductions in payments for our inpatient and outpatient services. Final regulations implementing Medicare's new prospective payment system for outpatient hospital services were also promulgated recently. To date, our cash flows have been somewhat negatively affected by the delays in processing our claims under this new system. In addition, a number of states have adopted or are considering legislation designed to reduce their Medicaid expenditures and to provide universal coverage and additional care, including enrolling Medicaid recipients in managed care programs and imposing additional taxes on hospitals to help finance or expand these states' Medicaid systems. We believe that hospital operating margins across the industry, including ours, have been, and may continue to be, under continuing pressure because of limited pricing flexibility and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. Competition from other hospitals or health care providers may reduce our patient volume and profitability. The hospital industry is highly competitive. Our hospitals face competition for patients from other hospitals in our markets, large tertiary care centers and outpatient service providers that provide similar services to those provided by our hospitals. Our 5 hospitals with 920 licensed beds licensed in the Phoenix metropolitan area compete with over 20 other hospitals and numerous outpatient providers in this market. Our largest competitor in this market is the not-for-profit Banner Health System which owns 6 hospitals with 2,030 licensed beds in the Phoenix metropolitan area. Our 3 hospitals with 491 licensed beds in Orange County, California compete with over 95 other hospitals and numerous outpatient providers in the Los Angeles/Orange County metropolitan area. Our largest competitors in this market are the investor-owned Tenet Healthcare Corporation which owns 28 hospitals with 5,550 licensed beds and the not-for-profit Memorial Health Services which owns 5 hospitals with 1,615 licensed beds in the Los Angeles/Orange County metropolitan area. Our MacNeal Hospital with 427 licensed beds in Berwyn, Illinois competes with over 60 other hospitals and numerous outpatient providers in the Chicago metropolitan area. Our largest competitors in this market are the not- for-profit Advocate Health Care which owns 10 hospitals with 3,271 licensed beds and the not-for-profit Resurrection Health Care which owns 8 hospitals with 2,596 licensed beds in the Chicago metropolitan area. Some of the hospitals that compete with ours are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. Some of our competitors are larger and more established, have greater geographic coverage, offer a wider range of services (including extensive medical research and medical education programs) or have more capital or other resources than we do. If our competitors are able to finance capital improvements, recruit physicians, expand services or obtain favorable managed care contracts at their facilities, we may experience a decline in patient volume. Our prepaid Medicaid managed health care plan also faces competition within the Arizona market which it serves. As in the case of our hospitals, some of our competitors in this market are owned by governmental agencies or not-for-profit corporations with greater financial resources than us. Other competitors have larger membership bases, are more established and have greater geographic coverage areas which give them an advantage in competing for a limited pool of eligible health plan members. Moreover, because our leverage in negotiating with Arizona's state Medicaid program for higher reimbursement fees depends, to an extent, upon the number of enrollees in our health plan eligible for the program, a failure to attract future enrollees may negatively impact our ability to maintain our profitability in this market. Our performance depends on our ability to recruit and retain quality physicians. The success of our hospitals depends in part on the following factors: o the number and quality of the physicians on the medical staffs of our hospitals; o the admitting practices of those physicians; and o the maintenance of good relations with those physicians. Most physicians at our hospitals also have admitting privileges at other hospitals. If we are unable to provide adequate support personnel or technologically advanced equipment and facilities that meet the needs of physicians, they may be discouraged from referring patients to our facilities, which could adversely affect our profitability. Our hospitals face competition for staffing, which may increase our labor costs and reduce profitability. We compete with other health care providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician health care professionals. In the health care industry generally, including in our markets, the scarcity of nurses and other medical support personnel has become a significant operating issue. This shortage may require us to increase wages and benefits to recruit and retain nurses and other medical support personnel or to hire more expensive temporary personnel. We have on several occasions in the past, and expect to in the future, raised wages for our nurses and other medical support personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because approximately 90% of our revenues consist of fixed, prospective payments, based on our results of operations for the year ended June 30, 2001, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have a material adverse effect on our profitability. We conduct business in a heavily regulated industry, and changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce our revenues and profitability. The health care industry is subject to extensive Federal, state and local laws and regulations relating to licensing, the conduct of operations, the ownership of facilities, the addition of facilities and services, confidentiality, maintenance and security issues associated with medical records, billing for services; and prices for services. Although we believe that our facilities are in substantial compliance with such laws and regulations, if a determination were made that we were in material violation of such laws or regulations, our operations and financial results could be materially adversely affected. In many instances, the industry does not have the benefit of significant regulatory or judicial interpretation of these laws and regulations, particularly in the case of Medicare and Medicaid antifraud and abuse amendments, codified under section 1128B(b) of the Social Security Act and known as the "Anti-Kickback Statute." This law prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent to generate referrals of orders for services or items reimbursable under Medicare, Medicaid and other Federal health care programs. As authorized by Congress, the United States Department of Health and Human Services, has issued regulations which describe some of the conduct and business relationships immune from prosecution under the Anti-Kickback Statute. The fact that a given business arrangement does not fall within one of these "safe harbor" provisions does not render the arrangement illegal, but business arrangements of health care service providers that fail to satisfy the applicable safe harbor criteria risk increased scrutiny by enforcement authorities. Some of the financial arrangements which we maintain with our physicians do not meet the requirements for safe harbor protection. The regulatory authorities that enforce the Anti-Kickback Statute may in the future determine that one or more of these arrangements violate the Anti-Kickback Statute or other Federal or state laws. A determination that we have violated the Anti-Kickback Statute or other Federal laws could subject us to liability under the Social Security Act, including criminal and civil penalties, as well as exclusion from participation in government programs such as Medicare and Medicaid or other Federal health care programs. In addition, the portion of the Social Security Act commonly known as the "Stark Law" prohibits physicians from referring Medicare and Medicaid patients to providers of designated health services if the physician or a member of his or her immediate family has an ownership interest in or compensation arrangement with that provider. There are exceptions to the Stark Law for physicians maintaining an ownership interest in an entire hospital, employment agreements, leases, physician recruitment and certain other physician arrangements. Other federal regulation we are subject to include laws and regulations regarding self-interested referrals, administration of claims and privacy of information. All of the states in which we operate have adopted or have considered adopting similar anti-kickback and physician self-referral legislation, some of which extends beyond the scope of the Federal law to prohibit the payment or receipt of remuneration for the referral of patients and physician self-referrals, irrespective of the source of the payment for the care. Little precedent exists for the interpretation or enforcement of these laws. Both Federal and state government agencies have announced heightened and coordinated civil and criminal enforcement efforts. Government officials responsible for enforcing health care laws could assert that we, or any of the transactions in which we are involved, are in violation of any of these laws. It is also possible that the courts could ultimately interpret these laws in a manner that is different from our interpretations. A determination that we have violated these laws, or the public announcement that we are being investigated for possible violations of these laws, could have a material adverse effect on our business, financial condition, results of operations or prospects, and our business reputation could suffer significantly. Some states require prior approval for the purchase of major medical equipment or the purchase, construction, expansion, sale or closure of health care facilities, based upon a determination of need for additional or expanded health care facilities or services. The governmental determinations, embodied in Certificates of Need, may be required for capital expenditures exceeding a prescribed amount, changes in bed capacity or services and certain other matters. One state in which we currently own a hospital, Illinois, has Certificate of Need laws affecting acute care hospital services. We cannot predict whether we will be able to obtain required Certificates of Need in the future. Any failure to obtain any required Certificates of Need may impair our ability to operate profitably. The laws, rules and regulations described above are complex and subject to interpretation. In the event of a determination that we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed. For a more detailed discussion of the laws, rules and regulations described above, see "Government Regulation and Other Factors." Providers in the health care industry have been the subject of Federal and state investigations, and we may become subject to investigations in the future. Both Federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of hospital companies, as well as their executives and managers. These investigations relate to a wide variety of topics, including: o referral, cost reporting and billing practices; o laboratory and home health care services; and o physician ownership and joint ventures involving hospitals. In addition, the Federal False Claims Act permits private parties to bring qui tam, or whistleblower, lawsuits against companies. Some states have adopted similar whistleblower and false claims provisions. The Office of the Inspector General of Health and Human Services and the Department of Justice have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Initiatives include a focus on hospital billing for outpatient charges associated with inpatient services, as well as hospital laboratory billing practices. As a result of these regulations and initiatives, some of our activities could become the subject of governmental investigations or inquiries. For example, we have significant Medicare and Medicaid billings, we provide some durable medical equipment and home health care services, and we have joint venture arrangements involving physician investors. In addition, our executives and managers, many of whom have worked at other health care companies that are or may become the subject of Federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. We are aware that several of our hospitals have been or are being investigated in connection with activities conducted prior to our acquisition of them. Under the terms of our various acquisition agreements, the prior owners of our hospitals are responsible for any liabilities arising from pre-closing violations. The prior owners' resolution of these matters or failure to resolve these matters, in the event that any resolution was deemed necessary, may have a material adverse effect on our business, financial condition or results of operation. See Note 8 of the Notes to Combined Statements of Operations and Cash Flows of Phoenix Baptist Hospital and Medical Center, Inc., Arrowhead Community Hospital and Medical Center, Inc. and Affiliates. Any investigations of us, our executives, managers, facilities or operations could result in significant liabilities or penalties to us, as well as adverse publicity. If any one of the regions in which we operate experiences an economic downturn or other material change, our overall business results may suffer. Among our operations as of September 30, 2001, four hospitals, five diagnostic imaging centers and a prepaid Medicaid managed health plan are located in Phoenix, Arizona, three hospitals and two ambulatory surgery centers are located in Orange County, California, and one hospital and its related clinics are located in metropolitan Chicago, Illinois. For the pro forma year ended June 30, 2001 and the three months ended September 30, 2001, our revenues and consolidated Adjusted EBITDA, including corporate overhead, were generated as follows: Year ended Three months ended June 30, 2001 September 30, 2001 --------------------- -------------------- Adjusted Adjusted Revenues EBITDA(1) Revenues EBITDA(1) Operations -------- --------- -------- --------- ---------- Phoenix.......................... 37.2% 30.2% 34.9% 24.6% Orange County.................... 18.2% 27.1% 18.6% 22.4% Metropolitan Chicago............. 32.4% 52.4% 31.3% 56.3% Phoenix Health Plan and other.... 12.2% 9.1% 15.2% 18.3% Corporate overhead expenses(2)... 0.0% (18.8)% 0.0% (21.6)% ----- ----- ----- ----- 100.0% 100.0% 100.0% 100.0% ===== ===== ===== ===== ------------------- (1) Adjusted EBITDA represents EBITDA, or net income before interest expense (net of interest income), income taxes, depreciation, amortization, and is further adjusted to add back non-cash stock compensation, certain other non-operating expenses and restructuring and impairment charges. This definition of Adjusted EBITDA is derived from and consistent with the Indenture for the new notes. EBITDA is commonly used as an analytical indicator within the health care industry and serves as a measure of leverage capacity and debt service ability. We believe the adjustments made to EBITDA in calculating Adjusted EBITDA are appropriate to reflect our calculations of the debt leverage and interest coverage ratios under the Indenture and the 2001 senior secured credit facility. Adjusted EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles, and the items excluded in determining Adjusted EBITDA are significant components in understanding and assessing financial performance. Because neither EBITDA nor a calculation of Adjusted EBITDA is a measurement determined in accordance with generally accepted accounting principles, it is susceptible to varying calculations, and as a result our calculation of Adjusted EBITDA as presented may not be comparable to EBITDA or other similarly titled measures used by other companies. (2) Reflected in Consolidated Financial Statements only. Any material change in the current demographic, economic, competitive or regulatory conditions in any of these regions could adversely affect our overall business results because of the significance of our operations in each of these regions to our overall operating performance. Moreover, due to the concentration of our revenues in only three regions, our business is less diversified and, accordingly, is subject to greater regional risk than that of some of our larger competitors. California has a statute and regulations that require hospitals to meet seismic performance standards, and hospitals that do not meet the standards may be required to retrofit their facilities. The law requires that these hospitals evaluate their facilities and develop a plan and schedule for complying with the standards which, if necessary, must be filed with the State of California by 2002. We have filed all of the necessary documentation with the State of California that was required by January 1, 2002. We expect that the cost of performing the necessary evaluations and filing the documentation will be approximately $0.3 million. The estimated cost to comply with the seismic regulations and standards required by 2008, is an additional $10.1 million. Upon completion of the $10.1 million in improvements, the California facilities will be compliant with the requirements of the seismic regulations through 2029. We estimate that the majority of the square footage in our facilities will be compliant with the seismic regulations and standards required by 2030 once we have completed such $10.1 million in improvements, but we are unable at this time to estimate our costs for full compliance with the 2030 requirements. We are dependent on our senior management team and local management personnel, and the loss of the services of one or more of our senior management team or key local management personnel could have a material adverse effect on our business. The success of our business is largely dependent upon the services and management experience of our senior management team, which includes Charles N. Martin, Jr., our Chairman and Chief Executive Officer; William L. Hough, our President and Chief Operating Officer; Joseph D. Moore, our Executive Vice President, Chief Financial Officer and Treasurer, and Keith B. Pitts, our Vice Chairman. In addition, we depend on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our senior officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. We do not maintain key man life insurance policies on any of our officers. If we were to lose any of our senior management team or members of our local management teams, or if we are unable to attract other necessary personnel in the future, it could have a material adverse effect on our business, financial condition and results of operations. If we were to lose the services of one or more members of our senior management team or a significant portion of our hospital management staff at one or more of our hospitals, we would likely experience a significant disruption in our operations and failures of the affected hospitals to adhere to their respective business plans. Should we be unable to control our health care costs at Phoenix Health Plan, or if the health plan should lose its governmental contract, our profitability may be adversely affected. For the year ended June 30, 2001 and the three months ended September 30, 2001, our Phoenix Health Plan generated approximately 12.2% and 15.2% of our revenues, respectively, and 9.1% and 18.3%, of our Adjusted EBITDA, respectively, on a pro forma basis. Phoenix Health Plan derives substantially all of its revenues through a contract with the Arizona Health Care Cost Containment System (the "Arizona Health Care System"), which is the state agency that administers Arizona's state Medicaid program. The Arizona Health Care System pays capitated rates to Phoenix Health Plan and Phoenix Health Plan subcontracts with physicians, hospitals and other health care providers to provide services to its enrollees. If we fail to effectively manage our health care costs, these costs may exceed the payments we receive. Many factors can cause actual health care costs to exceed the capitated rates paid by the Arizona Health Care System, including: o our ability to contract with cost-effective health care providers; o the increased cost of individual health care services; o the type and number of individual health care services delivered; and o the occurrence of catastrophes, epidemics or other unforeseen occurrences. Our contract with the Arizona Health Care System expires on September 30, 2003, and although by its terms it is renewable annually by the Arizona Health Care System, it is terminable for any reason upon 90 days' notice. If this contract were terminated or not renewed or further extended, our profitability could be adversely affected by the loss of these revenues and cash flow. If claims brought against our facilities exceed the scope of our liability coverage or coverage is denied, our overall business results may suffer. Plaintiffs frequently bring actions against hospitals and other health care providers alleging malpractice, product liability or other legal theories. Many of these actions involve large claims and significant defense costs. To cover these claims, we self-insure our general and professional risks up to $1.0 million on a per-occurrence basis and up to $13.2 million on an aggregate per-claim basis. For losses above the self-insurance limits, we maintain insurance from unrelated commercial carriers on an occurrence basis for general liability and a claims-made basis for professional liability up to $100.0 million per occurrence and in the aggregate. Some of the claims, however, could exceed the scope of the coverage in effect or coverage of particular claims or damages could be denied. Furthermore, our insurance coverage may not continue to be available at a reasonable cost.

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+RISK FACTORS You should carefully consider the following factors in addition to the other information in this Registration Statement before investing in the notes. Risks Related to Our Debt Our high level of debt may limit our ability to successfully operate our business. We have a substantial amount of debt. On September 30, 2001, we had $312.9 million of outstanding debt, excluding letters of credit and guarantees, including $12.9 million of senior indebtedness. Of such total debt, $300 million would have consisted of the notes, and $12.9 million would have consisted of capitalized lease obligations and other debt, resulting in a pro forma percentage of debt-to-total capitalization of 49.1%. For the year ended June 30, 2001, on a pro forma basis, earnings were insufficient to cover fixed charges by $5.3 million. For the three months ended September 30, 2001, on a pro forma basis, the ratio of earnings to fixed charges was 1.16. Subject to the restrictions in the indenture and the 2001 senior secured credit facility, we and our subsidiaries may be able to incur substantial additional indebtedness in the future. The 2001 senior secured credit facility permits revolving borrowings and letters of credit of up to $125 million in the aggregate outstanding at any one time, all of which would be senior to the notes and the subsidiary guarantees, and we may borrow substantial additional indebtedness in the future, some or all of which would also be senior to the notes and the subsidiary guarantees. Our substantial indebtedness could have important consequences to you. For example, it could: o make it more difficult for us to satisfy our obligations with respect to the notes; o increase our vulnerability to general adverse economic, market and industry conditions and limit our flexibility in planning for, or reacting to, these conditions; o increase our vulnerability to interest rate fluctuations because much of our debt may be at variable interest rates; o limit our ability to obtain additional financing to fund future acquisitions and working capital, capital expenditures or other needs; and o limit our ability to compete with others who are not as highly-leveraged. Our ability to make scheduled payments of principal and interest or to satisfy our other debt obligations, to refinance our indebtedness, including the notes, or to fund capital expenditures will depend on our future performance. Prevailing economic conditions and financial, business and other factors, many of which are beyond our control, will also affect our ability to meet these needs. We may not be able to generate sufficient cash flow from operations or realize anticipated revenue growth or operating improvements, or obtain future borrowings in an amount sufficient to enable us to pay our debt, including the notes, or to fund our other liquidity needs. We may need to refinance all or a portion of our debt, including the notes, on or before maturity. We may not be able to refinance any of our debt, including our 2001 senior secured credit facility and the notes, when needed on commercially reasonable terms or at all. Operating and financial restrictions in our debt agreements will limit our operational and financial flexibility. Restrictions and covenants in our existing debt agreements, as well as the 2001 senior secured credit facility and the indenture, and any future financing agreements, may adversely affect our ability to finance future operations or capital needs or to engage in other business activities. Specifically, our debt agreements restrict our ability to: o declare dividends or redeem or repurchase capital stock; o prepay, redeem or repurchase debt, including the notes; o incur liens; o make loans and investments; o incur additional indebtedness; o amend or otherwise change debt and other material agreements; o make capital expenditures; o engage in mergers, acquisitions and asset sales; o enter into transactions with affiliates; and o change our primary business. Although it is difficult for us to predict future liquidity requirements with certainty, we believe that the net proceeds from the offering of the old notes, together with our current cash and cash equivalents, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Our acquisition program requires substantial capital resources, and the operations of our existing hospitals and newly acquired hospitals require ongoing capital expenditures for renovation, expansion and the addition of medical equipment and technology. More specifically, we are currently, and may in the future be, contractually obligated to make significant capital expenditures relating to the facilities we acquire. Our debt agreements may restrict our ability to incur additional indebtedness to fund these expenditures. Also, our 2001 senior secured credit facility requires us to comply with the financial ratios included in that facility. If we fail to comply with the requirements of the 2001 senior secured credit facility, the lenders can declare the entire amount owed thereunder immediately due and payable and prohibit us from making payments of interest and principal on the notes until the default is cured or all such debt is paid or otherwise satisfied in full. If we are unable to repay such borrowings, such lenders could proceed against the collateral securing the 2001 senior secured credit facility. A breach of any of the restrictions or covenants in our debt agreements could cause a default under our 2001 senior secured credit facility, other debt or the notes. A significant portion of our indebtedness then may become immediately due and payable. We are not certain whether we would have, or be able to obtain, sufficient funds to make these accelerated payments, including payments on the notes. If any senior debt is accelerated, our assets may not be sufficient to repay in full such indebtedness and our other indebtedness, including the notes, in which event the interests of the senior debt lenders may conflict with the interests of the holders of the notes. Risks Related to this Offering Subordination: Your rights to receive payment on the notes will be junior to our senior debt. The obligations under the notes will be subordinated to substantially all of our existing and future senior debt, in particular our 2001 senior secured credit facility, meaning that, in bankruptcy or insolvency, you will receive payment on the notes only after the senior debt is paid in full. Any subsidiary guarantee will be subordinated in right of payment to all senior indebtedness of the relevant guarantor subsidiary including its guarantee of the 2001 senior secured credit facility. The notes will also be effectively subordinated to all of our secured debt to the extent of the assets securing such secured indebtedness, and to the obligations of any subsidiary that is not a guarantor to the extent of its assets. As of September 30, 2001, we had $12.9 million of senior debt, excluding letters of credit and guarantees, with an additional $125 million of revolving loans available under the 2001 senior secured credit facility. Our indenture allows us to incur additional indebtedness, which may be senior indebtedness, based on, among other things, our ability to meet an interest coverage ratio. See "Description of the Notes - Covenants - Limitation on Indebtedness" for a description of the additional indebtedness we are allowed to incur under the indenture. Our ability to incur additional indebtedness is also currently limited by the terms of our 2001 senior secured credit facility, even if such debt would be permitted under our indenture. However, the limitations on indebtedness in our 2001 senior secured credit facility are subject to a number of exceptions which permit us to incur debt including, among others, purchase money obligations and capitalized leases and, with the lending commitment of one or more lenders under that facility or new lenders and subject to financial tests, up to $250 million of additional term loans, all of which would be senior indebtedness. In a bankruptcy, liquidation, reorganization or dissolution relating to us, our assets will be available to pay the notes and the subsidiary guarantees only after all payments have been made on our senior indebtedness. In addition, all payments on the notes and the subsidiary guarantees will be blocked in the event of a payment default on our senior debt and may be blocked for up to 179 of 360 consecutive days in the event of certain non-payment defaults on our senior debt. Holders of the notes will participate in the assets remaining after we and our guarantor subsidiaries have paid all of the debt senior to the notes with all other holders of our and our guarantor subsidiaries' indebtedness which is deemed to be of the same class as the notes. However, because the indenture requires that amounts otherwise payable to holders of the notes in a bankruptcy or similar proceeding be paid to holders of debt senior to the notes under the bankruptcy laws instead, holders of the notes may receive less, ratably, than holders of trade payables in any such proceeding, even if such trade payables are not senior debt. In any of these cases, we and our guarantor subsidiaries may not have sufficient funds to pay all of our creditors, and holders of notes may receive less, ratably, than the holders of other debt. We conduct most of our operations through, and depend on funds from, our subsidiaries, and funds we receive from our subsidiaries may be insufficient to make payments on the notes. We are a holding company with no material assets except for the stock of our direct subsidiaries. As a holding company, we conduct substantially all of our operations through our direct and indirect subsidiaries. Moreover, we are dependent on dividends or other intercompany transfers of funds from our subsidiaries to meet our debt service and other obligations, including payment of principal and interest on the notes. The ability of our subsidiaries to pay dividends or make other payments or advances to us will depend on their operating results and will be subject to applicable laws and restrictions contained in agreements governing the debt of such subsidiaries. Initially, certain of our subsidiaries were not required to provide a guarantee of the notes. In the future, the lenders under our 2001 senior secured credit facility may agree that other subsidiaries need not provide guarantees thereunder, in which case such subsidiaries will not be required to provide guarantees of the notes. Thus, the assets of these subsidiaries would be available for payment on the notes and other liabilities of Vanguard (or of any subsidiary guarantor holding such non-guarantor subsidiary's stock) only after satisfaction of all of such non-guarantor subsidiary's liabilities. We may be unable to raise the funds necessary to repurchase the notes upon a change of control. In the event of a change of control, we are required to make an offer for cash to repurchase the notes at 101% of the principal amount of the notes, plus accrued and unpaid interest, if any, thereon to the repurchase date. However, our 2001 senior secured credit facility requires that we repay all indebtedness thereunder or obtain the consent of the lenders prior to such repurchase of outstanding notes, and any exercise by the holders of the notes of their right to require us to repurchase the notes may cause an event of default under the 2001 senior secured credit facility. If a change of control occurs at a time when we are required to pay outstanding amounts under the 2001 senior secured credit facility or obtain such consents, and if we do not refinance such borrowings or obtain such consents, we will remain prohibited from repurchasing the notes, which would constitute an event of default under the indenture which would, in turn, constitute an event of default under our 2001 senior secured credit facility and under our other senior indebtedness. If we fail to comply with the requirements of the 2001 senior secured credit facility, the lenders can declare the entire amount owed thereunder immediately due and payable and prohibit us from making payments of interest and principal on the notes until all such debt is paid or otherwise satisfied in full, and can also enforce their security interests against our assets. On September 30, 2001, we had $12.9 million of senior indebtedness, in addition to the $5.6 million of undrawn letters of credit under the 2001 senior secured credit facility. In addition, we do not now, and would not expect to, have the financial resources sufficient to repurchase all of the notes if all our obligations to purchase or repay indebtedness occurred simultaneously upon a change of control. See "Description of the Notes - Repurchase of Notes Upon a Change of Control" for a more detailed description of the change of control provision. In the event that our subsidiary guarantees are deemed to be fraudulent conveyances, your claim against a guarantor could be lost or limited. Certain of our current and future domestic restricted subsidiaries will guarantee the notes. The issuance of these guarantees could be subject to review under applicable fraudulent transfer or conveyance laws in a bankruptcy or other similar proceeding. Under these laws, the issuance of a guarantee will generally be a fraudulent conveyance if either (1) the guarantor issued the guarantee with the intent of hindering, delaying or defrauding its creditors or (2) the guarantor received less than reasonably equivalent value or fair consideration in return for the guarantee and any of the following is true: o the guarantor was insolvent or became insolvent when it issued the guarantee; o the guarantor was left with an unreasonably small amount of capital after issuing the guarantee; or o the guarantor intended to incur, or believed that it would incur, debts beyond its ability to pay as they matured. Since our subsidiary guarantors issued the guarantees for our benefit and only indirectly for their own benefit, the guarantees could be subject to a claim that they were given for less than reasonably equivalent value or fair consideration. Although the definition of "insolvency" differs among jurisdictions, in general, the guarantor would be considered insolvent when it issued the guarantee if: o its liabilities exceeded the fair value of its assets; or o the present market value of its assets is less than the amount it would need to pay its total existing debts and liabilities as they mature (including those contingent liabilities which are likely to become certain). We cannot predict which standard a court would apply when determining whether a guarantor was insolvent when the notes were issued or how the court would decide this issue regardless of the standard. Even if a court determined that the guarantor was not insolvent when the notes were issued, you should be aware that payments under the guarantees may constitute fraudulent transfers on other grounds. In addition, the liability of each guarantor under its guarantee is limited to the amount that will not constitute a fraudulent conveyance or improper corporate distribution under applicable laws. We cannot predict which standard a court would apply when determining the maximum liability of each guarantor. To the extent that the note guarantee of any guarantor is voided as a fraudulent conveyance or otherwise held to be unenforceable, your claim against that guarantor could be lost or limited. Risks Related to Our Business We may be unable to achieve our acquisition and growth strategy and we may have difficulty acquiring not-for-profit hospitals due to regulatory scrutiny. An important element of our business strategy is expansion by acquiring hospitals in our existing and in new urban and suburban markets and by entering into partnerships or affiliations with other health care service providers. The competition to acquire hospitals is significant, including competition from health care companies with greater financial resources than us, and we may not be able to make suitable acquisitions on favorable terms, and we may have difficulty obtaining financing, if necessary, for such acquisitions on satisfactory terms. In addition, we may not be able to effectively integrate any acquired facilities with our operations. Even if we continue to acquire additional facilities and/or enter into partnerships or affiliations with other health care service providers, Federal and state regulatory agencies may constrain our ability to grow. Additionally, many states, including some where we have hospitals and others where we may in the future attempt to acquire hospitals, have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the not-for-profit seller. These review and approval processes can add time to the consummation of an acquisition of a not-for-profit hospital, and future actions on the state level could seriously delay or even prevent future acquisitions of not-for-profit hospitals. Furthermore, as a condition to approving an acquisition, the attorney general of the state in which the hospital is located may require us to maintain specific services, such as emergency departments, or to continue to provide specific levels of charity care, which may affect our decision to acquire or the terms of an acquisition of these hospitals. Difficulties with integrating our acquisitions may disrupt our ongoing operations. We may not be able to profitably or effectively integrate the operations of, or otherwise achieve the intended benefits from, any acquisitions we make or partnerships or affiliations we may form. The process of integrating acquired hospitals may require a disproportionate amount of management's time and attention, potentially distracting management from its day-to-day responsibilities. This process may be even more difficult in the case of hospitals we may acquire out of bankruptcy or otherwise in financial distress. In addition, poor integration of acquired facilities could cause interruptions to our business activities, including those of the acquired facilities. As a result, we may incur significant costs related to acquiring or integrating these facilities and may not realize the anticipated benefits. Moreover, acquired businesses may have unknown or contingent liabilities, including liabilities for failure to comply with health care laws and regulations. Although our policy is to conform the practices of acquired facilities to our standards, and generally to obtain indemnification from sellers covering these matters, we could in the future become liable for past activities of acquired businesses and such liabilities could be material. If we are unable to enter into favorable contracts with managed care plans, our operating revenues may be reduced. Our ability to negotiate favorable contracts with health maintenance organizations, preferred provider organizations and other managed care plans significantly affects the revenue and operating results of our hospitals. Revenues derived from health maintenance organizations, preferred provider organizations and other managed care plans accounted for approximately 65% and 61% of our patient revenues for the year ended June 30, 2001 and the three months ended September 30, 2001, respectively. Managed care organizations offering prepaid and discounted medical services packages represent an increasing portion of our admissions, a general trend in the industry which has limited hospital revenue growth nationwide. In addition, private payers are increasingly attempting to control health care costs through direct contracting with hospitals to provide services on a discounted basis, increased utilization review, including the use of hospitalists, and greater enrollment in managed care programs such as health maintenance organizations and preferred provider organizations. Our future success will depend, in part, on our ability to renew existing managed care contracts and enter into new managed care contracts on terms favorable to us. Other health care companies, including some with greater financial resources, greater geographic coverage or a wider range of services, may compete with us for these opportunities. If we are unable to contain costs through increased operational efficiencies or to obtain higher reimbursements and payments from managed care or government payers, our results of operations and cash flow will be adversely affected. As of September 30, 2001, West Anaheim Medical Center in Anaheim, California receives payments under a long term "take-or-pay" contract with a managed care payer which generated approximately $22.9 million, or 3.4%, of our revenues for the year ended June 30, 2001 and $5.5 million, or 2.7%, of our revenues for the three months ended September 30, 2001. Under this "take or pay" arrangement the payer has agreed to purchase in each contractual year a fixed amount of patient days at a fixed rate per day primarily from West Anaheim Medical Center, except that a portion of such patient days can also be purchased, at the option of the payer, at our Huntington Beach Hospital in Huntington Beach, California or at our two ambulatory surgery centers in Orange County, California. The rate is adjusted annually to reflect any increases in the consumer price index and may also be adjusted pursuant to a contractual formula if the level of care for the patients which the payer directs to our facilities increases. Under this contract, the payer is obligated to purchase from our facilities patient days which will cost the payer an aggregate of $22,932,000 for the contract year ending March 31, 2002. If annual patient days costing less than $22,932,000 are purchased during the contract year ended March 31, 2002, then the payer must reimburse the West Anaheim Medical Center for the difference between $22,932,000 and the total amount of patient days purchased even though no additional patient days are provided. The managed care payer of this contract has given us notice that it intends to terminate this contract, effective May 18, 2005. We do not know at this time whether we will be able to extend or renew this contract beyond May 18, 2005, even if we agreed to reduce our health care charges to such payer, or replace these revenues with other new business. If we are unable to renew or replace this contract, our earnings will be adversely impacted. Changes in governmental programs may significantly reduce our revenues. Government health care programs, principally Medicare and Medicaid, accounted for approximately 20% and 28% of our revenues for the year ended June 30, 2001 and the three months ended September 30, 2001, respectively. Recent legislative changes, including those enacted as part of the Balanced Budget Act of 1997, have resulted in limitations on and, in some cases, reductions in levels of, payments to health care providers for certain services under many of these government programs. Many changes imposed by the Balanced Budget Act of 1997 are being phased in over a period of years. Certain rate reductions resulting from the Balanced Budget Act of 1997 are being mitigated by the Balanced Budget Refinement Act of 1999 and will be further mitigated by the Benefits Improvement Protection Act of 2000. Nonetheless, the Balanced Budget Act of 1997 significantly reduced the level of payment under the Medicare and Medicaid programs. These changes have resulted, and we expect will continue to result, in significant reductions in payments for our inpatient and outpatient services. Final regulations implementing Medicare's new prospective payment system for outpatient hospital services were also promulgated recently. To date, our cash flows have been somewhat negatively affected by the delays in processing our claims under this new system. In addition, a number of states have adopted or are considering legislation designed to reduce their Medicaid expenditures and to provide universal coverage and additional care, including enrolling Medicaid recipients in managed care programs and imposing additional taxes on hospitals to help finance or expand these states' Medicaid systems. We believe that hospital operating margins across the industry, including ours, have been, and may continue to be, under continuing pressure because of limited pricing flexibility and growth in operating expenses in excess of the increase in prospective payments under the Medicare program. Competition from other hospitals or health care providers may reduce our patient volume and profitability. The hospital industry is highly competitive. Our hospitals face competition for patients from other hospitals in our markets, large tertiary care centers and outpatient service providers that provide similar services to those provided by our hospitals. Our 5 hospitals with 920 licensed beds licensed in the Phoenix metropolitan area compete with over 20 other hospitals and numerous outpatient providers in this market. Our largest competitor in this market is the not-for-profit Banner Health System which owns 6 hospitals with 2,030 licensed beds in the Phoenix metropolitan area. Our 3 hospitals with 491 licensed beds in Orange County, California compete with over 95 other hospitals and numerous outpatient providers in the Los Angeles/Orange County metropolitan area. Our largest competitors in this market are the investor-owned Tenet Healthcare Corporation which owns 28 hospitals with 5,550 licensed beds and the not-for-profit Memorial Health Services which owns 5 hospitals with 1,615 licensed beds in the Los Angeles/Orange County metropolitan area. Our MacNeal Hospital with 427 licensed beds in Berwyn, Illinois competes with over 60 other hospitals and numerous outpatient providers in the Chicago metropolitan area. Our largest competitors in this market are the not- for-profit Advocate Health Care which owns 10 hospitals with 3,271 licensed beds and the not-for-profit Resurrection Health Care which owns 8 hospitals with 2,596 licensed beds in the Chicago metropolitan area. Some of the hospitals that compete with ours are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. Some of our competitors are larger and more established, have greater geographic coverage, offer a wider range of services (including extensive medical research and medical education programs) or have more capital or other resources than we do. If our competitors are able to finance capital improvements, recruit physicians, expand services or obtain favorable managed care contracts at their facilities, we may experience a decline in patient volume. Our prepaid Medicaid managed health care plan also faces competition within the Arizona market which it serves. As in the case of our hospitals, some of our competitors in this market are owned by governmental agencies or not-for-profit corporations with greater financial resources than us. Other competitors have larger membership bases, are more established and have greater geographic coverage areas which give them an advantage in competing for a limited pool of eligible health plan members. Moreover, because our leverage in negotiating with Arizona's state Medicaid program for higher reimbursement fees depends, to an extent, upon the number of enrollees in our health plan eligible for the program, a failure to attract future enrollees may negatively impact our ability to maintain our profitability in this market. Our performance depends on our ability to recruit and retain quality physicians. The success of our hospitals depends in part on the following factors: o the number and quality of the physicians on the medical staffs of our hospitals; o the admitting practices of those physicians; and o the maintenance of good relations with those physicians. Most physicians at our hospitals also have admitting privileges at other hospitals. If we are unable to provide adequate support personnel or technologically advanced equipment and facilities that meet the needs of physicians, they may be discouraged from referring patients to our facilities, which could adversely affect our profitability. Our hospitals face competition for staffing, which may increase our labor costs and reduce profitability. We compete with other health care providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician health care professionals. In the health care industry generally, including in our markets, the scarcity of nurses and other medical support personnel has become a significant operating issue. This shortage may require us to increase wages and benefits to recruit and retain nurses and other medical support personnel or to hire more expensive temporary personnel. We have on several occasions in the past, and expect to in the future, raised wages for our nurses and other medical support personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because approximately 90% of our revenues consist of fixed, prospective payments, based on our results of operations for the year ended June 30, 2001, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have a material adverse effect on our profitability. We conduct business in a heavily regulated industry, and changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce our revenues and profitability. The health care industry is subject to extensive Federal, state and local laws and regulations relating to licensing, the conduct of operations, the ownership of facilities, the addition of facilities and services, confidentiality, maintenance and security issues associated with medical records, billing for services; and prices for services. Although we believe that our facilities are in substantial compliance with such laws and regulations, if a determination were made that we were in material violation of such laws or regulations, our operations and financial results could be materially adversely affected. In many instances, the industry does not have the benefit of significant regulatory or judicial interpretation of these laws and regulations, particularly in the case of Medicare and Medicaid antifraud and abuse amendments, codified under section 1128B(b) of the Social Security Act and known as the "Anti-Kickback Statute." This law prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent to generate referrals of orders for services or items reimbursable under Medicare, Medicaid and other Federal health care programs. As authorized by Congress, the United States Department of Health and Human Services, has issued regulations which describe some of the conduct and business relationships immune from prosecution under the Anti-Kickback Statute. The fact that a given business arrangement does not fall within one of these "safe harbor" provisions does not render the arrangement illegal, but business arrangements of health care service providers that fail to satisfy the applicable safe harbor criteria risk increased scrutiny by enforcement authorities. Some of the financial arrangements which we maintain with our physicians do not meet the requirements for safe harbor protection. The regulatory authorities that enforce the Anti-Kickback Statute may in the future determine that one or more of these arrangements violate the Anti-Kickback Statute or other Federal or state laws. A determination that we have violated the Anti-Kickback Statute or other Federal laws could subject us to liability under the Social Security Act, including criminal and civil penalties, as well as exclusion from participation in government programs such as Medicare and Medicaid or other Federal health care programs. In addition, the portion of the Social Security Act commonly known as the "Stark Law" prohibits physicians from referring Medicare and Medicaid patients to providers of designated health services if the physician or a member of his or her immediate family has an ownership interest in or compensation arrangement with that provider. There are exceptions to the Stark Law for physicians maintaining an ownership interest in an entire hospital, employment agreements, leases, physician recruitment and certain other physician arrangements. Other federal regulation we are subject to include laws and regulations regarding self-interested referrals, administration of claims and privacy of information. All of the states in which we operate have adopted or have considered adopting similar anti-kickback and physician self-referral legislation, some of which extends beyond the scope of the Federal law to prohibit the payment or receipt of remuneration for the referral of patients and physician self-referrals, irrespective of the source of the payment for the care. Little precedent exists for the interpretation or enforcement of these laws. Both Federal and state government agencies have announced heightened and coordinated civil and criminal enforcement efforts. Government officials responsible for enforcing health care laws could assert that we, or any of the transactions in which we are involved, are in violation of any of these laws. It is also possible that the courts could ultimately interpret these laws in a manner that is different from our interpretations. A determination that we have violated these laws, or the public announcement that we are being investigated for possible violations of these laws, could have a material adverse effect on our business, financial condition, results of operations or prospects, and our business reputation could suffer significantly. Some states require prior approval for the purchase of major medical equipment or the purchase, construction, expansion, sale or closure of health care facilities, based upon a determination of need for additional or expanded health care facilities or services. The governmental determinations, embodied in Certificates of Need, may be required for capital expenditures exceeding a prescribed amount, changes in bed capacity or services and certain other matters. One state in which we currently own a hospital, Illinois, has Certificate of Need laws affecting acute care hospital services. We cannot predict whether we will be able to obtain required Certificates of Need in the future. Any failure to obtain any required Certificates of Need may impair our ability to operate profitably. The laws, rules and regulations described above are complex and subject to interpretation. In the event of a determination that we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed. For a more detailed discussion of the laws, rules and regulations described above, see "Government Regulation and Other Factors." Providers in the health care industry have been the subject of Federal and state investigations, and we may become subject to investigations in the future. Both Federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of hospital companies, as well as their executives and managers. These investigations relate to a wide variety of topics, including: o referral, cost reporting and billing practices; o laboratory and home health care services; and o physician ownership and joint ventures involving hospitals. In addition, the Federal False Claims Act permits private parties to bring qui tam, or whistleblower, lawsuits against companies. Some states have adopted similar whistleblower and false claims provisions. The Office of the Inspector General of Health and Human Services and the Department of Justice have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Initiatives include a focus on hospital billing for outpatient charges associated with inpatient services, as well as hospital laboratory billing practices. As a result of these regulations and initiatives, some of our activities could become the subject of governmental investigations or inquiries. For example, we have significant Medicare and Medicaid billings, we provide some durable medical equipment and home health care services, and we have joint venture arrangements involving physician investors. In addition, our executives and managers, many of whom have worked at other health care companies that are or may become the subject of Federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. We are aware that several of our hospitals have been or are being investigated in connection with activities conducted prior to our acquisition of them. Under the terms of our various acquisition agreements, the prior owners of our hospitals are responsible for any liabilities arising from pre-closing violations. The prior owners' resolution of these matters or failure to resolve these matters, in the event that any resolution was deemed necessary, may have a material adverse effect on our business, financial condition or results of operation. See Note 8 of the Notes to Combined Statements of Operations and Cash Flows of Phoenix Baptist Hospital and Medical Center, Inc., Arrowhead Community Hospital and Medical Center, Inc. and Affiliates. Any investigations of us, our executives, managers, facilities or operations could result in significant liabilities or penalties to us, as well as adverse publicity. If any one of the regions in which we operate experiences an economic downturn or other material change, our overall business results may suffer. Among our operations as of September 30, 2001, four hospitals, five diagnostic imaging centers and a prepaid Medicaid managed health plan are located in Phoenix, Arizona, three hospitals and two ambulatory surgery centers are located in Orange County, California, and one hospital and its related clinics are located in metropolitan Chicago, Illinois. For the pro forma year ended June 30, 2001 and the three months ended September 30, 2001, our revenues and consolidated Adjusted EBITDA, including corporate overhead, were generated as follows: Year ended Three months ended June 30, 2001 September 30, 2001 --------------------- -------------------- Adjusted Adjusted Revenues EBITDA(1) Revenues EBITDA(1) Operations -------- --------- -------- --------- ---------- Phoenix.......................... 37.2% 30.2% 34.9% 24.6% Orange County.................... 18.2% 27.1% 18.6% 22.4% Metropolitan Chicago............. 32.4% 52.4% 31.3% 56.3% Phoenix Health Plan and other.... 12.2% 9.1% 15.2% 18.3% Corporate overhead expenses(2)... 0.0% (18.8)% 0.0% (21.6)% ----- ----- ----- ----- 100.0% 100.0% 100.0% 100.0% ===== ===== ===== ===== ------------------- (1) Adjusted EBITDA represents EBITDA, or net income before interest expense (net of interest income), income taxes, depreciation, amortization, and is further adjusted to add back non-cash stock compensation, certain other non-operating expenses and restructuring and impairment charges. This definition of Adjusted EBITDA is derived from and consistent with the Indenture for the new notes. EBITDA is commonly used as an analytical indicator within the health care industry and serves as a measure of leverage capacity and debt service ability. We believe the adjustments made to EBITDA in calculating Adjusted EBITDA are appropriate to reflect our calculations of the debt leverage and interest coverage ratios under the Indenture and the 2001 senior secured credit facility. Adjusted EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles, and the items excluded in determining Adjusted EBITDA are significant components in understanding and assessing financial performance. Because neither EBITDA nor a calculation of Adjusted EBITDA is a measurement determined in accordance with generally accepted accounting principles, it is susceptible to varying calculations, and as a result our calculation of Adjusted EBITDA as presented may not be comparable to EBITDA or other similarly titled measures used by other companies. (2) Reflected in Consolidated Financial Statements only. Any material change in the current demographic, economic, competitive or regulatory conditions in any of these regions could adversely affect our overall business results because of the significance of our operations in each of these regions to our overall operating performance. Moreover, due to the concentration of our revenues in only three regions, our business is less diversified and, accordingly, is subject to greater regional risk than that of some of our larger competitors. California has a statute and regulations that require hospitals to meet seismic performance standards, and hospitals that do not meet the standards may be required to retrofit their facilities. The law requires that these hospitals evaluate their facilities and develop a plan and schedule for complying with the standards which, if necessary, must be filed with the State of California by 2002. We have filed all of the necessary documentation with the State of California that was required by January 1, 2002. We expect that the cost of performing the necessary evaluations and filing the documentation will be approximately $0.3 million. The estimated cost to comply with the seismic regulations and standards required by 2008, is an additional $10.1 million. Upon completion of the $10.1 million in improvements, the California facilities will be compliant with the requirements of the seismic regulations through 2029. We estimate that the majority of the square footage in our facilities will be compliant with the seismic regulations and standards required by 2030 once we have completed such $10.1 million in improvements, but we are unable at this time to estimate our costs for full compliance with the 2030 requirements. We are dependent on our senior management team and local management personnel, and the loss of the services of one or more of our senior management team or key local management personnel could have a material adverse effect on our business. The success of our business is largely dependent upon the services and management experience of our senior management team, which includes Charles N. Martin, Jr., our Chairman and Chief Executive Officer; William L. Hough, our President and Chief Operating Officer; Joseph D. Moore, our Executive Vice President, Chief Financial Officer and Treasurer, and Keith B. Pitts, our Vice Chairman. In addition, we depend on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our senior officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. We do not maintain key man life insurance policies on any of our officers. If we were to lose any of our senior management team or members of our local management teams, or if we are unable to attract other necessary personnel in the future, it could have a material adverse effect on our business, financial condition and results of operations. If we were to lose the services of one or more members of our senior management team or a significant portion of our hospital management staff at one or more of our hospitals, we would likely experience a significant disruption in our operations and failures of the affected hospitals to adhere to their respective business plans. Should we be unable to control our health care costs at Phoenix Health Plan, or if the health plan should lose its governmental contract, our profitability may be adversely affected. For the year ended June 30, 2001 and the three months ended September 30, 2001, our Phoenix Health Plan generated approximately 12.2% and 15.2% of our revenues, respectively, and 9.1% and 18.3%, of our Adjusted EBITDA, respectively, on a pro forma basis. Phoenix Health Plan derives substantially all of its revenues through a contract with the Arizona Health Care Cost Containment System (the "Arizona Health Care System"), which is the state agency that administers Arizona's state Medicaid program. The Arizona Health Care System pays capitated rates to Phoenix Health Plan and Phoenix Health Plan subcontracts with physicians, hospitals and other health care providers to provide services to its enrollees. If we fail to effectively manage our health care costs, these costs may exceed the payments we receive. Many factors can cause actual health care costs to exceed the capitated rates paid by the Arizona Health Care System, including: o our ability to contract with cost-effective health care providers; o the increased cost of individual health care services; o the type and number of individual health care services delivered; and o the occurrence of catastrophes, epidemics or other unforeseen occurrences. Our contract with the Arizona Health Care System expires on September 30, 2003, and although by its terms it is renewable annually by the Arizona Health Care System, it is terminable for any reason upon 90 days' notice. If this contract were terminated or not renewed or further extended, our profitability could be adversely affected by the loss of these revenues and cash flow. If claims brought against our facilities exceed the scope of our liability coverage or coverage is denied, our overall business results may suffer. Plaintiffs frequently bring actions against hospitals and other health care providers alleging malpractice, product liability or other legal theories. Many of these actions involve large claims and significant defense costs. To cover these claims, we self-insure our general and professional risks up to $1.0 million on a per-occurrence basis and up to $13.2 million on an aggregate per-claim basis. For losses above the self-insurance limits, we maintain insurance from unrelated commercial carriers on an occurrence basis for general liability and a claims-made basis for professional liability up to $100.0 million per occurrence and in the aggregate. Some of the claims, however, could exceed the scope of the coverage in effect or coverage of particular claims or damages could be denied. Furthermore, our insurance coverage may not continue to be available at a reasonable cost.