e10vk
 

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
     
(Mark One)    
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2006
OR
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          .
 
Commission File No. 0-26770
 
NOVAVAX, INC.
(Exact name of Registrant as specified in its charter)
 
     
Delaware   22-2816046
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
9920 Belward Campus Drive,   20850
Rockville, Maryland   (Zip Code)
(Address of principal executive offices)    
 
Registrant’s telephone number, including area code:
(240) 268-2000
 
Securities registered pursuant to Section 12(b) of the Act:
NONE
 
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, Par Value $0.01 per share
 
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No þ
 
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer o     Accelerated Filer þ     Non-Accelerated filer o
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
As of June 30, 2006, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant based on the closing sale price of such stock as reported by the NASDAQ National Market on such date was $242,418,088. For purposes of this calculation, shares of common stock held by directors, officers and stockholders whose ownership exceeds ten percent of the common stock outstanding at June 30, 2006 were excluded. Exclusion of such shares held by any person should not be construed to indicate that the person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the Registrant, or that the person is controlled by or under common control with the Registrant.
 
As of February 28, 2007, there were 61,845,090 shares of the Registrant’s Common Stock, par value $.01 per share, outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Registrant’s Definitive Proxy Statement to be filed no later than 120 days after the fiscal year ended December 31, 2006 in connection with the Registrant’s 2007 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K.
 


 

 
Table of Contents
 
                 
        Page No.
 
  Business   1
  Risk Factors   11
  Unresolved Staff Comments   25
  Properties   25
  Legal Proceedings   26
  Submission of Matters to a Vote of Security Holders   26
 
  Market for Registrant’s Common Equity and Related Stockholder Matters   26
  Selected Financial Data   28
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   28
  Quantitative and Qualitative Disclosures about Market Risk   43
  Financial Statements and Supplementary Data   44
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   44
  Controls and Procedures   44
  Other Information   45
 
  Directors, Executive Officers and Corporate Governance   45
  Executive Compensation   46
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   46
  Certain Relationships and Related Transactions and Director Independence   47
  Principal Accountant Fees and Services   47
 
  Exhibits and Financial Statement Schedules   47
  51
 
When used in this Annual Report on Form 10-K, except where the context otherwise requires, the terms “we”, “us”, “our”, “Novavax” and “the Company” refer to Novavax, Inc.


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Table of Contents
 
         
Index To The Consolidated Financial Statements
  Page No.
 
  F-2
Consolidated Financial Statements:
   
  F-5
  F-6
  F-7
  F-8
  F-9


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PART I
 
Item 1.   BUSINESS
 
This Annual Report on Form 10-K contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act that involve risks and uncertainties. In some cases, forward-looking statements are identified by words such as “believe,” “anticipate,” “intend,” “plan,” “will,” “may” and similar expressions. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this report. All of these forward-looking statements are based on information available to us at this time, and we assume no obligation to update any of these statements. Actual results could differ from those projected in these forward-looking statements as a result of many factors, including those identified in the section titled “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere. We urge you to review and consider the various disclosures made by us in this report, and those detailed from time to time in our filings with the Securities and Exchange Commission, that attempt to advise you of the risks and factors that may affect our future results.
 
Overview
 
Novavax, Inc., a Delaware corporation (“Novavax” or the “Company”) was incorporated in 1987, and is a biopharmaceutical company focused on creating differentiated, value-added vaccines that improve upon current preventive options for a range of infectious diseases. These vaccines leverage the Company’s virus-like particle (“VLP”) platform technology, Novasome® adjuvants and unique production technology. The Company also has a drug delivery platform based on micellar nanoparticles (“MNPs”), proprietary oil and water nanoemulsions used for the topical delivery of drugs. The MNP technology was the basis for Novavax’s first Food and Drug Administration — approved estrogen replacement product, ESTRASORB®.
 
In 2005, Novavax completed its transition from a specialty pharmaceutical company that sold and marketed women’s health products to an innovative, biopharmaceutical company focused on vaccines.
 
  •  In October 2005, the Company entered into a License and Supply Agreement for ESTRASORB with Esprit Pharma, Inc. (“Esprit”). Under this agreement, the Company continues to manufacture ESTRASORB, and Esprit has an exclusive license to sell ESTRASORB in North America.
 
  •  In April 2006, the Company entered into a License and Development Agreement and a Supply Agreement with Esprit to co-develop, supply and commercialize the Company’s MNP-based testosterone product candidate for the treatment of female hypoactive sexual desire disorder. Esprit was granted exclusive rights to market this product in North America.
 
The Company is now firmly focused on its VLP vaccine technology platform. VLPs imitate the three-dimensional structures of viruses but are composed of recombinant proteins believed to be incapable of causing infection and disease. The Company is initially focused on the influenza virus but is committed to expanding its product pipeline to numerous other infectious diseases.
 
Novavax has developed vaccines that target the H5N1, H9N2 and other subtypes of avian influenza with pandemic potential as well as vaccines that protect against seasonal influenza. In 2006, Novavax generated robust pre-clinical data that demonstrates its pandemic influenza vaccine can generate a protective immune response in relevant animal models, including the ferret. Data also show that a single VLP vaccine can provide cross-protection against a broad variety of influenza virus subtypes. The Company has begun toxicology studies required prior to the initiation of human clinical trials with its pandemic influenza vaccine and anticipates that human clinical trials could begin by mid-2007. The Company plans to conduct additional pre-clinical studies for its seasonal influenza VLP vaccine during 2007 with the goal of advancing to the clinic in the first half of 2008.
 
In addition, the Company has developed a unique production process for making its VLP-based vaccines using portable, disposable manufacturing technology that permits the development of the vaccine to be readily positioned where and when it is needed. This proprietary production technology uses insect cells rather than chicken eggs or mammalian cells, which can reduce lead time from many months to a matter of weeks. Because the equipment is


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both portable and disposable, it can be deployed quickly where needed and is capable of rapid scale-up to meet demand.
 
In summary, Novavax has a unique blend of capabilities including formulation and vaccine technologies, development infrastructure, including clinical; portable, disposable and scalable manufacturing; and commercial production facilities. Our strategy is to license our differentiated vaccine candidates at various stages of development to realize their value. The portfolio of our technologies and capabilities is summarized in the following table.
 
         
Technology/Capability
 
Description
 
Product/Examples
 
Recombinant vaccines
  Virus-like particle vaccines produced in cultured insect cells   Pandemic avian influenza & seasonal human influenza, HIV/AIDS, SARS and other infectious diseases
Novasomes®
  Non-phospholipid vesicles that can be used as adjuvants to enhance vaccine effectiveness; also serve as a vehicle for topical or oral drug delivery of certain molecules   Adjuvants for influenza and HIV-1 and other vaccines
Micellar Nanoparticles
  Oil and water nanoemulsion that allows topical systemic delivery of certain molecules   ESTRASORB® and ANDROSORBtm
Recombinant tolerogens
  Tolerization for prevention of inflammation leading to stroke and other diseases   E-Selectin tolerogen
Facilities
  Manufacturing using current Good Manufacturing Practices (‘‘cGMP”)   Clinical manufacturing for biologics, and clinical and commercial manufacturing for pharmaceuticals
 
Over the past twelve months, we have taken steps to strengthen our balance sheet and significantly improve our capital resources. In the first half of 2006, we completed two equity transactions through the sale of our common stock, with gross proceeds totaling $58.0 million. Also during the first half of 2006, holders of $7 million principal amount of our 4.75% senior convertible notes due July 19, 2009 exercised their optional right to convert their notes plus accrued interest into 1,294,564 shares of Novavax common stock, at the per share conversion price of $5.46. The licensing arrangement with Esprit for ESTRASORB added an additional $2.5 million of cash in October 2006. We believe the cash raised from these transactions provides us a strong foundation from which to execute our strategic plan. (see Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations, “Summary of Significant Transactions” for further details).
 
Our Strategy
 
The key elements of our business strategy are as follows:
 
  •  Leveraging our technological leadership in influenza vaccines.
 
Our recombinant VLP technology is well suited to create a differentiated vaccine against pandemic and seasonal influenza. This technology addresses several of the technical and logistical issues associated with a potential pandemic. It allows rapid creation of new vaccines that have high fidelity to emerging strains of influenza and the manufacturing process can be rapidly commissioned and scaled up. In addition, the technology provides the potential to differentiate a seasonal flu vaccine.


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  •  Maximizing the commercial impact of ESTRASORB and continuing to expand our drug delivery and formulation technologies.
 
After licensing the North American marketing rights for ESTRASORB and ANDROSORB to Esprit, we are looking to license the rights to market this product in other territories. In addition, we continue our efforts to improve the packaging of ESTRASORB to improve our margins on the product.
 
Our proven MNP technology has resulted in several product candidates that can be licensed to pharmaceutical companies. We have been able to demonstrate the benefits of our formulation for several compounds and are actively seeking to license these product candidates.
 
  •  Leveraging our formulation science to develop adjuvants for better vaccines.
 
Adjuvants improve immunogenicity of vaccines and they are becoming central for competitive advantage of new vaccines. Our inherent strengths in formulations are well suited to develop new adjuvants, such as Novasomes, that can lead to best-in-class vaccines. These adjuvants can also be products in themselves and can be licensed to other companies to be used with their antigens.
 
  •  Developing new technologies, evaluating strategic alliances and acquisitions and fortifying our intellectual property.
 
We continue to improve upon our current portfolio of technologies in formulations and vaccines. We believe these improvements will result in new intellectual property, making us more competitive.
 
  •  Leveraging collaborations and partnerships to advance products and technologies.
 
We are engaged in seeking collaborations and partnerships to develop and commercialize our products. These include partnerships with governmental and academic organizations as well as other industry partners.
 
Research and Development Activities
 
Biologics
 
We develop and produce biopharmaceutical proteins for use as vaccines against pandemic and seasonal influenza and other infectious diseases, and as tolerogens to prevent inflammatory responses in the initiation and progression of stroke and other illnesses. Our lead vaccine technology platform is based on virus-like particles (“VLPs”), which are self-assembling protein structures that resemble viruses. These are non-infectious particles that for many viral diseases have been shown in animal and human studies to make effective vaccines. VLPs closely mimic natural virus particles with repeating protein structures that can elicit broad and strong antibody and cellular immune responses, but lack the genetic material required for replication. We have several ongoing development programs involving VLP vaccines that address urgent medical needs, including pandemic and seasonal influenza, HIV-1/AIDS and other infectious diseases. We collaborate with governmental, commercial and leading academic institutions in development, safety testing and clinical trials.
 
Influenza VLP Vaccine.  According to the Center for Disease Control, every year between 5% and 20% of the U.S. population is infected by the influenza virus. While the severity of illness varies, influenza causes an estimated 36,000 deaths in the U.S. and 500,000 worldwide annually. These seasonal outbreaks have in recent years been caused by subtypes of influenza virus designated as H3N2 and H1N1. More recently, unexpected subtypes of avian origin have resulted in severe morbidity and mortality in a limited number of people. Highly pathogenic H5N1 influenza viruses are now widespread in poultry in Asia and have spread to some European countries, where they have been linked to human infection. Genetic reassortment between avian and human influenza subtypes, or genetic mutations, may lead to the emergence of a virus capable of causing worldwide illness, a pandemic.
 
All currently available influenza vaccines are produced by growing virus in chicken eggs, from which the virus is extracted and further processed. This 50- year-old production method requires six to nine month lead times and significant investment in fixed production facilities, which, once commissioned, cannot have their capacity easily increased. The vaccine shortage during the 2004 flu season highlighted the limitations of current production methods and the need for increased vaccine manufacturing capacity. It also heightened concerns regarding


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manufacturers’ capacity to respond to a pandemic, when the number of vaccine doses required will be higher than the number required for seasonal flu vaccines and lead times will be even shorter.
 
Novavax is applying its expertise in producing VLPs to develop vaccines for both seasonal and pandemic strains of influenza. We produce VLPs using a baculovirus expression system in insect cells with disposable, low-cost equipment that can be readily dispersed both nationally and internationally. By not requiring a fixed plant, production capacity can be increased quickly to whatever extent is required. Lead times for production are expected to be measured in weeks, not months. Proof-of-concept of the VLP approach in influenza has been obtained in various pre-clinical studies. In a recent study, co-expression of three genes (hemagglutinin, neuraminidase and matrix derived from the H9N2 influenza in insect cells) resulted in the self-assembly of influenza H9N2 VLPs. The H9N2 VLPs elicited protective immune responses in mice and ferrets. In view of these encouraging preclinical data, we have accelerated and prioritized the development of our VLP influenza vaccines. We have completed comprehensive pre-clinical studies in 2006 with the objective of initiating human clinical studies with influenza VLP vaccines in 2007.
 
HIV-1/AIDS VLP Vaccine.  The human toll of AIDS is staggering and now kills more people worldwide than any other infectious disease. Nearly 40 million people are infected with HIV-1, including four to six million people who were newly infected in 2005, according to the World Health Organization (“WHO”). Under a five-year National Institutes of Health (“NIH”) grant, which was awarded in 2003, we are working in collaboration with leading scientists from the University of Alabama — Birmingham, Emory University and Harvard Medical School in the development of a second-generation AIDS vaccine. In January 2007, the Company announced that it has significantly enhanced both the quality and purity of its VLP vaccine for HIV/AIDS. This second generation AIDS vaccine is based on the HIV-1 viral envelope with a natural three-dimensional structure to trigger a protective immune response. Preclinical studies are under way using the improved HIV-1 vaccine, and planning has begun to advance this new vaccine to human clinical trials in collaboration with the U.S. government. Early versions of Novavax’s VLP vaccine were successful in triggering immune responses in preclinical studies. Novavax scientists and its collaborators discovered a way to optimize the expression of the HIV-1 envelope, which is a principle target for immunity in humans.
 
SARS VLP Vaccine.  In 2005, the NIH awarded us a $1.1 million, three-year grant to develop a vaccine to prevent Severe Acute Respiratory Syndrome (“SARS”). SARS is a severe form of pneumonia, accompanied by a fever and caused by a coronavirus. WHO has reported over 8,000 SARS cases with nearly 800 deaths since the first case of SARS was reported in February 2003. Our SARS VLP vaccine is also based on the production of coronavirus-like VLPs in insect cells.
 
Hepatitis E Vaccine.  Hepatitis E is the most prevalent form of acute hepatitis in the developing world. Hepatitis E is transmitted through contaminated water and is indistinguishable from the disease caused by the Hepatitis A virus. The disease is rarely fatal, although the risk of death and the intensity of the illness increase with age, with pregnant women being at a particularly high risk.
 
In collaboration with the National Institute of Allergy and Infectious Disease, Walter Reed Army Institute for Research, and GlaxoSmithKline Pharmaceuticals, we have developed vaccines to prevent hepatitis caused by the Hepatitis E Virus. The recombinant Hepatitis E vaccine produced by us is in clinical trials conducted by GlaxoSmithKline. As reported in the New England Journal of Medicine (March 1, 2007), this recombinant Hepatitis E vaccine was evaluated for safety and efficacy in a phase II, randomized, double-blind, placebo-controlled trial in 2,000 healthy adults susceptible to Hepatitis E virus infection and found to be effective in the prevention of Hepatitis E. GlaxoSmithKline has commercial rights and we will share royalties with the NIH, if marketed.
 
E-Selectin Tolerogen.  In collaboration with the National Institute of Neurological Disorders and Stroke we have been developing E-selectin-based molecularly-derived products for the prevention of strokes. In September 2002, a published report in the professional journal Stroke provided experimental evidence on prevention of stroke in stroke-prone rats. These results provided supportive evidence that E-selectin tolerization may help in the prevention of strokes and other illness where inflammatory and immune responses are involved in the initiation and progression of disease. We were awarded a government contract for the pre-clinical development and manufacture of E-selectin for Phase I clinical trials to be run by the National Institute of Neurological Disease and Stroke and the NIH.


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Novasome Adjuvant Program.  Adjuvants are agents that enhance the immune response generated by antigens. As a consequence, smaller amounts of antigen can elicit the desired immune response, referred to as an antigen sparing effect. In addition, adjuvants may elicit responses from multiple components of the immune system leading to an improved level of immunity and protection. Novasomes, our proprietary adjuvants, are currently being evaluated in both the influenza and the HIV-1/AIDS VLP vaccine programs. Preclinical data have demonstrated an encouraging degree of improvement in immune responses with a variety of antigens. If warranted by future studies, Novasomes will be included in human studies of our VLP vaccines.
 
Formulation Science
 
The formulations group is committed to the creation and development of innovative and effective technologies for enhancing the performance of Active Pharmaceutical Ingredients (“APIs”) that are approved by the Food and Drug Administration (“FDA”). Use of APIs simplifies clinical testing and FDA approval because of the safety and efficacy records of the APIs. The key drivers for these research programs are those therapeutic segments and clinical conditions that cannot be satisfied by the conventional dosage forms.
 
We have two drug delivery platform technologies:
 
  •  Micellar Nanoparticles:  This is a nanotechnology-based, lotion-like formulation that has achieved a significant break through in transdermal therapeutics. Upon topical application, an MNP formulation deposits the API in both a readily available solution form as well as in a long-acting particulate depot form onto the skin. The inactive ingredients used in the formulation not only help in forming an occlusive barrier that acts as a pseudo-patch, but also drives the drug into the systemic circulation. Unlike conventional passive transdermal delivery systems such as patches, gels, and creams with chemical permeation enhancers, the MNPs have been shown to accommodate and deliver a wide spectrum of drugs having diverse lipophilicities (i.e., affinities for a hydrophobic or oil phase), molecular weights, melting points, and dosages.
 
  •  Novasomes:  These are non-phospholipid-based, proprietary vesicular structures that can be either used for delivery of drugs or as vaccine adjuvants. Typically, Novasomes can be utilized for encapsulation of both hydrophilic and lipophilic drugs. The formulation design enhances deposition and retention of the active ingredients within the superficial skin layers (epidermis) but limits their passage into the systemic circulation. Novasomes, when formulated as vaccine adjuvants for co-administration with a vaccine preparation, have demonstrated a significantly improved immunogenicity profile.
 
The focus of our drug delivery product development is transdermal delivery — both from a traditional and a non-traditional perspective. Traditionally, this route of administration is known to offer therapeutic benefits like avoiding hepatic first pass metabolism, overcoming stability and toxicity issues related to oral administration, and has been viewed as a non-invasive pathway to achieve drug transport into the systemic circulation through topical application. It is generally accepted that the best drug candidates for transdermal delivery are non-ionic, lipophilic and potent and have a low molecular weight and a low melting point. Our first set of product candidates falls in this category, which includes testosterone, nicotine, fentanyl, clonidine, loratadine and oxybutynin.
 
ESTRASORB, our first internally developed product, is a topical estradiol replacement lotion that helps validate the MNP-based transdermal technology. ESTRASORB is the first topical emulsion for estrogen therapy approved by the FDA for the treatment of moderate to severe vasomotor symptoms (hot flashes) associated with menopause. This product is unique in that it is the first commercial nanoparticle-based transdermal pharmaceutical product. ESTRASORB has undergone the complete product development-to-commercialization cycle. In October 2005, the Company licensed the marketing rights for ESTRASORB to Esprit. This licensing agreement has provided a cash consideration of $12.5 million within the first year as well as sales-based milestone payments and a double digit royalty on all sales. We retained rights to manufacture the product for Esprit at set prices and retained marketing rights for all territories outside of North America. However, the cost at which we manufacture ESTRASORB currently exceeds the fixed price at which we sell the product to Esprit.
 
Our MNP testosterone product candidate for the treatment of female hypoactive sexual disorder is the second product in our pipeline. In April 2006, we entered into a second License and Supply Agreement with Esprit to


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co-develop, supply and commercialize this MNP testosterone product candidate. Under the terms of the License Agreement, Esprit was granted exclusive rights to this MNP testosterone product candidate in North America. We will receive a royalty on all net sales of the product as well as milestone payments on specific pre-determined clinical and regulatory milestones. Esprit will be responsible for all development costs and will lead all clinical programs. Under the term of the Supply Agreement, we will be responsible for manufacturing the product.
 
The MNP platform addresses several issues related to product development:
 
  •  Ability to formulate APIs with a wider range of chemical characteristics compared to traditional transdermal drug delivery technologies.
 
  •  Rapid and reliable product development, optimization, and screening.
 
  •  More simple, quick, and cost-effective regulatory approval than the approval process for a New Chemical Entity.
 
Research and Development Funding
 
Total externally contracted research and development costs were $1.9 million in 2006, $1.8 million in 2005 and $1.7 million in 2004. Total internally-sponsored research and development costs were $9.8 million in 2006, $3.3 million in 2005 and $5.6 million in 2004. Our manufacturing start-up costs related to preparing our manufacturing facility for commercial production of ESTRASORB were included in research and development until April 2004, at which time the manufacturing costs have been included in cost of sales and inventory. Total manufacturing start-up costs related to ESTRASORB included in research and development were $1.7 million in 2004. Further development costs of $0.2 million for ESTRASORB were included in 2005 internally sponsored research and development costs.
 
Competition
 
Technologies
 
The biopharmaceutical industry is intensely competitive and is characterized by rapid technological progress. We compete in two primary technology areas — vaccines and transdermal pharmaceutical delivery.
 
We compete in a competitive and capital intensive vaccine arena. Our technology is based upon utilizing the baculovirus expression system in insect cells to make VLPs. We believe this system offers many advantages when compared to other technologies and is uniquely suited for developing pandemic and seasonal influenza vaccines as well as other infectious diseases. The table below provides a list of key competitors and corresponding influenza vaccine technologies.
 
     
Company
 
Competing Technology Description
 
Sanofi Pasteur, Inc.
  Inactivated sub-unit — egg based
Medimmune Vaccines, Inc.
  Nasal, live attenuated — cell based
GlaxoSmithKline Biologicals
  Inactivated — egg based
Novartis, Inc.
  Inactivated sub-unit — egg based
Merck & Co., Inc.
  Novel vaccines


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The transdermal drug delivery arena is highly competitive with a broad array of passive and active transdermal drug delivery technologies. Our technologies include MNPs and Novasomes. The MNP technology which is the basis for our FDA- approved product ESTRASORB competes with a number of companies and technologies. The following table highlights several competitors and their corresponding technologies.
 
     
Company
 
Competing Technology Description
 
Noven Pharmaceuticals
  Passive transdermal patches
Antares Pharma, Inc.
  Passive topical gels
Acrux Limited
  Passive metered dose transdermal spray
Solvay Group
  Passive topical gels
Alza Corporation
  Active transdermal — micro projection enhanced permeation, electro transport
Transpharma Medical Ltd.
  Active transdermal — radio-frequency enhanced permeation
Altea Therapeutics Corporation
  Active transdermal — thermally enhanced permeation
 
Hormone Therapy Products
 
Through ESTRASORB and our MNP testosterone product candidate, we continue to compete with specialty biopharmaceutical firms and large pharmaceutical companies in the U. S., Europe and elsewhere that are engaged in the discovery, development and marketing of hormone therapies, and other products that do or could compete with our currently marketed product and product candidates. These companies, as well as academic institutions, governmental agencies and private research organizations, also compete with us in recruiting and retaining highly qualified scientific personnel and consultants.
 
In 2005, we licensed ESTRASORB to Esprit. The estrogen therapy market is highly competitive, well-established and includes many products marketed by major pharmaceutical companies. The oral segment, which accounts for over 75% of the estrogen therapy market, is dominated by Wyeth’s Premarin®, an oral estrogen tablet. Wyeth commits significant resources to promoting its portfolio of estrogen products and has a dominant presence with healthcare professionals that utilize oral estrogen therapy products. Further, we compete with Wyeth and numerous other companies marketing oral products, including manufacturers of generic 17 -estradiol. Gynodiol, our marketed oral estrogen therapy product also competes in the crowded, competitive oral estrogen therapy market. Transdermal estrogen therapy products (patches) currently account for approximately 15% of the estrogen therapy market. Patch products are well accepted and many, such as Vivelle DOT®, have been marketed for several years. Solvay Pharmaceuticals, a large international pharmaceutical company, recently introduced an ethanol-based gel product, Estrogel that is directly competing with ESTRASORB. In addition to the currently approved and marketed products, several estrogen therapy products are in development.
 
New Products
 
In general, competition among pharmaceutical products is based in part on product efficacy, safety, reliability, availability, price and patent position. An important factor is the relative timing of the market introduction of our products and our competitors’ products. Accordingly, the speed with which we can develop products, complete the clinical trials and approval processes and supply commercial quantities of the products to the market is an important competitive factor. Our competitive position also depends upon our ability to attract and retain qualified personnel, obtain patent protection or otherwise develop proprietary products or processes, and secure sufficient capital resources for the often substantial period between technological conception and commercial sale.
 
Patents and Proprietary Rights
 
We generally seek patent protection for our technology and product candidates in the U.S. and abroad. We have submitted patent applications that are pending in the U.S. and other countries. The patent position of biotechnology


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firms generally is highly uncertain and involves complex legal and factual questions. Our success will depend, in part, on whether we can:
 
  •  Obtain patents to protect our own technologies and products;
 
  •  Obtain licenses to use the technologies of third parties, which may be protected by patents;
 
  •  Protect our trade secrets and know-how; and
 
  •  Operate without infringing the intellectual property and proprietary rights of others.
 
Patent rights; licenses.  Our licensors and we have patents and continue to seek patent protection for technologies that relate to our product candidates, as well as technologies that may prove useful for future product candidates. We currently have over 50 U.S. patents and corresponding foreign patents and patent applications relating to vaccines, biologics, and drug delivery systems and applications for various biological and chemical uses.
 
We have U.S. patent applications pending in both the U.S. and worldwide covering the composition, manufacture and use of our organized lipid structures and related technologies. A current U.S. patent issued in 1997 covers our MNP technology and methods of their production. In addition, the Company continues to build upon its technology portfolio and file appropriate intellectual property disclosures and patent applications.
 
Consistent with statutory guidelines issued under the Federal Technology Transfer Act of 1986 designed to encourage the dissemination of science and technology innovation and provide sharing of technology that has commercial potential, our collaborative research efforts with the U.S. government and with other private entities receiving federal funding provide that developments and results must be freely published, that information or materials supplied by us will not be treated as confidential and that we will be required to negotiate a license to any such developments and results in order to commercialize products. There can be no assurance that we will be able to successfully obtain any such license at a reasonable cost, or that such developments and results will not be made available to our competitors on an exclusive or nonexclusive basis.
 
Trade Secrets.  To a more limited extent, we rely on trade secret protection and confidentiality agreements to protect our interests. It is our policy to require employees, consultants, contractors, manufacturers, collaborators, and other advisors to execute confidentiality agreements upon the commencement of employment, consulting or collaborative relationships with us. We also require signed confidentiality agreements from any entity that is to receive confidential information. With respect to employees, consultants and contractors, the agreements generally provide that all inventions made by the individual while rendering services to us shall be assigned to us as our property.
 
Government Regulations
 
The development, production and marketing of pharmaceutical and biological products developed by Novavax or our collaborators is subject to regulation for safety, efficacy and quality by numerous governmental authorities in the U.S. and other countries. In the U. S., the development, manufacturing and marketing of human pharmaceuticals and vaccines are subject to extensive regulation under the federal Food, Drug, and Cosmetic Act, and biological products are subject to regulation both under provisions of that Act and under the Public Health Service Act. The FDA assesses the safety and efficacy of products and regulates, among other things, the testing, manufacture, labeling, storage, record keeping, and advertising and promotion. The process of obtaining FDA approval for a new product is costly and time-consuming.
 
Before applying for FDA approval to market any new drug product candidates, we must first submit an Investigational New Drug application (an “IND”) that explains to the FDA the results of pre-clinical testing conducted in laboratory animals and what we propose to do for human testing. At this stage, the FDA decides whether it is reasonably safe to move forward with testing the drug on humans. We must then conduct Phase I studies and larger-scale Phase II and III human clinical trials that demonstrate the safety and efficacy of our products to the satisfaction of the FDA. Once these trials are complete, a New Drug Application (an “NDA”) can be filed with the FDA requesting approval of the drug marketing.


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Vaccine clinical development follows the same general pathway as for drugs and other biologics. A sponsor who wishes to begin clinical trials with a vaccine must submit an IND describing the vaccine, its method of manufacture and quality control tests for release. Pre-marketing (pre-licensure) vaccine clinical trials are typically done in three phases. Initial human studies, referred to as Phase I, are safety and immunogenicity studies performed in a small number of closely monitored subjects. Phase II studies are dose-ranging studies and may enroll hundreds or thousands of subjects. Finally, Phase III trials typically enroll thousands of individuals and provide the critical documentation of effectiveness and important additional safety data required for licensing.
 
If successful, the completion of all three phases of clinical development can be followed by the submission of a Biologics License Application (a “BLA”). Also during this stage, the proposed manufacturing facility undergoes a pre-approval inspection during which production of the vaccine as it is in progress is examined in detail. Vaccine approval also requires the provision of adequate product labeling to allow health care providers to understand the vaccine’s proper use, including its potential benefits and risks, to communicate with patients and parents, and to safely deliver the vaccine to the public. Until a vaccine is given to the general population, all potential adverse events cannot be anticipated. Thus, many vaccines undergo Phase IV studies after a BLA has been approved and the vaccine is licensed and on the market.
 
In addition to obtaining FDA approval for each product, each domestic manufacturing establishment must be registered with the FDA, is subject to FDA inspection and must comply with current Good Manufacturing Practices (“cGMP”) regulations. To supply products for use either in the U.S. or outside the U.S., including clinical trials, U.S. and non — U.S. manufacturing establishments, including third-party facilities, must comply with cGMP regulations and are subject to periodic inspection by the corresponding regulatory agencies in their home country under reciprocal agreements with the FDA and/or by the FDA.
 
Preclinical studies may take several years to complete and there is no guarantee that the FDA will permit an IND based on those studies to become effective and the product to advance to clinical testing. Clinical trials may take several years to complete. After the completion of the required phases of clinical trials, if the data indicate that the drug or biologic product is safe and effective, a BLA or NDA (depending on whether the product is a biologic or pharmaceutical product) is filed with the FDA to approve the marketing and commercial shipment of the drug. This process takes substantial time and effort and the FDA may not accept the BLA or NDA for filing, and, even if filed, the FDA might not grant approval. FDA approval of a BLA or NDA may take up to two years and may take longer if substantial questions about the filing arise. The FDA may require post-marketing testing and surveillance to monitor the safety of the applicable products.
 
In addition to regulatory approvals that must be obtained in the U.S. an investigational product is also subject to regulatory approval in other countries in which it is intended to be marketed. No such product can be marketed in a country until the regulatory authorities of that country have approved an appropriate license application. FDA approval does not assure approval by other regulatory authorities. In addition, in many countries, the government is involved in the pricing of the product. In such cases, the pricing review period often begins after market approval is granted.
 
We are also subject to regulation under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Resource Conservation and Recovery Act and other present and potential federal, state or local regulations. These and other laws govern our use, handling and disposal of various biological and chemical substances used in, and wastes generated by, our operations. Our research and development involves the controlled use of hazardous materials, chemicals and viruses. Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by state and federal regulations, the risk of accidental contamination or injury from these materials cannot be completely eliminated. In the event of such an accident, we could be held liable for any damages that result, and any such liability could exceed our resources. Additionally, for formulations containing controlled substances, we are subject to Drug Enforcement Act (“DEA”) regulations.
 
There have been a number of federal and state proposals during the last few years to subject the pricing of pharmaceutical and biological products to government control and to make other changes to the medical care system of the U.S. It is uncertain what legislative proposals will be adopted or what actions federal, state or private payors for medical goods and services may take in response to any medical reform proposals or legislation. We


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cannot predict the effect medical or health care reforms may have on our business, and no assurance can be given that any such reforms will not have a material adverse effect.
 
Manufacturing
 
We have a 24,000 square foot manufacturing facility situated within a Cardinal Health, Inc. facility in Philadelphia, Pennsylvania. It is staffed by our employees and operates under our quality system. ESTRASORB, our first FDA-approved commercial product, is being manufactured at this facility. There have been no adverse 483 observations from FDA inspections associated with the production of ESTRASORB.
 
For our vaccine business, we have a research and development facility in Rockville, Maryland and have established laboratories and staff to support the non-GMP production and process development of more advanced manufacturing processes and product characterization method for our vaccine candidates. We have completed renovations of cGMP suites at this facility which will incorporate disposable cell culture equipment obtained from Wave Biotech to support the manufacturing requirements for early stage clinical trial materials for our pandemic and seasonal influenza vaccine candidates and other biologic products.
 
We intend to continue expanding our own product development and manufacturing capability while utilizing third-party contractors where we lack sufficient internal capability. Any plans to expand our internal manufacturing capabilities at our Rockville, Maryland facilities, including the facilities necessary to manufacture, test and package an adequate supply of finished products in order to meet our long term clinical needs, will require significant resources and will be subject to ongoing government approval and oversight.
 
We have the quality infrastructure to support release testing and stability evaluation of cGMP materials. We also have the regulatory support to ensure compliance with FDA and other regulatory authorities.
 
Sources of Supply
 
Most of the raw materials and other supplies required in our business are generally available from various suppliers in quantities adequate to meet our needs. In some cases, we currently have only one supplier for certain of our manufacturing components. We have plans in place to develop multiple suppliers for all critical supplies before the time we would put any of our product candidates into commercial production.
 
Marketing and Sales
 
We continue to explore opportunities for corporate alliances and partners to help develop and ultimately commercialize and market our product candidates. Our strategy is to enter into collaborative arrangements with pharmaceutical and other companies for some or all aspects of product development, manufacturing, marketing and sales of our products that will require broad marketing capabilities and overseas marketing. These collaborators are generally expected to be responsible for funding or reimbursing all or a portion of the development costs, including the costs of later stage clinical testing necessary to obtain regulatory clearances and for commercial scale manufacturing, in exchange for rights to market specific products in particular geographic territories.
 
Employees
 
As of February 28, 2007, we had 56 full-time employees and 4 part-time employees for a total of 60, 15 of whom hold M.D. or Ph.D. degrees and 7 of whom hold other advanced degrees. Of our total workforce, 48 are engaged primarily in research, development and manufacturing activities and 12 are engaged primarily in business development, finance and accounting and administrative functions. None of our employees are represented by a labor union or covered by a collective bargaining agreement, and we consider our employee relations to be good.
 
Availability of Information
 
Novavax was incorporated in 1987 under the laws of the State of Delaware. Our principal executive offices are located at 9920 Belward Campus Drive, Rockville, Maryland, 20850. Our telephone number is (240) 268-2000 and our Internet address is www.novavax.com. The contents of our website are not part of this Annual Report on Form 10-K.


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We make available, free of charge and through our website, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments to any such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after filed with or furnished to the Securities and Exchange Commission.
 
Item 1A.   RISK FACTORS
 
You should carefully consider the following risk factors in evaluating our business. There are a number of risk factors that could cause our actual results to differ materially from those that are indicated by forward-looking statements. Some of the risks described relate principally to our business and the industry in which we operate. Others relate principally to the securities market and ownership of our common stock. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect us. If any of the following risks occur, our business, financial condition or results of operations could be materially and adversely affected. You should also consider the other information included in this Annual Report on Form 10-K for the fiscal year ended December 31, 2006.
 
RISKS RELATED TO OUR BUSINESS
 
We have a history of losses and our future profitability is uncertain.
 
Our expenses have exceeded our revenues since our formation in 1987, and our accumulated deficit at December 31, 2006 was $165.0 million. Our net revenues for the last three fiscal years were $4.7 million in 2006, $7.4 million in 2005 and $8.3 million in 2004. We have received a limited amount of product-related revenue from research contracts, licenses and agreements to provide vaccine products, services and adjuvant technologies. We cannot be certain that we will be successful in entering into strategic alliances or collaborative arrangements with other companies that will result in other significant revenues to offset our expenses. Our net losses for the last three fiscal years were $23.1 million in 2006, $11.2 million in 2005 and $25.9 million in 2004.
 
Our historical losses have resulted from research and development expenses for our vaccine and drug delivery product candidates and sales and marketing expenses for ESTRASORB, protection of our intellectual property and other general operating expenses. Our losses increased due to the launch of ESTRASORB as we expanded our manufacturing capacity and sales and marketing capabilities. More recently, our losses have increased, and will continue to increase, as a result of higher research and development efforts to support the development of our pandemic and seasonal influenza vaccines.
 
We expect to continue to incur significant operating expenses and anticipate that our expenses and losses will increase in the foreseeable future as we seek to:
 
  •  initiate Phase I/II clinical trials for our pandemic and seasonal flu vaccines;
 
  •  initiate additional preclinical studies for other product candidates using our VLP vaccine technology platform;
 
  •  expand our manufacturing capacity, which will require that we build-out a portion of our research and development space as a Food and Drug Administration, or FDA, compliant and validated product manufacturing facility;
 
  •  relocate some of our business operations to a newly leased facility;
 
  •  maintain, expand and protect our intellectual property portfolio;
 
  •  hire additional clinical, quality control, scientific and management personnel; and
 
  •  add operations, financial, accounting, facilities engineering and information systems personnel, consistent with expanding our operations.
 
As a result, we expect our cumulative operating loss to increase until such time, if ever, product sales, licensing fees, royalties, milestones, contract research and other sources generate sufficient revenue to fund our continuing


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operations. We cannot predict when, if ever, we might achieve profitability and cannot be certain that we will be able to sustain profitability, if achieved.
 
We have repositioned ourselves from a specialty pharmaceutical company and face all the risks inherent in the implementation of a new business strategy.
 
In conjunction with the sale of our prenatal and related product lines coupled with the grant of an exclusive North American license to Esprit Pharma, Inc. to our lead product ESTRASORB during the second half of 2005, we have changed the focus of the Company from the development and commercialization of specialty pharmaceutical products to the research and development of new products using our proprietary drug delivery and biological platforms. We cannot predict whether we will be successful in implementing our new business strategy.
 
We intend to focus our research and development activities on areas in which we have particular strengths and on technologies that appear promising. These technologies often are on the cutting edge of modern science. As a result, the outcome of any research or development program is highly uncertain. Only a small fraction of these programs ultimately result in commercial products or even product candidates and a number of events could delay our development efforts and negatively impact our ability to obtain regulatory approval for, and to market and sell, a product candidate. Product candidates that initially appear promising often fail to yield successful products. In many cases, preclinical or clinical studies will show that a product candidate is not efficacious or that it raises safety concerns or has other side effects that outweigh their intended benefit. Success in preclinical or early clinical trials may not translate into success in large-scale clinical trials. Further, success in clinical trials will likely lead to increased investment, adversely affecting short-term profitability, to bring such products to market. Even after a product is approved and launched, general usage or post-marketing studies may identify safety or other previously unknown problems with the product, which may result in regulatory approvals being suspended, limited to narrow indications or revoked, or which may otherwise prevent successful commercialization.
 
We have limited financial resources and we are not certain that we will be able to maintain our operations or to fund the development of future products.
 
We do not expect to generate revenues from product sales, licensing fees, royalties, milestones, contract research or other sources in an amount sufficient to fund our operations, and we will therefore use our cash resources and expect to require additional funds to maintain our operations, continue our research and development programs, commence future preclinical studies and clinical trials, seek regulatory approvals and manufacture and market our products. We will seek such additional funds through public or private equity or debt financings, collaborative arrangements and other sources. We cannot be certain that adequate additional funding will be available to us on acceptable terms, if at all. If we cannot raise the additional funds required for our anticipated operations, we may be required to delay significantly, reduce the scope of or eliminate one or more of our research or development programs, downsize our general and administrative infrastructure, or seek alternative measures to avoid insolvency, including arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies, product candidates or products. If we raise additional funds through future offerings of shares of our common stock or other securities, such offerings would cause dilution of existing stockholders’ percentage ownership in the Company. These future offerings also could have a material and adverse effect on the price of common stock.
 
Many of our competitors have significantly greater resources and experience, which may negatively impact our commercial opportunities and those of our current and future licensees.
 
The biotechnology and pharmaceutical industries are subject to intense competition and rapid and significant technological change. We have many potential competitors, including major drug and chemical companies, specialized biotechnology firms, academic institutions, government agencies and private and public research institutions. Many of our competitors have significantly greater financial and technical resources, experience and expertise in:
 
  •  research and development;
 
  •  preclinical testing;


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  •  designing and implementing clinical trials;
 
  •  regulatory processes and approvals;
 
  •  production and manufacturing; and
 
  •  sales and marketing of approved products.
 
Principal competitive factors in our industry include:
 
  •  the quality and breadth of an organization’s technology;
 
  •  management of the organization and the execution of the organization’s strategy;
 
  •  the skill of an organization’s employees and its ability to recruit and retain skilled employees;
 
  •  an organization’s intellectual property portfolio;
 
  •  the range of capabilities, from target identification and validation to drug discovery and development to manufacturing and marketing; and
 
  •  the availability of substantial capital resources to fund discovery, development and commercialization activities.
 
Large and established companies such as Merck & Co., Inc., GlaxoSmithKline PLC, Novartis, Inc., Sanofi and Medimmune Inc., among others, compete in the vaccine market. In particular, these companies have greater experience and expertise in securing government contracts and grants to support their research and development efforts, conducting testing and clinical trials, obtaining regulatory approvals to market products, and manufacturing such products on a broad scale.
 
Smaller or early-stage companies and research institutions may also prove to be significant competitors, particularly through collaborative arrangements with large and established pharmaceutical or other companies. As these companies develop their technologies, they may develop proprietary positions, which may prevent or limit our product commercialization efforts. We will also face competition from these parties in recruiting and retaining qualified scientific and management personnel, establishing clinical trial sites and patient registration for clinical trials, and in acquiring and in-licensing technologies and products complementary to our programs or potentially advantageous to our business. If any of our competitors succeeds in obtaining approval from the FDA or other regulatory authorities for their products sooner than we do or for products that are more effective or less costly than ours, our commercial opportunity could be significantly reduced.
 
In order to effectively compete, we will have to make substantial investments in manufacturing and sales and marketing or partner with one or more established companies. There is no assurance that we will be successful in gaining significant market share for any product or product candidate. Our technologies and products also may be rendered obsolete or noncompetitive as a result of products introduced by our competitors to the marketplace more rapidly and at a lower cost.
 
We may have product liability exposure.
 
The administration of drugs to humans, whether in clinical trials or after marketing clearances are obtained, can result in product liability claims. We maintain product liability insurance coverage in the total amount of $10 million for claims arising from the use of our currently marketed products and products in clinical trials prior to FDA approval. Coverage is becoming increasingly expensive, however, and we may not be able to maintain insurance at a reasonable cost. There can be no assurance that we will be able to maintain our existing insurance coverage or obtain coverage for the use of our other products in the future. This insurance coverage and our resources may not be sufficient to satisfy liabilities resulting from product liability claims. A successful claim may prevent us from obtaining adequate product liability insurance in the future on commercially desirable items, if at all. Even if a claim is not successful, defending such a claim would be time-consuming and expensive, may damage our reputation in the marketplace, and would likely divert management’s attention.


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If we lose or are unable to attract key management or other personnel, we may experience delays in product development.
 
We depend on our senior executive officers as well as key scientific and other personnel. The loss of these individuals could harm our business and significantly delay or prevent the achievement of research, development or business objectives. We have not purchased key-man life insurance on any of our executive officers or key personnel, and therefore may not have adequate funds to find acceptable replacements for them. Competition for qualified employees is intense among pharmaceutical and biotechnology companies, and the loss of qualified employees, or an inability to attract, retain and motivate additional highly skilled employees required for the expansion of our activities, could hinder our ability to complete human studies successfully and develop marketable products.
 
We also rely from time-to-time on outside advisors who assist us in formulating our research and development and clinical strategy. We may not be able to attract and retain these individuals on acceptable terms, which could have a material adverse effect on our business, financial condition and results of operations.
 
We have experienced significant management turnover.
 
Our current President and Chief Executive Officer, Rahul Singhvi, assumed this responsibility in August 2005. Most of our executive officers have joined us since that time. This lack of management continuity, and the resulting lack of long-term history with our Company, could result in operational and administrative inefficiencies and added costs. If we were to experience additional turnover at the executive level, these risks would be exacerbated.
 
Our substantial indebtedness could adversely affect our cash flow and prevent us from fulfilling our obligations.
 
As of December 31, 2006, we had $23.2 million of outstanding indebtedness. Our substantial amount of outstanding indebtedness could have significant consequences. For example, it:
 
  •  could increase our vulnerability to general adverse economic and industry conditions;
 
  •  requires us to dedicate a substantial portion of our cash flow from operations to service payments on our indebtedness, reducing the availability of our cash flow to fund future capital expenditures, working capital, execution of our growth strategy, research and development costs and other general corporate requirements;
 
  •  could result in the acceleration of the maturity of our other financial obligations if a default under the terms of existing obligations were to occur;
 
  •  could limit our flexibility in planning for, or reacting to, changes in our business and the industry, which may place us at a competitive disadvantage compared with competitors that have less indebtedness; and
 
  •  could limit our ability to obtain additional funds, even when necessary to maintain adequate liquidity.
 
We may incur additional indebtedness for various reasons, which would increase the risks associated with our substantial leverage.
 
The conversion of our outstanding convertible debt, and the issuance of shares of our common stock upon conversion or exercise of preferred stock and/or warrants or in future offerings would cause dilution of existing security holders’ interests in the Company and may cause the price of our common stock to go down.
 
As of December 31, 2006, we had outstanding convertible notes in the aggregate principal amount of $22 million that as of such date were convertible into an aggregate of 4,029,304 shares of our common stock. The issuance of shares of our common stock upon conversion of such notes, as well as in connection with future capital raising activities, would cause immediate and potentially substantial equity dilution for existing stockholders and the price of our common stock could be subject to significant downward pressure.


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We have made loans to certain of our directors, which could have a negative impact on our stock price.
 
On March 21, 2002, pursuant to the Novavax, Inc. 1995 Stock Option Plan, the Company approved the payment of the exercise price of options by two of its directors through the delivery of full-recourse, interest-bearing promissory notes in the aggregate amount of $1,480,000. The borrowings accrue interest at 5.07% per annum and are secured by an aggregate of 261,667 shares of common stock owned by the directors. The notes were payable upon the earlier to occur of the following: (i) the date on which the director ceases for any reason to be a director of the Company (ii) in whole, or in part, to the extent of net proceeds, upon the date on which the director sells all or any portion of the pledged shares or (iii) payable in full on March 21, 2007.
 
In May 2006, one of these directors resigned from the Company’s Board of Directors. Following his resignation the Company approved an extension of the former director’s $448,000 note. The note continues to accrue interest at 5.07% per annum and is secured by 95,000 shares of common stock owned by the former director and is payable on December 31, 2007, or earlier to the extent of the net proceeds from any sale of the pledged shares.
 
The terms and interest rate remain unchanged for the promissory note for the active director and is due to be repaid in full on March 21, 2007.
 
Due to heightened sensitivity in the current environment surrounding related-party transactions, these transactions could be viewed negatively in the market and our stock price could be negatively affected. Our corporate governance policies have been revised and our 2005 Stock Incentive Plan prohibits any loans or guarantees to directors, officers or employees.
 
PRODUCT DEVELOPMENT RISKS
 
Because our product development efforts depend on new and rapidly evolving technologies, we cannot be certain that our efforts will be successful.
 
Our work depends on new, rapidly evolving technologies and on the marketability and profitability of innovative products. Commercialization involves risks of failure inherent in the development of products based on innovative technologies and the risks associated with drug development generally. These risks include the possibility that:
 
  •  these technologies or any or all of the products based on these technologies will be ineffective or unsafe, or otherwise fail to receive necessary regulatory clearances;
 
  •  the products, if safe and effective, will be difficult to manufacture on a large scale or uneconomical to market;
 
  •  proprietary rights of third parties will prevent us or our collaborators from exploiting technologies or marketing products; and
 
  •  third parties will market superior or equivalent products.
 
We have not completed the development of products other than ESTRASORB and we may not succeed in obtaining the FDA approval necessary to sell additional products.
 
The development, manufacture and marketing of our pharmaceutical and biological products are subject to government regulation in the U.S. and other countries. In the U.S. and most foreign countries, we must complete rigorous preclinical testing and extensive human clinical trials that demonstrate the safety and efficacy of a product in order to apply for regulatory approval to market the product. ESTRASORB is the only product developed by the Company to have been approved for sale in the U.S. Approval outside the U.S. may take longer or may require additional clinical trials. We also have product candidates in preclinical laboratory or animal studies.
 
The steps required by the FDA before our proposed investigational products may be marketed in the U.S. include:
 
  •  performance of preclinical (animal and laboratory) tests;


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  •  submissions to the FDA or an Investigational New Drug application (“IND”) which must become effective before human clinical trials may commence;
 
  •  performance of adequate and well-controlled human clinical trials to establish the safety and efficacy of the investigational product in the intended target population;
 
  •  performance of a consistent and reproducible manufacturing process intended for commercial use;
 
  •  submission to the FDA of a Biologics License Application (“BLA”) or a New Drug Application (“NDA”); and
 
  •  FDA approval of the BLA or NDA before any commercial sale or shipment of the product.
 
The processes are expensive and can take many years to complete, and we may not be able to demonstrate the safety and efficacy of our products to the satisfaction of such regulatory authorities. Regulatory authorities may also require additional testing and we may be required to demonstrate that our proposed products represents an improved form of treatment over existing therapies, which we may be unable to do so without conducting further clinical studies. Moreover, if the FDA grants regulatory approval of a product, the approval may be limited to specific indications or limited with respect to its distribution. Expanded or additional indications for approved drugs may not be approved, which could limit our revenues. Foreign regulatory authorities may apply similar limitations or may refuse to grant any approval. Consequently, even if we believe that preclinical and clinical data are sufficient to support regulatory approval for our product candidates, the FDA and foreign regulatory authorities may not ultimately grant approval for commercial sale in any jurisdiction. If our drug candidates are not approved, our ability to generate revenues may be limited and our business will be adversely affected.
 
We must identify products and product candidates for development with our technologies and establish successful third-party relationships.
 
Our long-term ability to generate product-related revenue depends in part on our ability to identify products and product candidates that may utilize our drug delivery and biological technologies. If internal efforts do not generate sufficient product candidates, we will need to identify third parties that wish to license our technologies for development of their products or product candidates. We may be unable to license our technologies to third parties for a number of reasons, including:
 
  •  an inability to negotiate license terms that would allow us to make an appropriate return from resulting products;
 
  •  an inability to identify suitable products or product candidates within, or complementary to, our areas of expertise; or
 
  •  an unwillingness on the part of competitors to utilize the technologies of a competing company.
 
Our near and long-term viability will also depend in part on our ability to successfully establish new strategic collaborations with pharmaceutical and biotechnology companies and government agencies. Establishing strategic collaborations and obtaining government funding is difficult and time-consuming. Potential collaborators may reject collaborations based upon their assessment of our financial, regulatory or intellectual property position; government agencies may reject contract or grant applications based on their assessment of public need, the public interest and our products’ ability to address these areas. If we fail to establish a sufficient number of collaborations or government relationships on acceptable terms, we may not generate sufficient revenue.
 
Even if we successfully establish new collaborations or obtain government funding, these relationships may never result in the successful development or commercialization of any product candidates or the generation of any sales or royalty revenue. Reliance on such relationships also exposes us to a number of risks. We may not have the ability to control the activities of our partner and cannot assure you that they will fulfill their obligations to us, including with respect to the license, development and commercialization of products and product candidates, in a timely manner or at all. We cannot assure you that such partners will devote sufficient resources to our products and product candidates or properly maintain or defend our intellectual property rights; we also can give no assurances that our partners will not utilize such rights in such a way as to invite or cause litigation. Any failure on the part of


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our partners to perform or satisfy their obligations to us could lead to delays in the development or commercialization of products and product candidates, and affect our ability to realize product revenues. Disagreements, including disputes over the ownership of technology developed with such collaborators, could result in litigation, which would be time-consuming and expensive, and may delay or terminate research and development efforts, regulatory approvals, and commercialization activities. If we or our partners fail to maintain our existing agreements or in the event we fail to establish agreements as necessary, we could be required to undertake research, development, manufacturing and commercialization activities solely at our own expense. These activities would significantly increase our capital requirements and, given our current limited sales, marketing and distribution capabilities, significantly delay the commercialization of products and product candidates.
 
Even though we have received governmental support in the past, we may not continue to receive support at the same level or at all.
 
The U.S. government, through its various agencies, has provided grants to fund certain research and development efforts. There can be no assurances that the Company will continue to receive the same level of funding from the U.S. government, if at all.
 
If we or our collaborators are unable to manufacture our products in sufficient quantities or are unable to obtain regulatory approvals for a manufacturing facility for our products, we may experience delays, and be unable to meet demand, and may lose potential revenues.
 
Completion of our clinical trials and commercialization of our product candidates require access to, or development of, facilities to manufacture a sufficient supply of our product candidates. We have limited experience manufacturing any of our product candidates in the volumes that will be necessary to support large-scale clinical trials or commercial sales. Efforts to establish capabilities, if pursued, may not meet initial expectations as to scheduling, reproducibility, yield, purity, cost, potency or quality.
 
If we or our collaborators are unable to manufacture our product candidates in clinical quantities or, when necessary, commercial quantities, then we will need to rely on third parties to manufacture compounds for clinical and commercial purposes. These third-party manufacturers must receive FDA approval before they can produce clinical material or commercial products. Our products may be in competition with other products for access to these facilities and may be subject to delays in manufacture if third parties give other products greater priority. In addition, we may not be able to enter into any necessary third-party manufacturing arrangements on acceptable terms, or on a timely basis. There are very few contract manufacturers who currently have the capability to produce our proposed product candidates, and the inability of any of these contract manufacturers to deliver our required quantities of product candidates on a timely basis and at commercially reasonable prices would negatively affect our operations.
 
Before we or our collaborators can begin commercial manufacturing of any of our product candidates, we or our collaborators must obtain regulatory approval of the manufacturing facility and process. Manufacturing of our proposed product candidates must comply with the FDA’s current Good Manufacturing Practices (“cGMP”) requirements, and non-U.S. regulatory requirements. The cGMP requirements govern quality control and documentation policies and procedures. In complying with cGMP and non-U.S. regulatory requirements, we will be obligated to expend time, money and effort in production, record keeping and quality control to assure that the product meets applicable specifications and other requirements. We or our collaborators must also pass a pre-approval inspection before FDA approval. If we or our collaborators fail to comply with these requirements, our product candidates would not be approved. If we or our collaborators fail to comply with these requirements after approval, we would be subject to possible regulatory action and may be limited in the jurisdictions in which we are permitted to sell our products. The FDA and non-U.S. regulatory authorities also have the authority to perform unannounced periodic inspections of our manufacturing facility to ensure compliance with cGMP and non- U.S. regulatory requirements.


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We rely on a limited number of suppliers for some of our manufacturing materials. Any problems experienced by any of these suppliers could negatively affect our operations.
 
We rely on third-party suppliers and vendors for some of the materials used in the manufacture of our product candidates. For supply of early clinical trial materials, we rely on a limited number of suppliers. Any significant problem experienced by one of our suppliers could result in a delay or interruption in the supply of materials to us until such supplier resolves the problem or an alternative source of supply is located. We have limited experience with alternative sources of raw materials. Any delay or interruption would negatively affect our operations.
 
We have limited marketing capabilities, and if we are unable to enter into collaborations with marketing partners or develop our own sales and marketing capability, we may not be successful in commercializing any approved products.
 
We currently have limited sales, marketing and distribution capabilities. As a result, we will depend on collaborations with third parties that have established distribution systems and sales forces. To the extent that we enter into co-promotion or other licensing arrangements, our revenues will depend upon the efforts of third parties, over which we may have little or no control. If we are unable to reach and maintain agreements with one or more pharmaceutical companies or collaborators, we may be required to market our products directly. Developing a marketing and sale force is expensive and time consuming and could delay a product launch. We cannot be certain that we will be able to attract and retain qualified sales personnel or otherwise develop this capability.
 
If reforms in the health care industry make reimbursement for our potential products less likely, the market for our potential products will be reduced, and we will lose potential sources of revenue.
 
Our successes may depend, in part, on the extent to which reimbursement for the costs of therapeutic products and related treatments will be available from third-party payers such as government health administration authorities, private health insurers, managed care programs, and other organizations. Over the past decade, the cost of health care has risen significantly, and there have been numerous proposals by legislators, regulators, and third-party health care payors to curb these costs. Some of these proposals have involved limitations on the amount of reimbursement for certain products. Similar federal or state health care legislation may be adopted in the future and any products that we or our collaborators seek to commercialize may not be considered cost-effective. Adequate third-party insurance coverage may not be available for us to establish and maintain price levels that are sufficient for realization of an appropriate return on our investment in product development. Moreover, the existence or threat of cost control measures could cause our corporate collaborators to be less willing or able to pursue research and development programs related to our product candidates.
 
RISKS FROM COLLABORATION RELATIONSHIPS AND STRATEGIC ACQUISITIONS
 
The return on our investment in ESTRASORB depends in large part on the success of our relationship with Esprit Pharma, Inc. and our ability to manufacture the product.
 
In October 2005, we entered into a License Agreement and a Supply Agreement with Esprit Pharma Inc., (“Esprit”) for ESTRASORB. Under the License agreement, we granted Esprit exclusive rights to market ESTRASORB in North America.
 
While our License Agreement with Esprit gives us some limited protections with respect to that company’s ESTRASORB marketing and sales efforts and, we believe, creates incentives for Esprit consistent with our own, we cannot control the amount and timing of the marketing efforts that Esprit devotes to ESTRASORB or make any assurances that Esprit’s promotion and marketing of ESTRASORB in North America will be successful. We do not have a history of working together with Esprit and cannot predict the success of the collaboration, nor can we give any assurances that Esprit will not reduce or curtail its efforts to market ESTRASORB because of factors affecting its business or operations beyond our control. Loss of Esprit as a partner in the commercialization of ESTRASORB, any dispute over the terms of our decisions regarding the License and Supply Agreements, or other adverse developments in our relationship with Esprit may harm our business and might accelerate our need for additional capital. We also can give no assurances that Esprit will be more successful than us in gaining market acceptance of ESTRASORB. Prescription trends for ESTRASORB have not met our expectations to date and Esprit will face


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similar obstacles to gaining market share of the estrogen therapy market, including competition from large and established companies with similar estrogen therapy products.
 
Numerous companies worldwide currently produce and sell estrogen products for clinical indications identical to those for ESTRASORB. Currently, the oral and patch product segment account for approximately 75% and 15% of the market, respectively, according to 2004 Verispan data. Wyeth commits significant resources to the sale and marketing of its product, Premarin®, in order to maintain its market leadership position. Several other companies compete in the estrogen category including Berlex Laboratories, Inc., Novartis Pharma AG and Solvay Pharmaceuticals. In particular, Solvay has introduced an alcohol-based gel product, Estrogel, which is directly competitive with ESTRASORB. These and other products sold by our competitors have all achieved a degree of market penetration superior to ESTRASORB.
 
In addition, under the Supply Agreement, we are obligated to supply Esprit with ESTRASORB through the manufacture of the product at our manufacturing facility in Philadelphia, Pennsylvania. We have only limited experience with the large capacity manufacturing required for the commercial sale of a product. Although we have validated our manufacturing methods for the product with the FDA, we will remain subject to that agency’s rules and regulations regarding cGMP, which are enforced by the FDA through its facilities inspection program. Compliance with such rules and regulations requires us to spend substantial funds and hire and retain qualified personnel. We face the possibility that we may not be able to meet Esprit’s supply requirements under the agreement in a timely fashion at acceptable quality, quantity and prices or in compliance with applicable regulations. If our facility fails to comply with applicable regulations, we will be forced to utilize a third party contractor to manufacture the product. We may not be able to enter into alternative manufacturing arrangements at commercially acceptable rates, if at all. Moreover, the manufacturers we use may not provide sufficient quantities of product to meet our specifications or our delivery, cost and other requirements.
 
We must utilize our manufacturing facility for products other than ESTRASORB in order to avoid operating the facility at a loss.
 
Currently we are manufacturing ESTRASORB at our facility in Philadelphia, Pennsylvania at a loss and it is likely we will continue to manufacture ESTRASORB at a loss until production volumes increase or we enter into additional contract manufacturing agreements with third parties to more fully utilize our manufacturing facility’s capacity. The facility is able to accommodate much greater production capacity than its current schedule, which, if more fully utilized, would offset the fixed costs related to the manufacturing process and facility. In addition, we are negotiating revisions to our agreements for packaging costs of ESTRASORB as well as our fixed lease costs for the manufacturing facility. If these negotiations result in higher packaging or lease costs for us, it may have a material adverse impact on future financial results.
 
Our plan to use collaborations to leverage our capabilities and to grow in part through the strategic acquisition of other companies and technologies may not be successful if we are unable to integrate our partners’ capabilities or the acquired companies with our operations or if our partners’ do not meet expectations.
 
As part of our strategy, we intend to continue to evaluate strategic partnership opportunities and consider acquiring complementary technologies and businesses. In order for our future collaboration efforts to be successful, we must first identify partners whose capabilities complement and integrate well with ours. Technologies to which we gain access may prove ineffective or unsafe. Our current agreements that grant us access to such technologies may expire and may not be renewed. Our partners may prove difficult to work with or less skilled than we originally expected. In addition, any past collaborative successes are no indication of potential future success. In order to achieve the anticipated benefits of an acquisition, we must integrate the acquired company’s business, technology and employees in an efficient and effective manner. The successful combination of companies in a rapidly changing biotechnology industry may be more difficult to accomplish than in other industries. The combination of two companies requires, among other things, integration of the companies’ respective technologies and research and development efforts. We cannot assure you that this integration will be accomplished smoothly or successfully. The difficulties of integration are increased by the necessity of coordinating geographically separated organizations and addressing possible differences in corporate cultures and management philosophies. The integration of certain


19


 

operations will require the dedication of management resource that may temporarily distract attention from the day-to-day operations of the combined companies. The business of the combined companies may also be disrupted by employee retention uncertainty and lack of focus during integration. The inability of management to integrate successfully the operations of the two companies, in particular, to integrate and retain key scientific personnel, or the inability to integrate successfully two technology platforms, could have a material adverse effect on our business, results of operations and financial condition.
 
Our collaboration agreements may prohibit us from conducting research in areas that may compete with our collaboration products, while our collaborators may not be limited to the same extent. This could negatively affect our ability to develop products and, ultimately, prevent us from achieving a continuing source of revenues.
 
We anticipate that some of our corporate or academic collaborators will be conducting multiple product development efforts within each disease area that is the subject of its collaboration with us. We generally have agreed not to conduct independently, or with any third party, certain research that is competitive with the research conducted under our collaborations. Therefore, our collaborations may have the effect of limiting the areas of research that we may pursue, either alone or with others. Some of our collaborators, however, may develop, either alone or with others, products in related fields that are competitive with the products or potential products that are the subject of their collaborations with us. In addition, competing products, either developed by the collaborators or to which the collaborators have rights, may result in their withdrawing support for our product candidates.
 
Generally under our academic collaborations, we retain the right to exclusively license any technologies developed using funding we provided. If we elect to not license a particular technology, the academic collaborator is typically free to use the technology for any purpose, including the development and commercialization of products that might compete with our products.
 
Because we depend on third parties to conduct some of our laboratory testing and human studies, we may encounter delays in or lose some control over our efforts to develop products.
 
We are dependent on third-party research organizations to conduct some of our laboratory testing and human studies. If we are unable to obtain any necessary testing services on acceptable terms, we may not complete our product development efforts in a timely manner. If we rely on third parties for laboratory testing and human studies, we may lose some control over these activities and become too dependent upon these parties. These third parties may not complete testing activities on schedule or when we request. We may not be able to secure and maintain suitable research organizations to conduct our laboratory testing and human studies.
 
REGULATORY RISKS
 
We may fail to obtain regulatory approval for our products on a timely basis or comply with our continuing regulatory obligations after approval is obtained.
 
Delays in obtaining regulatory approval can be extremely costly in terms of lost sales opportunities and increased trial costs. The speed with which we complete our clinical trials and our applications for marketing approval will depend on several factors, including the following:
 
  •  the rate of patient enrollment and retention, which is a function of many factors, including the size of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the study and the nature of the protocol;
 
  •  Institutional Review Board approval of the protocol and the informed consent form;
 
  •  prior regulatory agency review and approval;
 
  •  our ability to manufacture or obtain sufficient quantities of materials for use in clinical trials;
 
  •  negative test results or side effects experienced by trial participants;


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  •  analysis of data obtained from preclinical and clinical activities, which are susceptible to varying interpretations and which interpretations could delay, limit or prevent regulatory approval;
 
  •  changes in the policies of regulatory authorities for drug or vaccine approval during the period of product development; and
 
  •  the availability of skilled and experienced staff to conduct and monitor clinical studies and to prepare the appropriate regulatory applications.
 
We have limited experience in conducting and managing the preclinical studies and clinical trials necessary to obtain regulatory marketing approvals. We may not be able to obtain the approvals necessary to conduct clinical trials. We also face the risk that the results of our clinical trials may be inconsistent with the results obtained in preclinical studies or that the results obtained in later phases of clinical trials may be inconsistent with those obtained in earlier phases. A number of companies in the specialty biopharmaceutical and product development industry have suffered significant setbacks in advanced clinical trials, even after experiencing promising results in early animal and human testing.
 
Furthermore, even if a product gains regulatory approval, such approval is likely to limit the indicated uses for which it may be marketed and the product and the manufacturer of the product will be subject to continuing regulatory review, including adverse event reporting requirements and the FDA’s general prohibition against promoting products for unapproved uses. Failure to comply with any post-approval requirements can, among other things, result in warning letters, product seizures, recalls, fines, injunctions, suspensions or revocations of marketing licenses, operating restrictions and criminal prosecutions. Any of these enforcement actions, any unanticipated changes in existing regulatory requirements or the adoption of new requirements, or any safety issues that arise with any approved products, could adversely affect our ability to market products and generate revenues and thus adversely affect our ability to continue our business.
 
We also may be restricted or prohibited from marketing or manufacturing a product, even after obtaining product approval, if previously unknown problems with the product or its manufacture are subsequently discovered and we cannot assure you that newly discovered or developed safety issues will not arise following any regulatory approval. With the use of any drug by a wide patient population, serious adverse events may occur from time to time that initially do not appear to relate to the drug itself, and only if the specific event occurs with some regularity over a period of time does the drug become suspect as having a casual relationship to the adverse event. Any safety issues could cause us to suspend or cease marketing of our approved products, possibly subject us to substantial liabilities, and adversely affect our ability to generate revenues and our financial condition.
 
Because we are subject to environmental, health and safety laws, we may be unable to conduct our business in the most advantageous manner.
 
We are subject to various laws and regulations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals, emissions and wastewater discharges, and the use and disposal of hazardous or potentially hazardous substances used in connection with our research, including infectious disease agents. We also cannot accurately predict the extent of regulations that might result from any future legislative or administrative action. Any of these laws or regulations could cause us to incur additional expense or restrict our operations.
 
We have facilities in Maryland and Pennsylvania that are subject to various local, state and federal laws and regulations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals and the use and disposal of hazardous or potentially hazardous substances, including chemicals, micro-organisms and various hazardous compounds used in connection with our research and development activities. In the U.S. these laws include the Occupational Safety and Health Act, the Toxic Test Substances Control Act and the Resource Conservation and Recovery Act. We cannot eliminate the risk of accidental contamination or discharge or injury from these materials. Federal, state, and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. We could be subject to civil damages in the event of an improper or unauthorized release of, or exposure of individuals to, these hazardous materials. In addition, claimants may sue us for injury or contamination that results from our use or the use by third parties of these materials, and our liability


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may exceed our total assets. Compliance with environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development or production efforts.
 
Although we have general liability insurance, these policies contain exclusions from insurance against claims arising from pollution from chemical or pollution from hazardous. Our collaborators are working with these types of hazardous materials in connection with our collaborations. In the event of a lawsuit or investigation, we could be held responsible for any injury we or our collaborators cause to persons or property by exposure to, or release of, any hazardous materials. However, we believe that we are currently in compliance with all applicable environmental and occupational health and safety regulations.
 
INTELLECTUAL PROPERTY RISKS
 
Our success depends on our ability to maintain the proprietary nature of our technology.
 
Our success in large part depends on our ability to maintain the proprietary nature of our technology and other trade secrets, including our proprietary drug delivery and biological technologies. To do so, we must prosecute and maintain existing patents, obtain new patents and pursue trade secret and other intellectual property protection. We also must operate without infringing the proprietary rights of third parties or letting third parties infringe our rights. We currently have over 50 U.S. patents and corresponding foreign patents and patent applications covering our technologies. However, patent issues relating to pharmaceuticals involve complex legal, scientific and factual questions. To date, no consistent policy has emerged regarding the breadth of biotechnology patent claims that are granted by the U.S. Patent and Trademark Office or enforced by the federal courts. Therefore, we do not know whether our patent applications will result in the issuance of patents, or that any patents issued to us will provide us with any competitive advantage. We also cannot be sure that we will develop additional proprietary products that are patentable. Furthermore, there is a risk that others will independently develop or duplicate similar technology or products or circumvent the patents issued to us.
 
There is a risk that third parties may challenge our existing patents or claim that we are infringing their patents or proprietary rights. We could incur substantial costs in defending patent infringement suits or in filing suits against others to have their patents declared invalid or claim infringement. It is also possible that we may be required to obtain licenses from third parties to avoid infringing third-party patents or other proprietary rights. We cannot be sure that such third-party licenses would be available to us on acceptable terms, if at all. If we are unable to obtain required third-party licenses, we may be delayed in or prohibited from developing, manufacturing or selling products requiring such licenses.
 
Although our patents include claims covering various features of our products and product candidates, including composition, methods of manufacture and use, our patents do not provide us with complete protection against the development of competing products. Some of our know-how and technology is not patentable. To protect our proprietary rights in unpatentable intellectual property and trade secrets, we require employees, consultants, advisors and collaborators to enter into confidentiality agreements. These agreements may not provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use or disclosure.
 
If we infringe or are alleged to infringe intellectual property rights of third parties, it will adversely affect our business, financial condition and results of operations.
 
Our research, development and commercialization activities, including any product candidates or products resulting from these activities, may infringe or be claimed to infringe patents owned by third parties and to which we do not hold licenses or other rights. There may rights we are not aware of, including applications that have been filed but not published that, when issued, could be asserted against us. These third parties could bring claims against us and that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay research, development, manufacturing or sales of the product or biologic drug candidate that is the subject of the suit.
 
As a result of patent infringement claims, or in order to avoid potential claims, we may choose or be required to seek a license from the third party. These licenses may not be available on acceptable terms, or at all. Even if we are


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able to obtain a license, the license would likely obligate us to pay license fees or royalties or both, and the rights granted to us might be nonexclusive, which could result in our competitors gaining access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations, if, as a result of actual or threatened patent infringement claims, we are unable to enter into licenses on acceptable terms. All of the issues described above could also impact our collaborators, which would also impact the success of the collaboration and therefore us.
 
There has been substantial litigation and other proceedings regarding patent and other intellectual property rights in the pharmaceutical and biotechnology industries. In addition to infringement claims against us, we may become a party to other patent litigation and other proceedings, including interference proceedings declared by the U.S. Patent and Trademark Office and opposition proceedings in the European Patent Office, regarding intellectual property rights with respect to our products and technology.
 
We may become involved in lawsuits to protect or enforce our patents or the patents of our collaborators or licensors, which could be expensive and time consuming.
 
Competitors may infringe our patents or the patents of our collaborators or licensors. As a result, we may be required to file infringement claims to counter infringement for unauthorized use. This can be expensive, particularly for a company of our size, and time-consuming. In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover its technology. An adverse determination of any litigation or defense proceedings could put one or more of our patents at risk of being invalidated or interpreted narrowly and could put our patent applications at the risk of not issuing.
 
Interference proceedings brought by the U.S. Patent and Trademark Office may be necessary to determine the priority of inventions with respect to our patent applications or those of our collaborators or licensors. Litigation or interference proceedings may fail and, even if successful, may result in substantial costs and distraction to our management. We may not be able, alone or with our collaborators and licensors, to prevent misappropriation of our proprietary rights, particularly in countries where the laws may not protect such rights as fully as in the U.S.
 
Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation. In addition, during the course of this kind of litigation, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If investors perceive these results to be negative, the market price for our common stock could be significantly harmed.
 
We may need to license intellectual property from third parties and if our right to use the intellectual property we license is affected, our ability to develop and commercialize our product candidates may be harmed.
 
We expect that we will need to license intellectual property from third parties in the future and that these licenses will be material to our business. We will not own the patents or patent applications that underlie these licenses and we will not control the enforcement of the patents. We will rely upon our licensors to properly prosecute and file those patent applications and prevent infringement of those patents.
 
While many of the licenses under which we have rights provide us with exclusive rights in specified fields, the scope of our rights under these and other licenses may be subject to dispute by our licensors or third parties. In addition, our rights to use these technologies and practice the inventions claimed in the licensed patents and patent applications are subject to our licensors abiding by the terms of those licenses and not terminating them. Any of our licenses may be terminated by the licensor if we are in breach of a term or condition of the license agreement, or in certain other circumstances.
 
Our product candidates and potential product candidates will require several components that may each be the subject of a license agreement. The cumulative license fees and royalties for these components may make the commercialization of these product candidates uneconomical.


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If patent laws or the interpretation of patent laws change, our competitors may be able to develop and commercialize our discoveries.
 
Important legal issues remain to be resolved as to the extent and scope of available patent protection for biotechnology products and processes in the U.S. and other important markets outside the U.S., such as Europe and Japan. Foreign markets may not provide the same level of patent protection as provided under the U.S. patent system. We expect that litigation or administrative proceedings will likely be necessary to determine the validity and scope of certain of our and others’ proprietary rights. Any such litigation or proceeding may result in a significant commitment of resources in the future and could force us to do one or more of the following: cease selling or using any of our products that incorporate the challenged intellectual property, which would adversely affect our revenue; obtain a license from the holder of the intellectual property right alleged to have been infringed, which license may not be available on reasonable terms, if at all; and redesign our products to avoid infringing the intellectual property rights of third parties, which may be time-consuming or impossible to do. In addition, changes in, or different interpretations of, patent laws in the U.S. and other countries may result in patent laws that allow others to use our discoveries or develop and commercialize our products. We cannot assure you that the patents we obtain or the unpatented technology we hold will afford us significant commercial protection.
 
RISKS RELATED TO OUR COMMON STOCK AND ORGANIZATIONAL STRUCTURE
 
Because our stock price has been and will likely continue to be volatile, the market price of our common stock may be lower or more volatile than you expected.
 
Our stock price has been highly volatile. The stock market in general and the market for biotechnology companies in particular have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. From January 1, 2006 through March 9, 2007, the closing price of our common stock has been as low as $2.77 per share and as high as $8.31 per share. The market price of our common stock may be influenced by many factors, including:
 
  •  future announcements about our Company or our collaborators or competitors, including the results of testing, technological innovations or new commercial products;
 
  •  negative regulatory actions with respect to ESTRASORB or our product candidates or regulatory approvals with respect to our competitors’ products;
 
  •  depletion of our cash reserves and/or the approach of our convertible debt maturity date if additional revenues are not generated or additional capital is not raised;
 
  •  changes in government regulations;
 
  •  developments in our relationships with our collaboration partners;
 
  •  announcements relating to health care reform and reimbursement levels for new drugs;
 
  •  announcement by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
 
  •  sales of substantial amounts of our stock by existing stockholders (including stock by insiders or 5% stockholders);
 
  •  litigation;
 
  •  public concern as to the safety of our products;
 
  •  significant set-backs or concerns with the industry or the market as a whole; and
 
  •  the other factors described in this “Risk Factor” section.
 
The stock market has experienced extreme price and volume fluctuation that have particularly affected the market price for many emerging and biotechnology companies. These fluctuations have often been unrelated to the operating performance of these companies. These broad market fluctuations may cause the market price of our common stock to be lower or more volatile than expected.


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We have never paid dividends on our capital stock, and we do not anticipate paying any such dividends in the foreseeable future.
 
We have never paid cash dividends on our common stock. We currently anticipate that we will retain all of our earnings for use in the development of our business and do not anticipate paying any cash dividends in the foreseeable future. As a result, capital appreciation, if any, of our common stock would be the only source of gain for stockholders until dividends are paid if at all.
 
Provisions of our Certificate of Incorporation and By-laws, Delaware law, and our Shareholder Rights Plan could delay or prevent the acquisition of the Company, even if such acquisition would be beneficial to stockholders, and could impede changes in our Board.
 
Our organizational documents could hamper a third party’s attempt to acquire, or discourage a third party from attempting to acquire control of, the Company. We have also adopted a shareholder rights plan, or “poison pill,” that empowers our Board to delay or negotiate, and thereby possibly thwart, any tender offer or takeover attempt the Board opposes. Stockholders who wish to participate in these transactions may not have the opportunity to do so. These provisions also could limit the price investors are willing to pay in the future for our securities and make it more difficult to change the composition of our Board in any one year. These provisions include the right of the Board to issue preferred stock with rights senior to those of common stock without any further vote or action by stockholders, the existence of a staggered Board with three classes of directors serving staggered three-year terms and advance notice requirements for stockholders to nominate directors and make proposals.
 
The Company also is afforded the protections of Section 203 of the Delaware General Corporation Law, which will prevent us from engaging in a business combination with a person who acquires at least 15% of our common stock for a period of three years from the date such person acquired such common stock, unless advance board or stock holder approval was obtained.
 
Any delay or prevention of a change of control transaction or changes in our Board of Director or management could deter potential acquirers or prevent the completion of a transaction in which our stockholders could receive a substantial premium over the then current market price for their shares.
 
Item 1B.   UNRESOLVED STAFF COMMENTS
 
None.
 
Item 2.   PROPERTIES
 
We have current operations in four leased facilities. In January 2007, we commenced a lease for approximately 51,200 square feet in Rockville, Maryland, which is our new corporate headquarters and will include administrative offices, vaccine research and development along with future expansion activities. We lease approximately 13,900 square feet at our other facility in Rockville, Maryland for contract vaccine research, development and manufacturing of early stage clinical supplies. We lease approximately 32,900 square feet for administrative office space and research and development activities at our former corporate headquarters in Malvern, Pennsylvania of which approximately 28,000 square feet is being subleased. Our manufacturing facility for ESTRASORB and other contract manufacturing is located in Philadelphia, Pennsylvania, where we lease approximately 24,000 square feet of manufacturing space. We believe that these facilities are sufficient for our current needs. We have additional space in our current facilities to accommodate our anticipated growth over the next several years.


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A summary of our current facilities is set forth below.
 
             
    Approximate
     
Property Location
  Square Footage    
Purpose
 
Rockville, MD
    51,200     Corporate headquarters and vaccine research and development
Rockville, MD
    13,900     Vaccine research and development and early clinical phase manufacturing
Malvern, PA
    32,900     Former corporate headquarters and research and development
Philadelphia, PA
    24,000     Manufacturing and packaging facility for ESTRASORB
             
Total square footage
    122,000      
Malvern, PA sublease
    (28,000 )    
             
Net square footage
    94,000      
             
 
We had another approximately 2,800 square foot facility in Pacific Grove, California for product research and development activities which was closed in January 2007. The lease expired on January 31, 2007.
 
Item 3.   LEGAL PROCEEDINGS
 
The Company is a defendant in a lawsuit filed in December 2003 by a former director alleging that the Company wrongfully terminated the former director’s stock options. In April 2006, a directed verdict in favor of the Company was issued and the case was dismissed. The plaintiff has filed an appeal with the court. Management believes the lawsuit is without merit and the likelihood of an unfavorable outcome of such appeal is minimal. Accordingly, no liability related to this contingency is accrued in the consolidated financial statements as of December 31, 2006.
 
Item 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matters were submitted to a vote of our security holders during the fourth quarter of the fiscal year ended December 31, 2006.
 
PART II
 
Item 5.   MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
Our common stock trades on the NASDAQ National Market System under the symbol “NVAX”. The following table sets forth the range of high and low closing sale prices for our common stock as reported on The NASDAQ National Market for each quarter in the two most recent years:
 
                 
Quarter Ended
  High     Low  
 
March 31, 2006
  $ 8.31     $ 3.88  
June 30, 2006
  $ 7.62     $ 4.19  
September 30, 2006
  $ 4.99     $ 2.84  
December 31, 2006
  $ 5.30     $ 3.67  
March 31, 2005
  $ 3.35     $ 1.35  
June 30, 2005
  $ 1.64     $ 1.13  
September 30, 2005
  $ 2.56     $ 0.70  
December 31, 2005
  $ 6.01     $ 1.67  


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On March 9, 2007, the last sale price reported on the NASDAQ National Market for our common stock was $3.11. Our common stock was held by approximately 12,000 stockholders of record as of February 28, 2007, one of which is Cede & Co., a nominee for Depository Trust Company (or “DTC”). All of the shares of common stock held by brokerage firms, banks and other financial institutions as nominees for beneficial owners are deposited into participant accounts at DTC, and are therefore considered to be held of record by Cede & Co. as one stockholder. We have not paid any cash dividends on our common stock since our inception. We do not anticipate declaring or paying any cash dividends in the foreseeable future.
 
Securities Authorized for Issuance under our Equity Compensation Plans
 
Information regarding our equity compensation plans, including both stockholder approved plans and non-stockholder approved plans, is included in Item 12. of this Annual Report on Form 10-K.
 
Unregistered Sales of Equity Securities; Use of Proceeds from Registered Securities
 
During the year ended December 31, 2005, the Company issued unregistered shares of its common stock to two individuals. In August 2005, the Company issued 50,000 shares of restricted common stock to its former Chairman of the Board, Denis M. O’Donnell, M.D., in connection with his separation from the Company as an employee.
 
Also in August 2005, the Company issued 250,000 shares of restricted common stock to Nelson M. Sims, the Company’s former President, Chief Executive Officer and director, in connection with his separation from the Company. The Company issued the shares pursuant to Section 4(2) of the Securities Act of 1933 and received no cash consideration. In accordance with his separation agreement, Mr. Sims agreed to the cancellation of all then-outstanding options and other rights to purchase shares of the Company. In exchange, Mr. Sims received his salary through the date of resignation and reimbursement of certain expenses. The Company also agreed to pay him severance benefits, part of which included the 250,000 shares of restricted common stock.
 
In July 2004, the Company issued 952,381 shares of common stock at $5.25 per share, for gross proceeds of $5.0 million to an accredited investor in reliance on Regulation D promulgated under the Securities Act of 1933, as amended. A resale registration statement was filed and declared effective in August 2004.
 
Also in July 2004, the Company entered into definitive agreements for the private placement of $35 million aggregate principal amount of senior convertible notes to a group of private investors. The notes carry a 4.75% coupon, payable semi-annually, mature on July 19, 2009 and are currently convertible into 4,029,304 shares of Novavax common stock at $5.46 per share.
 
Issuer Purchases of Equity Securities
 
During the fiscal year ended December 31, 2006, the Company purchased 19,393 shares of Novavax common stock from various participants’ 401(K) retirement plan at an average price of $4.79 per share.


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Item 6.   SELECTED FINANCIAL DATA
 
The following table sets forth selected financial data for each of the years in the five-year period ended December 31, 2006. The information below should be read in conjunction with our financial statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in the Annual Report on Form 10-K. These historical results are not necessarily indicative of results that may be expected for future periods.
 
                                         
    For the Years Ended December 31,  
    2002     2003     2004     2005     2006  
    (In thousands, except per share data)  
 
Statements of Operations Data:
                                       
Revenues
  $ 15,005     $ 11,785     $ 8,260     $ 7,388     $ 4,683  
Loss from operations
    (21,558 )     (16,054 )     (24,464 )     (9,171 )     (24,607 )
Net loss
    (22,697 )     (17,273 )     (25,920 )     (11,174 )     (23,068 )
Basic and diluted net loss per share
  $ (0.93 )   $ (0.58 )   $ (0.70 )   $ (0.26 )   $ (0.39 )
Shares used in computing basic and diluted net loss per share
    24,433,868       29,852,797       36,926,034       42,758,302       58,664,365  
                                         
    As of December 31,  
    2002     2003     2004     2005     2006  
 
Balance Sheet Data:
                                       
Cash and investments
  $ 3,005     $ 27,633     $ 17,876     $ 31,893     $ 73,595  
Total current assets
    6,242       32,062       23,937       37,611       77,342  
Working capital
    378       27,226       15,361       32,735       72,003  
Total assets
    57,505       84,159       77,993       84,382       121,877  
Long term debt, less current portion
    41,103       41,100       35,970       29,678       22,458  
Accumulated deficit
    (87,527 )     (104,800 )     (130,720 )     (141,894 )     (164,962 )
Total stockholders’ equity
    8,073       35,944       33,281       49,652       94,001  
 
Item 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Certain statements contained herein or as may otherwise be incorporated by reference herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, but are not limited to, statements regarding product sales, royalties, milestone payments and other information related to license agreements and collaboration arrangements, governmental grant applications, future licensing of our products, future product development and related clinical trials, manufacturing capabilities and future research and development, including Food and Drug Administration approval. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from those expressed or implied by such forward-looking statements.
 
Such factors include, among other things, the following: general economic and business conditions; competition; ability to enter into future collaborations; collaborators may delay or terminate their relationship with us; our ability to obtain government funding; unexpected changes in technologies and technological advances; our ability to obtain rights to technology; ability to obtain and enforce patents; ability to commercialize and manufacture products; our ability to maintain commercial-scale manufacturing capabilities; results of clinical studies; progress of research and development activities; business abilities and judgment of personnel; our ability to be able to attract and retain qualified personnel; changes in, or failure to comply with, governmental regulations; changes in intellectual property laws, health care legislation or other federal and state laws to which the Company is subject; or substantial indebtedness; the rate at which we utilize capital; our ability to obtain adequate financing in


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the future through product licensing, co-promotional arrangements, public or private equity financing or otherwise; and other factors referenced herein.
 
All forward-looking statements contained in this annual report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements, except as specifically required by law. Accordingly, past results and trends should not be used to anticipate future results or trends.
 
Overview
 
Novavax, Inc., a Delaware corporation (“Novavax” or the “Company”), was incorporated in 1987, and is a biopharmaceutical company focused on creating differentiated, value-added vaccines that leverage the Company’s proprietary virus-like particle (“VLP”) technology as well as its proprietary Novasomes® adjuvants. VLPs imitate the three-dimensional structures of viruses but are composed of recombinant proteins and therefore, are believed incapable of causing infection and disease. Our proprietary production technology uses insect cells rather than chicken eggs or mammalian cells. The Company’s product targets include vaccines against the H5N1, H9N2 and other subtypes of avian influenza with pandemic potential and against human seasonal influenza as well as other infectious diseases. The Company also has a drug delivery platform based on its micellar nonparticle (“MNP”) technology, proprietary oil and water nano emulsions used for the topical delivery of drugs. The MNP technology was the basis for the development of the Company’s first Food and Drug Administration — approved estrogen replacement product, ESTRASORB®.
 
During 2005, Novavax transitioned from a specialty pharmaceutical company, which included the sale and marketing of products serving the women’s health space, to an innovative, biopharmaceutical company.
 
  •  In October 2005, the Company entered into a License and Supply Agreement for ESTRASORB with Esprit Pharma, Inc. (“Esprit”). Under these agreements, the Company continues to manufacture ESTRASORB and Esprit has an exclusive license to sell ESTRASORB in North America.
 
  •  In April 2006, the Company entered into a License and Development Agreement and a Supply Agreement with Esprit to co-develop, supply and commercialize the Company’s MNP-based testosterone product candidate for the treatment of female hypoactive sexual desire disorder. Esprit was granted exclusive rights to market the product in North America.
 
The Company has a unique blend of capabilities consisting of formulation technologies, vaccine technologies and drug development infrastructure, including clinical and commercial production facilities. We are leveraging our capabilities to develop differentiated, value-added vaccine products and licensing them at various stages of development to realize their value.
 
Summary of Significant Transactions
 
License and Development Agreement and Supply Agreement with Espirit Pharma, Inc.
 
In October 2005, we entered into License and Supply Agreements for ESTRASORB with Esprit Pharma, Inc. Under the License Agreement, Esprit obtained exclusive rights to market ESTRASORB in North America and we will continue to manufacture ESTRASORB.
 
In consideration for the rights granted, Esprit paid us a minimum cash consideration of $12.5 million: $2.0 million which was paid at closing, $8.0 million which was paid in December 2005, and $2.5 million which was paid in October 2006 on the first anniversary date of the License Agreement. We receive royalties on all net sales of ESTRASORB as well as milestone payments based on specific pre-determined net sales levels of ESTRASORB. In 2005, we wrote off $2.2 million, the remaining net balance of the intangible asset for ESTRASORB rights at the date of the transaction. As part of this transaction, Esprit also paid us $0.3 million for inventory and sales and promotional materials for which we had a book value of $0.4 million. We incurred $20,000 of fees related to this transaction and recorded a gain of $10.1 million.
 
In April 2006, we entered into a License and Development Agreement and a Supply Agreement with Esprit to co-develop, supply and commercialize our MNP testosterone product candidate for the treatment of female


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hypoactive sexual desire disorder. Under the terms of the License and Development Agreement, Esprit was granted exclusive rights to market any products developed and approved in North America. We will receive a royalty on all net sales of the product as well as milestone payments on specific pre-determined clinical and regulatory milestones. Esprit will be responsible for all development costs and will lead all clinical programs. Under the term of the Supply Agreement, we will be responsible for manufacturing any product.
 
Sublease Agreement with PuriCore, Inc.
 
In April 2006, we entered into a sublease agreement with Sterilox Technologies, Inc. (now known as PuriCore, Inc.) to sublease 20,469 square feet of the Company’s Malvern, Pennsylvania corporate headquarters at a premium price per square foot. The new sublease, with a commencement date of July 1, 2006, expires on September 30, 2009. This sublease is consistent with our strategic focus to increase our presence in Rockville, Maryland, where our vaccine operations are currently located. In line with that strategy, in October 2006, we entered into a lease for an additional 51,000 square feet in Rockville, Maryland. Accordingly, in October 2006, the Company entered into an Amendment to the Sublease Agreement with PuriCore, Inc. to sublease an additional 7,500 square feet of the Malvern corporate headquarters at a premium price per square foot. This amendment has a commencement date of October 25, 2006 and expires concurrent with the initial lease on September 30, 2009.
 
License Agreement Renewal with IGI, Inc.
 
In December 2005, we received a $1,000,000 payment from IGI, Inc. in accordance with an option in a licensing agreement signed between the Company and IGI in December 1995. This payment gives IGI a ten-year renewal on licensed technologies in specific fields and was recorded as licensing fee income for the year ended December 31, 2005.
 
Asset Purchase Agreement with Pharmelle, LLC (the “Pharmelle Transaction”)
 
In September 2005, as part of the Company’s strategic repositioning, we entered into an Asset Purchase Agreement with Pharmelle, LLC for the sale of assets related to the AVC Cream and Suppositories, NovaNatal and NovaStart products, as well as assets relating to certain formerly-marketed products. The assets sold included, but were not limited to, intellectual property, the New Drug Application for AVC products, inventory and sales and promotional materials. In connection with the sale, Pharmelle agreed to assume (i) those liabilities and obligations arising after the closing date of the transaction in connection with the performance by Pharmelle of certain assumed contracts, (ii) those liabilities and obligations arising after the closing date in connection with products sold by Pharmelle after the closing date or the operation of the business relating to such products or the assets after such date (including any product liability claims associated with such products), and (iii) all liability and responsibility for returns of the products made after the closing date, regardless of when such products were produced, manufactured or sold.
 
In consideration for the sale of these assets, Pharmelle paid us $2.5 million in cash and assumed the liabilities noted above. In addition, we are entitled to royalties on AVC for a five-year period if net sales exceed certain levels. During 2005, we wrote off $1.1 million, the net balance of the intangible assets related to the AVC product acquisition and $0.3 million of inventory, recorded a $0.3 million liability for future obligations and recorded a gain on the transaction of $0.8 million.
 
In July 2006, we entered into an amendment to the Asset Purchase Agreement with Pharmelle, LLC, to revise the royalty formula. We are now entitled to royalties on AVC products for a five-year period based on a percentage of gross margins if net sales exceed certain levels. We did not record any royalty income under this agreement during 2006.
 
Pharmelle has sold the asset and assigned the Asset Purchase Agreement to Azur Pharma Inc. in early 2007.


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Equity Financing Transactions
 
In March 2006, we completed an agent-led equity offering of 5,205,480 shares of common stock at $7.30 per share, for gross proceeds of $38.0 million. The stock was offered and sold pursuant to an existing shelf registration statement. Net proceeds were approximately $36.1 million.
 
In February 2006, we completed an offering of 4,597,700 shares of common stock at $4.35 per share for gross proceeds of $20.0 million to a group of institutional investors including Kleiner Perkins Caufield & Byers and Prospect Venture Partners. The stock was offered and sold pursuant to an existing shelf registration statement. Net proceeds were approximately $19.9 million.
 
In November 2005, we completed an agent-led offering of 4,186,047 shares of common stock at $4.30 per share, for gross proceeds of $18.0 million. The stock was issued pursuant to an existing shelf registration statement with net proceeds of approximately $17.0 million.
 
In July 2005, we completed an agent-led offering of 4,000,000 shares of common stock at $1.00 per share, for gross proceeds of $4.0 million. The stock was issued pursuant to an existing shelf registration statement with net proceeds of approximately $3.6 million.
 
Convertible Notes Conversion
 
In March 2006, certain holders of $7.0 million principal amount of our 4.75% senior convertible notes due July 15, 2009 exercised their optional right to convert their notes plus accrued interest of $68,000 into 1,294,564 shares of Novavax common stock, at the per share conversion price of $5.46. This reduced the aggregated principal of such notes outstanding from $29.0 million to $22.0 million at December 31, 2006.
 
In October 2005, certain holders of $6.0 million face amount of our 4.75% senior convertible notes due July 15, 2009 exercised their optional right to convert their notes plus accrued interest of $81,000 into 1,070,635 shares of Novavax common stock, at the per share conversion price of $5.68. This reduced the aggregate principal amount of such notes outstanding from $35.0 million to $29.0 million at December 31, 2005.
 
Restructuring of the Sales Force
 
From March through August 2005, we implemented measures to reduce costs associated with our commercial operations by downsizing and then eliminating our sales force to correspond with our strategy of transitioning from a commercial business model to one focused on our core competency of new product development. The March 2005 restructuring reduced our sales force from 100 to 47 employees and the August restructuring eliminated the remaining sales force. Included in 2005 sales and marketing expenses is $0.4 million related to these two restructurings.
 
Cancellation of King Pharmaceuticals Agreements
 
In January 2001, we entered into a co-promotion agreement with King Pharmaceuticals, Inc. (“King”) for our topical estrogen therapy, ESTRASORB, in the U.S. and Puerto Rico (the “Territory”). We also entered into a license agreement with King for many countries outside the U.S. The co-promotion and license agreements (the “Agreements”) granted King the right to share equally in the revenues and expenses for manufacturing and marketing ESTRASORB in the Territory and exclusive rights to many countries outside the U.S. The Agreements also entitled us to up to $5.0 million in milestone payments from King for achievement of milestones outlined in the Agreements.
 
In June 2001, we amended the Agreements (the “Amended Agreements”). The Amended Agreements clarified the terms of two milestone payments totaling $5.0 million. The Amended Agreements also granted King exclusive rights to promote, market and distribute ESTRASORB in Canada, Switzerland, Greece, Italy, Spain and the Netherlands, the only countries excluded from the original license agreement. In addition, the Amended Agreements included the co-promotion and license of a topical testosterone therapy for testosterone deficient women that was in development.


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In July 2004, we mutually agreed to terminate the Amended Agreements (the “King Transaction”). The King Transaction included the return to us of all worldwide rights for ESTRASORB and the MNP testosterone product candidate, as well as all rights to other women’s health products that we may successfully develop utilizing the MNP technology. The King Transaction also included the redemption of $40.0 million of our convertible notes held by King. Additionally, we hired 50 members of King’s women’s health sales force to provide competitive sales force coverage. As part of this transaction, we paid King a net of $14.0 million in cash and issued King 3,775,610 shares of common stock, which at the time of closing were valued at approximately $18.1 million.
 
The King Transaction resulted in a gain on the redemption of the convertible notes held by King of $11.2 million for the year ended December 31, 2004. This gain was determined based on the fair value of the convertible notes plus accrued interest as of the transaction date compared to the notes’ total book value. In addition, an intangible asset for ESTRASORB rights of $2.5 million was recorded, which represents the difference between assets and liabilities acquired or written off, the net cash paid in the transaction, the common stock issued and transaction fees and expenses. The recorded intangible was determined to be a fair value for the rights re-acquired based on the sales levels of ESTRASORB, the status of obtaining product approvals outside the U.S. and the deferred further development of the MNP testosterone product candidate. Included in the assets and liabilities written off were deferred financing costs of $0.4 million relating to the convertible notes held by King, and remaining deferred revenue of $2.2 million relating to previous licensing fees for ESTRASORB, mentioned above.
 
Critical Accounting Policies and Use of Estimates
 
We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the U.S. Such accounting principles require that our management make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical and anticipated results and trends and on various other assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results could differ materially from these estimates. The items in our consolidated financial statements that have required us to make significant estimates and judgments are as follows:
 
Revenue Recognition and Allowances
 
The Company recognizes revenue in accordance with the provisions of Staff Accounting Bulleting No. 104, Revenue Recognition (“SAB No. 104”). For product sales, revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed and determinable and collectibility is reasonably assured. The Company establishes allowances for estimated uncollectible amounts, product returns, rebates and charge backs based on historical trends and specifically identified problem accounts. A large part of the Company’s product sales are to Esprit or to distributors who resell the products to their customers. The Company provides rebates to members of certain buying groups who purchase from the Company’s distributors, to distributors that sell to their customers at prices determined under a contract between the Company and the customer, and to state agencies that administer various programs such as the federal Medicaid and Medicare programs. Rebate amounts are usually based upon the volume of purchases or by reference to a specific price for a product. The Company estimates the amount of the rebate that will be paid, and records the liability as a reduction of revenue when the Company records our sale of the products. Settlement of the rebate generally occurs from three to 12 months after sale. The Company regularly analyzes the historical rebate trends and makes adjustments to recorded reserves for changes in trends, distributor inventory levels, product prescription data and generic competition and makes adjustments to the recorded reserves for changes in trends, distributor inventory levels, product prescription data and generic competition and makes adjustments to the recorded reserves based on such information.
 
Under the terms of the Asset Purchase Agreement with Pharmelle, LLC, the Company no longer has responsibility for rebates or returns related to AVCtm Cream and Suppositories, NovaNatal and NovaStart as of the date of the sales of such assets. Under the License and Supply Agreements with Esprit Pharma, Inc., the Company


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no longer has responsibility for rebates related to ESTRASORB or returns related to ESTRASORB sales made subsequent to entering into the License Agreement on October 19, 2005.
 
The shipping and handling costs the Company incurs are included in cost of products sold in its statements of operations.
 
For upfront payments and licensing fees related to contract research or technology, the Company follows the provisions of SAB No. 104 in determining if these payments and fees represent the culmination of a separate earnings process or if they should be deferred and recognized as revenue as earned over the life of the related agreement. Milestone payments are recognized as revenue upon achievement of contract-specified events and when there are no remaining performance obligations. Revenue earned under research contracts is recognized in accordance with the terms and conditions of such contracts for reimbursement of costs incurred and defined milestones.
 
Stock-Based Compensation
 
Prior to January 1, 2006, the Company’s equity-based employee compensation cost under its various stock incentive and option plans was accounted for under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, as permitted by Standard of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”)
 
Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standard No. 123 (revised), Accounting for Stock-based Payment (“SFAS No. 123R”) using the modified-prospective method. This standard requires the Company to measure the cost of employee services received in exchange for equity share options granted based on the grant-date fair value of options. The cost is recognized as compensation expense over the vesting period of the options.
 
Research and Development
 
Research and development costs are expensed as incurred. Such costs include internal research and development expenditures (such as salaries and benefits, raw materials and supplies) and contracted services (such as sponsored research, consulting and testing services) of proprietary research and development activities and similar expenses associate with collaborative research agreements.
 
Income Taxes
 
The Company’s income taxes are accounted for using the liability method. Under the liability method, deferred income taxes are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss carry forward. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled.
 
The effect of changes in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. A valuation allowance is established when necessary to reduce net deferred tax assets to the amount expected to be realized. The Company has provided a full valuation allowance against its net deferred tax assets as of December 31, 2006 and 2005.
 
Goodwill and Intangible Assets
 
Goodwill originally results from business acquisitions. Assets acquired and liabilities assumed are recorded at their fair values; the excess of the purchase price over the identifiable net assets acquired is recorded as goodwill. Other intangible assets are a result of product acquisitions, non-compete arrangements and internally discovered patents. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”) goodwill and intangible assets deemed to have indefinite lives are not amortized but are subject to impairment tests annually, or more frequently should indicators of impairment arise. The Company utilizes a discounted cash flow analysis that includes profitability information, estimated future operating results, trends and other information in assessing whether the value of the indefinite-lived intangible assets can be recovered. Under SFAS No. 142, goodwill


33


 

impairment is deemed to exist if the carrying value of a reporting unit exceeds its estimated fair value. In accordance with the requirements of SFAS No. 142, the Company initially tested its goodwill for impairment as of January 1, 2002 and determined that no impairment was present. The Company thereafter performed the required annual impairment test as of December 31 of each year on the carrying amount of its goodwill.
 
The Company evaluates the recoverability of the carrying value of its long-lived assets and identifiable intangibles periodically and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. Examples of events or changes in circumstances that indicate that the recoverability of the carrying value of an asset should be assessed include but are not limited to the following: a significant decrease in the market value of an asset, a significant change in the extent or manner in which an asset is used, a significant physical change in an asset, a significant adverse change in legal factors or in the business climate that could affect the value of an asset, an adverse action or assessment by a regulator, an accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset, a current period operating or cash flow loss combined with a history of operating or cash flow losses, and/or a projection of forecast that demonstrates continuing losses associate with an asset used for the purpose of producing revenue. The Company considers historical performance and anticipated future results in its evaluation of potential impairment. Accordingly, when indicators of impairment are present, the Company evaluates the carrying value of these assets in relation to the operating performance of the business and future discounted and undiscounted cash flows is less than the assets’ carrying value.
 
Recent Accounting Pronouncements
 
Other than the adoption of Statement of Financial Accounting Standards No. 123 (revised), Accounting for Stock-Based Payment (“SFAS No. 123R”), there have been no material changes in our critical accounting policies or critical accounting estimates since December 31, 2005, nor have we adopted any accounting policy that has or will have a material impact on our consolidated financial statements. For further discussion of our accounting policies see Note 2 “Summary of Significant Accounting Policies” in the Notes to the Consolidated Financial Statements included herewith.
 
SFAS No. 123R
 
As of January 1, 2006 (“effective date”), we adopted SFAS No. 123R in accounting for stock options issued to our employees, directors and consultants using the modified prospective method. The modified prospective method requires that compensation costs be recognized for all share-based payments granted after the effective date and for all awards granted prior to the effective date that are unvested using the requirements of SFAS No. 123R. Prior to the adoption of SFAS No. 123R, we accounted for our stock-based compensation using the principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”) as permitted by Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (“SFAS No. 123”). APB No. 25 generally did not require that options granted to employees be expensed. Since we elected to use the modified prospective method, there are no one-time effects from the adoption of SFAS No. 123R, such as a cumulative effect adjustment.
 
There were no modifications to outstanding stock options as of December 31, 2005 and 2006. There have been no changes in the quantity or type of instruments used in share-based payment programs. There has been no material modifications to the valuation methodologies or assumptions from those used in estimating the fair value of options under SFAS No. 123 other than the adjustments for expected volatility. Prior to the adoption of SFAS. No. 123R, we utilized the preceding 12 month period historical stock prices in determining the expected volatility. With the adoption of SFAS No. 123R, we use the historical volatilities based on stock prices since the inception of the stock plans in determining the expected volatility. Forfeiture rates are estimated based on historical activities since the inception of the stock plans. There have been no changes in the normal terms of share-based payments agreements. For grants awarded prior to January 1, 2006, we accounted for compensation cost using a graded method. For grants awarded on or after January 1, 2006, we accounted for compensation cost using a straight-line method. As December 31, 2006, the aggregate fair value of the remaining compensation cost of unvested options, as determined using a Black-Scholes option valuation model, was approximately $2.4 million (net of estimated forfeitures). This remaining compensation costs is expected to be recognized over a weighted average period of 1.7 years.


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The effects of adopting SFAS No. 123R are recorded as compensation costs in the operating costs and expenses as follows:
 
         
    Twelve Months
 
    Ended
 
    December 31,
 
    2006  
    (In thousands)  
 
Cost of products sold (which includes idle capacity)
  $ 48  
Research and development
    547  
General and administrative
    1,167  
         
Total effect of adopting SFAS No. 123R
  $ 1,776  
         
 
SFAS No. 157
 
In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements, but does not require any new fair value measurements. SFAS No. 157 will become effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating what impact, if any, SFAS No. 157 will have on our financial conditions, results or operations or liquidity.
 
SAB No. 108
 
In September 2006, the SEC staff issued Staff Accounting Bulleting No. 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (“SAB No. 108”). SAB No. 108 was issued to provide consistency between how registrants quantify financial statement misstatements and requires us to quantify financial statement misstatements and requires us to quantify misstatements based on their impact on each of our consolidated financial statements and related disclosure. SAB No. 108 is effective as of the end of our 2006 fiscal year, allowing a one-time transitional cumulative effect adjustment to retained earning as of January 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. The adoption of this SAB did not have any impact on our consolidated financial statements.
 
FIN 48
 
In July 2006, the Financial Accounting Standards Board issued FASB Interpretation 48, Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109 (“FIN 48”) FIN 48, which clarifies Statement 109, Accounting for Income Taxes, establishes the criterion that an individual tax position has to meet for some or all of the benefits of that position to be recognized in the Company’s financial statements. On initial application, FIN 48 will be applied to all tax positions for which the statute of limitations remains open. Only tax positions that meet the more-likely-than-not recognition threshold at the adoption date will be recognized or continue to be recognized. The cumulative effect of applying FIN 48 will be reported as an adjustment to retained earnings at the beginning of the period in which it is adopted.
 
FIN 48 is effective for fiscal years beginning after December 15, 2006, and will be adopted by the Company on January 1, 2007. We are currently evaluating what impact, if any, adopting FIN 48 will have on our consolidated financial statements.
 
SFAS No. 159
 
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159 — The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”). SFAS No. 159 provides companies an option to report certain financial assets and liabilities at fair value. The intent of SFAS No. 159 is to reduce the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets


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and liabilities differently. SFAS No. 159 is effective for financial statements issued for fiscal years after November 15, 2007. The Company is evaluating the impact this new standard will have on its financial position and results of operations.
 
Results of Operations for Fiscal Years 2006, 2005 and 2004
(In thousands, except percentage changes and share and per share information)
 
The following is a discussion of the historical consolidated financial condition and results of operations of Novavax, Inc. and its wholly owned subsidiary and should be read in conjunction with the consolidated financial statements and notes thereto set forth in this Annual Report on Form 10-K. Additional information concerning factors that could cause actual results to differ materially from those in the Company’s forward-looking statements is contained from time to time in the Company’s SEC filings.
 
                                                         
    2006     2005        
          Change from 2005           Change from 2004     2004  
 
Revenues:
                                                       
Total net product sales
  $ 2,501     $ (2,048 )     (45 )%   $ 4,549     $ (1,848 )     (29 )%   $ 6,397  
Contract research and development
    1,886       88       5 %     1,798       60       3 %     1,738  
Royalties, milestone and licensing fees
    296       (745 )     (72 )%     1,041       916       733 %     125  
                                                         
    $ 4,683     $ (2,705 )     (37 )%   $ 7,388     $ (872 )     (11 )%   $ 8,260  
                                                         
 
Revenues for 2006 consisted of product sales of $2.5 million compared to $4.6 million in 2005; contract research and development revenues of $1.9 million in 2006 compared to $1.8 million in 2005; and royalties, milestone and licensing fees of $0.3 million in 2006 compared to $1.0 million in 2005. Total revenues for 2006 were $4.7 million as compared to $7.4 million for 2005, a decrease of $2.7 million or 37%. The primary reason for this decrease in revenues was the divestiture of assets related to AVC Cream and Suppositories, NovaNatal and NovaStart products to Pharmelle, LLC in September 2005 and the licensing of exclusive rights to market ESTRASORB in North America to Esprit Pharma, Inc. in October 2005. Under the terms of the License and Supply Agreements with Esprit, the Company agreed to manufacture and supply ESTRASORB. As a result, product sales for 2006 consist primarily of ESTRASORB sales to Esprit under the October 2005 Supply Agreement and commercial Gynodiol sales. Included in ESTRASORB net sales for 2006 was a $(0.2) million adjustment to the ESTRASORB sales return allowance for product sold commercially prior to the licensing of ESTRASORB to Esprit. ESTRASORB sales were lower than expected for 2006 due to weak market demand for this product. During 2006, Esprit established several marketing programs for ESTRASORB that they anticipate will increase market demand.
 
Contract research and development revenues for 2006 totaled $1.9 million as compared to 2005 contract research and development revenues of $1.8 million. Revenues in the current year were recognized under a National Institutes of Health (“NIH”) grant to develop a second generation HIV/AIDS vaccine, three manufacturing contracts and one additional government contract.
 
Royalties, milestone and licensing fees for 2006 consisted of $0.3 million from royalties pursuant to the License Agreement with Esprit Pharma for ESTRASORB. This represents a $0.7 million decrease from $1.0 million in royalties, milestones and license fees for 2005 which consisted of a $1.0 million renewal fee received from IGI, Inc. in December 2005 in accordance with an option in a licensing agreement signed between the Company and IGI in December 1995. This payment gives IGI a ten-year renewal on licensed technologies in specific fields.
 
Revenues for 2005 consisted of product sales of $4.5 million compared to $6.4 million in 2004; contract research revenues of $1.8 million compared to $1.7 million in 2004; and royalties, milestone and licensing fees of $1.0 million in 2005 compared to $0.1 million in 2004. Total revenues for 2005 were $7.4 million compared to $8.3 million for 2004, a decrease of $0.9 million or 11%. Of the total decrease in revenues, product sales accounted


36


 

for $1.8 million partially offset by a $0.9 million increase in royalties, milestone and licensing fees. The reason for the net decrease in net product sales is primarily due to the following:
 
  •  In September 2005, we entered into the Pharmelle Transaction for the sale of assets related to AVC Cream and Suppositories, NovaNatal and NovaStart products. As a result, the 2005 vitamin and AVC product sales only reflect a partial year of revenues for these product lines.
 
  •  During 2005, the vitamin lines continued to be negatively impacted by generic products and new product competition.
 
  •  Sales of Gynodiol in 2005 were lower than the prior year primarily due to an out-of-stock situation for certain prescription strengths.
 
  •  In October 2005, we entered into the Esprit Transaction. Under these agreements, Esprit obtained exclusive rights to market ESTRASORB in North America and the Company agreed to manufacture and sell ESTRASORB to Esprit for a lower price than what we previously sold ESTRASORB to our distributors. 2005 ESTRASORB net product sales include sales to our distributors through the date of this agreement and to Esprit after this date.
 
Contract research revenues in 2005 totaled $1.8 million compared to 2004 contract research revenues of $1.7 million. Royalties, milestone and licensing fees increased by $0.9 million from $0.1 million in 2004 to $1.0 million in 2005 primarily due to a $1.0 million license renewal fee received from IGI, Inc. for a ten year renewal on licensed technologies in specific fields.
 
Operating Costs and Expenses:
 
                                                         
    2006     2005        
          Change from
          Change from
       
          2005           2004     2004  
 
Operating costs and expenses:
                                                       
Cost of products sold
  $ 4,924     $ (867 )     (15 )%   $ 5,791     $ 2,301       66 %   $ 3,490  
Excess inventory costs over market
    1,549       30       2 %     1,519       1,519       100 %      
Research and development
    11,529       6,454       127 %     5,075       (2,294 )     (31 )%     7,369  
Selling and marketing
    101       (6,819 )     (99 )%     6,920       (16,668 )     (71 )%     23,588  
General and administrative
    11,187       3,073       38 %     8,114       (602 )     (7 )%     8,716  
Facility exit costs
          (105 )     (100 )%     105       (618 )     (85 )%     723  
Gain on sales of product assets
          10,965       100 %     (10,965 )     (10,965 )     (100 )%      
Gain on redemption of debt
                            11,162       100 %     (11,162 )
                                                         
    $ 29,290     $ 12,731       77 %   $ 16,559     $ (16,165 )     (50 )%   $ 32,724  
                                                         
 
Cost of Products Sold and Idle Capacity
 
Cost of products sold, which includes fixed idle capacity costs at our manufacturing facility, decreased to $4.9 million in 2006 compared to $5.8 million in 2005. Of the $4.9 million cost of products sold for 2006, $2.5 million was due to idle capacity costs at our manufacturing facility compared to $3.2 million in 2005. The remaining $2.4 million primarily represents the cost of ESTRASORB sales to Esprit under our October 2005 Supply Agreement, Gynodiol cost of products sold and costs related to manufacturing contracts. Of the $5.8 million cost of products sold for 2005, $3.2 million was due to idle capacity at our manufacturing facility. Idle capacity costs for 2005 were $0.7 million higher than in 2006 due partially to the accounting of excess inventory costs over market in 2006, which is discussed in more detail below. Other factors contributing to the decrease in cost of products sold was lower production volumes, the divestiture of assets related to AVC Cream and Suppositories, NovaNatal and NovaStart products to Pharmelle, LLC in September 2005, and lower Gynodiol sales in 2006 when compared to the prior year.


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Cost of products sold, which includes fixed idle capacity costs at our manufacturing facility, increased to $5.8 million in 2005, compared to $3.5 million in 2004, a 66% increase. Of the $5.8 million cost of products sold for 2005, $3.2 million was due to idle plant capacity costs at our manufacturing facility compared to $0.7 million in 2004. The remaining $2.6 million increase was primarily due to ESTRASORB, which accounted for 45% of net product sales in 2005, as opposed to 28% of net product sales in 2004, and carries a much higher cost of product sold than our other products. ESTRASORB cost of product sold percentages have been and will continue to be high until we increase production volumes for both ESTRASORB and other manufactured products to offset the fixed costs and depreciation related to the manufacturing facility, on-going facility costs and costs associated with the personnel required to manufacture products at this facility. With the sale of vitamin and AVC lines, future cost of products sold will correspond to our ESTRASORB sales to Esprit, Gynodiol sales to distributors and manufacturing costs related to other products produced at our manufacturing facility. Until this facility reaches maximum capacity fixed idle capacity costs will continue to be included in cost of products sold.
 
Excess Inventory Costs over Market
 
As part of the October 2005 License and Supply Agreement for ESTRASORB, we agreed to manufacture and sell ESTRASORB to Esprit Pharma, Inc. at a price that was lower than our current production costs for the inventory manufactured and sold. These excess costs over the fixed price are being paid under the Supply Agreement with Esprit totaled $1.5 million for the year ended December 31, 2006 and $1.5 million for the fourth quarter of fiscal year 2005. It is most likely we will continue to manufacture ESTRASORB at a loss until production volumes increase or we enter into additional contract manufacturing agreements with third parties to more fully utilize our manufacturing facility’s capacity. The current facility is able to accommodate much greater production than is currently scheduled, which, if more fully utilized, would offset the fixed costs related to the manufacturing process and facility. In addition, we are negotiating revisions to our agreements for packaging costs of ESTRASORB as well as our fixed lease costs for the manufacturing facility. If these negotiations result in higher packaging or facility lease costs for us, it may have a material adverse impact on future operating and financial results.
 
Research and Development Expenses
 
Research and development costs increased from $5.1 million in 2005 to $11.5 million in 2006, an increase of$6.5 million or 127%. This increase was due primarily to higher research and development spending to support our strategic focus on creating differentiated, value-added vaccines that leverage the Company’s proprietary virus-like particle (“VLP”) technology. Research and development expenses were significantly higher in 2006 due to increases in personnel, facility and outside testing costs (including sponsored research and consulting agreements) associated with expanded preclinical testing and process development, manufacturing and quality-related programs necessary to move the Company’s influenza vaccine candidates into clinical testing. Also contributing to this increase was the recognition of $0.5 million of non-cash compensation costs resulting from the implementation of SFAS No. 123R in 2006, using the modified prospective method, while no costs were recorded in 2005 utilizing the accounting recognition methods under APB No. 25.
 
Research and development costs decreased from $7.4 million in 2004 to $5.1 million in 2005. The decrease of $2.3 million or 31% was due to manufacturing start-up costs in 2004 being accounted for as research and development expense until April 2004. Manufacturing costs in the first quarter of 2004 totaling $1.7 million were incurred to prepare and validate the ESTRASORB facility for current Good Manufacturing Practices and FDA compliance and not to build inventory. Beginning in April 2004, manufacturing costs were included in cost of sales and inventory. Vaccine contract research costs, which are included in total research and development expenses, decreased from $3.2 million in 2004 to $2.6 million in 2005. This decrease was due to higher costs reimbursed or paid under a government contract in 2004, as well as a reduction in facility costs for 2005.
 
Estimated Cost and Time to Complete Major Projects
 
The expenditures that will be necessary to execute our business plan are subject to numerous uncertainties, which may adversely affect our liquidity and capital resources. As of December 31, 2006, our proprietary product and vaccine candidates were in early stages of development. Due to the inherent nature of product development, future market demand for products and factors outside of our control, such as clinical results and regulatory


38


 

approvals, we are unable to estimate the completion dates and the estimated total costs for those product candidates. The duration and the cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical trial protocol, including, but not limited to, the following:
 
  •  number of patients that ultimately participate in the trial;
 
  •  duration of the patient follow-up that seems appropriate in view of the results;
 
  •  number of clinical sites included in the trials; and
 
  •  length of time required to enroll suitable patient subjects.
 
In addition, we test our potential products and vaccines in numerous preclinical studies to identify, among other things, the daily dosage amounts. We may conduct multiple clinical trials to cover a variety of indications for each product candidate. As we obtain results for our trials we may elect to discontinue clinical trials for certain product candidates or indications. We further believe that it is not possible to predict the length of regulatory approval time. Factors that are outside our control could significantly delay the approval and marketability of our product candidates.
 
As a result of the uncertainties discussed above and other risks and uncertainties, the duration and completion costs of our research and development projects are difficult to estimate and are subject to numerous variations. Our inability to complete our research and development projects in a timely manner could significantly increase our capital requirements and could adversely impact our liquidity. These uncertainties could force us to seek external sources of financing from time to time in order to continue pursuing our business strategy. For more discussion of the risks and uncertainties and our liquidity, see Item 1A “Risk Factors” and see “Liquidity and Capital Resources”.
 
Selling and Marketing Expenses
 
Selling and marketing expenses were $101,000 in 2006 compared to $6.9 million in 2005. This decrease of $6.8 million, or 99%, was due to our strategy of transitioning from a specialty pharmaceutical company, which included the sale and marketing of products serving the women’s health space, to an innovative, biopharmaceutical company focused on creating differentiated, value-added vaccines that leverage the Company’s proprietary VLP technology. With the sale of our vitamin and AVC lines to Pharmelle, LLC in September 2005 and the licensing of ESTRASORB in North America to Esprit in October 2005, our ongoing selling and marketing expenses consist primarily of costs related to sales of Gynodiol. These ongoing costs should be minimal.
 
Selling and marketing expenses were $6.9 million in 2005 compared to $23.6 million in 2004. This significant decrease of $16.7 million, or 71%, was due to the reduction of the Company’s sales force in March 2005 and the elimination of its remaining sales force in August 2005. This corresponded with our strategy of transitioning from a commercial business model to that of one focused on our core competency of new product development. With the sale of our vitamin and AVC lines to Pharmelle and the licensing of ESTRASORB in North America to Esprit, the only remaining product that we are selling directly to our distributors is Gynodiol.
 
General and Administrative
 
General and administrative costs were $11.2 million in 2006 compared to $8.1 million in 2005. This $3.1 million increase was partially due to $1.2 million of non-cash compensation costs resulting from the implementation of SFAS No. 123R in 2006, using the modified prospective method, while no costs were recorded in 2005 utilizing the accounting recognition methods under APB No. 25. Other factors contributing to this increase were higher personnel, legal and consulting costs related to the Company’s VLP-based vaccine development programs. The Company took steps to strengthen its intellectual property portfolio and initiate business development and commercial assessment activities related to its new vaccine development strategy.
 
Also included in 2006 is a $167,000 reserve against a note receivable and its corresponding accrued interest due from a former director of the Company. This reserve represents the difference between the book value of the receivables less the market value of the pledged shares of common stock of the Company as of December 31, 2006. The Company also made a loan to another director which is due to mature on March 21, 2007.


39


 

 
Included in 2005 general and administrative expense was a $400,000 offset for Opportunity Grant funds received from the Commonwealth of Pennsylvania for the reimbursement of certain costs incurred with the move of our corporate headquarters and product development activities from Maryland to Pennsylvania. As a result of the Company’s recent decision to relocate its corporate headquarters and vaccine development activities back to Maryland, the Commonwealth of Pennsylvania has demanded repayment of the $400,000 Opportunity Grant received in 2005. The Company has recorded a liability in 2006 reflecting its obligation to repay this amount.
 
General and administrative costs were $8.1 million in 2005 compared to $8.7 million in 2004. This $0.6 million decrease, or 7%, is primarily due to receiving $0.4 million from the Commonwealth of Pennsylvania for the reimbursement of certain costs incurred with the move to our corporate headquarters and product development activities to Malvern, Pennsylvania as well as cost saving measures implemented in 2004 and 2005. This decrease was partially offset by increases in legal fees and business development costs, related to strategic initiatives.
 
Other Operating Costs and Expenses
 
In 2005, we recorded gains on sales of product assets totaling $11.0 million, which consisted of a $10.1 million gain from the licensing of exclusive rights to market ESTRASORB in North America to Esprit Pharma, Inc. in October 2005 and a $0.9 million gain from the divestiture of assets related to AVC Cream and Suppositories, NovaNatal and NovaStart products to Pharmelle, LLC in September 2005.
 
In 2004, we recorded a one-time gain on the redemption of convertible notes held by King Pharmaceuticals, Inc. of $11.2 million related to the King Transaction (see “Summary of Significant Transactions”).
 
A charge for facility exit costs of $0.7 million was recorded in 2004. As previously described, in September 2004 we moved to Malvern, Pennsylvania to consolidate and expand our corporate headquarters and product development activities. We vacated our facility in Columbia, Maryland and recorded a liability of $0.2 million for lease termination costs and wrote-off the net value of the Columbia leasehold assets of $0.5 million. A further adjustment was made in 2005 of $0.1 million for additional contract termination costs.
 
Interest Income/(Expense):
 
                                                         
    2006     2005        
          Change from 2005           Change from 2004     2004  
 
Interest income (expense)
                                                       
Interest income
  $ 3,267     $ 2,937       890 %   $ 330     $ 12       4 %   $ 318  
Interest expense
    (1,727 )     (606 )     (26 )%     (2,333 )     489       27 %     (1,844 )
                                                         
    $ 1,540     $ 3,543       177 %   $ (2,003 )   $ 477       31 %   $ (1,526 )
                                                         
 
Interest income was $3.3 million in 2006 and $0.3 million in 2005 and 2004. This increase in interest income was due primarily to significantly higher investment balances resulting from the net proceeds from three equity financing transactions during the fourth quarter of 2005 and the first quarter of 2006 which totaled $73.0 million as well as higher interest rates. Interest expense was $1.7 million in 2006, $2.3 million in 2005 and $1.8 million in 2004. Interest expense relates primarily to the convertible notes with King Pharmaceuticals, Inc. of $40.0 million in 2003 through July 2004, at which time these notes were redeemed and the Company issued new 4.75% senior convertible notes totaling $35.0 million to a group of institutional investors. In October 2005, certain holders of $6.0 million face amount of the convertible notes exercised their optional right to convert their notes plus accrued interest into 1,070,635 shares of Novavax common stock. This reduced the aggregate principal amount of the convertible notes outstanding to $29.0 million as of December 31, 2005. In March 2006, certain holders of $7.0 million face amount of the convertible notes exercised their optional right to convert their notes plus accrued interest into 1,294,564 shares of Novavax common stock. This further reduced the aggregate principal amount of the convertible notes outstanding to $22.0 million as of December 31, 2006. Included in interest expense for 2005 and 2006 is a $0.3 million and a $0.3 million write-off of deferred financing costs that corresponds to the conversion of $6.0 million in convertible debt in 2005 and $7.0 million in convertible debt in 2006. Also included in interest


40


 

expense for 2006, 2005 and 2004 is $0.3 million, $0.4 million and $0.2 million, respectively, of amortization of deferred financing costs that corresponds to the issuance of the 4.75% senior convertible notes in 2004.
 
Net Losses:
 
                                                         
    2006     2005        
          Change from
          Change from
       
          2005           2004     2004  
 
Net loss
  $ (23,068 )   $ (11,894 )     (106 )%   $ (11,174 )   $ 14,746       57 %   $ (25,920 )
                                                         
Net loss per share
  $ (0.39 )   $ (0.13 )     (50 )%   $ (0.26 )   $ 0.44       63 %   $ (0.70 )
                                                         
Weighted shares outstanding
    58,664,365                       42,758,302                       36,926,034  
                                                         
 
Net loss for 2006 was $23.1 million or $(0.39) per share, as compared to $11.2 million or $(0.26) per share for 2005, an increase of $11.9 million. The increased loss was primarily due to the gain on sales of product assets totaling $11.0 million recorded in 2005. Also contributing to this higher loss in 2006 was a $2.7 million decrease in revenues, a $1.9 million increase in operating costs and expenses in support of the Company’s new vaccine development strategy and $0.1 million in facility exit costs offset by a $2.9 million increase in interest income and a $0.6 million decrease in interest expense, all previously discussed.
 
Net loss for 2005 was $11.2 million or $(0.26) per share, as compared to $25.9 million or $(0.70) per share for 2004, a decrease of $14.7 million, or $0.44 per share. The decreased loss in 2005 was due to the gain on sales of product assets of $11.0 million, a decrease of $15.7 million in operating expenses and $0.6 million in facility exit costs, partially offset by the $0.9 million decrease in 2005 revenues, the gain on redemption of convertible debt held by King Pharmaceuticals, Inc. of $11.2 million and an increase of $0.5 million in interest expense, all previously discussed.
 
Weighted shares outstanding increased from 36.9 million shares in 2004 to 58.7 million shares in 2006 due primarily to the equity financing transactions in the second half of 2005 and the first quarter of 2006 coupled with the conversion of $13.0 million of senior convertible notes into shares of Novavax common stock during this same period. In addition, exercises of stock options and issuance of restricted stock as compensation also contributed to this increase in weighted shares outstanding.
 
Liquidity and Capital Resources
 
Our future capital requirements depend on numerous factors including but not limited to, the commitments and progress of our research and development programs, the progress of preclinical and clinical testing, the time and costs involved in obtaining regulatory approvals, the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights, competing technological and market developments, and manufacturing costs related to ESTRASORB. We plan to continue to have multiple vaccines and products in various stages of development and we believe our research and development as well as general administrative expenses and capital requirements will continue to exceed our revenues. Future activities, particularly vaccine and product development,


41


 

are subject to our ability to raise funds through debt or equity financing, or collaborative arrangements with industry partners and government agencies.
 
         
    Year Ended
 
    December 31, 2006  
    (In thousands)  
 
Summary of Cash Flows:
       
Net cash (used in) provided by:
       
Operating activities
  $ (14,810 )
Investing activities
    (66,815 )
Financing activities
    56,893  
         
Net decrease in cash and cash equivalents
    (24,732 )
Cash and cash equivalents at beginning of year
    31,893  
         
Cash and cash equivalents at end of year
  $ $7,161  
         
 
In addition to revenues of $20.3 million during the three-year period ended December 31, 2006, we have funded our operations primarily from the following activities:
 
                                 
Net Proceeds (in Millions)
  2004     2005     2006     Total  
 
Sales of common stock in public offerings, net
  $     $ 20.7     $ 56.0     $ 76.7  
Sales of common stock in a private placement
    4.7                   4.7  
Sales of product assets
          12.7             12.7  
License payments received
          1.0       2.5       2.5  
Issuance of convertible notes
    32.9                   32.9  
Uses associated with the King Transaction
    (15.0 )                 (15.0 )
Exercise of stock options and warrants
    0.4       0.4       1.7       2.5  
                                 
    $ 23.0     $ 34.8     $ 60.2     $ 117.0  
                                 
 
As of December 31, 2006, we held $73.6 million in cash and investments as compared to $31.9 million at December 31, 2005. Of the $41.7 million increase in cash and investments during 2006, $56.7 million was obtained from financing activities, primarily reflecting proceeds of $56.0 million from the issuance of common stock and $1.7 million from purchases under the Company’s stock incentive programs offset by debt repayments of $0.7 million; $14.8 million was used for operating activities, consisting of a net loss of $23.1 million, as previously discussed, offset by non-cash activities of $5.6 million and $2.7 million generated by the change in operating assets and liabilities; and $1.5 million was used for investing activities (exclusive of short-term investment purchases, sales and maturities) consisting of general capital expenditures.
 
As of December 31, 2006, our working capital was $72.0 million compared to $32.7 million as of December 31, 2005. This $39.3 million increase primarily reflects the $56.0 million net proceeds from two equity financing transactions that occurred during the first quarter of 2006, $1.7 million from the exercise of stock options offset by $17.7 million in operating and capital investment activities and $0.7 million in principal payments on our outstanding debt obligations.
 
We intend to use the proceeds from our recent equity financing transactions for general corporate purposes, including but not limited to our internal research and development programs, such as preclinical and clinical testing and studies for our vaccine and other product candidates, the development of new technologies, capital improvements and general working capital. In the first quarter of 2007, we entered into sponsored research and licensing arrangements with two academic institutions to conduct early stage research in the vaccine area. These and similar arrangements that we may enter into may aggregate to a material amount of research and development spending that will accelerate the use of such proceeds. We will continue to fund our operations through product licensing, co-development arrangements on new products, or the public or private sale of securities of the Company. There can be no assurance that we will be able to obtain additional capital or, if such capital is available, that the terms of any financing will be satisfactory to the Company.


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As of December 31, 2006, the Company had $22 million of senior convertible notes outstanding (the “Notes”). The Notes carry a 4.75% coupon; are currently convertible into shares of Novavax common stock at $5.46 per share; and mature on July 19, 2009. The Note holders have the right to redeem all or a portion of the Notes if the weighted average price of the Company’s common stock is less than the then applicable conversion price (currently $5.46 per share) of the Company’s common stock on each of 30 trading days out of the 40 consecutive trading days immediately prior to either the third anniversary (July 19, 2007) or the fourth anniversary (July 19, 2008) of the issue date of the Notes. If the Note holders exercise their optional redemption right, the Company may elect to pay up to 50 per cent of the outstanding Notes being redeemed in shares of Common Stock. The redemption of the Company’s senior convertible notes would have an adverse effect on the Company’s current cash position and its ability to fund its operations. Based on our assessment of the availability of capital and our business operations as currently contemplated, in the absence of new financings, any potential redemption of Notes, licensing arrangements or partnership agreements, we believe we will have adequate capital resources into the second half of 2008.
 
If we are unable to obtain additional capital, we will continue to assess our capital resources and we may be required to delay, reduce the scope of, or eliminate one or more of our product research and development programs, downsize our organization, or reduce general and administrative infrastructure.
 
Contractual Obligations and Commitments
 
We utilize different financing instruments, such as debt and operating leases, to finance various equipment and facility needs. The following table summarizes our current financing obligations and commitments (in thousands) as of December 31, 2006:
 
                                         
          Less than
    1 - 3
    4 - 5
    More than
 
    Total     1 Year     Years     Years     5 Years  
 
Commitments & Obligations
                                       
Convertible notes
  $ 22,000     $     $ 22,000     $     $  
Operating leases
    9,419       1,660       5,062       2,588       109  
Notes payable
    1,189       731       458              
Manufacturing facility lease
    2,460       1,140       1,320              
                                         
Total principal payments
    35,068       3,531       28,840       2,588       109  
Less: Subleases
    (1,315 )     (479 )     (836 )            
                                         
Net principal payments
    33,753       3,052       28,004       2,588       109  
Interest
    2,696       1,072       1,624              
                                         
Total commitments & obligations
  $ 36,449     $ 4,124     $ 29,628     $ 2,588     $ 109  
                                         
 
Off-Balance Sheet Arrangements
 
The Company is not involved in any off-balance sheet agreements that have or are reasonably likely to have a material future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.
 
Item 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
The primary objective of our investment activities is to preserve our capital until it is required to fund operations while at the same time maximizing the income we receive from our investments without significantly increasing risk. As of December 31, 2006, we had cash and cash equivalents and short-term investments of $73.6 million as follows:
 
         
Cash and cash equivalents
  $ 7.2 million  
Short-term investments
  $ 66.4 million  
 
Our exposure to market risk is confined to our investment portfolio. We maintain an investment portfolio of investment grade government agency notes and corporate bonds. The securities in our investment portfolio are classified as held until maturity securities and are, due to their predominantly short-term nature, subject to minimal


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interest rate risk. While we do not believe that an increase in market rates of interest would have any significant negative impact on the realizable value of our investment portfolio, changes in interest rates affect the investment income we earn on our investments and, therefore, impact our cash flow and results of operations. We are headquartered in the U.S. where we conduct the vast majority of our business activities. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.
 
At December 31, 2006, the Company had a total debt of $23.2 million, most of which bears interest at fixed interest rates. The Company therefore does not believe that it is exposed to any material interest rate risk as a result of its borrowing activities.
 
Information required under this section is also contained in Part I, Item IA of this report and in Item 8 of this report, and is incorporated herein by reference.
 
Item 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
The information required by this item is set forth on pages F-1 to F-33.
 
Item 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
On April 17, 2006, Novavax, Inc. dismissed Ernst & Young LLP as its independent registered public accounting firm. The report of Ernst & Young LLP on the consolidated financial statements for the fiscal year ended December 31, 2005 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. The report of Ernst & Young LLP on the consolidated financial statements for the fiscal year ended December 31, 2004 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles, except that the opinion contained a “going concern” explanatory paragraph. The Company’s Audit Committee participated in and approved the decision to change independent registered public accounting firms.
 
In connection with its audits for the two most recent fiscal years and through April 17, 2006, there have been no disagreements with Ernst & Young LLP on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of Ernst & Young LLP would have caused them to make reference thereto in their report on the consolidated financial statements for such years. During the two fiscal years ended December 31, 2005 and 2004 and through April 17, 2006, there were no reportable events (as defined in Regulation S-K Item 304 (a)(1)(v)). The Registrant requested that Ernst & Young LLP furnish it with a letter addressed to the SEC stating whether or not it agrees with the above statements. A copy of such letter, dated April 20, 2006 is filed as Exhibit 16 to the Form 8-K filed on April 21, 2006.
 
On April 20, 2006, the Company engaged Grant Thornton LLP to act as the Company’s independent registered public accounting firm. Grant Thornton LLP replaced Ernst & Young LLP. Prior to the engagement of Grant Thornton, neither the Company nor anyone on behalf of the Company consulted with Grant Thornton during the Company’s two most recent fiscal years and through April 20, 2006, in any manner regarding: (A) either the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company’s financial statements, and neither was a written report provided to the Company nor was oral advice provided that Grant Thornton concluded was an important factor considered by the Company in reaching a decision as to the accounting, auditing, or financial reporting issue, or (B) the subject of either a disagreement or a reportable event, as defined in Item 304 (a)(1)(iv), respectively, of Regulation S-K.
 
Item 9A.   CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
 
The Company’s chief executive officer and chief financial officer have reviewed and evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this annual report. Based on that review and evaluation, which included the participation of management and certain other employees of the


44


 

Company, the chief executive officer and chief financial officer have concluded that the Company’s current disclosure controls and procedures, as designed and implemented, are effective.
 
Changes in Internal Control over Financial Reporting
 
The Company’s management, including our principal executive officer and principal financial officer, has evaluated any changes in the Company’s internal control over financial reporting that occurred during the year ended December 31, 2006, and has concluded that there was no change that occurred during the year ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
Management’s Annual Report on Internal Control over Financial Reporting
 
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934, as amended. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2006 based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
 
Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Grant Thornton LLP, an independent registered public accounting firm, as stated in their report which is included elsewhere herein.
 
Item 9B.   OTHER INFORMATION
 
None.
 
PART III
 
Item 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
Certain of the information required by this item is set forth below. The remainder is contained in our definitive Proxy Statement for our 2007 Annual Meeting of Stockholders to be held on June 20, 2007 (the “2007 Proxy Statement”) and is incorporated herein by this reference. We expect to file the 2007 Proxy Statement within 120 days after the close of the fiscal year ended December 31, 2006.
 
Executive Officers of the Registrant
 
Our executive officers hold office until the first meeting of the Board of Directors following the Annual Meeting of Stockholders and until their successors are duly chosen and qualified, or until they resign or are removed from office in accordance with our By-laws.


45


 

 
The following table provides certain information with respect to our executive officers.
 
             
        Principal Occupation and Other Business
Name
 
Age
 
Experience During the Past Five Years
 
Rahul Singhvi
  42   President and Chief Executive Officer and Director of Novavax since August 2005. Senior Vice President and Chief Operating Officer of Novavax from April 2005 to August 2005 and Vice President — Pharmaceutical Development and Manufacturing Operations from April 2004 to April 2005. For 10 years prior to joining the Company, served in several positions with Merck & Co., culminating as Director of the Merck Manufacturing Division from 1999 to 2004.
Jeffrey W. Church
  50   Vice President, Chief Financial Officer, Treasurer and Corporate Secretary of Novavax since September 2006. For 8 years prior to joining the Company, served as Chief Financial Officer, Treasurer and Secretary with GenVec, Inc.
Raymond J. Hage, Jr. 
  39   Senior Vice President, Commercial Operations since October 2006. Senior Vice President and Chief Operating Officer from August 2005 to October 2006 and Vice President of Marketing and Corporate Development of Novavax from January 2004 to August 2005. Prior to joining the Company, served in several positions including an independent marketing consultant with CHS, Inc. in 2003, Director of Marketing with Cephalon, Inc. from 2002 to 2003 and for 10 years held various marketing and sales roles at Eli Lilly culminating as Director of US Women’s Health from 2001 to 2002.
 
Code of Ethics
 
The Company has adopted a Code of Business Conduct and Ethics applicable to its principal executive officer, principal financial officer, controller, and persons performing similar functions, and has made the code an exhibit to its Annual Report on Form 10-K for the 2003 Fiscal Year ended December 31, 2003. The Code is also available, and the Company will file and post a Current Report on Form 8-K for amendments to and waivers of its Code for its principal executive and financial officers, on its website at www.novavax.com.
 
Item 11.   EXECUTIVE COMPENSATION
 
We incorporate herein by reference the information concerning executive compensation to be contained in the 2007 Proxy Statement.
 
Item 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
We incorporate herein by reference the information concerning security ownership of certain beneficial owners and management and related stockholder matters to be contained in the 2007 Proxy Statement.


46


 

 
The following table provides the Company’s equity compensation plan information as of December 31, 2006. Under these plans, the Company’s common stock may be issued upon the exercise of options. See also the information regarding stock options of the Company in Note 9, “Stock Options” to the Consolidated Financial Statements included herewith.
 
Equity Compensation Plan Information
 
                         
                Number of Securities
 
                Remaining Available
 
                for Future Issuance
 
    Number of Securities
          Under Equity
 
    to be Issued
    Weighted-Average
    Compensation Plans
 
    Upon Exercise of
    Exercise Price of
    (Excluding Securities
 
    Outstanding Options,
    Outstanding Options,
    Reflected in Column
 
    Warrants and Rights
    Warrants and Rights
    (a))
 
Plan Category
  (a)     (b)     (c)  
 
Equity compensation plans approved by security holders(1)
    5,711,919     $ 3.83       1,002,450  
Equity compensation plans not approved by security holders
                 
 
 
(1) Includes the Company’s 2005 Stock Incentive Plan, 1995 Stock Option Plan and 1995 Director Stock Option Plan.
 
Item 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
We incorporate herein by reference the information concerning certain related party transactions set forth in Note 13 to our Consolidated Financial Statements included herewith. We incorporate herein by reference the information concerning certain other relationships and related transactions and director independence to be contained in the 2007 Proxy Statement.
 
Item 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES
 
We incorporate herein by reference the information concerning principal accountant fees and services to be contained in the 2007 Proxy Statement.
 
PART IV
 
Item 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
(a) The following documents are filed as part of the Annual Report:
 
(1) Index to Consolidated Financial Statements
 
         
Reports of Independent Registered Public Accounting Firms
  F- 2
Consolidated Balance Sheets as of December 31, 2006 and 2005
  F- 5
Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004
  F- 6
Consolidated Statements of Stockholders’ Equity for years ended December 31, 2006, 2005 and 2004
  F- 7
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004
  F- 8
Notes to Consolidated Financial Statements
  F- 9
 
(2) Financial Statement Schedules
 
All financial statement schedules are omitted because they are not applicable, not required under the instructions or all the information required is set forth in the financial statements or notes thereto.


47


 

 
(3) Exhibits
 
Exhibits marked with a single asterisk (*) are filed herewith.
 
Exhibits marked with a double plus sign (††) refer to management contracts, compensatory plans or arrangements.
 
Confidential treatment has been requested for portions of exhibits marked with a double asterisk (**).
 
All other exhibits listed have previously been filed with the Commission and are incorporated herein by reference.
 
         
  3 .1   Amended and Restated Certificate of Incorporation of the Company (Incorporated by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1996, filed March 21, 1997 (the “1996 Form 10-K”)), as amended by the Certificate of Amendment dated December 18, 2000 (Incorporated by reference to Exhibit 3.4 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000, filed March 29, 2001 (the “2000 Form 10-K”)), as further amended by the Certificate of Amendment dated July 8, 2004 (Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, filed August 9, 2004 (the “2004 2Q Form 10-Q”))
  3 .2   Amended and Restated By-Laws of the Company (Incorporated by reference to Exhibit 3.5 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2001, filed August 13, 2001 (the “2001 Q2 Form 10-Q”))
  4 .1   Specimen stock certificate for shares of common stock, par value $.01 per share (Incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form 10, File No. 0-26770, filed September 14, 1995 (the “Form 10”))
  4 .2   Rights Agreement, dated as of August 8, 2002, by and between the Company and Equiserve Trust Company, which includes the Form of Summary of Rights to Purchase Series D Junior Participating Preferred Stock as Exhibit A, the Form of Right Certificate as Exhibit B and the Form of Certificate of Designation of Series D Junior Participating Preferred Stock as Exhibit C. (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K, filed August 9, 2002)
  4 .3   Registration Rights Agreement, dated as of July 16, 2004, by and between the Company and the Buyers identified therein. (Incorporated by reference to Exhibit 4.7 to the Registration Statement on Form S-3, File No. 333-118210, filed August 13, 2004)
  10 .1††   Novavax, Inc. 1995 Stock Option Plan, as amended (Incorporated by reference to Appendix A of the Company’s Definitive Proxy Statement filed March 31, 2003 in connection with the Annual Meeting held on May 7, 2003)
  10 .2††   Novavax, Inc. 1995 Director Stock Option Plan (Incorporated by reference to Exhibit 10.5 to the Form 10)
  10 .3††   Novavax, Inc. 2005 Stock Incentive Plan (Incorporated by reference to Appendix A of the Company’s Definitive Proxy Statement filed March 29, 2005 in connection with the Annual Meeting held on May 4, 2005)
  10 .4††   Employment Agreement, dated as of November 9, 2005, by and between the Company and Rahul Singhvi (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed November 15, 2005)
  10 .5††   Employment Agreement, dated as of November 9, 2005, by and between the Company and Raymond J. Hage, Jr. (Incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed November 15, 2005)
  10 .6††   Employment Agreement, dated as of August 11, 2006, by and between the Company and Jeffrey W. Church (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed August 17, 2006)
  10 .7††   Change in Control Severance Benefit Plan, as adopted August 10, 2005 (Incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K, filed August 16, 2005)
  10 .8††   Amended and Restated Change in Control Severance Benefit Plan, as adopted July 26, 2006 (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006, filed November 14, 2006)


48


 

         
  10 .9††   Form of Indemnity Agreement, as authorized August 10, 2005 (Incorporated by reference to Exhibit 99.2 to the Company’s Current Report on Form 8-K, filed August 16, 2005)
  10 .10   Secured Promissory Note, dated March 21, 2002, by and between the Company and Mitchell J. Kelly (Incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 0-26770, filed March 28, 2003 (the “2002 Form 10-K”))
  10 .11   Pledge Agreement, dated March 21, 2002, by and between the Company and Mitchell J. Kelly (Incorporated by reference to Exhibit 10.10 to the 2002 Form 10-K)
  10 .12   Secured Promissory Note, dated March 21, 2002, by and between the Company and Denis M. O’Donnell, M.D. (Incorporated by reference to Exhibit 10.11 to the 2002 Form 10-K)
  10 .13   Pledge Agreement, dated March 21, 2002, by and between the Company and Denis M. O’Donnell, M.D. (Incorporated by reference to Exhibit 10.12 to the 2002 Form 10-K)
  10 .14   Facilities Reservation Agreement, dated as of February 11, 2002, by and between the Company and Packaging Coordinators, Inc. (Incorporated by reference to Exhibit 10.13 to the 2001 Form 10-K)
  10 .15   Lease Agreement, dated as of July 15, 2004, between Liberty Property Limited Partnership and the Company (Incorporated by reference to Exhibit 10.1 to the 2004 2Q Form 10-Q)
  10 .16   Sublease Agreement, dated April 28, 2006, by and between the Company and Sterilox Technologies, Inc. (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006, filed August 14, 2006)
  10 .17   Amendment dated as of October 25, 2006 to the Sublease Agreement, dated April 28, 2006, by and between the Company and Sterilox Technologies, Inc. (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006, filed November 14, 2006)
  10 .18   Lease, commencing April 1, 2005, by and between United Health Care Services, Inc. and the Company (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005, filed August 9, 2005)
  10 .19   Sublease Agreement by and between Human Genome Sciences, Inc., and the Company dated October 6, 2006 (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed December 13, 2006)
  10 .20   License Agreement between IGEN, Inc. and the Company (Incorporated by reference to Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1995, filed April 1, 1996)
  10 .21   Note, dated December 20, 2002, by and between the Company and PIDC Local Development Corporation (Incorporated by reference to Exhibit 10.35 to the 2002 Form 10-K)
  10 .22   Security Agreement, dated December 20, 2002, by and between the Company and PIDC Local Development Corporation (Incorporated by reference to Exhibit 10.36 to the 2002 Form 10-K)
  10 .23   Note, dated December 20, 2002, by and between the Company and PIDC Local Development Corporation (Incorporated by reference to Exhibit 10.37 to the 2002 Form 10-K)
  10 .24   Security Agreement, dated December 20, 2002, by and between the Company and PIDC Local Development Corporation (Incorporated by reference to Exhibit 10.38 to the 2002 Form 10-K)
  10 .25   HIV Vaccine Design and Development Agreement, effective September 26, 2003, by and between the Company and the National Institute of Allergy and Infectious Diseases, a component of the National Institutes of Health, an agency of the Department of Health and Human Services (Incorporated by reference to Exhibit 10.33 to the Company’s Annual Report on Form 10-K (as amended) for the fiscal year ended December 31, 2004, filed March 15, 2005)
  10 .26   Form of Senior Convertible Note (Incorporated by reference to Exhibits 99.4 to the Company’s Current Report on Form 8-K, filed July 19, 2004)
  10 .27   Exchange Agreement, dated July 16, 2004, between the Company, King Pharmaceuticals, Inc. and Parkedale Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 99.5 to the Company’s Current Report on Form 8-K, filed July 19, 2004)
  10 .28   Termination Agreement, dated as of July 16, 2004 among King Pharmaceuticals, Inc., Parkedale Pharmaceuticals, Inc. and the Company (Incorporated by reference to Exhibit 99.6 to the Company’s Current Report on Form 8-K, filed July 19, 2004)

49


 

         
  10 .29   Asset Purchase Agreement, dated and entered into as of September 22, 2005, by and among the Company, Fielding Pharmaceutical Company and Pharmelle, LLC (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed September 28, 2005)
  10 .30   Amendment dated and entered into as of July 5, 2006, to Asset Purchase Agreement, dated and entered into as of September 22, 2005, by and among the Company, Fielding Pharmaceutical Company and Pharmelle, LLC (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter-ended September 30, 2006, filed November 14, 2006)
  10 .31**   License Agreement by and between the Company and Esprit Pharma, Inc., dated October 18, 2005. (Incorporated by reference to Exhibit 10.33 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, filed March 6, 2006)
  10 .32**   Supply Agreement by and between the Company and Esprit Pharma, Inc., dated October 18, 2005. (Incorporated by reference to Exhibit 10.33 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, filed March 6, 2006)
  10 .33**   License and Development Agreement, dated April 26, 2006, by and between the Company and Esprit Pharma, Inc. (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006, filed August 14, 2006)
  10 .34**   Exclusive License Agreement, dated February 26, 2007, between the Company and the University of Massachusetts *
  14     Code of Business Conduct and Ethics (Incorporated by reference to Exhibit 14 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, filed March 15, 2004)
  23 .1   Consent of Grant Thornton LLP, Independent Registered Public Accounting Firm*
  23 .2   Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm*
  31 .1   Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
  31 .2   Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
  32 .1   Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by Rahul Singhvi, President and Chief Executive Officer of the Company*
  32 .2   Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by Jeffrey W. Church, Vice President, Chief Financial Officer, Treasurer and Corporate Secretary of the Company*

50


 

 
SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
NOVAVAX, INC.
 
  By: 
/s/  Rahul Singhvi
President and Chief Executive Officer and Director
 
Date: March 12, 2007
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
 
             
Name
 
Title
 
Date
 
/s/  RAHUL SINGHVI

Rahul Singhvi
  President and Chief Executive Officer and Director (Principal Executive Officer)   March 12, 2007
         
/s/  JEFFREY W. CHURCH

Jeffrey W. Church
  Vice President, Chief Financial Officer, Treasurer and Corporate Secretary (Principal Financial and Accounting Officer)   March 12, 2007
         
/s/  JOHN LAMBERT

John Lambert
  Chairman of the Board of Directors   March 12, 2007
         
/s/  GARY C. EVANS

Gary C. Evans
  Lead Director   March 12, 2007
         
/s/  JOHN O. MARSH, JR.

John O. Marsh, Jr.
  Director   March 12, 2007
         
/s/  MICHAEL A. McMANUS

Michael A. McManus
  Director   March 12, 2007
         
/s/  THOMAS P. MONATH

Thomas P. Monath
  Director   March 12, 2007
         
/s/  DENIS M. O’DONNELL, M.D.

Denis M. O’Donnell, M.D.
  Director   March 12, 2007
         
/s/  JAMES B. TANANBAUM

James B. Tananbaum
  Director   March 12, 2007


51


 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
Years ended December 31, 2006, 2005 and 2004
 
Contents
 
         
  F-2
  F-5
  F-6
  F-7
  F-8
  F-9


F-1


 

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
Board of Directors and Shareholders
Novavax, Inc.
 
We have audited the accompanying consolidated balance sheet of Novavax, Inc. (a Delaware corporation) and Subsidiary as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Novavax, Inc. and Subsidiary as of December 31, 2006, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
 
As described in footnote 2 to the financial statements, Novavax, Inc. adopted Statement of Financial Accounting Standard No. 123(R) as of January 1, 2006.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Novavax Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 12, 2007 expressed an unqualified opinion thereon.
 
/s/  Grant Thornton LLP
 
Philadelphia, Pennsylvania
March 12, 2007


F-2


 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
Board of Directors and Shareholders
Novavax, Inc.
 
We have audited management’s assessment, included in the accompanying Form 10-K, that Novavax, Inc. (a Delaware Corporation) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Novavax’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, management’s assessment that Novavax, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Novavax, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Novavax, Inc. and Subsidiary as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended and our report dated March 12, 2007 expressed an unqualified opinion thereon.
 
/s/  Grant Thornton LLP
 
Philadelphia, Pennsylvania
March 12, 2007


F-3


 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Board of Directors and Shareholders of
Novavax, Inc.
 
We have audited the accompanying consolidated balance sheet of Novavax, Inc. as of December 31, 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above, present fairly, in all material respects, the consolidated financial position of Novavax, Inc. at December 31, 2005, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
 
/s/  Ernst & Young LLP
 
March 3, 2006
Philadelphia, Pennsylvania


F-4


 

 
NOVAVAX, INC.
 
CONSOLIDATED BALANCE SHEETS
 
                 
    December 31,  
    2006     2005  
    (In thousands, except share information)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 7,161     $ 31,893  
Short-term investments
    66,434        
Accounts and other receivables, net of allowance for doubtful accounts
of $117 and $429 at December 31, 2006 and 2005
    1,274       3,571  
Inventory
    600       800  
Prepaid expenses and other current assets
    1,873       1,347  
                 
Total current assets
    77,342       37,611  
Property and equipment, net
    9,861       11,589  
Goodwill
    33,141       33,141  
Intangible assets, net
    978       1,110  
Other non-current assets
    555       931  
                 
Total assets
  $ 121,877     $ 84,382  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
Accounts payable
  $ 1,530     $ 1,426  
Accrued expenses and other current liabilities
    3,078       2,597  
Current portion of notes payable
    731       715  
Facility exit costs
          138  
                 
Total current liabilities
    5,339       4,876  
Convertible notes
    22,000       29,000  
Non-current portion of notes payable
    458       678  
Deferred rent
    79       176  
                 
Total liabilities
    27,876       34,730  
                 
                 
Commitments and contingencies
           
                 
Stockholders’ equity:
               
Preferred stock, $.01 par value, 2,000,000 shares authorized; no shares issued and outstanding
           
Common stock, $.01 par value, 100,000,000 shares authorized; 62,139,851 shares issued and 61,791,089 shares outstanding at December 31, 2006, and 50,259,494 shares issued and 50,005,646 shares outstanding at December 31, 2005
    622       503  
Additional paid-in capital
    261,822       195,361  
Unearned compensation
          (425 )
Notes receivable from directors
    (1,031 )     (1,480 )
Accumulated deficit
    (164,962 )     (141,894 )
Treasury stock, 348,762 shares at December 31, 2006 and 253,848 shares at December 31, 2005, cost basis
    (2,450 )     (2,413 )
                 
Total stockholders’ equity
    94,001       49,652  
                 
Total liabilities and stockholders’ equity
  $ 121,877     $ 84,382  
                 
 
The accompanying notes are an integral part of these consolidated financial statements.


F-5


 

 
NOVAVAX, INC.
 
CONSOLIDATED STATEMENTS OF OPERATIONS
 
                         
    For the Years Ended December 31,  
    2006     2005     2004  
    (In thousands, except share and per share information)  
 
Revenues:
                       
Net product sales
  $ 2,501     $ 4,549     $ 6,397  
Contract research and development
    1,886       1,798       1,738  
Royalties, milestone and licensing fees
    296       1,041       125  
                         
Total revenues
    4,683       7,388       8,260  
                         
Operating costs and expenses:
                       
Cost of products sold
    4,924       5,791       3,490  
Excess inventory costs over market
    1,549       1,519        
Research and development
    11,529       5,075       7,369  
Selling and marketing
    101       6,920       23,588  
General and administrative
    11,187       8,114       8,716  
Facility exit costs
          105       723  
Gain on sales of product assets
          (10,965 )      
Gain on redemption of debt
                (11,162 )
                         
Total operating costs and expenses
    29,290       16,559       32,724  
                         
Loss from operations
    (24,607 )     (9,171 )     (24,464 )
Interest income (expense), net
    1,539       (2,003 )     (1,526 )
Other income
                70  
                         
Net loss
  $ (23,068 )   $ (11,174 )   $ (25,920 )
                         
Basic and diluted loss per share
  $ (0.39 )   $ (0.26 )   $ (0.70 )
                         
Weighted average number of common shares used in computing basic and diluted net loss per share
    58,664,365       42,758,302       36,926,034  
                         
 
The accompanying notes are an integral part of these consolidated financial statements.


F-6


 

 
NOVAVAX, INC.
 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Years Ended December 31, 2006, 2005 and 2004
 
                                                                 
                Additional
          Notes
                Total
 
    Common Stock     Paid-in
    Unearned
    Receivable
    Accumulated
    Treasury
    Stockholders’
 
    Shares     Amount     Capital     Compensation     From Directors     Deficit     Stock     Equity  
    (In thousands, except share information)        
 
Balance, December 31, 2003
    34,972,183     $ 349     $ 144,288           $ (1,480 )   $ (104,800 )   $ (2,413 )   $ 35,944  
Exercise of stock options
    107,550       1       368                               369  
Stock options issued as compensation
                53                               53  
Shares issued for King Transaction
    3,775,610       38       18,085                               18,123  
Sale of common stock
    952,381       10       4,990                               5,000  
Financing costs allocated to raising additional capital
                (288 )                             (288 )
Net loss
                                  (25,920 )           (25,920 )
                                                                 
Balance, December 31, 2004
    39,807,724     $ 398     $ 167,496     $     $ (1,480 )   $ (130,720 )   $ (2,413 )   $ 33,281  
Exercise of stock options
    342,654       3       392                               395  
Issuance of common stock for prior services
    300,000       3       252                               255  
Restricted stock issued as compensation
    552,434       6       570       (425 )                       151  
Conversion of convertible debt
    1,070,635       11       6,070                               6,081  
Sales of common stock
    8,186,047       82       21,918                               22,000  
Financing costs allocated to raising additional capital
                (1,337 )                             (1,337 )
Net loss
                                  (11,174 )           (11,174 )
                                                                 
Balance, December 31, 2005
    50,259,494     $ 503     $ 195,361     $ (425 )   $ (1,480 )   $ (141,894 )   $ (2,413 )   $ 49,652  
Unearned compensation against additional paid in capital in accordance with SFAS No. 123R
                    (425 )     425                                
Non-cash compensation costs for stock options
                    1,776                                       1,776  
Exercise of stock options
    497,613       5       1,713                                       1,718  
Conversion of convertible debt
    1,294,564       13       7,055                                       7,068  
Restricted stock issued as compensation
    285,000       3       (3 )                                      
Amortization of restricted stock for compensation
                    491                                       491  
Treasury stock issued in lieu of payment of services rendered
                    (32 )                             57       25  
Sales of common stock
    9,803,180       98       57,902                                       58,000  
Financing costs allocated to raising additional capital
                    (2,016 )                                     (2,016 )
Reclassification due to change in status of a director
                                    449                       449  
Repurchase of common stock
                                                    (94 )     (94 )
Net loss
                                            (23,068 )             (23,068 )
                                                                 
Balance, December 31, 2006
    62,139,851     $ 622     $ 261,822     $     $ (1,031 )   $ (164,962 )   $ (2,450 )   $ 94,001  
                                                                 
 
The accompanying notes are an integral part of these consolidated financial statements.


F-7


 

 
NOVAVAX, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                         
    For the Years Ended December 31,  
    2006     2005     2004  
    (In thousands)  
 
Operating Activities
                       
Net loss
  $ (23,068 )   $ (11,174 )   $ (25,920 )
Reconciliation of net loss to net cash used in operating activities:
                       
Amortization
    132       681       776  
Depreciation
    2,921       2,794       2,277  
Provision for bad debts
    111       4       413  
Reserve for note receivable and accrued interest
    167              
Amortization of net discounts on short-term investments
    (1,135 )            
Amortization of deferred financing costs
    797       662       166  
Retirement of capital assets
    382       65       58  
Deferred rent
    (97 )     10       12  
Non-cash expense for services
    25              
Non-cash stock compensation
    2,267       406       53  
Facility exit costs
          105       723  
Gain on redemption of debt
                (11,162 )
Gain on sales of product assets
          (10,965 )        
Net proceeds from sales of product assets
          12,733        
Changes in operating assets and liabilities:
                       
Accounts and other receivables
    2,186       (248 )     720  
Inventory
    200       2,102       (2,609 )
Prepaid expenses and other current assets
    281       852       (1,128 )
Accounts payable and accrued expenses
    594       (3,866 )     5,311  
Facility exit costs
    (138 )     (168 )     (51 )
Other assets
    (435 )     198       262  
                         
Net cash used by operating activities
    (14,810 )     (5,809 )     (30,099 )
                         
Investing Activities
                       
Capital expenditures
    (1,516 )     (230 )     (1,608 )
Proceeds from disposal of property and equipment
          68        
Purchases of short-term investments
    (121,546 )            
Proceeds from maturities of short-term investments
    56,247              
                         
Net cash used in investing activities
    (66,815 )     (162 )     (1,608 )
                         
Financing Activities
                       
Net proceeds from issuance of convertible notes
                32,943  
Net payments associated with King Transaction
                (15,010 )
Principal payments on notes payables
    (715 )     (1,070 )     (1,064 )
Net proceeds from issuance of common stock
    55,984       20,663       4,712  
Proceeds from the exercise of stock options
    1,718       395       369  
Purchase of treasury stock
    (94 )            
                         
Net cash provided by financing activities
    56,893       19,988       21,950  
                         
Net change in cash and cash equivalents
    (24,732 )     14,017       (9,757 )
Cash and cash equivalents at beginning of year
    31,893       17,876       27,633  
                         
Cash and cash equivalents at end of year
  $ 7,161     $ 31,893     $ 17,876  
                         
Supplemental disclosure of non-cash transactions:
                       
Conversion of convertible debt and accrued interest to common stock
  $ 7,068     $ 6,081     $  
                         
Equipment purchases included in accounts payable
  $ 59     $ 139     $ 101  
                         
Financed insurance premiums
  $ 511     $ 501     $ 862  
                         
Treasury stock reissued for accrued interest to King
  $     $     $ 800  
                         
Supplemental disclosure of cash flow information:
                       
Cash paid for interest
  $ 1,233     $ 1,719     $ 54  
                         
 
The accompanying notes are an integral part of these consolidated financial statements.


F-8


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004
 
1.   Organization
 
Novavax, Inc., a Delaware corporation (“Novavax” or the “Company”), was incorporated in 1987, and is a biopharmaceutical company focused on creating differentiated, value-added vaccines that leverage the Company’s proprietary virus-like particle (“VLP”) technology as well as its proprietary Novasomes® adjuvants. VLPs imitate the three-dimensional structures of viruses but are composed of recombinant proteins and therefore, are believed incapable of causing infection and disease. Our proprietary production technology uses insect cells rather than chicken eggs or mammalian cells. The Company’s product targets include vaccines against the H5N1, H9N2 and other subtypes of avian influenza with pandemic potential and against human seasonal influenza as well as other infectious diseases. The Company also has a drug delivery platform based on its micellar nonparticle (“MNP”) technology, proprietary oil and water nano emulsions used for the topical delivery of drugs. The MNP technology was the basis for the development of the Company’s first Food and Drug Administration — approved estrogen replacement product, ESTRASORB®.
 
During 2005, Novavax transitioned from a specialty pharmaceutical company, which included the sale and marketing of products serving the women’s health space, to an innovative, biopharmaceutical company.
 
  •  In October 2005, the Company entered into a License and Supply Agreement for ESTRASORB with Esprit Pharma, Inc. (“Esprit”). Under these agreements, the Company continues to manufacture ESTRASORB and Esprit has an exclusive license to sell ESTRASORB in North America.
 
  •  In April 2006, the Company entered into a License and Development Agreement and a Supply Agreement with Esprit to co-develop, supply and commercialize the Company’s MNP-based testosterone product candidate for the treatment of female hypoactive sexual desire disorder. Esprit was granted exclusive rights to market the product in North America.
 
The Company has a unique blend of capabilities consisting of formulation technologies, vaccine technologies and drug development infrastructure, including clinical and commercial production facilities. The Company is leveraging its capabilities to develop differentiated, value-added vaccine products and licensing them at various stages of development to realize their value.
 
The products currently under development or in clinical trials by the Company will require significant additional research and development efforts, including extensive preclinical and clinical testing and regulatory approval, prior to commercial use. There can be no assurance that the Company’s research and development efforts will be successful or that any potential products will prove to be safe and effective in clinical trials. Even if developed, these products may not receive regulatory approval or be successfully introduced and marketed at prices that would permit the Company to operate profitably. The Company also recognizes that the commercial launch of any product is subject to certain risks including, but not limited to, manufacturing scale-up and market acceptance. No assurance can be given that the Company can generate sufficient product revenue to become profitable or generate positive cash flow from operations at all or on a sustained basis.
 
2.   Summary of Significant Accounting Policies
 
Basis of Presentation
 
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiary (Fielding Pharmaceutical Company). All significant intercompany accounts and transactions have been eliminated in consolidation.
 
Use of Estimates
 
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of


F-9


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.
 
Reclassifications
 
Amounts appearing in the prior year’s footnote disclosure have been reclassified to conform to the current year’s presentation.
 
Cash Equivalents and Short-Term Investments
 
Cash equivalents consist of highly liquid investments with original maturities of three months or less from the date of purchase. As of December 31, 2006, the Company had short-term investments, with original maturity dates ranging from 105 days to six months. These short-term investments have been classified as held to maturity securities, as the Company has the positive intent and ability to hold them until maturity. Investments are recorded at face value less any premiums or discounts. These premiums or discounts are then amortized over the remaining maturity periods of the investments using the straight-line method. Included in net interest income on the consolidated statement of operations for the year ended December 31, 2006 is $1,135,000 of amortization of premiums/discounts related to these short-term investments. The Company had no short-term investments in 2005.
 
As of December 31, 2006, short-term investments were comprised of $55,760,000 of commercial paper, $1,628,000 of asset-backed securities and $9,046,000 of corporate obligations. There were no short-term investments as of December 31, 2005.
 
Financial Instruments and Concentration of Credit Risk
 
Financial instruments, which possibly expose the Company to concentration of credit risk, consist primarily of cash and cash equivalents, short-term investments, accounts receivable and convertible notes payable. The Company has invested its cash in asset backed securities, high-grade corporate debt securities and money market instruments. The Company’s investment policy limits investments to certain types of instruments, places restrictions on maturities and concentrations in certain industries and requires the Company to maintain a certain level of liquidity. The Company has not experienced any losses on such accounts and management believes the risk of loss to be minimal. The carrying value of cash and cash equivalents, short-term investments and accounts receivable approximates their fair value based on their short-term maturities at December 31, 2006 and 2005. The Company has certain debt instruments at fixed rates, with lower interest rates than the prevailing market rates. The Company has obtained favorable rates through January 2010. The fair values of convertible notes approximate their carrying value as of December 31, 2006 and 2005 based on rates currently available to the Company for debt with similar terms and remaining maturities.
 
Accounts and Other Receivables
 
Accounts receivables are reported in the consolidated balance sheets as outstanding principal less any charge-offs and allowance for doubtful accounts. The Company charges off uncollectible receivables when the likelihood of collection is remote. Generally, the Company considers receivables past due 30 days subsequent to the billing date. The Company performs ongoing credit evaluations of its customers and generally extends credit without requiring collateral. The Company maintains an allowance for doubtful accounts that is determined based on historical experience and management’s expectations of future losses. Accounts deemed uncollectible are charged to the allowance. Provisions for bad debts and recoveries on accounts previously provided for are added to the allowance. As of December 31, 2006 and 2005, the Company had an allowance for doubtful accounts of approximately $117,000 and $429,000, respectively.


F-10


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Included in accounts and other receivables as of December 31, 2005 was $2,500,000 due from Esprit Pharma, Inc. related to the License Agreement with Esprit (see Note 3 Summary of Significant Transactions) which was paid in full in October 2006.
 
As of December 31, 2006, 2005 and 2004, three customers accounted for 87%, 80% and 81% of the Company’s gross product sales and 78%, 98% and 74% of the Company’s product sales accounts receivable, respectively.
 
Inventories
 
Inventories consist of raw materials, work-in-process and finished goods, and are priced at the lower of cost or market using the first-in-first-out method and consist of the following at December 31:
 
                 
    2006     2005  
    (In thousands)  
 
Raw materials
  $ 263     $ 358  
Work-in-process
    86       38  
Finished goods
    251       404  
                 
    $ 600     $ 800  
                 
 
During the year ended December 31, 2005, the Company implemented Statement of Financial Accounting Standard No. 151, Inventory Costs — an amendment of ARB No. 43, Chapter 4 (“SFAS No. 151”). Under SFAS No. 151, the Company allocated fixed production overhead costs to inventories based on the anticipated normal capacity of its manufacturing facility at the time. Included in cost of products sold for the year ended December 31, 2006 and 2005 is $2.5 million and $3.2 million, respectively, of idle capacity costs which represents the excess of fixed production overhead over that allocated to inventories.
 
During the year ended December 31, 2006 and 2005, $1.5 million and $1.5 million, respectively of inventory costs in excess of market value were included in the accompanying consolidated statement of operations related to the Supply Agreement with Esprit (see Note 3 Summary of Significant Transactions). Under the terms of this Supply Agreement, the Company sold ESTRASORB at a price below its manufacturing costs during the fourth quarter of 2005 and the year ended December 31, 2006.
 
It is likely the Company will continue to manufacture ESTRASORB at a loss until production volumes increase or it enters into additional contract manufacturing agreements with third parties to more fully utilize this manufacturing facility’s capacity. The facility is able to accommodate a much greater production than its current schedule, which, if more fully utilized, would offset the fixed costs related to the manufacturing process and facility. In addition, the Company is negotiating revisions to its agreements for packaging costs for ESTRASORB as well as its fixed lease costs for the manufacturing facility. If these negotiations result in higher packaging or lease costs to the Company, it may have a material adverse impact on future financial results.
 
Property and Equipment
 
Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, generally three to ten years. Amortization of leasehold improvements is provided over the shorter of the estimated useful lives of the improvements or the term of the lease. Repairs and maintenance costs are expensed as incurred.


F-11


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Property and equipment is comprised of the following at December 31:
 
                 
    2006     2005  
    (In thousands)  
 
Machinery and equipment
  $ 12,193     $ 11,275  
Leasehold improvements
    6,248       6,201  
Computer software and hardware
    396       320  
                 
      18,837       17,796  
Less accumulated depreciation and amortization
    (8,976 )     (6,207 )
                 
    $ 9,861     $ 11,589  
                 
 
Depreciation expense was approximately $2,921,000, $2,794,000, and $2,277,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
 
Goodwill and Intangible Assets
 
Goodwill originally results from business acquisitions. Assets acquired and liabilities assumed are recorded at their fair values; the excess of the purchase price over the identifiable net assets acquired is recorded as goodwill. Other intangible assets are a result of internally discovered patents. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), goodwill and intangible assets deemed to have indefinite lives are not amortized but are subject to impairment tests annually, or more frequently should indicators of impairment arise. The Company utilizes a discounted cash flow analysis that includes profitability information, estimated future operating results, trends and other information in assessing whether the value of indefinite-lived intangible assets can be recovered. Under SFAS No. 142, goodwill impairment is deemed to exist if the carrying value of a reporting unit exceeds its estimated fair value. In accordance with the requirements of SFAS No. 142, the Company initially tested its goodwill for impairment as of January 1, 2002 and determined that no impairment was present. The Company thereafter performed the required annual impairment test as of December 31 of each year on the carrying amount of its goodwill, which indicated the Company’s estimated fair value; of goodwill exceeded its carrying value; therefore, no impairment was identified during December 31, 2006 or 2005.
 
Goodwill and intangible assets consist of the following at December 31:
 
                                                 
    2006     2005  
          Accumulated
                Accumulated
       
    Gross     Amortization     Net     Gross     Amortization     Net  
    (In thousands)  
 
Goodwill
                                               
Goodwill-Company acquisition
  $ 33,141     $     $ 33,141     $ 33,141     $     $ 33,141  
                                                 
Intangible assets
                                               
Patents
  $ 2,525     $ (1,547 )   $ 978     $ 2,525     $ (1,415 )   $ 1,110  
                                                 


F-12


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Intangible assets are amortized on a straight-line basis over their estimated useful lives, ranging from five to 17 years. Amortization expense was $132,000, $681,000 and $776,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Estimated future amortization expenses for intangible assets as of December 31, 2006 are as follows:
 
         
    Amortization
 
Year
  Expense  
 
2007
  $ 132  
2008
    132  
2009
    132  
2010
    132  
2011
    132  
Thereafter
    318  
         
    $ 978  
         
 
The Company evaluates the recoverability of the carrying value of its long-lived assets and identifiable intangibles periodically and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. Examples of events or changes in circumstances that indicate that the recoverability of the carrying value of an asset should be assessed include, but are not limited to, the following: a significant decrease in the market value of an asset, a significant change in the extent or manner in which an asset is used, a significant physical change in an asset, a significant adverse change in legal factors or in the business climate that could affect the value of an asset, an adverse action or assessment by a regulator, an accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset, a current period operating or cash flow loss combined with a history of operating or cash flow losses, and/or a projection or forecast that demonstrates continuing losses associated with an asset used for the purpose of producing revenue. The Company considers historical performance and anticipated future results in its evaluation of potential impairment. Accordingly, when indicators of impairment are present, the Company evaluates the carrying value of these assets in relation to the operating performance of the business and future discounted and undiscounted cash flows expected to result from the use of these assets. Impairment losses are recognized when the sum of expected future cash flows is less than the assets’ carrying value. No such impairment losses have been recognized to date, with the exception of the leasehold assets written off in relation to the facility exit mentioned in Note 4 Long-term Lease and Accounting for Facility Exit Costs.
 
Revenue Recognition and Allowances
 
The Company recognizes revenue in accordance with the provisions of Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB No. 104”). For product sales, revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the seller’s price to the buyer is fixed or determinable and collectibility is reasonably assured. The Company recognizes these sales, net of allowances for returns and rebates. A large part of the Company’s product sales are to Esprit or to distributors who resell the products to their customers. The Company provides rebates to members of certain buying groups who purchase from the Company’s distributors, to distributors that sell to their customers at prices determined under a contract between the Company and the customer, and to state agencies that administer various programs such as the federal Medicaid and Medicare programs. Rebate amounts are usually based upon the volume of purchases or by reference to a specific price for a product. The Company estimates the amount of the rebate that will be paid, and records the liability as a reduction of revenue when the Company records our sale of the products. Settlement of the rebate generally occurs from three to 12 months after sale. The Company regularly analyzes the historical rebate trends and makes adjustments to recorded reserves for changes in trends and terms of rebate programs. In a similar manner, the Company estimates amounts for returns based on historical trends, distributor inventory levels, product


F-13


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

prescription data and generic competition and makes adjustments to the recorded reserves based on such information.
 
Under the terms of the Asset Purchase Agreement with Pharmelle, LLC (see Note 3 Summary of Significant Transactions) the Company no longer has responsibility for rebates or returns related to AVCtm Cream and Suppositories, NovaNatal and NovaStart as of the date of the sale of such assets. Under the License and Supply Agreements with Esprit Pharma, Inc. (see Note 3 Summary of Significant Transactions) the Company no longer has responsibility for rebates related to ESTRASORB or for returns related to ESTRASORB sales made subsequent to entering into the License Agreement on October 19, 2005.
 
The shipping and handling costs the Company incurs are included in cost of products sold in its consolidated statements of operations.
 
For upfront payments and licensing fees related to contract research or technology, the Company follows the provisions of SAB No. 104 in determining if these payments and fees represent the culmination of a separate earnings process or if they should be deferred and recognized as revenue as earned over the life of the related agreement. Milestone payments are recognized as revenue upon achievement of contract-specified events and when there are no remaining performance obligations.
 
Revenue earned under research contracts is recognized in accordance with the terms and conditions of such contracts for reimbursement of costs incurred and defined milestones. In 2005, revenue earned under a drug development contract was recognized on the percentage-of-completion method, whereby revenue was recognized in proportion to the estimated cost-to-complete the contract. In 2005, revenue earned under the renewal of the IGI agreement was recognized completely upon receipt of payment because the Company had no further performance obligations. Also in 2005, revenue earned under the License Agreement with Esprit Pharma, Inc. was recognized at the time of the agreement since the Company had no further performance obligations related to the license agreement (see Note 3 Summary of Significant Transactions).
 
Stock-Based Compensation
 
Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standard No. 123 (revised), Accounting for Share-based Payment (“SFAS No. 123R”) using the modified prospective method. This standard requires the Company to measure the cost of employee services received in exchange for equity share options granted based on the grant-date fair value of options. The cost is recognized as compensation expense over the vesting period of the options. Under the modified prospective method, compensation cost is included in operating expenses for the year ended December 31, 2006 and includes both the compensation cost of stock options granted prior to but not yet vested as of January 1, 2006 and compensation cost for all options granted subsequent to December 31, 2005.
 
Prior to adopting SFAS No. 123R on January 1, 2006, the Company’s equity-based employee compensation cost under its various stock incentive and option plans was accounted for under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, as permitted by Standard of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). Under the modified prospective method, results for prior periods have not been restated to reflect the effects of implementing SFAS No. 123R. Therefore, for the years ended December 31, 2005 and 2004, no option based employee compensation cost is reflected in the Company’s net loss, because all options granted had an exercise price equal to the underlying common stock price on the date of grant. The following table which is presented for comparative purposes only, provides the pro forma information as required by Statement of Financial Accounting Standard No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS No. 123, (“SFAS No. 148”), and illustrates the effect on net loss and loss per share for the years


F-14


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

ended December 31, 2005 and 2004 presented as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation prior to January 1, 2006.
 
                 
    Year Ended December 31,  
    2005     2004  
    (In thousands, except per share data)  
 
Net loss, as reported
  $ (11,174 )   $ (25,920 )
Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards(1) (Revised)
    (1,999 )     (4,358 )
                 
Pro forma net loss (Revised)
  $ (13,173 )   $ (30,278 )
                 
Net loss per share:
               
Basic and diluted — as reported (Revised)
  $ (0.26 )   $ (0.70 )
Basic and diluted — pro forma (Revised)
  $ (0.31 )   $ (0.82 )
 
 
(1) Does not include restricted stock compensation expense of $491,000 which is reported in the consolidated statements of operations.
 
These pro forma amounts are not necessarily indicative of future effects of applying the fair value-based method due to, among other things, the vesting period of the stock options and the fair value of additional stock options issued in future years.
 
The weighted average fair value of stock options on the date of grant and the assumptions used to estimate the fair value of stock options issued during the years ended December, 31, 2005 and 2004, using the Black-Scholes options valuation model were as follows:
 
                 
    2005     2004  
 
Weighted average fair value of options granted
  $ 3.17     $ 3.32  
Expected life (years)
    4.4       4.7  
Expected volatility
    129 %     59 %
Risk free interest rate
    4.0 %     3.0 %
Expected dividend
    0 %     0 %
Expected forfeiture
    0 %     0 %
 
The expected life of options granted was based on the Company’s historical share option exercise experience using the historical expected term from the vesting date. The expected volatility of the options granted for the years ended December 31, 2005 and 2004 was determined using historical volatilities based on stock prices since the inception of the plans. The expected volatility of the options granted for the years ended December 31, 2005 and 2004 was determined using historical volatilities based on stock prices for the preceding 12 month periods. The risk-free interest rate was determined using the yield available for zero-coupon U.S. government issues with a remaining term equal to the expected life of the options. The forfeiture rate for the years ended December 31, 2005 and 2004 was determined using historical rates since the inception of the plans. The Company has never paid a dividend, and as such the dividend yield is zero.
 
Compensation cost for grants issued prior to January 1, 2006 was accounted for using a graded method. Compensation cost for grants on or after January 1, 2006 was accounted for using a straight-lined method. Non-cash compensation expense related to all restricted stock issued has been recorded as compensation cost in accordance with SFAS No. 123R using the straight-line method of amortization.
 
For restricted stock issued prior to January 1, 2006, non-cash compensation cost was recorded using the straight-line method of amortization and unearned compensation was increased accordingly. The initial issuance of


F-15


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

restricted stock increased common stock and additional paid-in capital and was offset by unearned compensation, which was included in the stockholders’ equity section of the consolidated balance sheet. The balance as of December 31, 2005 for the unearned compensation account was $425,000 and in accordance with SFAS No. 123R was netted against additional paid-in capital as of January 1, 2006.
 
Advertising and Promotion Costs
 
All costs associated with advertising and promotions are expensed as incurred. Advertising and promotion expense was $0 in 2006, $1,730,000 in 2005 and $12,607,000 in 2004.
 
Research and Development Costs
 
Research and development costs are expensed as incurred. Such costs include internal research and development expenditures (such as salaries and benefits, raw materials and supplies) and contracted services (such as sponsored research, consulting and testing services) of proprietary research and development activities and similar expenses associated with collaborative research agreements.
 
The Company is part of a consortium that received a National Institute of Allergy and Infectious Diseases (“NIAID”) project program grant to develop HIV vaccine candidates. The Company expects to receive approximately $1.0 million through February 2008 for its participation in this grant effort.
 
Income Taxes
 
The Company’s income taxes are accounted for using the liability method. Under the liability method, deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss carryforward. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled.
 
The effect of changes in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. A valuation allowance is established when necessary to reduce net deferred tax assets to the amount expected to be realized. The Company has provided a full valuation allowance against its net deferred tax assets as of December 31, 2006 and 2005.
 
Net Loss per Share
 
Basic loss per share is computed by dividing the net loss available to common shareholders (the numerator) by the weighted average number of common shares outstanding (the denominator) during the period. Shares issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. The computation of diluted loss per share is similar to the computation of basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued (e.g. upon exercise of stock options). Potentially dilutive common shares are not included in the computation of diluted earnings per share if they are anti-dilutive. Net loss per share as reported was not adjusted for potential common shares, as they are anti-dilutive.
 
Comprehensive Loss
 
Under SFAS No. 130, Reporting Comprehensive Income, the Company is required to display comprehensive loss and its components as part of its consolidated financial statements. Comprehensive loss is comprised of the net loss and other comprehensive income (loss), which includes certain changes in equity that are excluded from the net loss. Comprehensive loss for the Company was the same as net loss for the years ended December 31, 2006, 2005 and 2004.


F-16


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Segment Information
 
The Company currently operates in one business segment, which is the research, development and commercialization of proprietary products utilizing its proprietary drug delivery and biological technologies. The Company is managed and operated as one business. A single management team that reports to the Chief Executive Officer comprehensively manages the entire business. The Company does not operate separate lines of business with respect to its products or product candidates. Accordingly, the Company does not have separately reportable segments as defined by Statement of Financial Accounting Standards No. 131, Disclosure about Segments of an Enterprise and Related Information.
 
Recent Accounting Pronouncements
 
Other than the adoption of Statement of Financial Accounting Standards No. 123 (revised), Accounting for Stock-Based Compensation (“SFAS No. 123R”), there have been no material changes in the Company’s critical accounting policies or critical accounting estimates since December 31, 2005, nor has the Company adopted any accounting policy that has or will have a material impact on its consolidated financial statements. For further discussion of the Company’s accounting policies see Note 2 “Summary of Significant Accounting Policies”.
 
SFAS No. 157
 
In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements, but does not require any new fair value measurements. SFAS No. 157 will become effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating what impact, if any, SFAS No. 157 will have on its financial condition, results of operations or liquidity.
 
SAB No. 108
 
In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (“SAB No. 108”). SAB No. 108 was issued to provide consistency between how registrants quantify financial statement misstatements and requires the Company to quantify financial statement misstatements based on their impact on each of its consolidated financial statements and related disclosure. SAB No. 108 is effective as of the end of the Company’s 2006 fiscal year, allowing a one-time transitional cumulative effect adjustment to retained earning as of January 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. The adoption of this SAB did not have any impact on the Company’s consolidated financial statements.
 
FIN 48
 
In July 2006, the Financial Accounting Standards Board issued FASB Interpretation 48, Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48, which clarifies Statement of Accounting Standard No. 109, Accounting for Income Taxes, establishes the criterion that an individual tax position has to meet for some or all of the benefits of that position to be recognized in the Company’s financial statements. On initial application, FIN 48 will be applied to all tax positions for which the statute of limitations remains open. Only tax positions that meet the more-likely-than-not recognition threshold at the adoption date will be recognized or continue to be recognized. The cumulative effect of applying FIN 48 will be reported as an adjustment to retained earnings at the beginning of the period in which it is adopted.


F-17


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
FIN 48 is effective for fiscal years beginning after December 15, 2006, and was adopted by the Company on January 1, 2007. The Company has not been able to complete its evaluation of the impact of adopting FIN 48 and as a result, is not able to estimate the effect the adoption will have on its financial position and results of operations.
 
SFAS No. 159
 
In February 2007, the FASB issued a Statement of Financial Accounting Standards No. 159 — The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”), which provides companies an option to report certain financial assets and liabilities at fair value. The intent of SFAS No. 159 is to reduce the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective for financial statements issued for fiscal years after November 15, 2007. The Company is evaluating the impact this new standard will have on its financial position and results of operations.
 
3.   Summary of Significant Transactions
 
License Agreement Renewal with IGI, Inc.
 
In December 2005, the Company received a $1,000,000 payment from IGI, Inc. (“IGI”) in accordance with an option in a licensing agreement signed between the Company and IGI in December 1995. This payment gives IGI a ten-year renewal on licensed technologies in specific fields and was included in royalties, milestone and licensing fees on the accompanying consolidated statement of operations for the year ended December 31, 2005.
 
License and Supply Agreements with Esprit Pharma, Inc.
 
In October 2005, the Company entered into License and Supply agreements for ESTRASORB with Esprit Pharma, Inc. (“Esprit”) Under the License Agreement, Esprit obtained exclusive rights to market ESTRASORB in North America and, under the Supply Agreement the Company will continue to manufacture ESTRASORB.
 
In consideration for the rights granted, Esprit paid the Company a minimum cash consideration of $12,500,000: $2,000,000 which was paid at closing, $8,000,000 which was paid in December 2005, and the remaining $2,500,000 which was paid in October 2006 in accordance with the License Agreement. The Company receives royalties on all net sales of ESTRASORB as well as milestone payments based on specific pre-determined net sales levels of ESTRASORB. The Company wrote off $2,175,000, the remaining net balance of its intangible asset for ESTRASORB rights at the date of the transaction. As part of the Supply Agreement, Esprit paid the Company $273,000 for inventory and sales and promotional materials for which the Company had a book value of $437,000. The Company incurred $200,000 of fees related to this transaction and recorded a gain of $10,125,000, which is included in gain on sales of product assets on the accompanying consolidated statement of operations for the year ended December 31, 2005.
 
License and Development Agreement and Supply Agreement with Esprit Pharma, Inc.
 
In April 2006, the Company entered into a second License and Supply Agreement with Esprit to co-develop, supply and commercialize our MNP testosterone medicine for the treatment of female hypoactive sexual desire disorder. Under the terms of the License and Development Agreement, Esprit was granted exclusive rights to market the products in North America. The Company will receive a royalty on all net sales of the product as well as milestone payments on specific pre-determined clinical and regulatory milestones. Esprit will be responsible for all development costs and will lead all clinical programs. Under the term of the Supply Agreement, the Company will be responsible for manufacturing the product.
 
Asset Purchase Agreement with Pharmelle, LLC ( the “Pharmelle Transaction”)
 
In September 2005, the Company entered into an Asset Purchase Agreement with Pharmelle, LLC for the sale of assets related to the AVC Cream and Suppositories, NovaNatal and NovaStart products, as well as assets relating


F-18


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

to certain formerly marketed products Vitelle, Nestabs, Gerimed, Irospan and Nessentials. The assets sold included, but were not limited to, intellectual property, the New Drug Application for AVC products, inventory and sales and promotional materials. In connection with the sale, Pharmelle agreed to assume those liabilities and obligations arising after the closing date of the transaction in connection with the performance by Pharmelle of certain assumed contracts, those liabilities and obligation arising after the closing date in connection with products sold by Pharmelle after the closing date or the operation of the business relating to such products or the assets after such date (including any product liability claims associated with such products), and all liability and responsibility for returns of the products made after the closing date, regardless of when such products were produced, manufactured or sold.
 
In consideration for the sale of these assets, Pharmelle paid the Company $2,500,000 in cash and assumed the liabilities noted above. In addition, the Company is entitled to royalties on AVC for a five-year period if net sales exceed certain levels. The Company wrote off $1,082,000, the net balance of its intangible assets related to the AVC product acquisition and $289,000 of inventory, recorded a $289,000 liability for future obligations and recorded a gain on the transaction of $840,000. This gain is included in gain on sales of product assets on the accompanying consolidated statement of operations for the year ended December 31, 2005.
 
In July 2006, the Company entered into an amendment to the Asset Purchase Agreement with Pharmelle to revise the royalty formula. The Company is now entitled to royalties on AVC products for a five-year period based on a percentage of gross margin if net sales exceed certain levels.
 
Restructuring of the Sales Force
 
From March through August 2005, the Company implemented measures to reduce costs associated with its commercial operations by downsizing its sales force to correspond with the Company’s strategy of transitioning from a commercial business model to that of one focused on the Company’s core competency of new product development. The March restructuring reduced the Company’s sales force numbers significantly while the August restructuring eliminated the remaining sales force. Included in sales and marketing expenses in the accompanying consolidated statement of operations for the year ended December 31, 2005 is $444,000 related to these two restructurings. Included in this amount are (i) one-time termination benefits of $305,000, all of which were paid as of December 31, 2005, (ii) auto lease contract termination costs of approximately $125,000, of which $2,000 is still included in accrued expenses as of December 31, 2005, and (iii) $14,000 of other associated costs, all of which were paid as of December 31, 2005.
 
Opportunity Grant Funds
 
In July 2005, the Company received a $400,000 Opportunity Grant from the Commonwealth of Pennsylvania for the reimbursement of certain costs incurred in connection with the move of the Company’s corporate headquarters and product development activities to Malvern, Pennsylvania. These funds were included as an offset to general and administrative expenses included in the Consolidated Statement of Operations for the year ended December 31, 2005. The Opportunity Grant had the following conditions: (i) the Company would create 95 full time jobs at the Malvern facility within three years; (ii) the Company would invest at least $9.4 million in capital improvements and fixtures and equipment at the Malvern facility within three years; and (iii) the Company would operate at the Malvern facility for a minimum of five years. If the Company failed to meet these conditions, it would be liable for a penalty equal to the full amount of the grant.
 
In line with its business strategy, the Company announced in December 2006, that it had signed a long-term lease for its new corporate headquarters and R & D facility in Rockville, Maryland, where its vaccine operations were currently located. As a result of the Company’s failure to comply with the conditions of the grant, the Department of Community & Economic Development (“DCED”) of the Commonwealth of Pennsylvania requested that the Company repay the full amount of the Opportunity Grant. The Company has recorded a current liability of $400,000 in the accompanying Consolidated Balance Sheet as of December 31, 2006 and a corresponding expense


F-19


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

in general and administrative expenses in the Consolidated Statement of Operations for the year ended December 31, 2006.
 
Cancellation of King Pharmaceuticals Agreements
 
In January 2001, the Company entered into a co-promotion agreement with King Pharmaceuticals, Inc. for the Company’s topical estrogen therapy, ESTRASORB, in the U.S. and Puerto Rico (the “Territory”). The Company also entered into a license agreement with King for many countries outside the U.S. The co-promotion and license agreements (the “Agreements”) granted King the right to share equally in the revenues and expenses for manufacturing and marketing ESTRASORB in the Territory and exclusive rights to many countries outside the U.S. The Agreements also entitled the Company to up to $5,000,000 in milestone payments from King for achievement of milestones outlined in the Agreements.
 
In June 2001, the Company amended the Agreements (the “Amended Agreements”). The Amended Agreements clarified the terms of two milestone payments totaling $5,000,000. The Amended Agreements also granted King exclusive rights to promote market and distribute ESTRASORB in Canada, Switzerland, Greece, Italy, Spain and the Netherlands, the only countries excluded from the original license agreement. In addition, the Amended Agreements included the co-promotion and license of a topical testosterone therapy for testosterone deficient women, that was in development.
 
In July 2004, King and the Company mutually agreed to terminate the Amended Agreements, among others, (the “King Transaction”). The King Transaction included the return to Novavax of all rights worldwide for ESTRASORB and the testosterone product candidate, as well as all rights to other women’s health products that the Company may successfully develop utilizing the MNP technology. The transaction also included the redemption of $40.0 million of the Company’s convertible notes held by King. Additionally, Novavax hired 50 members of King’s women’s health sales force to provide competitive sales force coverage. As part of the King Transaction, the Company paid King a net of $14.0 million in cash and issued King 3,775,610 shares of common stock, which at the time of closing were valued at approximately $18,123,000.
 
The King Transaction resulted in a gain on the redemption of the convertible notes held by King of $11,162,000, which is included in gain on redemption of debt on the consolidated statement of operations for the year ended December 31, 2004. This gain was determined based on the fair value of the convertible notes plus accrued interest as of the transaction date compared to the notes’ total book value. In addition, an intangible asset for ESTRASORB rights of $2,514,000 was recorded, which represents the difference between assets and liabilities acquired or written off, the net cash paid in the transaction, the common stock issued and transaction fees and expenses. The recorded intangible was determined to be a fair value for the rights re-acquired based on the sales levels of ESTRASORB, the status of obtaining approval outside the U.S. and the deferred further development of the testosterone product candidate. Included in the assets and liabilities written off were deferred financing costs of $351,000 relating to the convertible notes held by King, and remaining deferred revenue of $2,250,000 relating to previous licensing fees for ESTRASORB, mentioned above.
 
4.   Long-term Leases and Accounting for Facility Exit Costs
 
In December 2003, the Company prepared for the consolidation of warehousing and distribution functions for all its products by closing its distribution facility in Maryland Heights, Missouri. The Company entered into a service arrangement with Cardinal Health in Nashville, Tennessee for customer service, warehousing and product shipment to distribute current and future products. Prior to this restructuring, the Company purchased its prenatal vitamins in bulk and packaged the vitamins at the Missouri facility. As part of the restructuring, the Company also entered into an agreement with a third-party packager for the vitamin line of products.
 
One time costs associated with this restructuring included moving costs of approximately $15,000, along with transition payments to 10 production and support employees of approximately $75,000 in the aggregate were


F-20


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

included in general and administrative expenses. In addition, the Company held an auction, selling off most of the fixed assets that were located at the facility. The auction resulted in a loss on disposal of assets of approximately $129,000. As of December 31, 2004, all costs associated with the restructuring had been paid.
 
In July 2004, the Company entered into a lease agreement for a 32,900 square foot facility in Malvern, Pennsylvania for the consolidation and expansion of its corporate headquarters and product development activities. The lease, with a commencement date of September 15, 2004, has an initial term of ten years with two five-year renewal options and an early option to terminate after the first five years of the lease. Standard annual escalation rental rates were in effect during the initial lease term. In April, 2006 the Company entered into a sublease agreement with Sterilox Technologies, Inc., now known as PuriCore, Inc., to sublease 20,469 square feet of the Malvern corporate headquarters at premium price per square foot. The new sublease, has a commencement date of July 1, 2006 and expires on September 30, 2009. Consistent with its strategic focus, the Company increased its presence in Rockville, Maryland, where its vaccine operations are currently located. On December 7, 2006, the Company finalized a sublease agreement with Human Genome Sciences, Inc. (“HGS”) all initial contingencies for which have been met or been waived. On October 6, 2006, the Company and HGS executed a sublease agreement (the “HGS sublease”) whereby the Company will lease approximately 51,000 square feet of office, laboratory and administrative space in Rockville, MD. The office space will be used as the Company’s new corporate headquarters. The term of the HGS sublease commences on the dates of December 12, 2006 or the date on which a certain portion of the leased space is delivered to the Company and expires on the last day of the month which is six years following the date of delivery. The Company has the option to renew the HGS sublease for two additional periods of three years each and a third option to renew the HGS sublease until March 30, 2021.
 
In October 2006, the Company entered into an Amendment to the Sublease Agreement with PuriCore, Inc. to sublease an additional 7,500 square feet of the Malvern corporate headquarters at a premium price per square foot. This amendment has a commencement date of October 25, 2006 and expires on September 30, 2009. As a result of the premium price received on these sublease agreements, there were no facility exit costs associated with this transaction.
 
During 2004 through 2006, the Company applied the principles of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, in accounting for lease termination and other associated costs that would continue to be incurred under the operating lease which expired on October 31, 2006 related to the Company’s former corporate offices located in Columbia, Maryland.
 
A roll-forward of the facility exit cost liability is as follows:
 
                 
    Current     Non-Current  
    (In thousands)  
 
Original amount expensed and set up as a liability
  $ 151     $ 101  
Lease payments applied to the liability
    (58 )     (161 )
Adjustment to original estimate
    45       60  
                 
Balance as of December 31, 2005
    138        
Lease payments applied to the liability
    (142 )      
Adjustment to original estimate
    4        
                 
Balance as of December 31, 2006
  $     $  
                 


F-21


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

5.   Supplemental Financial Data
 
Allowance for Doubtful Accounts
 
A roll-forward of the allowance for doubtful accounts is as follows:
 
         
    (In thousands)  
 
Balance, December 31, 2003
  $ 376  
Provision for bad debts
    413  
Write off bad debts
    (37 )
         
Balance, December 31, 2004
    752  
Provision for bad debts
    4  
Other adjustments
    (327 )
         
Balance, December 31, 2005
    429  
Provision for bad debts
    111  
Write off bad debts
    (423 )
         
Balance, December 31, 2006
  $ 117  
         
 
Prepaid Expenses and Other Current Assets
 
Prepaid expenses and other current assets consist of the following at December 31:
 
                 
    2006     2005  
    (In thousands)  
 
Prepaid insurance
  $ 720     $ 593  
Current portion of deferred financing costs
    259       341  
Non-trade receivables
          75  
Notes receivable from former director, net of reserve
    281        
Interest receivable on directors’ notes
    359       284  
Other current assets
    53       54  
Interest receivable
    201        
                 
    $ 1,873     $ 1,347  
                 
 
Property and Equipment
 
Property and equipment is comprised of the following at December 31:
 
                 
    2006     2005  
    (In thousands)  
 
Machinery and equipment
  $ 12,193     $ 11,275  
Leasehold improvements
    6,248       6,201  
Computer software and hardware
    396       320  
                 
      18,837       17,796  
Less accumulated depreciation
    (8,976 )     (6,207 )
                 
    $ 9,861     $ 11,589  
                 
 
Depreciation expense was approximately $2,921,000, $2,794,000, and $2,277,000 for the years ended December 31, 2006, 2005 and 2004, respectively.


F-22


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Accrued Expenses
 
Accrued expenses consist of the following at December 31:
 
                 
    2006     2005  
    (In thousands)  
 
Sales return allowance
  $ 238     $ 282  
Sales rebate allowance
    14       18  
Employee benefits and compensation
    822       754  
Operating expenses
    1,529       917  
Interest expense
    475       626  
                 
    $ 3,078     $ 2,597  
                 
 
Sales Return Allowance
 
A roll-forward of the sales return allowance is as follows:
 
         
    (In thousands)  
 
Balance, December 31, 2003
  $ 158  
Provision for returns for 2004 sales
    885  
Additional provision for returns for 2003 sales
    771  
Additional provision for returns for 2002 sales
    463  
Returns received for 2002 sales
    (447 )
Returns received for 2003 sales
    (556 )
         
Balance, December 31, 2004
    1,274  
Provision for 2005 sales
    95  
Additional provision for 2004 sales
    98  
Additional provision for 2003 sales
    341  
Returns received from 2003 sales
    (926 )
Returns received from 2004 sales
    (600 )
         
Balance, December 31, 2005
    282  
Provision for 2006 sales
    218  
Additional provision for 2005 sales
    41  
Returns received from 2004 sales
    (129 )
Returns received from 2005 sales
    (174 )
         
Balance, December 31, 2006
  $ 238  
         


F-23


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

6.   Long-term debt
 
Notes Payable
 
Notes payable consist of the following at December 31:
 
                 
    2006     2005  
    (In thousands)  
 
Note payable; bears interest at 3.00% per annum; principal and interest due in monthly installments of $6,600 through December 2009
  $ 215     $ 287  
Note payable; bears interest at 2.850% per annum; principal and interest due in monthly installments of $6,573 through January 2010
    233       303  
Note payable; bears interest at 2.38% per annum; principal and interest due in monthly installments of $6,468 through January 2010
    231       302  
Note payable; insurance financing; bears interest at 5.09% per annum; principal and interest due in monthly installments of $56,868 through September 2006
          501  
Note payable; insurance financing; bears interest at 5.43% per annum; principal and interest due in monthly installments of $58,097 through September 2007
    510        
                 
Total
    1,189       1,393  
Less current portion
    (731 )     (715 )
                 
Long-term portion
  $ 458     $ 678  
                 
 
The notes payable (except for the notes payable for financing insurance premiums) are secured by $2.4 million of the Company’s machinery and equipment located at its manufacturing facility in Philadelphia, Pennsylvania.
 
Convertible Notes
 
From 2000 to 2002, the Company entered into a series of note purchase agreements with King Pharmaceuticals Inc. (“King”) totaling $40,000,000. All of the notes would have matured on December 19, 2007 with interest payable in semi-annual installments on June 30 and December 31. As part of the King Transaction, the Company redeemed these notes on July 19, 2004. For the six months ended June 30, 2004, the Company accrued interest of $800,000 relating to the King notes. This accrued interest was written off as part of the King Transaction and included in the resulting gain on the redemption of the convertible notes held by King (see Note 3 Summary of Significant Transactions). For the year ended December 31, 2003, the Company made cash interest payments of $1.6 million for the King notes. For the year ended December 31, 2002, the Company made cash interest payments of $600,000 and accrued an additional $800,000 for interest expense at year-end for which King agreed to accept payment in common stock. In February 2003, the Company issued King 307,692 shares of common stock to satisfy the accrued interest payable. For the year ended December 31, 2003, the Company capitalized $386,717 for interest incurred on debt used to finance the build-out of its manufacturing facility.
 
Concurrent with the King Transaction, in July 2004 the Company also entered into definitive agreements for the private placement of $35,000,000 aggregate principal amount of senior convertible notes to a group of institutional investors. The notes carry a 4.75% coupon, payable semi-annually, mature in five years and are currently convertible into shares of common stock at $5.46 per share. From the third anniversary of the issue date of the notes, and subject to certain conditions, the Company has the right to effect a mandatory conversion of the notes if the weighted average price of the common stock exceeds 175% of the then conversion price for each of 15 trading days out of any 30 consecutive trading days. Note holders have the right to require the Company to redeem all or a portion of the notes if the weighted average price of the common stock for each of 30 trading days out of 40 consecutive trading days prior to either the third or fourth anniversary of the issue date of the notes is less than the


F-24


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

then applicable conversion price of the Company’s common stock, provided, that a holder’s right to effect this optional redemption will not apply if certain revenue targets for ESTRASORB are achieved. The notes are also redeemable upon the occurrence of specified events of default as well as a “change of control” (as that term is defined in the notes) of Novavax. At December 31, 2006 and 2005, the Company had accrued interest of $475,260 and $626,000 respectively, relating to these notes.
 
In October 2005, certain holders of $6,000,000 face amount of the Company’s senior convertible notes exercised their optional conversion right to convert their notes plus accrued interest of $81,000 into 1,070,635 shares of Novavax common stock, at the per share conversion price then in effect of $5.68. This reduced the aggregate principal amount of such notes outstanding from $35,000,000 to $29,000,000.
 
In March 2006, certain holders of $7,000,000 face amount of the Company’s senior convertible notes exercised their optional conversion right to convert their notes plus accrued interest of $68,000 into 1,294,564 shares of Novavax common stock, at the per share conversion of $5.46. This reduced the aggregate principal amount of such notes outstanding from $29,000,000 to $22,000,000.
 
As a result of the financing and the King Transaction, the Company incurred $3,355,000 of transaction expenses, which increased the intangible asset for ESTRASORB rights by $1,010,000 (included in the total intangible asset for ESTRASORB rights of $2,514,000), decreased additional paid-in capital by $288,000, and increased deferred financing costs by $2,057,000. The deferred financing costs are being amortized over the life of the convertible notes. During the years ended December 31, 2006, 2005 and 2004, $279,000, $400,000 and $184,000, respectively, of deferred financing costs amortization were included in interest expense on the accompanying consolidated statements of operations. Concurrent with the conversions of $6,000,000 and $7,000,000 of senior convertible debt (mentioned above), the Company wrote off in 2006 and 2005, $267,000 and $262,000, respectively, of deferred financing costs. These write offs are included in interest expense on the accompanying consolidated statements of operations for the years ended December 31, 2006 and 2005.
 
Convertible notes consist of the following on December 31:
 
                 
    2006     2005  
    (In thousands)  
 
Note payable; 4.75% senior convertible, issued July 19, 2004, due July 15, 2009, currently convertible into 4,029,304 shares of Novavax common stock at $5.46 per share
  $ 22,000     $ 29,000  
                 
 
Aggregate future minimum principal payments on debt at December 31, 2006 are as follows:
 
         
Year
  Amount  
    (In thousands)  
 
2007
  $ 731  
2008
    226  
2009
    22,219  
2010
    13  
         
    $ 23,189  
         
 
Total cash interest payments for the three years ended December 31, 2006, 2005 and 2004 were $1,233,011, $1,719,000 and $54,000, respectively.


F-25


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
7.   Sale of Common Stock
 
During 2004, the Company received net proceeds of $369,000 from the exercise of 107,550 common stock options at a range of $3.24 to $4.30 per share.
 
Concurrent with the King Transaction, in July 2004 the Company issued 952,381 shares of common stock at $5.25 per share, for gross proceeds of $5.0 million to an accredited investor in reliance on Regulation D promulgated under the Securities Act of 1933, as amended. A resale registration statement was filed and declared effective for such shares in August 2004.
 
In July 2005, the Company completed an agent-led offering of 4,000,000 shares of common stock at $1.00 per share for gross proceeds of $4,000,000. The stock was issued pursuant to an existing shelf registration statement. Net proceeds after deducting underwriter, legal, accounting and other miscellaneous fees were approximately $3,631,000.
 
In August 2005, the Company issued 250,000 shares of common stock in a private placement to its former Chief Executive Officer for prior services, which had a fair market value of $215,000 at the time of issuance.
 
In August 2005, the Company approved the issuance of 50,000 shares of common stock to a director in a private placement for prior services and for his agreement to pledge such shares to a brokerage firm to secure the debt guarantee by the Company (see Note 13 Related Party Transactions). The fair value at the time of the approval of these shares was $37,000 and they were issued in December 2005.
 
In November 2005, the Company completed an offering of 4,186,047 shares of common stock at $4.30 per share. The stock was offered and sold pursuant to an existing shelf registration statement. Net proceeds after deducting underwriter fees, legal and other miscellaneous fees were approximately $17,032,000.
 
In February 2006, the Company completed an offering of 4,597,700 shares of common stock at $4.35 per share for gross proceeds of $20 million. The stock was offered and sold pursuant to an existing shelf registration statement. Net proceeds were approximately $19.9 million.
 
In March 2006, the Company completed an agent-led offering of 5,205,480 shares of common stock at $7.30 per share, for gross proceeds of $38.0 million. The stock was offered and sold pursuant to an existing shelf registration statement. Net proceeds were approximately $36.1 million.
 
During 2006, the Company received net proceeds of $1,718,000 for the exercise of 497,613 common stock options at a range of $0.74 to $5.81 per share.
 
8.   Stockholders’ Equity
 
On August 7, 2002, the Company adopted a Shareholder Rights Plan which provides for the issuance of rights to purchase shares of Series D Junior Participating Preferred Stock, par value $0.01 per share (the “Preferred Shares”), of the Company. Under the Shareholder Rights Plan, the Company distributed one preferred share purchase right (a “Right”) for each outstanding share of common stock, par value $.01 (the “Common Shares”), of the Company. The Rights were distributed to stockholders of record on August 16, 2002.
 
Each Right entitles the holder to purchase from the Company one-thousandth of a Preferred Share at a price of $40, subject to adjustment. The Rights become exercisable, with certain exceptions, 10 business days after any party, without prior approval of the Board of Directors, acquires or announces an offer to acquire beneficial ownership of 15% or more of the Company’s Common Shares. In the event that any party acquires 15% or more of the Company’s common stock, the Company enters into a merger or other business combination, or if a substantial amount of the Company’s assets are sold after the time that the Rights become exercisable, the Rights provide that the holder will receive, upon exercise, shares of the common stock of the surviving or acquiring company, as applicable, having a market value of twice the exercise price of the Right.


F-26


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
The Rights expire August 7, 2012, and are redeemable by the Company at a price of $0.00025 per Right at any time prior to the time that any party acquires 15% or more of the Company’s Common Shares. Until the earlier of the time that the Rights become exercisable, are redeemed or expire, the Company will issue one Right with each new Common Share issued.
 
9.   Stock Options and Restricted Stock Awards
 
The Company recorded compensation costs in the consolidated statement of operation associated with SFAS No. 123R as follows:
 
         
    Year Ended
 
    December 31, 2006  
    (In thousands)  
 
Cost of products sold (which includes idle capacity)
  $ 48  
Research and development
    561  
General and administrative
    1,167  
         
Total effect of adopting SFAS No. 123R
  $ 1,776  
         
 
The Company has granted stock option incentive awards under several plans. Under the 2005 Stock Incentive Plan (the “2005 Plan”), approved in May 2005 by the stockholders of the Company, options may be granted to officers, employees, consultants and advisors to Novavax and any present or future subsidiary to purchase a maximum of 2,000,000 shares of Novavax common stock and an additional 565,724 shares of common stock that had been held in reserve under the Company’s 1995 Stock Option Plan (the “1995 Plan”), were unused and were transferred to the Company 2005 Plan. In addition, a maximum 5,746,468 shares of common stock subject to existing options under the 1995 Plan may revert to and become issuable under the 2005 Plan if such existing options granted under the 1995 Plan should for any reason expire or otherwise terminate.
 
Under the 2005 Plan, the 1995 Plan and the 1995 Director Stock Option Plan (the “1995 Director Plan”) incentive stock options, having a maximum term of 10 years, can be or were granted at no less than 100% of the fair market value of Novavax’s stock at the time of grant and are generally exercisable in cumulative increments over several years from the date of grant. Both incentive and non-statutory stock options may be granted under these plans. There is no minimum exercise price for non-statutory stock options.
 
The exercise price is the fair market value per share of the Company’s common stock on the date of grant. Options granted to eligible directors are exercisable in full beginning six months after the date of grant and expire 10 years from the grant date. All options available under the 1995 Director Plan have been granted. Such options cease to be exercisable at the earlier of their expiration or three years after an eligible director ceases to be a director for any reason. In the event that an eligible director ceases to be a director on account of his or her death, any outstanding options (whether exercisable or not on the date of death) may be exercised within three years after such date (subject to the condition that no such option may be exercised after the expiration of 10 years from its date of grant).


F-27


 

 
NOVAVAX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Activity under the 2005 Plan, 1995 Plan and Director Plan was as follows:
 
                                                 
                1995 Director Stock
 
    2005 Stock Option Plan     1995 Stock Option Plan     Option Plan  
          Weighted
          Weighted
          Weighted
 
          Average
          Average
          Average
 
    Stock Options     Exercise Price     Stock Options     Exercise Price     Stock Options     Exercise Price  
 
Balance, December 31, 2003
                    4,211,643     $ 5.61       270,000     $ 4.03  
Granted
                    1,308,150       5.46              
Exercised
                    (107,550 )     3.43              
Expired or canceled
                    (350,275 )     7.69              
                                                 
Balance, December 31, 2004
                    5,061,968       5.48       270,000       4.03  
                                                 
Granted
    2,192,775     $ 1.22       486,825       2.13              
Exercised
                (312,654 )     0.96       (30,000 )     3.15  
Expired or canceled
    (88,850 )     1.46       (2,115,978 )     5.64       (70,000 )     4.61  
                                                 
Balance, December 31, 2005
    2,103,925     $ 1.21       3,120,161     $ 5.30       170,000     $ 3.95  
                                                 
Granted
    1,409,500     $ 4.50                          
Exercised
    (235,571 )     3.21       (242,042 )   $ 3.69       (20,000 )   $ 3.44  
Expired or canceled
    (241,916 )     2.41       (352,150 )     5.46              
                                                 
Balance, December 31, 2006
    3,035,938     $ 2.49       2,525,969     $ 5.43       150,000     $ 4.01  
                                                 
Shares exercisable at December 31, 2004
        $       2,683,195