Prepared by MERRILL CORPORATION
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549


FORM 8-K/A

CURRENT REPORT

PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934

JUNE 29, 2001
Date of Report (Date of earliest event reported)

INHALE THERAPEUTIC SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

Delaware   023556   94-3134940
(State or other jurisdiction
of incorporation)
  (Commission
File Number)
  (I.R.S. Employer
Identification No.)

150 Industrial Road
San Carlos, CA 94070
(Address of principal executive offices and zip code)

(650) 631-3100
(Registrant's telephone number, including area code)

(Former name, if changed since last report)





ITEM 2.  ACQUISITION OR DISPOSITION OF ASSETS.

    The purpose of this filing is to provide certain information as required by Item 7 with respect to the Merger (as defined below) which information was impracticable to provide at the time the registrant filed the Current Report on Form 8-K dated July 10, 2001.

    Effective June 29, 2001, Inhale Therapeutic Systems, Inc. ("Inhale") consummated its acquisition of privately-held Shearwater Corporation ("Shearwater"), pursuant to an Agreement and Plan of Merger and Reorganization, dated May 22, 2001, as amended (the "Agreement"), by and among Inhale, Square Acquisition Corp., a wholly owned subsidiary of Inhale (the "Merger Sub"), Shearwater, J. Milton Harris and Puffinus, L.P. Pursuant to the Agreement, Shearwater merged with and into Merger Sub, with Merger Sub being the surviving corporation (the "Merger"). The Merger is intended to qualify as a tax-free reorganization and will be accounted for using the purchase method of accounting.


ITEM 7.  FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS.

    The following financial statements and exhibits are filed as part of this Report, where indicated.

(a)
FINANCIAL STATEMENTS OF BUSINESS ACQUIRED.
(b)
PRO FORMA FINANCIAL INFORMATION.
(c)
EXHIBITS
Exhibit Number
  Description

2.1 * Agreement and Plan of Merger and Reorganization, dated May 22, 2001, by and among Inhale Therapeutic Systems, Inc., Square Acquisition Corp., Shearwater Corporation, J. Milton Harris and Puffinus, L.P.

2.2

*

Amendment to Agreement and Plan of Merger and Reorganization, dated June 21, 2001, by and among Inhale Therapeutic Systems, Inc., Square Acquisition Corp., Shearwater Corporation, J. Milton Harris and Puffinus, L.P.

23.1

 

Consent of Independent Auditors

99.1

*

Press Release titled "Inhale Announces Completion of Transaction to Acquire Shearwater Corporation" dated July 2, 2001.

*
Previously filed

2


SIGNATURES

    Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

        INHALE THERAPEUTIC SYSTEMS, INC.

Dated:

 

August 10, 2001


 

By:

 

/s/ 
BRIGID A. MAKES   
Brigid A. Makes
Vice President, Finance and Administration,
Chief Financial Officer

 

 

 

 

 

 

(Duly Authorized Officer and Principal Financial and Accounting Officer)

3


INDEX TO FINANCIAL STATEMENTS

Shearwater Corporation (formerly Shearwater Polymers, Inc.)

Report of Ernst & Young, LLP, Independent Auditors   F-1
Balance Sheet as of June 30, 2000   F-2
Statement of Income for the year ended June 30, 2000   F-3
Statement of Stockholders' Equity for the year ended June 30, 2000   F-4
Statement of Cash flows for the year ended June 30, 2000   F-5
Notes to Financial Statements   F-6

Balance Sheet as of March 31, 2001 (unaudited)

 

F-12
Statement of Income for the three-month and nine-month periods ended March 31, 2001
and March 31, 2000 (unaudited)
  F-13
Statement of Cash Flows for the nine-month periods ended March 31, 2001 and March 31, 2000 (unaudited)   F-14
Notes to Unaudited Financial Statements   F-15

Inhale Therapeutic Systems, Inc.

 

 

Unaudited Pro Forma Condensed Combined Financial Information

 

F-16
Unaudited Pro Forma Condensed Combined Balance Sheet as of March 31, 2001   F-17
Unaudited Pro Forma Condensed Combined Statement of Operations for the year ended December 31, 2000   F-18
Unaudited Pro Forma Condensed Combined Statement of Operations
for the three-month period ended March 31,2001
  F-19
Notes to Unaudited Pro Forma Condensed Combined Financial Information   F-20

Report of Ernst & Young, LLP, Independent Auditors

The Board of Directors
Shearwater Polymers, Inc.

    We have audited the accompanying balance sheet of Shearwater Polymers, Inc. as of June 30, 2000, and the related statements of income, 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 auditing standards generally accepted in the 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 financial statements referred to above present fairly, in all material respects, the financial position of Shearwater Polymers, Inc. at June 30, 2000, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States.

/s/ Ernst & Young LLP

Birmingham, Alabama
February 7, 2001

F–1



Shearwater Polymers, Inc.
Balance Sheet

 
  June 30,
2000

 
Assets        
Current assets:        
  Cash and cash equivalents   $ 2,144,000  
  Investments (held to maturity)     3,960,000  
  Accounts receivable, less allowance of $4,000     2,072,000  
  Inventories     1,874,000  
  Receivables—other     57,000  
  Income tax receivable     636,000  
  Prepaid expenses     277,000  
   
 
Total current assets     11,020,000  
Property, plant and equipment:        
  Land     395,000  
  Equipment     4,017,000  
  Automotive     62,000  
  Furniture and fixtures     122,000  
  Leasehold improvements     593,000  
  Construction-in-process     40,000  
   
 
      5,229,000  
  Less accumulated depreciation     (1,717,000 )
   
 
Net property and equipment     3,512,000  
Other assets:        
  Deposits     9,000  
  Related party receivables     270,000  
  Investment     20,000  
  Deferred income tax     2,119,000  
   
 
Total other assets     2,418,000  
   
 
Total assets   $ 16,950,000  
   
 
Liabilities and stockholders' equity        
Current liabilities:        
  Accounts payable   $ 1,282,000  
  Unearned revenue     1,208,000  
  Accrued expenses     964,000  
  Deferred income tax     6,000  
  Notes payable—current portion     295,000  
   
 
Total current liabilities     3,755,000  
Unearned revenue     214,000  
Notes payable     866,000  
Stockholders' equity:        
  Common stock, $.01 par; 2,000,000 shares authorized, 945,906 issued and outstanding     10,000  
  Additional paid-in capital     16,314,000  
  Deferred stock compensation     (5,089,000 )
  Retained earnings     880,000  
   
 
Total stockholders' equity     12,115,000  
   
 
Total liabilities and stockholders' equity   $ 16,950,000  
   
 

See accompanying notes.

F–2



Shearwater Polymers, Inc.
Statement of Income

 
  Year ended
June 30,
2000

 
Net sales   $ 15,174,000  
License revenue     931,000  
   
 
Total revenue     16,105,000  

Cost of sales

 

 

4,335,000

 
   
 
Gross profit     11,770,000  

Operating expenses:

 

 

 

 
  General and administrative     2,209,000  
  Research and development     1,989,000  
  Selling     580,000  
  Stock compensation     2,106,000  
   
 
      6,884,000  
   
 
Operating income     4,886,000  

Other income (expense):

 

 

 

 
  Interest income, net     121,000  
  Other expense     (207,000 )
   
 
      (86,000 )
   
 
Income before income taxes     4,800,000  

Income taxes

 

 

1,830,000

 
   
 
Net income   $ 2,970,000  
   
 

See accompanying notes.

F–3



Shearwater Polymers, Inc.
Statement of Stockholders Equity
For the year ended June 30, 2000

 
  Common
Stock

  Additional
Paid-In
Capital

  Deferred
Stock
Compensation

  Retained
Earnings

  Total
Stockholders'
Equity

Balance at June 30, 1999   $ 9,000   $ 9,668,000   $ (3,587,000 ) $ (2,090,000 ) $ 4,000,000
Proceeds from sale of stock     1,000     4,999,000             5,000,000
Stock option activity         1,647,000     (1,502,000 )       145,000
Net income                 2,970,000     2,970,000
   
 
 
 
 
Balance at June 30, 2000   $ 10,000   $ 16,314,000   $ (5,089,000 ) $ 880,000   $ 12,115,000
   
 
 
 
 

See accompanying notes.

F–4



Shearwater Polymers, Inc.
Statement of Cash Flows

 
  Year ended
June 30, 2000

 
Operating activities:        
Net income   $ 2,970,000  
Adjustments to reconcile net income to net cash provided by operating activities:        
  Depreciation and amortization     704,000  
  Deferred taxes     (70,000 )
  Gain on asset dispositions     19,000  
  Deferred stock compensation     2,105,000  
Changes in:        
  Accounts receivable     (996,000 )
  Inventories     (624,000 )
  Receivables—other     235,000  
  Income tax receivables     (199,000 )
  Prepaid expenses     (241,000 )
  Deposits     3,000  
  Related party receivables     (216,000 )
  Accounts payable     247,000  
  Unearned revenue     368,000  
  Accrued expenses     527,000  
   
 
Total adjustments     1,862,000  
   
 
Net cash provided by operating activities     4,832,000  

Investing activities:

 

 

 

 
Property and equipment purchased     (1,719,000 )
Property and equipment proceeds     399,000  
Investments purchased     (3,960,000 )
   
 
Net cash used in investing activities     (5,280,000 )

Financing activities:

 

 

 

 
Payment on notes     (265,000 )
Proceeds from issuance of notes     290,000  
Net payments on line of credit     (750,000 )
Proceeds from issuance of stock     5,000,000  
Stock option buy-back     (1,960,000 )
   
 
Net cash provided by financing activities     2,315,000  
   
 
Net increase in cash and cash equivalents     1,867,000  
Cash and cash equivalents at beginning of year     277,000  
   
 
Cash and cash equivalents at end of year   $ 2,144,000  
   
 
Cash paid during the year for:        
  Interest   $ 104,000  
  Income taxes, net of refunds     2,101,000  

See accompanying notes.

F–5



Shearwater Corporation
Notes to Financial Statements

1.  Organization and Description of the Business

    Shearwater Polymers, Inc. (the "Company") is a biopharmaceutical company which has developed new biomedical commercial applications of polyethylene glycol ("PEG"). The Company manufactures pharmaceutical grade PEG derivatives that are suitable for chemical attachment to pharmaceutical products and medical devices. The Company sells these products primarily to pharmaceutical companies throughout North America, Europe and Japan.

2.  Significant Accounting Policies

Cash and Cash Equivalents

    The Company considers all highly liquid investments with maturities of three months or less to be cash equivalents.

Inventories

    Inventories consist primarily of raw materials, work-in-process and finished goods and are stated at the lower of cost (first-in, first-out method) or market.

Property, Plant and Equipment

    All assets are recorded at cost. Depreciation is provided principally by using the straight-line method at rates based on the following estimated useful lives:

Description

  Life (Years)
Equipment   5 - 7
Automotive   5
Furniture and fixtures   3 - 7
Leasehold improvements   7 - 39

Investments

    The Company's investments consist of short-term notes. These investments are classified as held-to-maturity in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, because the Company has the positive intent and ability to hold the investments to maturity. These investments are classified as current assets and are stated at amortized cost.

Revenue Recognition

    Net sales are recognized when products are shipped.

    License revenue from license and supply agreements with pharmaceutical companies ("clients") consist of upfront, milestone and royalty payments. The Company defers upfront payments and recognizes them over their clients' drug development period. The Company recognizes milestone payments as revenue when all of the conditions to payment have been met and there are no further performance contingencies or conditions to the Company's receipt of payment. Such milestone payments, when recognized, are not refundable or creditable against future payments, and do not require any future performance by the Company in order to retain them. Royalties are recognized as

F–6


revenue as sales are made by clients of products developed pursuant to the license and supply agreements.

Advertising

    The Company expenses advertising costs in the period the costs are incurred.

Income Taxes

    The Company accounts for income taxes under the provisions of FASB Statement No. 109, Accounting for Income Taxes. Under Statement No. 109, deferred tax assets and liabilities are determined based upon differences between financial reporting and tax basis of assets and liabilities, and are measured at the enacted tax rates that will be in effect when the taxes are expected to be paid.

Stock-Based Compensation

    The Company issues awards under its stock option plans as described in Note 10. These stock options are accounted for in accordance with APB Opinion No.25, Accounting for Stock Issued to Employees.

New Accounting Pronouncement

    In June 1998, the FASB issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. In 1999, the FASB delayed the effective date of FASB Statement No. 133 until years beginning after June 15, 2000. FASB Statement No. 133 will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either offset against the change in fair value of the hedged item through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The Company expects to adopt Statement No. 133 effective after fiscal 2000, and believes that this statement will not have a significant impact on the Company's financial statements.

Use of Estimates

    In preparing financial statements in conformity with accounting principles generally accepted in the United States, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Actual results could differ from those estimates.

3.  Inventories

Inventories consist of the following at June 30:      
Raw Materials   $ 499,000
Work-in-Process     432,000
Finished Goods     943,000
   
    $ 1,874,000
   

F–7


4.  Notes Payable

Notes payable consist of the following at June 30:        
Note, payable in monthly installments of $3,956 through 07/05/04 including interest at 7.99%   $ 165,000  
Note, payable in monthly installments of $1,986 through 07/05/04 including interest at 7.99%     82,000  
Note, payable in monthly installments of $1,268 through 04/13/04 including interest at 7.50%     51,000  
Note, payable in monthly installments of $10,147 through 09/24/03 including interest at 7.50%     351,000  
Note, payable in monthly installments of $10,350 through 12/07/03 including interest at 7.50%     382,000  
Note, payable in monthly installments of $3,373 through 02/13/04 including interest at 7.50%     130,000  
   
 
Total notes payable     1,161,000  
Less amounts due within one year     (295,000 )
   
 
    $ 866,000  
   
 

    The above notes are collateralized by $1,824,873 of equipment owned by the Company.

    The following schedule presents the annual minimum scheduled principal payments for the fiscal years succeeding June 30, 2000:

2001   $ 295,000
2002     319,000
2003     344,000
2004     197,000
2005     6,000
Thereafter    
   
    $ 1,161,000
   

    The Company has a line of credit agreement, through November 2000, that allows the Company to borrow up to 80% of eligible receivables plus 50% of eligible inventories, with a maximum borrowing set at $750,000, at prime less .25%. The line of credit contains restrictive covenants that require the maintenance of a minimum tangible net worth and fixed charge coverage ratio. There were no outstanding borrowings under this line of credit at June 30, 2000. The line of credit is collateralized by substantially all assets of the Company.

5.  Concentrations

    Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and accounts receivable. The Company maintains its cash balances in two financial institutions located in Huntsville, Alabama, which are insured by the Federal Deposit Insurance Corporation up to $100,000. At June 30, 2000, the Company's uninsured cash balances approximate $1,944,000.

    At June 30, 2000, 82% of the outstanding accounts receivable balance were from two customers. For the year ended June 30, 2000, approximately 60% of net sales were from two major customers. A major raw material component of the Company's products is supplied by one vendor located in Japan.

F–8


6.  Income Taxes

    A summary of the components of the provision for income taxes for the year ended June 30, 2000 is as follows:

Current:        
  Federal   $ 1,725,000  
  State     175,000  
   
 
      1,900,000  

Deferred:

 

 

 

 
  Federal     (63,000 )
  State     (7,000 )
   
 
    $ 1,830,000  
   
 

    The primary differences between the income tax expense reflected on the financial statements and income taxes calculated at federal statutory income tax rates are due to state income taxes, non-deductible stock compensation and other non-deductible expenses.

    Total deferred tax assets of $2,400,000 related primarily to stock compensation, unearned revenue, vacation and Section 263A inventory adjustments. Total deferred liabilities of $287,000 related primarily to book and tax basis differences on property, plant and equipment.

7.  Leases

    The Company leases certain office equipment under operating lease agreements. Lease expense for the year ended June 30, 2000 was $352,000. The lease terms range from three to five years.

    Future minimum lease payments under non-cancelable leases are as follows:

2001   $ 362,000
2002     362,000
2003     350,000
2004     300,000
2005     300,000
Thereafter     1,200,000

8.  Related Party Transactions

    The Company leases its main office and manufacturing facility from Shearwater Polymers, LLC, a corporation which is 98%-owned by the President of the Company. This facility's lease payments are $25,000 per month and the lease will expire in July 2009.

    For the year ended June 30, 2000, the Company also leased a research facility on a month-to-month basis from the President and another member of the Board of Directors of the Company. The leasehold improvements relating to this facility were owned by the Company. For the year ended June 30, 2000, rent paid under this lease was $43,200. In June 2000, the President sold his interest in this facility and the Company sold the related leasehold improvements to the member of the Board of Directors.

    At June 30, 2000, the Company had accounts receivable from Shearwater Polymers, LLC and an officer of the Company of $261,000 and $23,000, respectively, which accrue interest at a rate of 5.1% and 7.0% per annum, respectively.

F–9


9.  Retirement Plan

    The Company has a 401(K) profit sharing plan that covers all employees who meet the minimum participation requirements. For those employees participating, annual compensation may be deferred up to the maximum prescribed by the Internal Revenue Code. The Company matches employee contributions at a rate of 50% on the first 10% contributed by the employee. Matching contributions for the year ended June 30, 2000 were $106,000.

10.  Stock Option Plan

    In December 1996, the Companies' Board of Directors approved the adoption of the Shearwater Polymers, Inc. 1996 Non-Qualified Stock Option Plan (the "Plan"). As approved under the Plan, a maximum of 250,000 shares of common stock are reserved and available for issuance. In fiscal 1999, the Board of Directors increased the number of shares of common stock approved under the Plan to a maximum of 300,000 shares. The Plan is intended to encourage employees and Directors to remain with the Company and to stimulate interest in owning stock in the Company. The Plan's purpose is carried out by granting options to purchase shares of common stock for an exercise price of $.10 per share. These options have limited transferability as defined in the Plan.

    FASB Statement No. 123, Accounting for Stock Based Compensation provides an alternative to APB Opinion No. 25 in accounting for stock-based compensation issued to employees. The statement allows for a fair value based method of accounting for employee stock options. However for companies that continue to follow the accounting provisions of APB Opinion No. 25, FASB Statement No.123 requires disclosure of the pro forma effect on net income as if the accounting provisions of the fair value method of FASB Statement No. 123 had been employed. In accordance with FASB Statement No. 123, the fair value of the option grant was determined by using the minimum value option pricing model with the following assumption for the year ended June 30, 2000:

Dividend yield   0%
Risk-free interest rate   5.5% to 6.5%
Expected lives, in years   5 to 10

    At June 30, 2000, the options outstanding had a weighted average remaining contractual life of 5.47 years. All options outstanding at June 30, 2000 were issued with an exercise price of $.10 and a term ranging from 5 to 10 years from the grant date. The weighted-average grant-date fair value of options issued during 2000 was approximately $61.90 per share.

    For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The effects of applying FASB Statement No. 123 for pro forma disclosure may not be representative of the effects on reported pro forma net income in future years. The Company's pro forma net loss applying FASB Statement No. 123 approximates reported results as these options are granted with an exercise price below the market price of the stock on the measurement date and is therefore subject to compensation expense each period under APB Opinion No. 25.

F–10


    In May 2000, the Company completed the purchase of 49,010 vested options at $40.00 per option for a total cost of $1,960,400. At June 30, 2000, 237,796 options were issued and outstanding. A summary of the stock option plan activity is as follows:

 
  Options
Outstanding

  Options
Exercisable

 
Balance at June 30, 1999   246,806   144,606  
  Vested     46,700  
  Granted   45,000    
  Purchased   (49,010 ) (49,010 )
  Forfeited   (5,000 ) (5,000 )
   
 
 
Balance at June 30, 2000   237,796   137,296  
   
 
 

11.  Subsequent Event (unaudited)

    Effective October 6, 2000, the Company changed its name to Shearwater Corporation.

    On June 29, 2001, the Company was purchased by Inhale Therapeutic Systems, Inc., for approximately $192.2 million in cash and stock.

F–11



Shearwater Corporation
Unaudited Balance Sheet
(In thousands)

 
  March 31,
2001

 
Assets        
Current Assets:        
  Cash and cash equivalents   $ 1,801  
  Investments     4,812  
  Accounts receivable, net     1,083  
  Inventories     2,221  
  Receivables—other     244  
  Prepaid expenses     286  
   
 
Total Current Assets     10,447  

Net property, plant and equipment

 

 

6,177

 

Other assets:

 

 

 

 
  Deposits     10  
  Investment     20  
  Deferred income tax     3,358  
   
 
Total other assets     3,388  
   
 
Total Assets   $ 20,012  
   
 
Liabilities and stockholders' equity        

Current liabilities:

 

 

 

 
  Accounts payable and accrued expenses   $ 1,058  
  Unearned revenue     3,725  
  Notes payable—current     295  
   
 
Total current liabilities     5,078  

Deferred income tax

 

 

6

 
Notes Payable     647  

Stockholders' equity

 

 

 

 
  Common stock, $.01 par; 2,000,000 shares authorized, 945,906 issued and outstanding     10  
  Additional paid in capital     17,719  
  Deferred stock compensation     (3,417 )
  Accumulated Deficit     (31 )
   
 
Total stockholders' equity     14,281  
   
 
Total liabilities and stockholders' equity   $ 20,012  
   
 

See accompanying notes

F–12



Shearwater Corporation
Unaudited Statement of Income
(In thousands)

 
  Three Months
Ended
March 31, 2001

  Three Months
Ended
March 31, 2000

  Nine Months
Ended
March 31, 2001

  Nine Months
Ended
March 31, 2000

Product sales   $ 1,741   $ 3,529   $ 9,265   $ 11,236
License and contract revenue     658     395     1,704     520
   
 
 
 
Total revenue     2,399     3,924     10,969     11,756

Cost of sales

 

 

993

 

 

1,303

 

 

4,287

 

 

3,034
   
 
 
 

Gross Profit

 

 

1,406

 

 

2,621

 

 

6,682

 

 

8,722

Operating Expenses

 

 

 

 

 

 

 

 

 

 

 

 
  Research and development     933     486     2,016     1,344
  Selling, general & administration     1,333     535     2,585     1,830
  Stock compensation     1,200     0     3,031     0
   
 
 
 
Total operating expenses     3,466     1,021     7,632     3,174

Income (loss) from operations

 

 

(2,060

)

 

1,600

 

 

(950

)

 

5,548

Other income (expense):

 

 

 

 

 

 

 

 

 

 

 

 
  Interest income, net     110     40     375     28
  Other income (expense)     1     3     (56 )   4
   
 
 
 
Income (loss) before taxes     (1,949 )   1,643     (631 )   5,580

Income tax (benefit) expense

 

 

(950

)

 

440

 

 

280

 

 

1,848
   
 
 
 
Net income (loss)   $ (999 ) $ 1,203   $ (911 ) $ 3,732
   
 
 
 

See accompanying notes

F–13



Shearwater Corporation
Unaudited Statement of Cash Flows
(in thousands)

 
  Nine Months
Ended
March 31, 2001

  Nine Months
Ended
March 31, 2000

 
Operating activities:              
Net income (loss)   $ (911 ) $ 3,732  
Adjustments to reconcile net income (loss) to net cash provided by operating activities:              
  Depreciation and amortization     683     621  
  Deferred taxes     (1,239 )   (2,054 )
  Stock compensation charges     3,077     1,167  
Changes in:              
  Accounts receivable     989     (522 )
  Inventories     (347 )   (282 )
  Receivables—other     (187 )   24  
  Income tax receivables     636     (157 )
  Prepaid expenses     (9 )   24  
  Deposits     (1 )   5  
  Related party receivables     270     (26 )
  Accounts payable and accrued expenses     (1,188 )   (285 )
  Unearned revenue     2,303     1,501  
   
 
 
Total adjustments     4,987     16  
   
 
 
Net cash provided by operating activities     4,076     3,748  

Investing activities:

 

 

 

 

 

 

 
Property and equipment purchased     (3,348 )   (362 )
Investments purchased     (852 )   (6,533 )
   
 
 
Net cash used in investing activities     (4,200 )   (6,895 )

Financing activities:

 

 

 

 

 

 

 
Payment on notes     (219 )   (656 )
Proceeds from the issuance of stock         5,000  
   
 
 
Net cash (used in)/provided by financing activities     (219 )   4,344  

Net (decrease)/increase in cash and cash equivalents

 

 

(343

)

 

1,197

 

Cash and cash equivalents at beginning of period

 

 

2,144

 

 

277

 
   
 
 
Cash and cash equivalents at end of period   $ 1,801   $ 1,474  
   
 
 

See accompanying notes

F–14


Shearwater Corporation
Notes to Unaudited Financial Statements

1.  ACCOUNTING POLICIES

    The unaudited balance sheet as of March 31, 2001, the unaudited statements of income for the three-month and nine-month periods ended March 31, 2001 and 2000,respectively, and the unaudited statements of cash flows for the nine-months ended March 31, 2001 and 2000, respectively, have been prepared on a basis consistent with the accounting policies disclosed in the audited financial statements of Shearwater Corporation, for the year end June 30, 2000. The unaudited balance sheet as of March 31, 2001, the unaudited statement of income for the three-month and nine-month periods ended March 31, 2001 and 2000,respectively, and the unaudited statement of cash flows for the nine-months ended March 31, 2001 and 2000, respectively, have been prepared by Shearwater Corporation, without audit, but include all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the financial position at such dates and the operating results and cash flows for those periods.

2.  INVENTORIES

    Inventories consist primarily of raw materials, work-in-process and finished goods and are stated at the lower of cost (first-in, first-out method) or market.

    Inventories consist of the following at March 31, 2001:

 
  (in thousands)

Raw Materials   $ 803
Work-in-Process     818
Finished Goods     600
   
    $ 2,221
   

3.  ACCOUNTING CHANGES

    In March 2000, the Financial Accounting Standards Board issued FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Option No. 25. The company was required to adopt the Interpretation on July 1, 2000. The Interpretation requires that a repurchase feature at less than fair value be accounted for as variable. The company has a stock option plan which allows the company to repurchase a stock option at a exercise price below fair market value upon certain events and conditions. As a result of adopting the Interpretation, the company is required to apply variable accounting to these options. The impact of adopting this standard results in a decrease to net income by approximately $1.4 million and $660,000 for the nine and three month periods ended March 31, 2001, respectively.

F–15


INHALE THERAPEUTIC SYSTEMS, INC.
UNAUDITED PRO FORMA CONDENSED
COMBINED FINANCIAL STATEMENTS

    The following unaudited pro forma condensed combined financial statements give effect to the merger of Square Acquisition Corp., ("Square") a wholly- owned subsidiary of Inhale Therapeutic Systems, Inc. ("Inhale"),with Shearwater Corporation ("Shearwater"), with Square surviving as a wholly-owned subsidiary of Inhale.

    The unaudited pro forma condensed combined financial information including the accompanying notes, have been derived from the historical financial statements of Inhale and Shearwater, are based on and qualified in their entirety by reference to, and should be read in conjunction with, the reported audited consolidated financial statements and the accompanying notes of Inhale and Shearwater.

    The unaudited pro forma condensed combined balance sheet as of March 31, 2001, has been prepared assuming the acquisition had been consummated as of that date. The unaudited pro forma condensed combined statement of operations are provided for the year ended December 31, 2000 and three months ended March 31, 2001, including the amortization of goodwill and other intangible assets, giving effect to the acquisition as though it had occurred as of January 1, 2000 and 2001, respectively.

    The acquisition of Shearwater has been accounted for using the purchase method of accounting and, accordingly, the purchase price has been allocated to the assets purchased and the liabilities assumed based on their fair values at the date of acquisition. The allocation of the aggregate purchase price for the acquisition, together with the liabilities assumed pursuant thereto, to the net assets acquired is based on an independent valuation analysis.

    Inhale's historical condensed financial information included in these pro forma financial statements is derived from its March 31, 2001 unaudited condensed consolidated financial statements included in its Form 10-Q for the same period, and from its December 31, 2000 audited consolidated financial statements included in its most recent Form 10-K, as amended. Shearwater's financial information included in these unaudited pro forma financial statements is derived from its three months ended March 31, 2001 unaudited financial statement, and from its twelve months ended December 31, 2000 unaudited financial statements.

    The unaudited pro forma condensed combined financial information is presented for illustrative purposes only and is not necessarily indicative of the operating results of financial positions that would have occurred if the transaction had been consummated at the dates indicated, nor is it necessarily indicative of future operating results or financial position of the combined companies and should not be construed as representative of these amounts for any future dates or periods.

F–16


INHALE THERAPEUTIC SYSTEMS, INC
UNAUDITED PRO FORMA CONDENSED
COMBINED BALANCE SHEET
(IN THOUSANDS)
March 31, 2001

 
  Historical
Inhale

  Historical
Shearwater

  Pro Forma
Adjustments

  Pro Forma
 
Assets                          
Current assets:                          
  Cash and cash equivalents   $ 80,042   $ 1,801   $ (72,500 )(B) $ 9,343  
  Short-term investments     373,839     4,812           378,651  
  Accounts receivable     3,333     1,083           4,416  
  Inventory and other assets     7,683     2,751           10,434  
   
 
 
 
 
  Total current assets     464,897     10,447     (72,500 )   402,844  

Property and Equipment, net

 

 

119,867

 

 

6,177

 

 

 

 

 

126,044

 
Marketable equity securities     3,444     20           3,464  
Goodwill and other intangibles     87,888         90,942  (C,D&E)   178,830  
Deposits and other assets     11,047     10           11,057  
Deferred income tax         3,358     (3,358 )(J)    
   
 
 
 
 
Total other assets     222,246     9,565     87,584     319,395  
   
 
 
 
 
Total assets   $ 687,143   $ 20,012   $ 15,084   $ 722,239  
   
 
 
 
 
Liabilities and stockholders' equity                          
Current liabilities                          
  Accounts payable and accrued liabilities   $ 28,351   $ 1,058   $
5,417
392
 (E)
 (C)
$
34,826
392
 
  Capital lease—current portion     977               977  
  Notes payable—current portion         295           295  
  Deferred revenue     10,144     3,725     (3,725 )(C)   10,144  
   
 
 
 
 
  Total current liabilities     39,472     5,078     2,084     46,634  

Capital lease obligation

 

 

18,791

 

 


 

 

 

 

 

18,791

 
Convertible subordinate notes and debentures     299,149               299,149  
Notes payable         647           647  
Other long-term liabilities     9,199     6           9,205  

Stockholders' equity

 

 

 

 

 

 

 

 

 

 

 

 

 
  Common stock     5     10     (10 )(A)   5  
  Capital in excess of par value     594,220     17,719     (1,405
(16,314
114,239
)(K)
)(A)
 (F)
  610,534
(16,314
114,239

)
  Deferred compensation     (1,553 )   (3,417 )   3,417  (A)   (1,553 )
  Accumulated other comprehensive gain     770        
(83,600

)(G)
  770
(83,600

)
  Accumulated deficit     (272,910 )   (31 )   (1,374
1,405
(3,358
)(A)
 (K)
)(J)
  (274,315
1,405
(3,358
)

)
   
 
 
 
 
  Total stockholders' equity     320,532     14,281     13,000     347,813  
   
 
 
 
 

Total liabilities and stockholders' equity

 

$

687,143

 

$

20,012

 

$

15,084

 

$

722,239

 
   
 
 
 
 

See accompanying notes

F–17


INHALE THERAPEUTIC SYSTEMS, INC.
UNAUDITED PRO FORMA CONDENSED
COMBINED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
For the year ended December 31, 2000

 
  Historical
Inhale

  Historical
Shearwater

  Pro Forma
Adjustments

  Pro Forma
 
Net Sales   $   $ 14,970   $   $ 14,970  
License and contract research revenue     51,629     1,873         53,502  
   
 
 
 
 
Total revenue     51,629     16,843         68,472  

Operating costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 
  Cost of product sales         5,898         5,898  
  Selling, general and administration     13,932     6,683     (745 )(K)   19,870  
  Research and development     101,544     2,214         103,758  
  Purchased in-process research and development     2,292             2,292  
  Amortization of goodwill and intangible assets             18,458  (H)   18,458  
   
 
 
 
 
Total operating costs and expenses     117,768     14,795     17,713     150,276  
   
 
 
 
 
Operating (loss)/Income     (66,139 )   2,048     (17,713 )   (81,804 )

Debt conversion premium, net

 

 

(40,687

)

 


 

 


 

 

(40,687

)
Interest income, net     8,428     337     (4,350 )(I)   4,415  
Other income (expense)     995     (204 )       791  
   
 
 
 
 
      (31,264 )   133     (4,350 )   (35,481 )
   
 
 
 
 
(Loss)/income before taxes     (97,403 )   2,181     (22,063 )   (117,285 )
Income taxes (benefit) expense         1,651     (1,651 )(J)    
   
 
 
 
 
Net income (loss)   $ (97,403 ) $ 530   $ (20,412 ) $ (117,285 )
   
 
 
 
 
Basic and diluted net loss per share   $ (2.32 )             $ (2.60 )

Shares used in basic and diluted

 

 

 

 

 

 

 

 

 

 

 

 

 
  Net loss per share calculation     41,998                 45,111  

See accompanying notes

F–18


INHALE THERAPEUTIC SYSTEMS, INC.
UNAUDITED PRO FORMA CONDENSED
COMBINED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
For the quarter ended March 31, 2001

 
  Historical
Inhale

  Historical
Shearwater

  Pro Forma
Adjustments

  Pro Forma
 
Net sales   $   $ 1,741   $   $ 1,741  
License and contract research revenue     14,097     658         14,755  
   
 
 
 
 
Total revenue     14,097     2,399         16,496  

Operating costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 
  Cost of product sales         993         993  
  Selling, general and administration     4,018     2,533     (660)  (K)   5,891  
  Research and development     30,271     933         31,204  
  Purchased in-process research and development     62,660             62,660  
  Amortization of goodwill and intangible assets     3,079         4,614  (H)   7,693  
   
 
 
 
 
Total operating costs and expenses     100,028     4,459     3,954     108,441  
   
 
 
 
 
Operating (loss)/income     (85,931 )   (2,060 )   (3,954 )   (91,945 )

Other income (expense):

 

 

 

 

 

 

 

 

 

 

 

 

 
Interest income, net     4,968     110     (1,088 )(I)   3,990  
Other income (loss)     (78 )   1           (77 )
   
 
 
 
 
      4,890     111     (1,088 )   3,913  
   
 
 
 
 
(Loss)/income before income taxes     (81,041 )   (1,949 )   (5,042 )   (88,032 )

Income tax (benefit)/expense

 

 


 

 

(950

)

 

950

 (J)

 


 
   
 
 
 
 
Net loss   $ (81,041 ) $ (999 ) $ (5,992 ) $ (88,032 )
   
 
 
 
 
Basic and diluted net loss per share   $ (1.59 )             $ (1.62 )

Shares used in basis and diluted net loss per share calculation

 

 

51,078

 

 

 

 

 

 

 

 

54,191

 

See accompanying notes

F–19


INHALE THERAPEUTIC SYSTEMS, INC.
NOTES TO THE UNAUDITED PRO FORMA
CONDENSED COMBINED FINANCIAL INFORMATION

    Effective June 29, 2001, the merger of Shearwater Corporation ("Shearwater") with and into Square Acquisition Corp. ("Square"), a wholly owned-subsidiary of Inhale Therapeutic Systems, Inc. ("Inhale") was completed pursuant to the Agreement and Plan of Merger and Reorganization, by and among Inhale, Shearwater, Square, J. Milton Harris and Puffinus, L.P., dated May 22, 2001, as amended.

    The aggregate consideration paid was established in the Agreement at $72.5 million in cash and 4,000,000 shares and options to acquire shares of Inhale common stock in exchange for all of the outstanding capital stock of Shearwater (including shares issuable pursuant to outstanding options). Pursuant to the Merger, each then-outstanding share of common stock of Shearwater was converted into the right to receive approximately 3.09 shares of common stock of Inhale and $55.94 in cash and each then-outstanding option to purchase Shearwater common stock was converted into the right to receive approximately 3.09 shares of Inhale common stock upon exercise. Holders of Shearwater options were also entitled to a cash payment of $55.94 per share of Shearwater common stock issuable. Approximately 3,112,610 shares of Inhale common stock were issued and $56,416,074 in cash was paid to the six former shareholders of Shearwater in the Merger. In addition, Inhale assumed all 287,536 outstanding options to purchase Shearwater common stock which were converted into options to purchase an aggregate of approximately 887,390 shares of Inhale common stock and Inhale paid $16,083,926 in cash to 83 Shearwater optionholders. No fractional shares of Inhale common stock were issued in connection with the Merger. All options issued in connection with this transaction were fully vested.

    Inhale's total cost to acquire Shearwater is estimated to be $192.2 million which includes an average stock price of approximately $29 per share of Inhale's common stock. The stock price used for the pro forma presentation is based on an average price from the date the terms were agreed to and announced. The aggregate purchase price for the acquisition is based on a valuation analysis completed by an independent valuation specialist.

    Shearwater's financial statements included in the pro forma financial information as of all dates and for all periods presented have been adjusted where appropriate, to present Shearwater's financial position and results of operations in accordance with accounting principles generally accepted in the United States.

    The cost to acquire Shearwater has been allocated to the assets acquired and liabilities assumed according to their respective fair values, with the excess purchase price being allocated to goodwill.

    The estimated purchase cost of Shearwater is as follows (in thousands):

Cash and consideration   $ 72,500
Value of securities issued     88,896
Assumption of Shearwater's common stock options     25,344
Estimated transaction costs and expenses     5,417
   
    $ 192,157
   

F–20


    The purchase price allocation as of June 29, 2001 is as follows (in thousands):

 
  Amount
  Useful
Life

  Annual
Amortization
Of
Intangibles

 
   
  (In Years)

   
Net tangible assets of Shearwater   $ 17,615     $
Intangible assets acquired:                
  Developed product technology     2,900   5     580
  Core technology     8,100   5     1,620
  In-process research and development     83,600      
  Assembled workforce     2,020   3     674
  Supplier and customer relationships     2,900   5     580
  Goodwill     75,022   5     15,004
   
     
Total purchase price allocation   $ 192,157       $ 18,458
   
     

    Developed Product Technology is based on proprietary know-how that is technologically feasible. Inhale expects to amortize the value assigned to developed product technology on a straight-line basis over an average estimated life of five years.

    Core Technology is based on developed technology or components of developed technologies that have a value as a basis of platform upon which future development can be profitably exploited. Inhale expects to amortize the value assigned to core technology on a straight-line basis over an average estimated life of five years.

    In-process research and development represents that portion of the purchase price of the acquisition related to the research and development activities which: (i) have not demonstrated their technological feasibility, and (ii) have no alternative future uses. Accordingly, Inhale expects to recognize an expense of $83.6 million upon consummation of the transaction.

    Assembled workforce is comprised of all the skilled employees and includes the estimated cost to replace existing employees, including recruiting and training costs and loss of productivity costs. Inhale expects to amortize the value assigned to the assembled workforce on a straight-line basis on an average estimated useful life of three years.

    Supplier and customer relationship is based on historical costs incurred and is comprised of management's estimation of resources that have been devoted to development of the relationships with key customers. Inhale expects to amortize the value assigned to customer relationships on a straight-line basis over an average estimated life of five years.

    Goodwill, which represents the excess of the purchased price of an investment in an acquired business over the fair value of the underlying net identifiable asset, will be amortized on a straight-line basis, and no goodwill will be amortized after that date. Effective January 1, 2002, goodwill will be subject to a non-amortization, impairment assessment, consistent with the new business combination accounting rules, and no goodwill will be amortized after that date.

DESCRIPTION OF PRO FORMA ADJUSTMENTS RECORDED IN
PRO FORMA FINANCIAL INFORMATION

(A)
To eliminate Shearwater's historical equity accounts.

(B)
To reflect the payment of cash to fund a purchase consideration in connection with the purchase.

(C)
To reflect the estimated fair value of identifiable intangible assets acquired as a result of the acquisition.

F–21


(D)
To reflect the goodwill originating from the acquisition.

(E)
To reflect the estimated transaction costs of the acquisition.

(F)
To reflect the issuance of Inhale's common stock to Shearwater Corporation and to replace Shearwater stock options.

(G)
To reflect the purchased in-process research and development charge. This charge is excluded from the unaudited pro forma condensed combined statements of operations due to its non-recurring nature.

(H)
To reflect the amortization of goodwill and identifiable intangible assets on a straight-line basis using an estimated useful lives of three to five years.

(I)
To reflect a reduction of interest income earned as a result of the $72.5 million cash payment, assumed at 6% for purposes of the unaudited pro forma condensed combined statement of operations.

(J)
To reflect a reduction of income tax resulting from consolidated federal and state tax return.

(K)
To eliminate variable accounting attributes in the acquired stock option plan as a result of purchase business combination accounting.

F–22




QuickLinks

Shearwater Polymers, Inc. Balance Sheet
Shearwater Polymers, Inc. Statement of Income
Shearwater Polymers, Inc. Statement of Stockholders Equity For the year ended June 30, 2000
Shearwater Polymers, Inc. Statement of Cash Flows
Shearwater Corporation Notes to Financial Statements
Shearwater Corporation Unaudited Balance Sheet (In thousands)
Shearwater Corporation Unaudited Statement of Income (In thousands)
Shearwater Corporation Unaudited Statement of Cash Flows (in thousands)