UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-Q 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
 
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______ to _______
 
Commission file number: 001-35610
 
ATOSSA GENETICS INC.
(Exact name of registrant as specified in its charter)
 
Delaware
 
26-4753208
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
 
 
 
1616 Eastlake Ave. East, Suite 510
 
98102
Seattle, WA
 
(Zip Code)
(Address of principal executive offices)
 
 
 
Registrant’s telephone number, including area code: (206) 325-6086
 
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     ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes   þ    No     ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer  ¨
Accelerated filer  ¨
Non-accelerated filer  ¨
Smaller reporting company  þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes   ¨    No     þ
 
The number of shares of the registrant’s common stock, $0.001 par value per share, outstanding at November 8, 2013 was 18,024,824.
 
 
   
ATOSSA GENETICS INC.
FORM 10-Q
QUARTERLY REPORT
 
INDEX
 
PART I. FINANCIAL INFORMATION
 
 
 
ITEM 1.
Consolidated Financial Statements – Unaudited
3
 
 
 
 
Consolidated Balance Sheets as of September  30, 2013 and December 31, 2012
3
 
 
 
 
Consolidated Statements of Operations for the nine months ended September 30, 2013 and 2012
4
 
 
 
 
Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012
5
 
 
 
 
Notes to Consolidated Financial Statements
6
 
 
 
ITEM 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
25
 
 
 
ITEM 3
Quantitative and Qualitative Disclosures about Market Risk
39
 
 
 
ITEM 4.
Controls and Procedures
39
 
 
 
PART II. OTHER INFORMATION
 
 
 
ITEM 1.
Legal Proceedings
39
 
 
 
ITEM 1A.
Risk Factors
41
 
 
 
ITEM 2.
Unregistered Sales of Equity Securities and Use of Proceeds
60
 
 
 
ITEM 3.
Defaults upon Senior Securities
60
 
 
 
ITEM 4.
Mine Safety Disclosures
60
 
 
 
ITEM 5.
Other Information
60
 
 
 
ITEM 6.
Exhibits
60
 
 
 
SIGNATURES
 
61
 
 
2

 
PART I. FINANCIAL INFORMATION
 
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED
 
ATOSSA GENETICS INC.
(A DEVELOPMENT STAGE COMPANY)
CONSOLIDATED BALANCE SHEETS
 
 
 
September 30,
 
December 31,
 
 
 
2013
 
2012
 
 
 
(Unaudited)
 
(Audited)
 
Assets
 
 
 
 
 
 
 
Current Assets
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
7,693,561
 
$
1,725,197
 
Accounts receivable, net
 
 
299,338
 
 
141,665
 
Prepaid expense
 
 
559,386
 
 
122,633
 
Retainers (deposits)
 
 
43,160
 
 
-
 
Total Current Assets
 
 
8,595,445
 
 
1,989,495
 
 
 
 
 
 
 
 
 
Fixed Assets
 
 
 
 
 
 
 
Furniture and equipment, net
 
 
443,272
 
 
159,967
 
Total Fixed Assets
 
 
443,272
 
 
159,967
 
 
 
 
 
 
 
 
 
Other Assets
 
 
 
 
 
 
 
Security deposit
 
 
36,446
 
 
36,447
 
Intangible assets, net
 
 
4,407,058
 
 
4,640,224
 
Total Other Assets
 
 
4,443,504
 
 
4,676,671
 
 
 
 
 
 
 
 
 
Total Assets
 
$
13,482,221
 
$
6,826,133
 
 
 
 
 
 
 
 
 
Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Current Liabilities
 
 
 
 
 
 
 
Accounts payable
 
$
31,131
 
$
68,217
 
Accrued expenses
 
 
1,069,759
 
 
1,374,385
 
Deferred rent
 
 
60,753
 
 
-
 
Payroll liabilities
 
 
357,489
 
 
207,996
 
Contingent liabilities
 
 
402,840
 
 
-
 
Other current liabilities
 
 
20,300
 
 
-
 
Total Current Liabilities
 
 
1,942,272
 
 
1,650,598
 
 
 
 
 
 
 
 
 
Stockholders' Equity
 
 
 
 
 
 
 
Preferred stock - $.001 par value; 10,000,000 shares authorized, 0
    shares issued and outstanding
 
 
-
 
 
-
 
Common stock - $.001 par value; 75,000,000 shares authorized, 17,444,824
    and 12,919,367 shares issued and outstanding
 
 
17,445
 
 
12,919
 
Additional paid-in capital
 
 
29,281,396
 
 
14,894,522
 
Accumulated deficit
 
 
(17,758,892)
 
 
(9,731,906)
 
Total Stockholders' Equity
 
 
11,539,949
 
 
5,175,535
 
 
 
 
 
 
 
 
 
Total Liabilities and Stockholders' Equity
 
$
13,482,221
 
$
6,826,133
 
 
The accompanying notes are an integral part of these consolidated financial statements
 
 
3

 
 
ATOSSA GENETICS INC.
(A DEVELOPMENT STAGE COMPANY)
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
 
 
For the Three Months Ended
September 30,
 
For The Nine Months Ended
September 30,
 
From April
30, 2009
(Inception)
Through
September 30,
 
 
 
2013
 
2012
 
2013
 
2012
 
2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Diagnostic testing service
 
$
72,187
 
$
104,011
 
$
361,905
 
$
376,696
 
$
837,307
 
Product sales
 
 
4,410
 
 
1,565
 
 
223,440
 
 
6,690
 
 
231,380
 
Total Revenue
 
 
76,597
 
 
105,576
 
 
585,345
 
 
383,386
 
 
1,068,687
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Diagnostic testing service
 
 
25,938
 
 
9,000
 
 
75,893
 
 
29,985
 
 
111,638
 
Product sales
 
 
-
 
 
-
 
 
238,669
 
 
-
 
 
243,833
 
Total Cost of Revenue
 
 
25,938
 
 
9,000
 
 
314,562
 
 
29,985
 
 
355,471
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loss on reduction of inventory to LCM
 
 
-
 
 
6,077
 
 
-
 
 
29,884
 
 
121,910
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Gross Profit
 
 
50,659
 
 
90,499
 
 
270,783
 
 
323,517
 
 
591,306
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selling expenses
 
 
373,418
 
 
87,704
 
 
965,383
 
 
281,971
 
 
1,605,259
 
Research and development expenses
 
 
321,111
 
 
548,108
 
 
731,258
 
 
1,508,944
 
 
4,288,644
 
General and administrative expenses
 
 
2,858,027
 
 
590,359
 
 
6,600,819
 
 
1,896,254
 
 
12,423,155
 
Total operating expenses
 
 
3,552,556
 
 
1,226,171
 
 
8,297,460
 
 
3,687,169
 
 
18,317,058
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating Loss
 
 
(3,501,897)
 
 
(1,135,672)
 
 
(8,026,677)
 
 
(3,363,652)
 
 
(17,725,752)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
 
53
 
 
46
 
 
53
 
 
1,219
 
 
6,641
 
Interest expense
 
 
1
 
 
7,756
 
 
360
 
 
11,816
 
 
39,531
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net Loss before Income Taxes
 
 
(3,501,845)
 
 
(1,143,382)
 
 
(8,026,984)
 
 
(3,374,249)
 
 
(17,758,642)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income Taxes
 
 
-
 
 
-
 
 
-
 
 
-
 
 
250
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net Loss
 
$
(3,501,845)
 
$
(1,143,382)
 
$
(8,026,984)
 
$
(3,374,249)
 
$
(17,758,892)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loss per common share - basic and diluted
 
$
(0.22)
 
$
(0.10)
 
$
(0.55)
 
$
(0.30)
 
$
(1.95)
 
Weighted average shares outstanding, basic & diluted
 
 
15,830,033
 
 
11,256,867
 
 
14,697,221
 
 
11,256,867
 
 
9,127,656
 
 
  The accompanying notes are an integral part of these consolidated financial statements.
 
 
4

 
ATOSSA GENETICS INC.
(A DEVELOPMENT STAGE COMPANY)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
 
 
For the Nine Months 
Ended   
September 30,
 
For The Period
From April 30,
2009 (Inception) to
 
 
 
2013
 
2012
 
September 
30, 2013
 
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
 
 
 
 
 
 
 
Net loss
 
$
(8,026,984)
 
$
(3,374,249)
 
$
(17,758,892)
 
Common shares issued for services
 
 
144,391
 
 
-
 
 
215,392
 
Compensation cost for stock options granted
 
 
1,187,717
 
 
96,251
 
 
1,479,981
 
Loss on reduction of inventory to LCM
 
 
-
 
 
29,884
 
 
121,910
 
Loan initiation fee accrued for notes payable
 
 
-
 
 
-
 
 
2,000
 
Depreciation and amortization
 
 
350,536
 
 
25,586
 
 
496,711
 
Contingent loss
 
 
402,840
 
 
-
 
 
402,840
 
Bad debt expense
 
 
228,841
 
 
-
 
 
228,841
 
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
 
 
 
 
 
 
 
Increase in accounts receivable
 
 
(386,514)
 
 
(174,183)
 
 
(528,179)
 
Increase in inventory
 
 
-
 
 
(29,884)
 
 
(121,910)
 
Decrease (Increase) in prepaid expenses
 
 
71,439
 
 
(8,791)
 
 
(51,194)
 
Increase in security deposits
 
 
(43,160)
 
 
(30,589)
 
 
(79,608)
 
Decrease (Increase) in accounts payable
 
 
(37,086)
 
 
7,335
 
 
31,131
 
Decrease in accrued payroll
 
 
149,493
 
 
-
 
 
149,493
 
Increase in deferred rent
 
 
60,753
 
 
-
 
 
60,753
 
Decrease (Increase) in accrued expenses
 
 
(304,626)
 
 
1,491,014
 
 
1,322,756
 
Increase in other current liabilities
 
 
20,300
 
 
-
 
 
20,300
 
Net cash used in operating activities
 
 
(6,182,060)
 
 
(1,967,626)
 
 
(14,007,675)
 
 
 
 
 
 
 
 
 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
 
 
 
 
 
 
 
Purchase of furniture & fixtures
 
 
(346,007)
 
 
-
 
 
(537,054)
 
Purchase of software
 
 
(54,667)
 
 
-
 
 
(135,133)
 
Net cash used in investing activities
 
 
(400,674)
 
 
-
 
 
(672,187)
 
 
 
 
 
 
 
 
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
 
 
 
 
 
 
 
Net proceeds from issuance of common stocks and warrants
 
 
12,551,098
 
 
400,000
 
 
22,375,423
 
Repayments of bank line of credit
 
 
-
 
 
(750,000)
 
 
-
 
Proceeds from (repayments of) loans from related parties
 
 
-
 
 
75,375
 
 
(2,000)
 
Cash released from commercial line of credit
 
 
-
 
 
750,000
 
 
-
 
Net cash provided by financing activities
 
 
12,551,098
 
 
475,375
 
 
22,373,423
 
 
 
 
 
 
 
 
 
 
 
 
NET INCREASE (DECREASE) IN CASH & CASH EQUIVALENTS
 
 
5,968,364
 
 
(1,492,251)
 
 
7,693,561
 
CASH & CASH EQUIVALENTS, BEGINNING BALANCE
 
 
1,725,197
 
 
1,910,821
 
 
-
 
CASH & CASH EQUIVALENTS, ENDING BALANCE
 
$
7,693,561
 
$
418,570
 
$
7,693,561
 
 
 
 
 
 
 
 
 
 
 
 
SUPPLEMENTAL DISCLOSURES:
 
 
 
 
 
 
 
 
 
 
Interest paid
 
$
359
 
$
13,892
 
$
33,067
 
Income taxes paid
 
$
-
 
$
-
 
$
250
 
NONCASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
 
 
 
 
 
 
 
Common stock and warrants issued for asset purchase
 
$
-
 
$
4,674,853
 
$
4,674,853
 
Options issued for previously accrued director compensation
 
$
-
 
$
45,000
 
$
45,000
 
Commitment shares distributed for capital contribution
 
$
2,387,250
 
$
-
 
$
2,387,250
 
Amortization of commitment shares issued for distributed shares
 
$
1,879,058
 
$
-
 
$
1,879,058
 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
5

 
 
ATOSSA GENETICS INC.
(A DEVELOPMENT STAGE COMPANY)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
NOTE 1: NATURE OF OPERATIONS
 
The Company’s operations began in December 2008 with the negotiations for the acquisition of the Mammary Aspirate Specimen Cytology Test System, or the MASCT System, patent rights and assignments and the FDA clearances for marketing, which acquisition was completed in January 2009. Atossa Genetics Inc. (the “Company”) was incorporated on April 30, 2009 in the State of Delaware. The Company was formed to develop and market the MASCT System, which was cleared by the FDA in 2003 as a medical device that is intended for use in the collection of nipple aspirate fluid for laboratory cytological testing.  The Company’s fiscal year ends on December 31st.
 
In December 2011, the Company established the National Reference Laboratory for Breast Health, or NRLBH, as a wholly-owned subsidiary. NRLBH is the Company’s CLIA-certified laboratory where the ForeCYTE and ArgusCYTE test specimens are examined by cytopathology. 
 
In September 2012, the Company acquired the assets of Acueity Healthcare, Inc. (“Acueity”). The purchased assets included 35 issued patents (18 issued in the U.S. and 17 issued in foreign countries) and 41 patent applications (32 in the U.S. and 9 in foreign countries), six 510(k) FDA marketing authorizations related to the manufacturing, use, and sale of the Viaduct Miniscope and accessories, the Manoa Breast Biopsy system, the Excisor Bioptome, the Acueity Medical Light Source, the Viaduct Microendoscope and accessories, and cash in the amount of $400,000. The microendoscopes are less than 0.9 mm outside diameter and can be inserted into a milk duct. This permits a physician to pass a microendoscope into the milk duct system of the breast and view the duct system via fiberoptic video images. Abnormalities that are visualized can then be biopsied from inside the duct with the biopsy tools that are inserted adjacent to the microendoscope. The patents relate to intraductal diagnostic and therapeutic devices and methods of use. The Company did not, however, acquire an inventory of these diagnostic tools, manufacturing capabilities or any personnel to market and sell the tools. The Company cannot provide any assurance that it will be successful commercializing these tools.
 
On October 4, 2013 the Company commenced the voluntary recall of the ForeCYTE Breast Health Test (also known as the MASCT System or ForeCYTE Test).  As a result of this recall, this product is currently not being marketed or distributed in the U.S.  The Company intends to obtain an additional FDA 510(k) clearance from the FDA for the ForeCYTE Test and to re-launch the test upon receiving regulatory clearance.
 
Development Stage Risk
 
From April 30, 2009 (inception) through September 30, 2013, the Company earned $1,068,687 in revenue from the sale of its products and laboratory services. The Company’s activities have been accounted for as those of a “Development Stage Enterprise” as set forth in Accounting Standards Codification (“ASC”) 915 “Development Stage Entities”, which was previously Statement of Financial Accounting Standards No. 7 (“SFAS 7”). Among the disclosures required by ASC 915 are that the Company’s financial statements be identified as those of a development stage company, and that the statements of operations, stockholders’ equity and cash flows disclose activity since the date of the Company’s inception.
 
Since its inception, the Company has been dependent upon the receipt of capital investment to fund its continuing activities. In addition to the normal risks associated with a new business venture, there can be no assurance that the Company’s business plan will be successfully executed. The Company’s ability to execute its business plan will depend on its ability to obtain additional financing and achieve a profitable level of operations. There can be no assurance that sufficient financing will be obtained. Further, the Company cannot give any assurance that it will generate substantial revenue or that its business operations will prove to be profitable.
 
 
6

 
NOTE 2: GOING CONCERN
 
The Company’s consolidated financial statements are prepared using generally accepted accounting principles in the United States of America applicable to a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has not yet established an ongoing source of revenue sufficient to cover its operating costs and allow it to continue as a going concern. The ability of the Company to continue as a going concern is dependent on the Company obtaining adequate capital to fund operating losses until it becomes profitable. If the Company is unable to obtain adequate capital, it could be forced to cease operations. The accompanying consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.
 
Management’s Plan to Continue as a Going Concern
 
In order to continue as a going concern, the Company will need, among other things, additional capital resources. Management’s plans to obtain such resources for the Company include (1) obtaining capital from the sale of its equity securities, (2) sales of the ForeCYTE System and laboratory service revenue (once cleared by the FDA and re-launched), and (3) short-term or long-term borrowings from banks, stockholders or other party(ies) when needed. However, management cannot provide any assurance that the Company will be successful in accomplishing any of its plans.
 
The ability of the Company to continue as a going concern is dependent upon its ability to successfully accomplish the plans described in the preceding paragraph and eventually to secure other sources of financing and attain profitable operations.

NOTE 3: SUMMARY OF ACCOUNTING POLICIES
 
Basis of Presentation:
 
The accompanying consolidated financial statements include the financial statements of Atossa Genetics Inc. and its wholly-owned subsidiary NRLBH. All significant intercompany account balances and transactions have been eliminated in consolidation. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.
 
Recently Issued Accounting Pronouncements:
 
The Company has adopted all recently issued accounting pronouncements that management believes to be applicable to the Company. The adoption of these accounting pronouncements, including those not yet effective, is not anticipated to have a material effect on the financial position or results of operations of the Company.
 
Revenue Recognition:
 
Overview
 
The Company recognizes product and service revenue in accordance with GAAP when the following overall fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or the service has been performed, (iii) the Company’s price to the customer is fixed or determinable and (iv) collection of the resulting accounts receivable is reasonably assured.
 
Product Revenue
 
The Company recognizes revenue for sales of the MASCT kits and devices on an accrual basis for sales to distributors when the above four criteria are met. For sales of MASCT kits and devices directly to physicians, the revenue is typically recognized upon receipt of cash as the Company has an insufficient sales history on which to determine the collectability. Shipping documents and the completion of any customer acceptance requirements, when applicable, will be used to verify product delivery. The Company will assess whether a price is fixed or determinable based upon the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. For sales directly to physicians, once a history of sales and collectability has been established, the Company will recognize revenue on an accrual basis with an offsetting reserve for doubtful accounts based on the history during the initial sales period.
 
 
7

  
Service Revenue
 
The Company records revenue for diagnostic testing on an accrual basis at the Medicare allowed and invoiced amount. Amounts invoiced above the Medicare amount, namely non-Medicare, are not recognized on an accrual basis and instead are recognized on a cash basis as received. Diagnostic testing revenue at the Medicare rate is recognized upon completion of the test, communication of results to the patient’s physician, and when collectability is reasonably assured. Customer purchase orders and/or contracts will generally be used to determine the existence of an arrangement. Once the Company has historical sales and can determine the proper amount to recognize as uncollectible, it will then begin to recognize the entire amount, both Medicare and non-Medicare billing on an accrual basis, with an offsetting allowance for doubtful accounts recorded based on history. The Company estimates it will utilize the diagnostic testing revenue history to determine a proper allowance for doubtful accounts beginning in 2014.
 
Cash and Cash Equivalents:
 
Cash and cash equivalents include cash and all highly liquid instruments with original maturities of three months or less.
 
Use of Estimates:
 
The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States of America requires management 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 consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Accordingly, actual results could differ from those estimates.
 
Accounts Receivable:
 
Accounts receivable are recorded at net realizable value consisting of the carrying amount less allowance for doubtful accounts, as needed. The Company assesses the collectability of accounts receivable based primarily upon the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends, and changes in customer payment patterns to evaluate the adequacy of these reserves. The Company’s allowance for doubtful accounts and bad debt expenses as of September 30, 2013 and December 31, 2012 was $228,841 and $0, respectively.    
 
Inventories:
 
The Company’s inventories are stated at lower of cost or market. Cost is determined on a moving-average basis. Costs of inventories include purchase and related costs incurred in delivering the products to their present location and condition. Market value is determined by reference to selling prices after the balance sheet date or to management’s estimates based on prevailing market conditions. Inherent in the lower of cost or market calculation are several significant judgments based on a review of the aging of the inventory, inventory movement of products, economic conditions, and replacement costs. Because the sales price of the MASCT System was substantially lower than its cost for the period ended September 30, 2013 and December 31, 2012, resulting in the net realizable value of the MASCT System being determined at zero as of September 30, 2013 and December 31, 2012, through taking the average sales price subtracted by selling expenses per unit. The Company assessed and recorded $0 and $29,884 loss on reduction of inventory to the lower of cost or market for the nine months ended September 30, 2013 and for the year ended December 31, 2012, respectively. Additionally, management periodically evaluates the composition of its inventories at least quarterly to identify slow-moving and obsolete inventories to determine if any valuation allowance is required. As of September 30, 2013 and December 31, 2012, management had identified no slow moving or obsolete inventory. The Company outsources product manufacturing to outside manufacturer contactors.  The ownership of the goods transfers from the manufacturer to the Company’s customer at the time the products are shipped to the customers. As of September 30, 2013, there are no inventories on our books.
 
 
8

  
The Company provides, either directly or through distributors, the ForeCYTE testing specimen collection kits to doctors with our MASCT System for doctors to collect specimens that are returned to the NRLBH for diagnostic analysis. These collection kits are considered part of the MASCT System. The Company’s direct sales personnel distributes the kits directly to physicians free of charge, or by offering a rebate to physicians. The Company has not intended to deem the kits as a primary product line due to their nominal cost and value per unit. As a result, the kits are immediately expensed and recorded as selling expense upon purchasing of the kits. 
 
Property, plant, and equipment:
 
Property, plant and equipment are stated at cost less accumulated depreciation. Expenditures for maintenance and repairs are charged to earnings as incurred; additions, renewals and betterments are capitalized. When property, plant and equipment are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts, and any gain or loss is included in operations.
 
Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows:
 
 
 
Useful Life
(in years)
 
Machinery and equipment
 
 
5
 
Leasehold improvements
 
 
2.083
 
 
Intangible assets:
 
Intangible assets consist of intellectual property and software acquired in the Acueity asset purchase. At least annually, we evaluate purchased intangibles for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. Estimating future cash flows related to an intangible asset involves significant estimates and assumptions. If our assumptions are not correct, there could be an impairment loss or, in the case of a change in the estimated useful life of the asset, a change in amortization expense. There was no impairment of intangible assets as of and for the nine months ended September 30, 2013 and year ended December 31, 2012, respectively.
 
Amortization is computed using the straight-line method over the estimated useful lives of the assets as follows:
 
 
 
Useful Life
(in years)
 
Patents
 
 
9-14
 
Software
 
 
3
 
 
Research and Development Expenses:
 
Research and development costs are generally expensed as incurred. The Company’s research and development expenses consist of costs incurred for internal and external research and development.
 
Share-Based Payments:
 
In December 2004, the Financial Accounting Standards Board, or the FASB, issued the Statement of Financial Accounting Standards, or SFAS, No. 123(R), “Share-Based Payment”, which replaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123(R) is now included in the FASB’s ASC Topic 718, “Compensation – Stock Compensation.” Under SFAS No. 123(R), companies are required to measure the compensation costs of share-based compensation arrangements based on the grant-date fair value and recognize the costs in the financial statements over the period during which employees or independent contractors are required to provide services. Share-based compensation arrangements include stock options and warrants, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. In March 2005, the SEC issued Staff Accounting Bulletin No. 107, or SAB 107, which expresses views of the staff regarding the interaction between SFAS No. 123(R) and certain SEC rules and regulations and provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods. On April 14, 2005, the SEC adopted a new rule amending the compliance dates for SFAS No. 123(R). Companies may elect to apply this statement either prospectively, or on a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods under SFAS No. 123.
 
 
9

     
The Company has fully adopted the provisions of FASB ASC 718 and related interpretations as provided by SAB 107. As such, compensation cost is measured on the date of grant as the fair value of the share-based payments. Such compensation amounts, if any, are amortized over the respective vesting periods of the option grant.

NOTE 4: PREPAID EXPENSES
 
Prepaid expenses consisted of the following:
 
 
 
September 30,
2013
 
December 31,
2012
 
Prepaid stock purchase agreement service fee
 
$
508,442
 
$
-
 
Prepaid insurance
 
 
27,445
 
 
62,551
 
Prepaid hardware/software maintenance and support service fee
 
 
23,499
 
 
20,000
 
Prepaid payroll taxes
 
 
-
 
 
40,082
 
 
 
$
559,386
 
$
122,633
 

NOTE 5: PROPERTY, PLANT, AND EQUIPMENT
 
Property, plant and equipment consisted of the following:
  
 
 
September 30, 
2013
 
December 31, 
2012
 
Machinery and equipment
 
$
269,771
 
$
97,383
 
Leasehold improvements
 
 
93,665
 
 
93,665
 
Capitalized new product development costs
 
 
173,766
 
 
-
 
Less: Accumulated depreciation
 
 
(93,930)
 
 
(31,081)
 
Property, plant, and equipment, net
 
$
443,272
 
$
159,967
 
 
Depreciation expense for the nine months ended September 30, 2013 and 2012 was $62,849 and $12,970, respectively.

NOTE 6: INTANGIBLE ASSETS
 
Intangible assets consisted of the following:
 
 
 
September 30,
 
December 31,
 
 
 
2013
 
2012
 
Patents
 
$
4,704,853
 
$
4,704,853
 
Software
 
 
105,133
 
 
50,466
 
Less: Accumulated amortization
 
 
(402,928)
 
 
(115,095)
 
 
 
$
4,407,058
 
$
4,640,224
 
  
Intangible assets amounted to $4,407,058 and $4,640,224 as of September 30, 2013 and December 31, 2012, respectively, and consisted of patents and software acquired. The acquired software mainly consisted of $58,000 in laboratory software and $31,500 in the newly developed Company website.  The amortization period for the purchased software is 3 years. Amortization expense related to software for the nine months ended September 30, 2013 and 2012 was $15,322 and $12,616, respectively.
 
 
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Patents amounted to $4,704,853 and $4,704,853 as of September 30, 2013 and December 31, 2012, respectively, and mainly consisted of patents acquired from Acueity on September 30, 2012 in an asset purchase transaction (see Note 13). Patent assets are amortized based on their determined useful life, and tested annually for impairment. The amortization period was from 9 to 14 years. Amortization expense related to patents was $272,511 and $0 for the nine months ended September 30, 2013 and 2012, respectively.
 
Future estimated amortization expenses as of September 30, 2013 for the five succeeding years is as follows:
  
As of September 30,
 
Amounts
 
2014
 
$
393,073
 
2015
 
 
381,331
 
2016
 
 
378,781
 
2017
 
 
363,902
 
2018
 
 
363,028
 
Thereafter
 
 
2,526,943
 
 
 
$
4,407,058
 

NOTE 7: PAYROLL LIABILITIES:
 
Payroll liabilities consisted of the following:
 
 
 
September 30, 
2013
 
December 31,
2012
 
Accrued bonus payable
 
$
297,290
 
$
189,131
 
Accrued payroll liabilities
 
 
40,318
 
 
-
 
Accrued payroll tax liabilities
 
 
19,881
 
 
18,865
 
 
 
$
357,489
 
$
207,996
 

NOTE 8: STOCKHOLDERS’ EQUITY
 
The Company is authorized to issue a total of 85,000,000 shares of stock consisting of 75,000,000 shares of Common Stock, par value $0.001 per share, and 10,000,000 shares of Preferred Stock, par value $0.001 per share.
 
Reverse Stock-Split
 
On September 28, 2010, the Board of Directors approved a 1-for-2.26332 reverse share split for all issued and outstanding shares of Common Stock, with no change to the par value of the Common Stock.
 
Prior Issuances of Common Stock at Inception
 
On April 30, 2009 (inception), the Company issued 1,767,316 shares (or 4,000,000 shares prior to the reverse stock-split on September 28, 2010) to Ensisheim Partners LLC, a related party to the Company through common ownership, for cash in the amount of $24,000, or $0.014 per share (or $0.006 per share prior to the reverse stock-split on September 28, 2010); 1,325,487 shares (or 3,000,000 shares prior to the reverse stock-split on September 28, 2010) to Manistee Ventures LLC, a related party to the Company through common ownership, for cash in the amount of $18,000, or $0.014 per share (or $0.006 per share prior to the reverse stock-split on September 28, 2010); and 883,662 shares (or 2,000,000 shares prior to the reverse stock-split on September 28, 2010) to the Chairman, CEO and President of the Company at that time for cash in the amount of $12,000, or $0.014 per share (or $0.006 per share prior to the reverse stock-split on September 28, 2010). 
 
Private Placements and Warrants
 
On April 28, May 31, June 10, and June 23, 2011, pursuant to Securities Purchase Agreements with various investors (the “Investors”), the Company issued 5,256,800 shares of the Company’s common stock and 5,256,800 warrants (the “Investor Warrants”), each of which entitles the investors to purchase the Company’s common stock, exercisable for 1.60 per share, for aggregate gross proceeds of $6,571,000 (the “Private Placement”).
 
 
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Placement Agent Fees
 
In connection with the Private Placement, the Company paid Dawson James Securities, Inc. (the “Placement Agent”), a cash fee equal to 10% of the gross proceeds from sale of the common stocks and warrants, plus a 3% non-accountable expense allowance, which resulted in a payment to the Placement Agent of an aggregate of $857,230 (the “Placement Agent Fee”). In addition, the Company entered into Warrant Agreements with the Placement Agent pursuant to which the Placement Agent received 788,520 warrants, each of which entitles the Placement Agent to purchase one share of the Company’s common stock at $1.60 per share, plus an additional 788,520 warrants (collectively with the warrants exercisable at $1.25 per share, the “Placement Agent Warrants”), each of which entitles the placement agent to purchase the Company’s common stock at $1.25 per share. The cash payment of the $857,230 Placement Agent Fee and the $495,876 aggregated initial fair value of the Placement Agent Warrants (see Fair Value Considerations below) were directly attributable to an actual offering and were charged through additional paid-in capital in accordance with the SEC Staff Accounting Bulletin (SAB) Topic 5A.
 
Warrants
 
The Warrants, including the Investor Warrants and the Placement Agent Warrants, are exercisable at any time commencing after June 23, 2011 which is the date that the Company completed a “significant private financing” under the terms of the Warrants (the “Initial Exercise Date”). The Warrants shall expire and no longer be exercisable on the fifth anniversary of the Initial Exercise Date (the “Expiration Date”). The Warrants may be exercised for cash or, at the option of the holder, may be exercised on a cashless basis; however if a registration statement is in effect for the resale of the common stock issuable upon exercise of the Warrants then the Warrants cannot be exercised on a cashless basis. As of September 30, 2013 such a registration statement was in effect and, therefore, the Warrants cannot be exercised on a cashless basis.
 
As of September 30, 2013, 4,775,550 warrants are outstanding including 325,000 warrants issued in the Acueity transation described below and substantially all of the Placement Agents Warrants have been exercised. There are no redemption features embodied in the Warrants and they have met the conditions provided in current accounting standards for equity classification.
  
Fair Value Considerations
 
The Company’s accounting for the issuance of warrants to the Investors and the Placement Agent required the estimation of fair values of the financial instruments. The development of fair values of financial instruments requires the selection of appropriate methodologies and the estimation of often subjective assumptions. The Company selected the valuation techniques based upon consideration of the types of assumptions that market participants would likely consider in exchanging the financial instruments in market transactions. The warrants were valued using a Black-Scholes-Merton Valuation Technique because it embodies all of the requisite assumptions (including trading volatility, estimated terms and risk free rates) necessary to fair value these instruments.
 
The Investor Warrants and the Placement Agent Warrants were initially valued at $1,808,025 or $0.344 per warrant, $228,712 or $0.290 per warrant, and $267,164 or $0.339 per warrant, respectively. The following tables reflect assumptions used to determine the fair value of the Warrants:
 
 
 
Fair
 
April-June2011
 
December 2011
 
 
Value
Hierarchy 
Level
 
Investor Warrants
 
Placement Agent 
Warrants
 
Placement 
Agent
Warrants
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Indexed shares
 
 
 
 
5,256,800
 
 
788,520
 
 
788,520
 
Exercise price
 
 
 
$
1.60
 
$
1.60
 
$
1.25
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Significant assumptions:
 
 
 
 
 
 
 
 
 
 
 
 
Stock price
 
3
 
$
0.906
 
$
0.906
 
$
0.906
 
Remaining term
 
3
 
 
6 years
 
 
6 years
 
 
6 years
 
Risk free rate
 
2
 
 
2.49
%
 
1.12
%
 
1.12
%
Expected volatility
 
3
 
 
53.55
%
 
54.21
%
 
54.21
%
 
 
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Fair value hierarchy of the above assumptions can be categorized as follows:
 
 
(1)
There were no Level 1 inputs.
 
 
(2)
Level 2 inputs include:
 
Risk-free rate- The risk-free rate of return reflects the interest rate for United States Treasury Note with similar time-to-maturity to that of the warrants.
 
 
(3)
Level 3 inputs include:
 
Stock price- The Company’s common stock was not publicly traded at the time the Warrants were issued. Therefore, the stock price was determined implicitly from an iterative process in order for the combined fair value of the common stock and the warrants to equal the amount of proceeds received in the Private Placement, based upon the assumption that the Private Placement was the result of an arm’s length transaction.
 
Remaining term- The Company does not have a history to develop the expected term for its warrants. Accordingly, the Company expected that the Initial Exercise Date would occur within one year from the date of issuance plus the contractual term in the calculations.
 
Expected volatility- We did not have a historical trading history sufficient to develop an internal volatility rate for use in the model. As a result, as required by ASC 718-10-30, the Company has accounted for the warrants using the calculated value method. The Company identified seven public entities in the similar industry for which share price information was available, and considered the historical volatilities of those public entities’ share prices in calculating the expected volatility appropriate to the Company.
 
Asset Purchase and Warrants
 
On September 30, 2012, pursuant to the asset purchase agreement with Acueity, the Company issued 862,500 shares of common stock and 325,000 warrants (“Acueity Warrants”) to the shareholders of Acueity, each of which entitles the recipients to subscribe for and purchase from the Company one share of the Company’s common stock at $5.00 per share (the “Exercise Price”), subject to a six-month lock up agreement.
 
Warrants
 
The Acueity Warrants are exercisable at any time commencing after September 30, 2012 (the “Issuance Date”) and shall expire and no longer be exercisable on the fifth anniversary of the Issuance Date (the “Expiration Date”). The Company may at any time during the term of the Acueity Warrants reduce the then current Exercise Price to any amount and for any period of time deemed appropriate by the Board of Directors of the Company. The Acueity Warrants do not have a cashless exercise provision. There are no redemption features embodied in the Acueity Warrants and they have met the conditions provided in current accounting standards for equity classification.
 
Fair Value Considerations
 
The Company’s accounting for the issuance of the Acueity Warrants required the estimation of fair values of the financial instruments. The development of fair values of financial instruments requires the selection of appropriate methodologies and the estimation of often subjective assumptions. The Company selected the valuation techniques based upon consideration of the types of assumptions that market participants would likely consider in exchanging the financial instruments in market transactions. The warrants were valued using a Black-Scholes-Merton Valuation Technique because it embodies all of the requisite assumptions (including trading volatility, estimated terms and risk free rates) necessary to fair value these instruments.
 
 
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The Acueity Warrants were valued at $762,353 or $2.3457 per warrant. The following tables reflect assumptions used to determine the fair value of the Warrants:
 
 
 
Fair
Value
Hierarchy
 
September 2012
 
 
 
 
Level
 
Acueity Warrants
 
 
 
 
 
 
 
 
 
 
 
Indexed shares
 
 
 
 
 
325,000
 
 
Exercise price
 
 
 
 
$
5.00
 
 
 
 
 
 
 
 
 
 
 
Significant assumptions:
 
 
 
 
 
 
 
 
Stock price
 
 
3
 
$
5.00
 
 
Remaining term
 
 
3
 
 
5 years
 
 
Risk free rate
 
 
2
 
 
0.62
%
 
Expected volatility
 
 
3
 
 
56.54
%
 
 
Fair value hierarchy of the above assumptions can be categorized as follows:
 
 
(1)
There were no Level 1 inputs.
 
 
(2)
Level 2 inputs include:
 
Risk-free rate- The risk-free rate of return reflects the interest rate for United States Treasury Note with similar time-to-maturity to that of the warrants.
 
 
(3)
Level 3 inputs include:
    
Stock price- The Company’s common stock was not publicly traded at the time the Acueity Warrants were issued. Therefore, the stock price was determined at the offering price of the then contemplated initial public offering, for which the registration statement on Form S-1 (File No. 333-179500) was subsequently declared effective by the Securities and Exchange Commission on November 7, 2012, and a prospectus was subsequently filed pursuant to Rule 424(b)(4) on November 9, 2012 (see Note 14).
 
Remaining term- The Company does not have a history to develop the expected term for its warrants. Accordingly, the Company expected that the Initial Exercise Date would occur within one year from the date of issuance plus the contractual term in the calculations.
 
Expected volatility- We did not have a historical trading history sufficient to develop an internal volatility rate for use in the model. As a result, as required by ASC 718-10-30, the Company has accounted for the warrants using the calculated value method. The Company identified seven public entities in the similar industry for which share price information was available, and considered the historical volatilities of those public entities’ share prices in calculating the expected volatility appropriate to the Company.
 
As of September 30, 2013, the Company has granted warrants to purchase 58,500 shares of common stock to the placement agent in connection with the financing facility with Aspire Capital. The warrants are exercisable at $5.80 or $5.70 per share and expire in 2017. An expense of $72,549 has been recognized during 2013 for issuance of these warrants. 
 
 
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On September 28, 2010, the Board of Directors approved the adoption of the 2010 Stock Option and Incentive Plan, or the 2010 Plan, subject to stockholder approval, to provide for the grant of equity-based awards to employees, officers, non-employee directors and other key persons providing services to the Company. Awards of incentive options may be granted under the 2010 Plan until September 2020. No other awards may be granted under the 2010 Plan after the date that is 10 years from the date of stockholder approval. An aggregate of 1,000,000 shares (or 2,263,320 shares prior to the reverse stock-split on September 28, 2010) were initially reserved for issuance in connection with awards granted under the 2010 Plan, such number of shares to be subject to adjustment as provided in the plan and in any award agreements entered into by the Company under the plan, and upon the exercise or conversion of any awards granted under the plan. On January 1, 2012, 450,275 shares were added to the 2010 Plan and on January 1, 2013, 500,000 shares were added to the 2010 Plan, as provided under the terms of the 2010 Plan.
 
The Company granted options to purchase 122,740 and 857,394 shares of common stock to employees during the three months and nine months ended September 30, 2013, respectively.  The Company issued zero and 5,546 shares of common stocks in connection with the exercise of employee’s stock options during the three months and nine months ended September 30, 2013.  As of September 30, 2013, there are 471,624 options available for grant under the 2010 Plan.

NOTE 9: INCOME TAXES
 
The Company accounts for income taxes as outlined in ASC 740, “Income Taxes”, which was previously Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). Under the asset and liability method of SFAS 109, deferred income tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided for the amount of deferred tax assets that, based on available evidence, are not expected to be realized.
 
As a result of the Company’s cumulative losses, management has concluded that a full valuation allowance against the Company’s net deferred tax assets is appropriate. No income tax liabilities existed as of September 30, 2013 and December 31, 2012 due to the Company’s continuing operating losses.

NOTE 10: CONCENTRATION OF CREDIT RISK
 
Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash deposits. Accounts at each institution are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $250,000. At September 30, 2013 and December 31, 2012, the Company had $7,443,561 and $1,475,197 in excess of the FDIC insured limit, respectively.

NOTE 11: COMMITMENTS AND CONTINGENCIES
 
Lease Commitments
 
On September 29, 2010, the Company entered into a commercial lease agreement with CompleGen, Inc. for laboratory space located in Seattle, WA. The lease provides for monthly rent of $3,658 and a security deposit of $3,658. The lease terms are from September 29, 2010 through March 31, 2011, at which time the lease has converted to month to month unless two months’ prior written notice of the intent to terminate the agreement is given. The monthly rent for the lease increased to $4,267 commencing January 2012. For the year ended December 31, 2012, the Company incurred $46,529 of rent expense for the lease. The lease was terminated in December 2012, and the rental deposit was applied to the rent of the final month.
 
On March 4, 2011, the Company entered into a commercial lease agreement with Sanders Properties, LLC for office space located in Seattle, WA. The lease provides for monthly rent of $1,100 and a security deposit of $1,500. The lease terms are from April 1, 2011 through March 31, 2014. For the nine months ended September 30, 2013, the Company incurred $8,800 of rent expense for the lease.
 
On December 9, 2011, the Company entered into another commercial lease agreement with Fred Hutchinson Research Center for lab and office space located in Seattle, WA. The lease provides for monthly rent of $16,395 for the period from February 24, 2012 to August 31, 2012, $19,923 for the period from September 1, 2012 to August 31, 2013, and $20,548 for the period from September 1, 2013 to November 29, 2014. The security deposit of $32,789 was paid in March 2012 and recorded as Security Deposit on the consolidated balance sheet as of December 31, 2012. For the nine months ended September 30, 2013, the Company incurred $233,260 of rent expense for the lease, which included leasing office management expenses.
 
 
15

  
                In July 2013, the Company entered into an agreement with ARE LLC (Alexandria) to lease additional office spaces in our existing building under a separate lease agreement. The lease is from August 2013 through November 2014, and the gross rent is $ 4,800 per month.
 
The future minimum lease payments due subsequent to September 30, 2013 under all non-cancelable operating leases for the next five years are as follows:
  
As of September 30,
 
Amount
 
2014
 
$
380,767
 
2015
 
 
62,451
 
2016
 
 
-
 
2017
 
 
-
 
2018
 
 
-
 
Thereafter
 
 
-
 
Total minimum lease payments
 
$
443,218
 
 
Affymetrix Purchase Commitment
 
In September 2013, the Company entered into an “Ownership Program Agreement” with Affymetrix, Inc, a manufacturer of GeneChip Systems, where Affymetrix has agreed to loan a GeneChip System 3000Dx v.2 (“instrument”) to us if we purchase and take delivery of a minimum thirty GeneChip Human Genme U133 Plus 2.0 (30-pack) arrays at $21,590 per 30 pack for the next three years for a total purchase obligation of $647,700 with a minimum purchase of ten 30-pack arrays per contract year.  At the end of the three year contract, upon fulfillment of the purchase commitment, the instrument title and ownership transfer to Atossa at no additional cost.   In addition to the GeneChip Human Genme, we must purchase a two year service contract for $51,600 to cover maintenance of the instrument during the contract period.   We placed an initial order for four 30-pack arrays in September 2013 for $94,723.  We are obligated to purchase 26 additional arrays during the next three year contract term.
 
Contingencies
 
On June 30, 2011, Robert Kelly, the Company’s former President, filed a counterclaim against the Company in an arbitration proceeding, alleging breach of contract in connection with the termination of a consulting agreement between Mr. Kelly (dba Pitslayer LLC) and the Company that was entered into in July 2010 in connection with his resignation from the Company as President and a director. The consulting agreement was terminated by the Company in September 2010. Mr. Kelly seeks $450,000 in compensatory damages, which is the amount he claims would have been earned had the consulting agreement been fulfilled to completion.
 
On December 11, 2012, Mr. Kelly filed a complaint in the United States District Court, Western Division of Washington seeking compensatory damages, interest and attorneys’ fees related to the termination of Mr. Kelly’s consulting contract and the rescission of shares issued to him in July 2010 in connection with his resignation from the Company as President and a director. The specific amount of damages sought is to be proven at trial and is not specified. On July 8, 2013, the court granted the Company’s motion to compel arbitration of these claims and therefore this action was dismissed.
 
On February 26, 2013, Mr. Victor Cononi filed a complaint in the United States District Court, Western Division of Washington seeking compensatory damages, interest and attorneys’ fees related to the rescission of shares issued to him in July 2010 in connection with Mr. Kelly’s resignation from the Company as President and a director. The specific amount of damages sought is to be proven at trial and is not specified. In August 2013, the court granted the Company’s motion to compel arbitration of these claims and therefore this action has  been dismissed.
 
A hearing in the arbitration has been postponed pending certain procedures in the above Western Division action and may be delayed further to accommodate other third party civil and federal criminal proceedings alleging securities and wire fraud that have been brought against Mr. Kelly with respect to his prior employment and predating his service with the Company.
 
 
16

    
The Company is reasonably confident in its defenses to Mr. Kelly’s and Mr. Cononi’s claims. Consequently, no provision or liability has been recorded for these claims as of September 30, 2013. However, it is at least reasonably possible that the Company’s estimate of liability may change in the near term. Any payments by reason of an adverse determination in this matter will be charged to earnings in the period of determination.
 
On October 10, 2013, a putative securities class action complaint was filed in the United States District Court for the Western District of Washington against us, certain of our directors and officers and the underwriters of our November 2012 initial public offering.  The complaint alleges that all defendants violated Sections 11 and 12(a)(2), and that we and certain of our directors and officers violated Section 15, of the Securities Act by making false and misleading statements and omissions in the offering’s registration statement, and that we and certain of our directors and officers violated Sections 10(b) and 20A of the Exchange Act and SEC Rule 10b-5 promulgated thereunder by making false and misleading statements and omissions in the registration statement and in certain of our subsequent press releases and SEC filings with respect to our NAF specimen collection process, our ForeCYTE Breast Health Test and our MASCT device.   This action seeks, on behalf of persons who purchased our common stock between November 8, 2012 and October 4, 2013, inclusive, damages of an unspecific amount. We believe this complaint is without merit and plan to defend ourselves vigorously.   Failure by us to obtain a favorable resolution of the claims set forth in the complaint could have a material adverse effect on our business, results of operations and financial condition.  Currently, the amount of such material adverse effect cannot be reasonably estimated, and no provision or liability has been recorded for these claims as of September 30, 2013.  The costs associated with defending and resolving the complaint and ultimate outcome cannot be predicted.  These matters are subject to inherent uncertainties and the actual cost, as well as the distraction from the conduct of our business, will depend upon many unknown factors and management’s view of these may change in the future.
 
FDA Warning Letter
 
On February 21, 2013, the Company received a Warning Letter (“Letter”) from the FDA regarding its Mammary Aspirate Specimen Cytology Test (MASCT) System and MASCT System Collection Test (together, the “System”).  The Letter arises from certain FDA findings during a July 2012 inspection, to which the Company responded in August 2012, explaining why the Company believed it was in compliance with applicable regulations and/or was implementing changes responsive to the findings of the FDA inspection.  The FDA alleges in the Letter that following 510(k) clearance of the MASCT System, the Company changed the System in a manner that requires submission of an additional 510(k) notification to the FDA. Specifically, the FDA stated that the Instructions For Use (IFU) in the original 510(k) submission stated that the user must “Wash the collection membrane with fixative solution into the collection vial…” while the current IFU states “…apply one spray of Saccomanno’s Fixative to the collection membrane…” and that “this change fixes the NAF specimen to the filter paper rather than washing it into a collection vial.” At the time that the changes were made the Company determined and documented that the change could not significantly affect the safety or effectiveness of the MASCT System, and thus, that a new 510(k) was not required in accordance with the FDA’s guidance document entitled, “Deciding When to Submit a 510(k) for a Change to an Existing Device.” The Letter also identified certain issues with respect to the Company’s marketing of the System and the Company’s compliance with FDA Good Manufacturing Practices (cGMP) regulations, among other matters. The Company responded to the Letter on March 13, 2013, and identified the corrective actions that had been made, or were otherwise underway The Company also filed a new 510(k) application for the MASCT System which was withdrawn in August 2013 after receiving feedback from the FDA.
 
On October 4, 2013, the Company initiated a voluntary recall of the system to address FDA’s concerns regarding the modifications identified in the Letter. As a result of this recall, this product is currently not being marketed or distributed in the U.S.  The Company plans to prepare a new premarket notification or 510(k) application for submission to the FDA that covers the collection, preparation, and processing of NAF specimens at our laboratory and includes the spray method of fixing specimens to the collection membrane.
 
To ensure that the 510(k) includes the information that FDA feels is appropriate, we have requested a pre-submission meeting with the FDA. This meeting is scheduled to be held on November 14, 2013. Once we understand what types of data FDA is seeking, we intend to submit the 510(k) shortly after the meeting.  Once filed we hope that the FDA will complete their review of our submission within 90 days; but of course we cannot predict if they will ask us for additional information or otherwise complete their review within the 90 days.
 
 
17

    
The Company has recorded a loss contingency as of September 30, 2013 of $402,840 related to the estimated costs of the recall, including the estimated costs of pursuing the additional 510(k) clearance.  The recall and 510(k) process may take longer than expected and we may incur costs that we have not anticipated.  Accordingly, the actual amount of the loss contingency may be higher than we currently expect.

NOTE 12: RELATED PARTY TRANSACTIONS
 
Loans from Officer
 
On May 26, 2009, the Company borrowed $5,000 from its Chairman of the Board and Chief Executive Officer as a short-term, unsecured loan via verbal agreement and did not bear any interest. Commencing June 30, 2010, the loan was converted into a written Promissory Note bearing an annual interest rate of 10%, with a maturity date of December 31, 2010. This note was repaid in full on May 16, 2011 including approximately $439 of accrued interest.
 
On June 30, 2010, the Company borrowed an additional $100,000 from its Chairman of the Board and Chief Executive Officer pursuant to a promissory note. The loan under the note was funded to the Company on July 12, 2010. The note bears a 10% interest rate per annum and carries a $4,000 loan origination fee which is accreted to the loan balance throughout the life of the loan. The $4,000 loan origination fee was fully accreted to the loan balance as of March 31, 2011 and December 31, 2010, and recorded as interest expense for the year ended December 31, 2010. This note (including the $4,000 origination fee) was repaid in full on May 19, 2011 including approximately $8,959 in accrued interest.
 
On November 3, 2010, the Company entered into a line of credit agreement for borrowing up to $500,000 from its Chairman of the Board and Chief Executive Officer pursuant to a promissory note. The note bears a 10% interest rate per annum. An aggregate of $140,000 was funded to the Company under the line of credit as of March 31, 2011 which was repaid on May 31, 2011, including approximately $6,093 in accrued interest. As of December 31, 2011, the unpaid principal balance drawn from the line of credit was $5,078, which was fully repaid on March 31, 2012.
 
On July 30, 2012, the Company entered into a line of credit agreement for borrowing up to $500,000 from its Chairman of the Board and Chief Executive Officer pursuant to a promissory note. The note bears a 12% interest rate per annum. An aggregate of $79,300 was funded to the Company under the line of credit as of December 31, 2012. The principal balance of $79,300 and interest of $1,440 was fully repaid on October 11, 2012.
 
Exclusive License Agreement
 
On July 27, 2009, the Company entered into an exclusive license agreement with Ensisheim Partners LLC (“Ensisheim”), an entity solely owned by the Chairman and Chief Executive Officer of the Company and the Chief Scientific Officer of the Company, who is also the wife of the Company’s Chairman and CEO. Pursuant to that agreement, Ensisheim granted the Company an exclusive, worldwide, perpetual, irrevocable, royalty-bearing, license to the MASCT System, with the right to grant and authorize sublicenses. The license agreement provided that the Company would pay Ensisheim a royalty equal to 2% of net sales revenue, with a minimum royalty of $12,500 per fiscal quarter during the term of the agreement, which would have increased to a minimum royalty of $25,000 per fiscal quarter beginning in the quarter in which the first commercial sale of a licensed product would have taken place. From inception through December 31, 2010, the Company had incurred $16,250 in patent-related expenses under the license agreement with Ensisheim, and $0 subsequent to December 31, 2010.
 
On June 17, 2010, the Company and Ensisheim entered into an Assignment Agreement, whereby Ensisheim assigned to the Company all rights to the patents and patent applications underlying the MASCT System. Pursuant to the assignment, the Company will have all responsibility for prosecution, maintenance, and enforcement and will indemnify Ensisheim from any and all claims against the patent estate. Ensisheim retained no residual rights with respect to the patents and patent applications. In conjunction with the assignment, the Company terminated the exclusive license agreement between the Company and Ensisheim dated July 27, 2009. As a result of the termination, the Company has no further obligations with respect to royalty payments to Ensisheim due under the old licensing agreement. As a result, the $12,500 of patent royalty payable to Ensisheim recorded as accrued royalty payable at December 31, 2009 has been reversed through royalty expense during the second quarter of 2010.
 
 
18

   
Commercial Lease Agreement
 
On December 24, 2009, the Company entered into a commercial lease agreement with Ensisheim for office space located in Seattle, Washington. The lease provided for annual rent of $13,200, plus applicable sales tax. From inception through December 31, 2009, the Company incurred $248 of rent expense for the lease with security deposit of $1,100. For the period of January 1, 2010 through June 30, 2010, the Company incurred $6,600 of rent expense for the lease. On July 15, 2010 the Company and Ensisheim terminated the lease, effective July 1, 2010 and the Company commenced use of the facility rent free until April 1, 2011 when the commercial lease agreement the Company entered into with Sanders Properties, LLC became effective (see Note 11). The $1,100 security deposit paid to Ensisheim was received as of December 31, 2012.
 
Executive Compensation
 
On May 19, 2010, the Company entered into employment agreements with three executives, including its Chief Executive Officer, its former President, and its Chief Scientific Officer. The annual base salaries under each agreement were calculated based on combined consideration of the success of capital raise and the operating results of the Company, and capped at $360,000, $350,000, and $250,000, respectively for the three executives.
 
On July 22, 2010, in connection with the resignation and departure of Robert L. Kelly, the President and a director, the Company entered into a consulting agreement with a limited liability company controlled by Mr. Kelly. Under the agreement, the Company was to receive consulting services relating to capital raising and investor relations. The agreement was terminated by the Company in September 2010, through which time a total of $30,000 consulting expense had been paid.
 
On July 22, 2010, the Company restated and amended the employment agreements with its CEO and CSO. The agreements modified the base annual salary amounts to $250,000 and $200,000, respectively, effective retroactively to May 19, 2010. For the nine months ended September 30, 2012, salaries and bonuses of CEO and CSO amounted to $269,438 and $200,550, of which $134,719 and $200,550 were recorded to research and development expense, respectively. For the nine months ended September 30, 2013, salaries and bonuses of CEO and CSO amounted to $258,635 and $191,908, of which $129,316 and $191,908 were recorded to research and development expense, respectively. 
 
Share-Based Compensation
 
The amended employment agreement with the CEO, entered into on July 22, 2010, granted options to purchase 250,000 shares (or 565,830 shares prior to the reverse stock-split on September 28, 2010) at a price of $5.00 per share, in consideration of his service to the Company. Of these options, 25% (or 62,500 shares) vested on December 31, 2010 with the remaining 75% (or 187,500 shares) to vest in equal quarterly installments over the next three years so long as the executive remains employed with the company. These options have five-year contractual terms.
 
The amended employment agreement with the CSO, entered into on July 22, 2010, granted options to purchase 100,000 shares (or 226,332 shares prior to the reverse stock-split on September 28, 2010) at a price of $5.00 per share in consideration of her service to the Company. Of these options, 25% (or 25,000 shares) vested on December 31, 2010 with the remaining 75% (or 75,000 shares) to vest in equal quarterly installments over the next three years so long as the executive remains employed with the company. These options have five-year contractual terms.
 
On April 4, 2011, 45,000 non-qualified stock options were granted under the 2010 Plan to Dr. Tim Hunkapiller for being a member of the Company’s Scientific Advisory Board and consulting services to be provided to the Company, at an exercise price of $1.25 per share. These options have a ten-year contractual term and shall vest as follows:
 
 
(i)
11,250 option shares shall vest ninety (90) days after the date of grant;
 
 
 
(ii)
11,000 option shares shall vest one hundred and eighty (180) days after the date of grant;
 
 
 
(iii)
11,500 option shares shall vest two hundred and seventy (270) days after the date of grant;
    
 
19

 
(iv)
11,250 option shares shall vest three hundred and sixty (360) days after the date of grant.
 
On September 1, 2011, 219,000 incentive stock options were granted under the 2010 Plan to employees and officers as part of their employment agreements, at an exercise price of $1.25 per share. These options have a ten-year contractual term and shall vest and become exercisable as follows:
 
(i)
twenty-five percent (25%) of the underlying shares on the first anniversary of the date of grant; and
 
 
 
(ii)
forty eighth (1/48) of the underlying shares monthly thereafter.
 
On September 1, 2011, 200,000 non-qualified stock options were granted under the 2010 Plan to non-employee directors for services to be provided to the Company, at an exercise price of $1.25 per share. These options have a ten-year contractual term and shall vest and become exercisable as follows:
 
(i)
80,000 option shares shall vest on September 1, 2011;
 
 
 
(ii)
30,000 options shares shall vest on December 1, 2011;
 
 
 
(iii)
30,000 options shares shall vest on March 1, 2012;
 
 
 
(iv)
30,000 options shares shall vest on June 1, 2012;
 
 
 
(v)
30,000 options shares shall vest on September 1, 2012.
   
On April 30, 2012, 19,757 non-qualified stock options were granted under the 2010 Plan to non-employee directors for serving as directors of the Company, at an exercise price of $6.00 per share. These options have a ten-year contractual term and shall vest and become exercisable in full immediately as of the grant date.
 
On December 17, 2012, 228,000 non-qualified stock options were granted under the 2010 Plan to employees as part of their employment agreements, at an exercise price of $4.24 per share. On December 20, 2012, 200,000 non-qualified stock options were granted outside of the 2010 Plan, but governed in all respects by the 2010 Plan, to an employee as part of his employment agreement, at an exercise price of $4.11 per share. These options each have a ten-year contractual term and shall vest and become exercisable as follows:
 
(i)
twenty-five percent (25%) of the underlying shares on the first anniversary of the date employment commenced; and
 
 
 
(ii)
one-sixteenth (1/16) of the underlying shares quarterly thereafter.
   
In accordance with the guidance provided in ASC Topic 718, Stock Compensation (formerly SFAS 123R), the compensation costs associated with these options are recognized, based on the grant-date fair values of these options, over the requisite service period, or vesting period. Accordingly, the Company recognized a compensation expense of $1,187,716 and $96,251 for the nine months ended September 30, 2013 and 2012, respectively.
 
The Company estimated the fair value of these options using the Black-Scholes-Merton option pricing model based on the following weighted-average assumptions:
 
 
20

 
 
 
2010 through December 2012
 
Employee
 
Employee &
Officers
 
Directors
 
CEO &
CSO
 
Date of Grant
 
December 2012
 
September 2011
 
April 2012 – September 2011
 
July 2010
 
 
 
 
 
 
 
 
 
 
 
Fair value of common stock on date of grant
 
$4.11-$4.24(D)
 
$0.9060(B)
 
$0.9060 (B &C )
 
$2.7560(A)
 
Exercise price of the options
 
$4.11 - $4.24
 
$1.25
 
$1.25-$6.00
 
$5.00
 
Expected life of the options (years)
 
5.74 - 6.11
 
5.65
 
5.00 – 5.65
 
3.33
 
Dividend yield
 
0.00%
 
0.00%
 
0.00%
 
0.00%
 
Expected volatility
 
42.44 – 44.58%
 
53.90%
 
53.90-62.46%
 
58.59%
 
 
 
 
 
 
 
 
 
 
 
Risk-free interest rate
 
0.91-0.99%
 
1.08%
 
0.89 – 1.08%
 
1.03%
 
Expected forfeiture per year (%)
 
10.00%
 
10.00%
 
0.00%
 
0.00%
 
Weighted average fair value of the options per unit
 
$1.7426-$1.7842
 
$0.3579
 
$0.3579-$3.0367
 
$0.6744
 
 
Year To Date September 2013
 
Employee
 
Employee &
Officers
 
Directors
 
CEO &
CSO
 
Date of Grant
 
January - August 2013
 
January - June 2013
 
May 2013
 
March 2013
 
 
 
 
 
 
 
 
 
 
 
Fair value of common stock on date of grant(E)
 
$3.95 - $5.19(D )
 
$4.11 - $4.58(D)
 
$6.59 (D)
 
$6.57 (D )
 
Exercise price of the options
 
$3.95 - $5.19
 
$4.11 - $4.58
 
$6.59
 
$6.57
 
Expected life of the options (years)
 
6.09 - 6.11
 
5.00 – 6.11
 
5.00 – 5.31
 
5.00
 
Dividend yield
 
0.00%
 
0.00%
 
0.00%
 
0.00%
 
Expected volatility
 
40.73 - 40.92%
 
40.96 - 41.05%
 
41.06-41.09%
 
47.09%
 
 
 
 
 
 
 
 
 
 
 
Risk-free interest rate
 
1.73 -1.97%
 
1.03-1.36%
 
0.73 - 0.84%
 
1.13%
 
Expected forfeiture per year (%)
 
10.00%
 
10.00%
 
10.00%
 
0.00%
 
Weighted average fair value of the options per unit
 
$1.35 - $2.18
 
$1.69 - $1.89
 
$2.41 - $2.49
 
$2.70
 
 
 
(A)
The fair value of the Company's common stock was derived implicitly from the public offering filed in March 2010 at $3.00 per share and from the terms of an underwritten offering contemplated in July 2010 at $6.00 per Unit that was filed in October 2010, with $2.756 per share being allocated to common stock using an iterative approach in order for the combined fair value of the common stock and warrants to equal the amount of consideration to be received for the offering.
 
 
(B)
The fair value of the Company's common stock was derived implicitly from the Private Placement during April through June 2011 at $1.25 per Unit, wherein one Unit was comprised of one share of common stock and one warrant to purchase one share of common stock at an exercise price of $1.60 per share.
 
 
(C)
The fair value of the Company's common stock was derived implicitly from the public offering filed in February 2012 at $6.00 per share.
 
 
(D)
The fair values of the Company's common stock were derived from the closing prices on the NASDAQ Capital Market as of the dates of grant.
 
In October 2010, the Company filed a Registration Statement on Form S-1 with the SEC. However, the market for early stage investments in medical technology transactions had deteriorated between mid-2010 and early 2011. In addition, the Company’s ability to negotiate with potential investors was limited. The Company’s cash position had also diminished since the summer of 2010 and the founders of the Company were unable to finance the Company at the level needed for growth. The withdrawal of the Registration Statement in February 2011 further weakened the impression of the Company in the market. The fair value of the Company’s common stock decreased from $2.756 in 2010 to $0.906 in 2011 primarily because the grants in 2011 relied on the arm’s-length negotiation of the private placement financing (for illiquid stock) as opposed to relying on an anticipated initial public offering (of publicly-traded stock), as was the case in 2010. The private placement transactions were between the company and over 200 accredited investors and ascribed a value of $0.906 to the Company’s common stock.
 
 
21

   
 
Fair value hierarchy of the above assumptions can be categorized as follows:
 
 
(1)
There were no Level 1 inputs.
 
(2)
Level 2 inputs include:
 
Risk-free rate- The risk-free rate of return reflects the interest rate for United States Treasury Note with similar time-to-maturity to that of the options.
 
(3)
Level 3 inputs include:
 
Expected lives- The expected lives of options granted were derived from the output of the option valuation model and represented the period of time that options granted are expected to be outstanding.
 
Expected forfeitures per year- The expected forfeitures are estimated at the dates of grant and will be revised in subsequent periods pursuant to actual forfeitures, if significantly different from the previous estimates.
 
Expected volatility- We did not have a historical trading history sufficient to develop an internal volatility rate for use in the model. As a result, as required by ASC 718-10-30, the Company has accounted for the options using the calculated value method. The Company identified five to seven public entities in the similar industry for which share price information was available, and considered the historical volatilities of those public entities’ share prices in calculating the expected volatility appropriate to the Company.
 
The estimates of fair value from the model are theoretical values of stock options and changes in the assumptions used in the model could result in materially different fair value estimates. The actual value of the stock options will depend on the market value of the Company’s common stock when the stock options are exercised.
 
Notwithstanding that the fair market value of the Company’s common stock in September 2011 was $0.906 per share, the Company filed a Registration Statement on Form S-1 in February 2012 to offer shares of its common stock at $5.00 to $7.00 per share. This increase in share value is justified by the accomplishments achieved by the Company between September 2011 and February 2012. Specifically, the MASCT System manufacturing had been completed, supplies for the Field Experience Trial were completed and the Company had established an FDA-compliant inventory and warehousing facility. Further, the National Reference Laboratory for Breast Health, the Company’s wholly-owned subsidiary, was established as a Delaware corporation, was equipped and staffed, and the protocols and procedures needed to be a CLIA-registered facility were put in place. Moreover, the ForeCYTE test, which involves cytopathology and five biomarkers of hyperplasia and one biomarker of sample integrity, was completed, tested, and validated to CLIA standards. Computer hardware and software was acquired, set up, made operational, and the ForeCYTE report template, with unique reporting information for the requesting physician and a patient letter template, were created. The company explored and identified a technology for the ArgusCYTE test, negotiated a supply agreement with the supplier, and tested and validated the test. An ArgusCYTE report template was also established and a new reporting scheme invented and a patent application filed.
 
Further, the Company negotiated the acquisition of the FullCYTE Microcatheter System from Hologics, reestablished the supply chain and began preparing for a commercial launch later in 2012 or early 2013. In doing so, the Company increased its U.S. patent portfolio from 5 to 31 and its total portfolio of patents and applications to over 120. The Hologic patent estate also contains the key patents that permit microcatheter-based intraductal treatment of cancer and pre-cancer. The Company also prepared marketing documents for the launch of the ForeCYTE and ArgusCYTE tests, which occurred in December 2011. The Company launched a clinical trial of the FullCYTE microcatheter to establish the feasibility of performing Next Generation Sequencing on the samples obtained with the microcatheter, negotiated the acquisition of the NextCYTE technology, and is conducting a study of the utility of the technology in providing superior information in the setting of cancer diagnosis and treatment selection.
 
 
22

 
The Company also established third-party relationships to perform the reimbursement billing in anticipation of the commercial launch and to permit electronic remittance of testing revenue. The Company commenced a Field Test Experience limited launch of both the ForeCYTE and ArgusCYTE tests on schedule in December 2011 and has seen significant market acceptance of both tests from the doctors and clinics using the tests. The Company passed a CLIA inspection and became CLIA-certified, has obtained several state licenses and has pending applications in all remaining states where licensure is required. Finally, the Board of Directors and scientific advisory board were each strengthened with the addition of key new executives and scientists.
 
The Board of Directors considered each of the foregoing achievements, and considered input from the Company’s investment bankers, in determining that the value of the Company supports a valuation of $5.00 to $7.00 per share of the Company’s common stock.
 
Options issued and outstanding as of September 30, 2013 and their activities during the nine months then ended are as follows:
 
 
 
Number of 
Underlying 
Shares
 
Weighted-
Average 
Exercise 
Price Per 
Share
 
Weighted-
Average 
Contractual 
Life 
Remaining 
in 
Years
 
Outstanding as of January 1, 2013
 
 
1,052,137
 
$
3.79
 
 
 
 
Granted
 
 
1,425,394
 
 
5.02
 
 
 
 
Expired
 
 
(3,812)
 
 
4.99
 
 
 
 
Forfeited
 
 
(221,522)
 
 
4.21
 
 
 
 
Exercised
 
 
(5,546)
 
 
1.79
 
 
 
 
Outstanding as of September 30, 2013
 
 
2,246,651
 
 
4.53
 
 
8.87
 
Exercisable as of September 30, 2013
 
 
1,044,549
 
 
4.54
 
 
8.21
 
Vested and expected to vest (1)
 
 
2,090,475
 
 
4.54
 
 
8.83
 
 
(1) vested shares and unvested shares after a forfeiture rate is applied.
 
As of September 30, 2013 and December 31, 2012, the aggregate intrinsic value of options outstanding was $3,604,669 and $1,150,416, respectively. 

NOTE 13: ASSET PURCHASE
 
On September 30, 2012, the Company entered into an asset purchase agreement with Acueity Healthcare, Inc (“Acueity”) to acquire substantially all of the assets of Acueity. Through the asset purchase, the Company acquired 35 issued patents (18 issued in the U.S. and 17 issued in foreign countries), 41 patent applications (32 in the U.S. and 9 in foreign countries), six 510(k) FDA marketing authorizations related to the manufacturing, use, and sale of the Viaduct Miniscope and accessories, the Manoa Breast Biopsy system, the Excisor Bioptome, the Acueity Medical Light Source, the Viaduct Microendoscope and accessories, and cash in the amount of $400,000; no liabilities were assumed in the transaction. In consideration for the assets, the Company issued 862,500 shares of common stock, valued at $5.00 per share, the offering price listed on the prospectus filed pursuant to Rule 424(b)(4) on November 9, 2012, and warrants to purchase up to 325,000 shares of common stock at an exercise price of $5.00 per share, to the shareholders of Acueity, subject to a six-month lock up agreement which has since lapsed. The warrants, which have a five-year term, do not have a cashless exercise provision. The warrants were valued at $2.3457 per warrant, using a Black-Scholes-Merton Valuation Technique because it embodies all of the requisite assumptions (including trading volatility, estimated terms and risk-free rates) necessary to determine the fair value of the warrants (see Note 8). There are no future financial obligations from the Company to Acueity from the commercialization of the acquired assets.
 
 
23

 
NOTE 14: SUBSEQUENT EVENTS
 
Voluntary Product Recall
 
On October 4, 2013 we initiated a voluntary recall to remove the ForeCYTE Breast Health Test and the MASCT device from the market. This voluntary recall includes the MASCT System Kit and Patient Sample Kit. The vast majority of these products (approximately ninety percent) are in inventory with our distributors and the remaining quantities are at customer sites across the United States. Distributors and customers have been instructed to stop using affected products and return them to Atossa immediately.
 
The purpose of this voluntary recall is to address concerns raised by the FDA in a Warning Letter received by Atossa in February 2013. In that Warning Letter, the  FDA raised concerns about (1) the current instructions for use (IFU); (2) certain promotional claims used to market these devices; and (3) the need for FDA clearance for certain changes made to the NAF specimen collection process identified in the current IFU. We are in the process of removing existing product from the market.
 
We are working with the FDA on this matter and this voluntary recall. We have notified distributors and customers by certified mail and we are arranging for the return of all recalled products.  We plan to prepare a new premarket notification or 510(k) application for submission to the FDA that covers the collection, preparation, and processing of NAF specimens at our laboratory and includes the spray method of fixing specimens to the collection membrane. However, we cannot market or distribute the modified product in the U.S. unless or until the new 510(k) is cleared by the FDA.
 
To ensure that the 510(k) includes the information that FDA feels is appropriate, we have requested a pre-submission meeting with the FDA.  This meeting is scheduled to be held on November 14, 2013.   Once we understand what types of data FDA is seeking, we intend to submit the 510(k) shortly after the meeting.   Once filed we hope that the FDA will complete their review of our submission within 90 days; but of course we cannot predict if they will ask us for additional information or otherwise complete their review within the 90 days.
 
The Company has recorded a loss contingency as of September 30, 2013 of $402,840 related to the estimated costs of the recall, including the estimated costs of pursuing the additional 510(k) clearance.  The recall and 510(k) process may take longer than expected and we may incur costs that we have not anticipated.  Accordingly, the actual amount of the loss contingency may be higher than we currently expect.  
 
Aspire Common Stock Purchase Agreement
 
From the October 1, 2013 through November 7, 2013, the Company has sold 200,000 shares of common stock to Aspire Capital with gross proceeds to the Company of $349,670, pursuant to the terms of the Common Stock Purchase Agreement with Aspire dated March 27, 2013.  The March 27, 2013 Common Stock Purchase Agreement with Aspire Capital was terminated on November 8, 2013 and on that date we entered into a new stock purchase agreement with Aspire Capital Fund, LLC.  The new stock purchase agreement provides that, upon the terms and subject to the conditions and limitations set forth therein, Aspire is committed to purchase up to an aggregate of $25 million of shares of our common stock over the 30 month term of the agreement. We cannot, however, sell any shares to Aspire under the new agreement unless and until a new registration statement is filed with and declared effective by the SEC.
 
 
24

 
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion of the financial condition and results of operations should be read in conjunction with the financial statements and the related notes included elsewhere in this report. This discussion contains forward-looking statements, which are based on assumptions about the future of the Company's business. The actual results could differ materially from those contained in the forward-looking statements. Please read “Forward-Looking Statements” included below for additional information regarding forward-looking statements.
 
Forward-Looking Statements
 
This report contains, in addition to historical information, certain information, assumptions and discussions that may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have made these statements in reliance on the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected or anticipated. Although we believe our assumptions underlying our forward-looking statements are reasonable as of the date of this report, we cannot assure you that the forward-looking statements set out in this report will prove to be accurate. We typically identify these forward-looking statements by the use of forward-looking words such as “expect,” “potential,” “continue,” “may,” “will,” “should,” “could,” “would,” “seek,” “intend,” “plan,” “estimate,” “anticipate” or the negative version of those words or other comparable words. Forward-looking statements contained in this report include, but are not limited to, statements about:
 
 
·
our ability to successfully sell our products and services at currently expected prices or otherwise at prices acceptable to us;
 
 
 
 
·
whether we will obtain in a timely manner clearance from the Food and Drug Administration to sell, market and distribute our MASCT System and ForeCYTE Test;
 
 
 
 
·
our ability to successfully re-launch our MASCT System and ForeCYTE Test;
 
 
 
 
·
the estimated costs associated with our product recall;
 
 
 
 
·
our ability to successfully develop and commercialize new tests, tools and technologies currently in development and in the time frames currently expected;
 
 
 
 
·
our ability to maintain our business relationships, including with our distributors, suppliers and customers, while we are undergoing the recall we commenced October 4, 2013 and while we seek additional regulatory clearance to market, sell and distribute our MASCT System and ForeCYTE Test;
 
 
 
 
·
our ability to engage third-party suppliers to manufacture the MASCT System, Microcatheter System, other devices under development and their components at quantities and costs acceptable to us;
 
 
 
 
·
our ability to satisfy ongoing FDA requirements for the MASCT System, ForeCYTE Test and Microcatheter System and to obtain regulatory approvals for our other products and services in development, including our ability to timely and adequately respond to the warning letter we received from the FDA on February 21, 2013 and any issues resulting therefrom;
 
 
 
 
·
our ability to defend the securities class action law suit filed against us on October 10, 2013, and other similar complaints that may be brought in the future, in a timely manner and within the coverage, scope and limits of our insurance policies;
 
 
 
 
·
the benefits and clinical accuracy of the ForeCYTE and ArgusCYTE tests and whether any product or service that we commercialize is safer or more effective than competing products and services;
 
 
25

 
 
·
our ability to establish and maintain intellectual property rights covering our products and services;
 
 
 
 
·
the willingness of health insurance companies, including those who are members of the MultiPlan, FedMed and HealthSmart networks, and other third-party payors to approve our products and services for coverage and reimbursement;
 
 
 
 
·
our ability to establish and maintain an independent sales representative force, including with our current and future distributors and their sub-distributors, to market our products and services that we may develop, both regionally and nationally;
 
 
 
 
·
our expectations regarding, and our ability to satisfy, federal, state and foreign regulatory requirements;
 
 
 
 
·
the accuracy of our estimates of the size and characteristics of the markets that our products and services may address;
 
 
 
 
·
our expectations as to future financial performance, expense levels and liquidity sources;
 
 
 
 
·
our ability to attract and retain key personnel; and
 
 
 
 
·
our ability to sell additional shares of our Common Stock to Aspire Capital under the terms of our Purchase Agreement with Aspire.
 
These and other forward-looking statements made in this report are presented as of the date on which the statements are made. We have included important factors in the cautionary statements included in this report, particularly in the section entitled “Risk Factors,” that we believe could cause actual results or events to differ materially from the forward-looking statements that we make. Our forward-looking statements do not reflect the potential impact of any new information, future events or circumstances that may affect our business after the date of this report. Except as required by law, we do not intend to update any forward-looking statements after the date on which the statement is made, whether as a result of new information, future events or circumstances or otherwise.
 
Company Overview
 
      We are a healthcare company focused on breast health.  We are developing a suite of tests and therapeutic medical devices, laboratory developed tests and services (LDT and/or invitro diagnostics) that address each of the four stages of the breast health care path: the cytological analysis of cells in nipple aspirate fluid (NAF),  the cytological analysis of cells in ductal lavage fluid collected from each individual breast duct with manual breast duct microcatheters; the profiling of newly diagnosed breast cancers through the determination of gene expression profiles in formalin-fixed paraffin embedded breast cancer biopsy tissue; and the monitoring of breast cancer survivors for pre-clinical recurrence through a blood test for circulating tumor cells.  We also have a  therapeutic program to provide targeted, localized treatment of cancerous and pre-cancerous conditions through our patented microcatheters.  All of our products and services are currently under development and are awaiting additional regulatory clearances prior to marketing and commercialization.  Our products and services under development include:
 
 
·
ForeCYTE Breast Health Test System: a test system comprised of a medical device for the collection and preparation of NAF specimens that are then processed using cytological testing procedures in our wholly-owned CLIA-certified laboratory, the NRLBH. The ForeCYTE Breast Health Test is not intended to be used to diagnose breast cancer or to serve as a replacement for mammography. We are currently seeking 510(k) clearances from the FDA for this test, which we anticipate receiving in the first quarter of 2014. Upon receiving the 510(k) clearances, we intend to re-launch the ForeCYTE Test.
 
 
 
 
·
FullCYTE Breast Health Test: a test system for women identified by their physician as being at high risk for breast cancer. The test is designed for a surgeon to use our patented Class II microcatheter medical devices to collect NAF specimens from individual breast ducts which are then analyzed using cytological testing procedures at the NRLBH. We plan to complete additional validation studies and regulatory clearance of our manufacturing precedures and processes for this test in 2014 and to launch the test in the second half of 2014.
 
 
26

   
 
·
NextCYTE Breast Cancer Test: a test for women newly diagnosed by their physician as having breast cancer that is a qualitative in vitro diagnostic test service, performed in a single laboratory, using the gene expression profile of formalin-fixed, paraffin embedded breast cancer tissue samples to assess a patient’s risk for distant metastasis. It uses advanced microarray expression technologies to quantify and analyze the entire tumor genetic transcriptome, which represents all genes that are being actively expressed within the tumor. This test is in the validation phase and after receiving FDA regulatory clearance we anticipate launching it in the second half of 2014.
 
 
 
 
·
ArgusCYTE Breast Health Test: a blood sample test for breast cancer survivors which provides information on the presence of circulating tumor cells. We completed the development of this test and conducted a limited trial launch in 2012. We are completing enhancements to this test and after receiving any necessary additional FDA clearances we plan to re-launch it in mid-2014.
 
 
 
 
·
Therapeutic Program: We are also developing our patented microcatheters for the delivery of pharmaceutical formulations directly into the milk ducts. We plan to initially target pre-cancerous lesions and ductal carcinoma in situ, or DCIS, a condition diagnosed in more than 65,000 patients each year. By using this localized delivery method, patients are expected to receive high local concentrations of these drugs at the site of the pre-cancerous lesions or DCIS potentially promoting efficacy of the treatment while limiting systemic exposure, which has the potential to lower the overall toxicity of these treatments. This program has not been approved by the FDA. We plan to identify a partner for the clinical development of the pharmaceutical to be used with our device in the first half of 2014.
 
Our leading test, the ForeCYTE Breast Health Test, was launched in a “field experience” trial in 2012 and nationally in the beginning of 2013.  In October 2013, we voluntarily recalled the ForeCYTE Breast Health Test (also known as the MASCT System or ForeCYTE Test).  As a result of this recall, we are not currently marketing this product in the U.S. We intend to obtain an additional FDA 510(k) clearance for the ForeCYTE Test and to re-launch the test upon receiving regulatory clearance.  However, the regulatory pathway to obtaining a 510(k) clearance can be lengthy, expensive and unpredictable; we therefore cannot provide any assurances that we will receive a new 510(k) clearance for ForeCYTE or any of our other tests under development in a timely fashion or at all.
 
Our laboratory, the NRLBH, was established in part to receive and process NAF samples collected with our ForeCYTE Test device.  The NRLBH has been certified pursuant to the Clinical Laboratory Improvement Amendments, or CLIA. CLIA certification is legally required to receive reimbursement from federal or state medical benefit programs, like Medicare and Medicaid, and is a practical requirement for most third-party insurance benefit programs. Our CLIA-certified laboratory, which is permitted to accept samples from all 50 states under its CLIA certification, its state licenses, or, in New York under recognized exemption provisions while its license application is pending, examines the specimens by cytological analysis.
 
 
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Current Operations
 
We launched our commercial operations in late 2011. In 2012 we initiated and completed the field experience trial of our first two tests, the ForeCYTE test and the ArgusCYTE test. In January 2013, we announced the national launch of the ForeCYTE Test. On April 30, 2013, we entered into a Distribution and Marketing Services Agreement with Millennium Medical Devices LLC, pursuant to which Millennium will market and distribute the ForeCYTE breast health test kits in New York City and Northern New Jersey. In May 2013, we entered into a distribution agreement with Fisher Healthcare, a division of Fisher Scientific Company, LLC, and in September 2013 we entered into a distribution agreement with McKesson Medical Surgical.
 
Our Voluntary Product Recall
 
On October 4, 2013 we initiated a voluntary recall to remove the ForeCYTE Breast Health Test and the MASCT device from the market. This voluntary recall includes the MASCT System Kit and Patient Sample Kit. The vast majority of these products (approximately ninety percent) are in inventory with our distributors and the remaining quantities are at customer sites across the United States. Distributors and customers have been instructed to stop using affected products and return them to Atossa immediately.
 
The purpose of this voluntary recall is to address concerns raised by the FDA in a Warning Letter received by Atossa in February 2013. In that Warning Letter, the FDA raised concerns about (1) the current instructions for use (IFU); (2) certain promotional claims used to market these devices; and (3) the need for FDA clearance for certain changes made to the NAF specimen collection process identified in the current IFU. We are in the process of removing existing product from the market.
 
 The MASCT device was originally cleared by the FDA for use as a sample collection device, with the provision that the fluid collected using this device can be used to determine and/or differentiate between normal, pre-cancerous, and cancerous cells. The MASCT device has not been cleared by the FDA for the screening or diagnosis of breast cancer. In addition, the ForeCYTE Breast Health Test has not been cleared or approved by the FDA for any indication as the company considered this to be a Laboratory Developed Test – or within a class of tests that has historically not required 510(k)s for. The ForeCYTE Breast Health Test and the MASCT device are not intended to serve a replacement for screening mammograms, diagnostic imaging tests, or biopsies. Patients are instructed to follow the recommendations and instructions of their physician with respect to breast cancer screening and diagnosis.
 
To date, we are unaware of any adverse incidents or injuries associated with the use of the ForeCYTE Breast Health test and the MASCT device or the processing method identified in the latest version of the IFU. Additionally, we are unaware of any risk to health or injury for clinicians or the patient population that have used these devices. However, there is a risk that these devices may produce false positive or false negative results. Although not cleared or intended for this use, if these devices are used as a substitute for recommended screening or diagnosis of breast cancer, FDA is concerned that patients may choose to forgo recommended mammograms and necessary biopsies.
 
We are working with the FDA on this matter and this voluntary recall. We have notified distributors and customers by certified mail and we are arranging for the return of all recalled products.  As of the date of this report, approximately 8% of the MASCT pumps and 84% of the MASCT patient collection kits have been returned to our processing center. We also plan to prepare a new premarket notification or 510(k) application for submission to the FDA that covers the collection, preparation, and processing of NAF specimens at our laboratory and includes the spray method of fixing specimens to the collection membrane. However, we cannot market or distribute the modified product in the U.S. unless or until the new 510(k) is cleared by the FDA.
 
 
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To ensure that the 510(k) includes the information that FDA feels is appropriate, we have requested a pre-submission meeting with the FDA.  This meeting is scheduled to be held on November 14, 2013.   Once we understand what types of data the FDA is seeking, we intend to submit the 510(k) shortly after the meeting.   Once filed we hope that the FDA will complete their review of our submission within 90 days; but of course we cannot predict if they will ask us for additional information or otherwise complete their review within the 90 days.
 
We have recorded a loss contingency as of September 30, 2013 of $402,840 related to the estimated costs of the recall, including the estimated costs of pursuing the additional 510(k) clearance.  The recall and 510(k) process may take longer than expected and we may incur costs that we have not anticipated.  Accordingly, the actual amount of the loss contingency may be higher than we currently expect.
 
When we re-launch our ForeCYTE Test, we will incur additional sales and marketing expenses. We will need to revise our sales and marketing tools and continue hiring direct sales employees in an effort to build a regional, and ultimately national, sales force.  We also expect to continue to hire clinical consultants to help healthcare providers begin to use our ForeCYTE Test.
 
From our inception (April 30, 2009) through September 30, 2013,  357 physicians have enrolled to provide the ForeCYTE Test and as of that date we have received, processed, and reported the results to physicians from 2,744 NAF samples processed and reported with our ForeCYTE Test (representing 1,372 patients) and 41 ArgusCYTE samples. From inception through September 30, 2013, we have generated $1,068,687 in product and service revenue. We incurred net losses of $3,501,845 and $8,026,984 for the three months and nine months ended September 30, 2013 and $17,758,892 since inception. As of September 30, 2013, we had an accumulated deficit of approximately $17,758,892. We have not yet established an ongoing source of revenue sufficient to cover our operating costs and allow us to continue as a going concern. Our ability to continue as a going concern is dependent on obtaining adequate capital to fund operating losses until we become profitable. We plan to obtain additional capital resources by selling our equity securities, selling the ForeCYTE test kits and generating laboratory service revenue from our tests, and borrowing from stockholders or others when needed. However, we cannot assure you that we will be successful in accomplishing any of these plans and, if we are unable to obtain adequate capital, we could be forced to cease operations.
 
Finally, the acquisition of the Acueity assets may become a complement to our current business at some point in the future. We are not currently allocating human or financial resources to these assets and do not expect to do so until after the launch of our other diagnostic tests in the United States. We intend to complete the steps necessary to begin marketing and selling these tools, such as re-establishment of the supply chain of component parts, securing manufacturers, performing test builds and commercial scale manufacturing, in the first half of 2014. This asset purchase is not expected to have an impact on the development and commercialization timetables of our existing product lines. We cannot, however, provide any assurances that delays related to the launch of our four diagnostic tests, independent of this asset purchase, would not delay the expected development of these diagnostic tools or that we will ultimately be successful selling these tools.
 
Our Common Stock Purchase Agreements with Aspire Capital Fund, LLC
 
On March 27, 2013 we entered into a stock purchase agreement with Aspire Capital Fund, LLC, and pursuant to that agreement we have sold common stock to Aspire with aggregate gross proceeds to us of approximately $11.3 million.  On November 8, 2013 we terminated that agreement and entered into a new stock purchase agreement with Aspire.
 
The November 8, 2013 stock purchase agreement with Aspire provides that, upon the terms and subject to the conditions and limitations set forth therein, Aspire is committed to purchase up to an aggregate of $25 million of shares of our common stock (this amount is in additional to the proceeds we received from sales to Aspire under the March 27, 2013 agreement with them) over the 30-month term of the agreement. Before we can sell any shares under the agreement, we must register the shares and have the registration statement declared effective by the SEC. Other terms and conditions of the agreement are described below.
 
Concurrently with entering into the purchase agreement, we also entered into a registration rights agreement with Aspire. The registration rights agreement provides that the Company will file one or more registration statements, as necessary, to register under the Securities Act of 1933, as amended, the sale of the shares of common stock that have been and may be issued to Aspire under the purchase agreement. The Company agreed to file an initial registration statement registering the sale of the shares by Aspire with the SEC within 10 days of entering into the purchase agreement with Aspire. We further agreed to keep the registration statement effective and to indemnify Aspire for liabilities in connection with the sale of the shares under the terms of the registration rights agreement.
 
 
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As described in more detail below, generally under the purchase agreement we have two ways we can elect to sell shares of common stock to Aspire on any business day we select: (1) through a regular purchase of up to 150,000 shares (but not to exceed $500,000) at a known price based on the market price of our common stock prior to the time of each sale, and (2) through a volume-weighted average price (“VWAP”) purchase of a number of shares up to 30% of the volume traded on the purchase date at a price equal to the lesser of the closing sale price or 95% of the VWAP for such purchase date.  Additionally, there are two milestone stock sales to Aspire described below.
 
Under the purchase agreement we issued 375,000 shares of our common stock to Aspire in consideration for entering into the purchase agreement (the “Commitment Shares”). After the SEC declares the initial registration statement effective, on any business day on which the closing sale price of our common stock equals or exceeds $0.25 per share, over the 30-month term of the purchase agreement, we have the right, in our sole discretion, to present Aspire with a purchase notice directing Aspire to purchase up to 150,000 shares of our common stock per business day; however, no sale pursuant to such purchase notice may exceed $500,000 per business day. The purchase price per share, which we call the “Regular Purchase Price,” is the lower of (i) the lowest sale price for our common stock on the purchase date or (ii) the arithmetic average of the three lowest closing sale prices for our common stock during the 12 consecutive business days ending on the business day immediately preceding the purchase date. The applicable purchase price will be determined prior to delivery of any purchase notice.
 
In addition, on any date on which we have submitted a purchase notice to Aspire in the amount of 150,000 shares, we also have the right, in our sole discretion, to present Aspire with a volume-weighted average price purchase notice, or a “VWAP Purchase Notice” directing Aspire to purchase an amount of our common stock equal to a percentage (not to exceed 30%) of the aggregate shares of common stock traded on the next business day subject to a maximum number of shares determined by us. The purchase price per share pursuant to such VWAP Purchase Notice shall be generally the lower of (i) the closing sale price on the purchase date, and (ii) 95% of the VWAP of our common stock traded on the Nasdaq Capital Market on the purchase day.
 
In addition to the regular purchase and VWAP purchase describe above, we are also obligated to sell, and Aspire is obligated to purchase, $1 million of our common stock upon the occurrence each of two milestone events, for total potential proceeds to us of $2 million.  The first event is the filing by us with the FDA of a premarket notification (510k) covering the collection, preparation, and processing of nipple aspirate fluid specimens in regard to the ForeCYTE Breast Health Test and the Mammary Aspiration Specimen Cytology Test device.  The purchase price for this milestone event will be equal to the lower of $2.00 per share or the Regular Purchase Price on the date of the event.  The second milestone event is the clearance by the FDA of the foregoing 510(k) application and the purchase price for the shares sold upon the occurrence of this milestone event is the lower of $4.00 per share or the Regular Purchase Price on the date of the event.
 
We have the right to sell up to $25 million of our shares of Common Stock to Aspire Capital. We are obligated to register these shares with the SEC. Also, we have agreed to initially register the Commitment Shares issued to Aspire Capital plus an additional 3,825,000 shares which we may sell to Aspire Capital in the future. Under the rules of the NASDAQ Capital Market, in no event may we issue more than 19.99% of our shares outstanding (which is approximately 3,528,199 shares based on 17,649,824 shares outstanding prior to the signing of the purchase agreement and is referred to as the “Exchange Cap” ) under the purchase agreement unless we obtain stockholder approval or an exception pursuant to the rules of the NASDAQ Capital Market is obtained to issue more than 19.99%. This limitation shall not apply if, at any time the Exchange Cap is reached and at all times thereafter, the average price paid for all shares issued and sold under the purchase agreement is equal to or greater than $1.99, which was the closing sale price of our Common Stock on November 7, 2013. We are not required or permitted to issue any shares of Common Stock under the purchase agreement if such issuance would breach our obligations under the rules or regulations of the NASDAQ Capital Market.
 
The number of Purchase Shares covered by, and the timing of, each purchase are determined by us, at our sole discretion. Provided, however, that the milestone sales described above are mandatory.  We may deliver multiple purchase notices to Aspire from time to time during the term of the purchase agreement, so long as the most recent purchase has been completed. There are no trading volume requirements or other restrictions under the purchase agreement. Aspire has no right to require any sales from us, but is obligated to make purchases as directed in accordance with the purchase agreement.
 
The purchase agreement contains customary representations, warranties, covenants, closing conditions and indemnification and termination provisions. The purchase agreement may be terminated by us at any time, at our discretion, without any cost or penalty. Aspire has covenanted not to cause or engage in any manner whatsoever, any direct or indirect short selling or hedging of our common stock. We did not pay any additional amounts to reimburse or otherwise compensate Aspire in connection with the transaction other than the commitment shares. There are no limitations on use of proceeds, financial or business covenants, restrictions on future financings, rights of first refusal, participation rights, penalties or liquidated damages in the purchase agreement.
 
Our gross proceeds will depend on the purchase prices and the frequency of sales of shares to Aspire; provided, however, that the maximum aggregate proceeds from sales of shares is $25 million. The actual maximum proceeds we receive from sales of stock to Aspire will depend on the price of our stock at the time of sales to Aspire. Our delivery of purchase notices will be made subject to market conditions, in light of our anticipated capital needs from time to time and under the limitations contained in the purchase agreement. We expect to use proceeds from sales of shares for general corporate purposes and working capital requirements.
 
The issuance of the all shares to Aspire under the purchase agreement is exempt from registration under the Securities Act, pursuant to the exemption for transactions by an issuer not involving any public offering under Section 4(2) of the Securities Act and Rule 506 of Regulation D promulgated thereunder.
 
 
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Revenue Sources
 
The commercialization of the ForeCYTE Test has provided us with two revenue sources: (i) sales-based revenue from the sale of the MASCT System device and patient kits to distributors, physicians, breast health clinics, and mammography clinics and (ii) service, or use-based, revenue from the preparation and interpretation of the NAF samples sent to our laboratory for analysis. The commercialization of the ArgusCYTE test provides only laboratory service revenue.
 
Commencing in December 2011, we began to market the ForeCYTE Test to physicians, primarily obstetric-gynecologists, as well as breast health and mammography clinics, for use in conjunction with other health screening examinations, including annual physical examinations and regularly scheduled cervical Pap smears and mammograms. We plan to initially use regional specialty product distributors, with independent sales representatives specializing in Women’s Health, to commercialize the ForeCYTE and ArgusCYTE Tests.
 
Commercial Lease Agreements
 
On September 29, 2010, the Company entered into a commercial lease agreement with CompleGen, Inc. for laboratory space located in Seattle, WA. The lease provided for monthly rent of $3,658 and a security deposit of $3,658. The lease terms were from September 29, 2010 through March 31, 2011, at which time the lease has converted to month to month. The monthly rent for the lease increased to $4,267 commencing January 2012. The lease was terminated in December 2012, and the rental deposit was applied to the rent of the final month.
 
On March 4, 2011, the Company entered into a commercial lease agreement with Sanders Properties, LLC for office space located in Seattle, WA. The lease provides for monthly rent of $1,100 and a security deposit of $1,500. The lease terms are from April 1, 2011 through March 31, 2014. For the nine months and three months ended September 30, 2013, the Company incurred $8,800 and $3,300 of rent expense, respectively, for the lease.
 
On December 9, 2011, the Company entered into another commercial lease agreement with Fred Hutchinson Research Center for lab and office space located in Seattle, WA. The lease provides for monthly rent of $16,395 for the period from February 24, 2012 to August 31, 2012, $19,923 for the period from September 1, 2012 to August 31, 2013, and $20,548 for the period from September 1, 2013 to November 29, 2014. The security deposit of $32,789 was paid in March 2012 and recorded as Security Deposit on the consolidated balance sheet. For the three months and nine months ended September 30, 2013, the Company incurred $87,521 and $251,659 of rent expense, respectively, which included leasing office management expenses.
 
In July 2013, the Company entered into an agreement with ARE LLC (Alexandria) to lease additional office spaces in our existing building under a separate lease agreement. The lease is from August 2013 through November 2014, and the gross rent is $ 4,800 per month.
 
We expect that these new laboratory facilities will be sufficient to meet our needs for the foreseeable future and we do not expect to need additional laboratory space for at least the next 24 months. We may need to secure additional office space as we grow our sales and marketing force and add to our administrative staff. Additional office space is readily available in our local market and we believe we can rent when necessary additional office space on acceptable terms.
 
Legal Proceedings
 
On June 30, 2011, Robert Kelly, the Company’s former President, filed a counterclaim against the Company in an arbitration proceeding, alleging breach of contract in connection with the termination of a consulting agreement between Mr. Kelly (dba Pitslayer LLC) and the Company that was entered into in July 2010 in connection with his resignation from the Company as President and a director. The consulting agreement was terminated by the Company in September 2010. Mr. Kelly seeks $450,000 in compensatory damages, which is the amount he claims would have been earned had the consulting agreement been fulfilled to completion.
 
On December 11, 2012, Mr. Kelly filed a complaint in the United States District Court, Western Division of Washington seeking compensatory damages, interest and attorneys’ fees related to the termination of Mr. Kelly’s consulting contract and the rescission of shares issued to him in July 2010 in connection with his resignation from the Company as President and a director. The specific amount of damages sought is to be proven at trial and is not specified. On July 8, 2013, the court granted the Company’s motion to compel arbitration of these claims and therefore this action was dismissed.
 
 
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On February 26, 2013, Mr. Victor Cononi filed a complaint in the United States District Court, Western Division of Washington seeking compensatory damages, interest and attorneys’ fees related to the rescission of shares issued to him in July 2010 in connection with Mr. Kelly’s resignation from the Company as President and a director. The specific amount of damages sought is to be proven at trial and is not specified. In August 2013, the court granted the Company’s motion to compel arbitration of these claims and therefore this action was dismissed.
  
A hearing in the arbitration has been postponed pending certain procedures in the above Western Division action and may be delayed further to accommodate other third party civil and federal criminal proceedings alleging securities and wire fraud that have been brought against Mr. Kelly with respect to his prior employment and predating his service with the Company.
 
The Company is reasonably confident in its defenses to Mr. Kelly’s and Mr. Cononi’s claims. Consequently, no provision or liability has been recorded for these claims as of June 30, 2013. However, it is at least reasonably possible that the Company’s estimate of liability may change in the near term. Any payments by reason of an adverse determination in this matter will be charged to earnings in the period of determination.
 
On October 10, 2013, a putative securities class action complaint was filed in the United States District Court for the Western District of Washington against us, certain of our directors and officers and the underwriters of our November 2012 initial public offering.  The complaint alleges that all defendants violated Sections 11 and 12(a)(2), and that we and certain of our directors and officers violated Section 15, of the Securities Act by making false and misleading statements and omissions in the offering’s registration statement, and that we and certain of our directors and officers violated Sections 10(b) and 20A of the Exchange Act and SEC Rule 10b-5 promulgated thereunder by making false and misleading statements and omissions in the registration statement and in certain of our subsequent press releases and SEC filings with respect to our NAF specimen collection process, our ForeCYTE Breast Health Test and our MASCT device.   This action seeks, on behalf of persons who purchased our common stock between November 8, 2012 and October 4, 2013, inclusive, damages of an unspecific amount. 
 
We believe this complaint is without merit and plan to defend ourselves vigorously.   Failure by us to obtain a favorable resolution of the claims set forth in the complaint could have a material adverse effect on our business, results of operations and financial condition.  Currently, the amount of such material adverse effect cannot be reasonably estimated, and no provision or liability has been recorded for these claims as of September 30, 2013.  The costs associated with defending and resolving the complaint and ultimate outcome cannot be predicted.  These matters are subject to inherent uncertainties and the actual cost, as well as the distraction from the conduct of our business, will depend upon many unknown factors and management’s view of these may change in the future.
 
Critical Accounting Policies and Estimates
 
Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate these estimates and judgments, including those described below. We base our estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results and experiences may differ materially from these estimates.
 
While our significant accounting policies are more fully described in Note 3 to our financial statements, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our reported financial results and affect the more significant judgments and estimates that we use in the preparation of our financial statements.
 
 
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Revenue Recognition
 
Overview
 
We will recognize product and service revenue in accordance with GAAP when the following overall fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or the service has been performed, (iii) our price to the customer is fixed or determinable, and (iv) collection is reasonably assured.
 
Product Revenue
 
We recognize revenue for sales of the MASCT kits and devices on an accrual basis for sales to distributors when the above four criteria are met. For sales of MASCT kits and devices directly to physicians, the revenue is typically recognized upon receipt of cash as we have an insufficient sales history on which to determine the collectability. Shipping documents and the completion of any customer acceptance requirements, when applicable, will be used to verify product delivery. We will assess whether a price is fixed or determinable based upon the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. For sales directly to physicians, once a history of sales and collectability has been established, we will recognize revenue on an accrual basis with an offsetting reserve for doubtful accounts based on the history during the initial sales period.
 
Service Revenue
 
We record revenue for diagnostic testing on an accrual basis at the Medicare allowed and invoiced amount. Amounts invoiced above the Medicare amount, namely non-Medicare, are not recognized on an accrual basis and instead are recognized on a cash basis as received. Diagnostic testing revenue at the Medicare rate is recognized upon completion of the test, communication of results to the patient’s physician, and when collectability is reasonably assured. Customer purchase orders and/or contracts will generally be used to determine the existence of an arrangement. Once the Company has historical sales and can determine the proper amount to recognize as uncollectible, it will then begin to recognize the entire amount, both Medicare and non-Medicare billing on an accrual basis, with an offsetting allowance for doubtful accounts recorded based on history. We estimate we will utilize the diagnostic testing revenue history to determine a proper allowance for doubtful accounts beginning in 2014.
 
Accounts Receivable
 
Accounts receivable are recorded at net realizable value consisting of the carrying amount less allowance for doubtful accounts, as needed. The Company assesses the collectability of accounts receivable based primarily upon the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends, and changes in customer payment patterns to evaluate the adequacy of these reserves. The Company’s allowance for doubtful accounts and bad debt expenses as of September 30, 2013 and December 31, 2012 was $228,841 and $0, respectively.   
 
Inventory
 
The Company’s inventories are stated at lower of cost or market. Cost is determined on a moving-average basis. Costs of inventories include purchase and related costs incurred in delivering the products to their present location and condition. Market value is determined by reference to selling prices after the balance sheet date or to management’s estimates based on prevailing market conditions. Inherent in the lower of cost or market calculation are several significant judgments based on a review of the aging of the inventory, inventory movement of products, economic conditions, and replacement costs. Because the sales price of the MASCT System was substantially lower than its cost for the nine months ended September 30, 2013 and since inception through September 30, 2013, resulting in the net realizable value of the MASCT System being determined at zero as of the balance sheet dates through taking the average sales price subtracted by selling expenses per unit, $0 and $121,910 of loss on reduction of inventory to the lower of cost or market was assessed and recorded as of September 30, 2013 and since inception through September 30, 2013, respectively. Additionally, management periodically evaluates the composition of its inventories at least quarterly to identify slow-moving and obsolete inventories to determine if valuation allowance is required. As of September 30, 2013, we had no inventory.
 
 
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The Company provides, either directly or through distributors, the ForeCYTE testing specimen collection kits to doctors with our MASCT System for doctors to collect specimens that are returned to the Company for diagnostic analysis. These collection kits are considered part of the MASCT System. During the initial marketing phase in 2012, the Company distributed the kits to customers at no cost and bundled them with the MASCT System, and has not intended to deem the kits as a primary product line due to their nominal cost and value per unit. As a result, the kits are immediately expensed and recorded as selling expense upon purchasing of the kits. 
 
Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Accordingly, actual results could differ from those estimates.
 
Intangible Assets
 
Intangible assets consist of intellectual property and software acquired. At least annually, we evaluate purchased intangibles for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. Estimating future cash flows related to an intangible asset involves significant estimates and assumptions. If our assumptions are not correct, there could be an impairment loss or, in the case of a change in the estimated useful life of the asset, a change in amortization expense.
 
Share-Based Payments
 
In December 2004, the Financial Accounting Standards Board, or the FASB, issued the Statement of Financial Accounting Standards, or SFAS, No. 123(R), “Share-Based Payment,” which replaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123(R) is now included in the FASB’s ASC Topic 718, “Compensation — Stock Compensation.” Under SFAS No. 123(R), companies are required to measure the compensation costs of share-based compensation arrangements based on the grant-date fair value and recognize the costs in the financial statements over the period during which employees or independent contractors are required to provide services. Share-based compensation arrangements include stock options and warrants, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. In March 2005, the SEC issued Staff Accounting Bulletin No. 107, or SAB 107, which expresses views of the staff regarding the interaction between SFAS No. 123(R) and certain SEC rules and regulations and provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods. On April 14, 2005, the SEC adopted a new rule amending the compliance dates for SFAS No. 123(R). Companies may elect to apply this statement either prospectively, or on a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods under SFAS No. 123.
 
We have fully adopted the provisions of FASB ASC 718 and related interpretations as provided by SAB 107. As such, compensation cost is measured on the date of grant as the fair value of the share-based payments. Such compensation amounts, if any, are amortized over the respective vesting periods of the option grant.
 
The amended employment agreement with the Chief Executive Officer, entered into on July 22, 2010, granted options to purchase 250,000 shares (or 565,830 shares prior to the reverse stock-split on September 28, 2010) at a price of $5.00 per share, in consideration of his service to the Company. Of these options, 25% (or 62,500 shares) vested on December 31, 2010 with the remaining 75% (or 187,500 shares) to vest in equal quarterly installments over the next three years so long as the executive remains employed with the company. These options have five-year contractual terms.
 
The amended employment agreement with the Chief Scientific Officer, entered into on July 22, 2010, granted options to purchase 100,000 shares (or 226,332 shares prior to the reverse stock-split on September 28, 2010) at a price of $5.00 per share in consideration of her service to the Company. Of these options, 25% (or 25,000 shares) vested on December 31, 2010 with the remaining 75% (or 75,000 shares) to vest in equal quarterly installments over the next three years so long as the executive remains employed with the company. These options have five-year contractual terms. 
 
 
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On April 4, 2011, 45,000 non-qualified stock options were granted under the 2010 Stock Option and Incentive Plan (the “Plan”) to Dr. Tim Hunkapiller for being a member of the Company’s Scientific Advisory Board and consulting services to be provided to the Company, at an exercise price of $1.25 per share. These options have a ten-year contractual term and shall vest as follows:
 
(i)
11,250 option shares shall vest ninety (90) days after the date of grant;
 
(ii)
11,250 option shares shall vest one hundred and eighty (180) days after the date of grant;
 
(iii)
11,250 option shares shall vest two hundred and seventy (270) days after the date of grant; and
 
(iv)
11,250 option shares shall vest three hundred and sixty (360) days after the date of grant.
 
On September 1, 2011, 219,000 incentive stock options were granted under the Plan to employees and officers as part of their employment agreements, at an exercise price of $1.25 per share. These options have a ten-year contractual term and shall vest and become exercisable as follows:
 
(i)
twenty-five percent (25%) of the underlying shares on the first anniversary of the date of grant; and
 
(ii)
one-forty eighth (1/48) of the underlying shares monthly thereafter.
  
On September 1, 2011, 200,000 non-qualified stock options were granted under the Plan to non-employee directors for services to be provided to the Company, at an exercise price of $1.25 per share. These options have a ten-year contractual term and shall vest and become exercisable as follows:
 
(i)
80,000 option shares shall vest on September 1, 2011;
 
(ii)
30,000 option shares shall vest on December 1, 2011;
 
(iii)
30,000 option shares shall vest on March 1, 2012;
 
(iv)
30,000 option shares shall vest on June 1, 2012; and
 
(v)
30,000 option shares shall vest on September 1, 2012.
     
On April 30, 2012, 19,757 non-qualified stock options were granted under the Plan to non-employee directors for serving as directors of the Company, at an exercise price of $6.00 per share. These options have a ten-year contractual term and shall vest and become exercisable in full immediately as of the grant date.
 
Results of Operations
 
Three Months and Nine Months Ended September 30, 2013 and 2012
 
Revenue and Cost of Goods Sold.  For the three months ended September 30, 2013, revenue totaled $76,597, consisting of $72,187 diagnostic testing service revenue from our ForeCYTE testing services and $4,410 in product sales revenue from sales of ForeCYTE kits and MASCT Systems. This represents a decrease of $28, 979, or 27 %, from the total revenue of $105,576 for the three months ended September 30, 2012. Revenue for the nine months ended September 30, 2013 totaled $585,345, consisting of $361,905 in diagnostic testing and $223,440 in product sales, an increase of $201,959, or 53%, from the total revenue of $383,386 in the same period in 2012. The growth in revenue is mainly due to $205,590 in product sales to Millennium for the initial purchase of 10,000 ForeCYTE kits.
 
Cost of revenue totaled $25,938 and $314,562 for the three and nine months ended September 30, 2013, compared to $9,000 and $29,985 in the same periods in 2012. The increase in cost of revenue is primarily attributable to cost of product sales to Millennium. Since the inventory of MASCT System was recorded at zero net realizable value as a result of the lower of cost or market analysis performed at December 31, 2012, no corresponding cost of goods sold was recorded for the sales of MASCT System during 2013.
 
 
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For the three months ended September 30, 2013, gross profit totaled $50,659, compared to $90,499 profit in the same period in 2012. For the nine months ended September 30, 2013, gross profit totaled $270,783 ($286,012 gross profit on diagnostic testing and $15,229 loss on product sales), compared to $323,517 in the same period in 2012. Loss on reduction of inventory to lower of cost or market was $0 for the nine months ended September 30, 2013. Our MASCT System is sometimes sold at a price substantially lower than its cost as is customary for laboratories that supply specimen collection kits. For these reasons, the manufacturing cost allocated to each inventory unit is high.
 
Operating Expenses. For the three months ended September 30, 2013, total operating expenses were $3, 552,556 consisting of G&A expenses of $2, 858,027, research and development expenses of $321,111, and selling expenses of $373,418, representing an increase of $2, 326,385, or 190% from $1,226,171 in the same period in 2012, consisting of G&A expenses of $548,108, research and development expenses of $590,359, and selling expenses of $87,704. For the nine months ended September 30, 2013, total operating expenses were $8,297,460, consisting of G&A expenses of $6,600,819, research and development expenses of $731,258, and selling expenses of $965,383, an increase of $4,610,291,or 125% , from total operating expenses of $3,687,169 in nine months ended September 30, 2012.
 
The Company distributes the kits to customers at no cost and bundles them with the MASCT System and has not intended to deem the kits as a primary product line due to their nominal cost and value per unit. We expect that our G&A and selling expenses continue to increase in the foreseeable future, and that if we successfully launch the MASCT System and our related laboratory service offerings, we would also begin to incur additional sales and marketing expenses as we continue building a regional, and ultimately national, sales force.  The Company also expected to incur additional sales and marketing expenses when if and when it receives additional FDA 510(k) clearance for its ForeCYTE Test and re-launches the test.
 
General and Administrative Expenses. G&A expenses for the three months ended September 30, 2013 were $2,858,027, an increase of $2, 267,668, or 384%, from $590,359 in the same period in 2012. The G&A expenses for the three months ended September 30, 2013 consisted primarily of $581,591 in salaries and bonus expense, $155,558 in legal and regulatory expense, $193,671 in consulting expense, $435,243 in estimated recall expenses ($402,840 in contingent liabilities and $32,403 in actual expenses), $228,841 in bad debt expenses, $67,141 in travel expense, $88,263 in insurance expense, and $248,759 in marketing expenses.  G&A expenses for the nine months ended September 30, 2013 were $6,600,819, an increase of $4,704,565, or 248%, from $1,896,254 for the nine months ended 2012. The G&A expenses for the nine months ended September 2013 consisted of $1,548,899 in salaries and bonus expense, $428,872 in capital raising fees, $622,581 in legal and regulatory expenses, $646,548 in consulting expense, $435,243 in estimated recall expenses ($402,840 in contingent liabilities and $32,403 in actual expenses), $228,841 in bad debt expenses, $135,686 in travel expense, $247,774 in insurance expense, $250,109 in marketing expenses, and $462,029 in Board of Directors annual fees primarily related to expenses associated with stock option grants for service on the Board in 2012 and 2013.
 
G&A expenses for the three months ended September 30, 2012 were $590,359 which  primarily consisted of $23,357 in salaries and bonus expense, $310,301 in legal expenses, $49,579 in consulting expense,  and $19,494 in insurance expense, G&A expenses for the nine months ended September 30, 2012 were $1,896,254 and primarily consisted of $224,521 in salaries and bonus expense, $883,399 in legal expenses, $151,245 in consulting expense, $25,541 in travel expense, $53,584 in insurance expense, and $38,500 in Board of Directors annual fees.
 
The increase in 2013 G&A expenses over 2012 was primarily attributable to an increase in administrative staff, an increase in consulting and professional fees related to regulatory matters and investor relations, an increased cost of insurance, estimated product recall expenses, bad debt expenses and an increased cost of fees to our non-employee directors resulting from the estimated value of options granted in 2013 for service in 2012 and 2013. We expect our G&A expenses will continue to grow as we hire additional administrative and manufacturing personnel to continue our launch of the MASCT System, and in particular when we re-launch our ForeCYTE Test after receiving additional FDA clearance, and our other products under development and as we incur additional costs associated with being a publicly traded company.
 
 
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Research and Development Expenses. Research and Development expenses for the three months ended September 30, 2013 were $321,111, a decrease of $226,997, or 41%, from $548,108 for the three months ended September 30, 2012. R&D expenses for the nine months ended September 30, 2013 were $731,258, a decrease of $777,686, or 52%, $1,508,944 from the same period in 2012.  The decrease in R&D expenses over the three and nine months ended September 30, 2012 is attributed to the completion of the development of the MASCT System for the national launch in 2013. We expect that our R&D expenses will increase as we add additional full time employees and incur additional costs to continue the development of our products and services under development.
  
Selling Expenses. Selling expenses for the three months ended September 30, 2013 were $373,418, an increase of $285,714, or 326%, from $87,704 for the three months ended September 30, 2012. Selling expense for the three months ended September 30, 2013 consisted primarily of $52,237 in selling and marketing professional fees, $205,875 in salaries, $22,500 in advertising, and $92,349 in patient collection kits provided to physicians without charge. Selling expenses for the nine months ended September 30, 2013 were $965,383, an increase of $683,412, or 242%, from $281,971 for the same period in 2012. Selling expense for the nine months ended September 30, 2013 consisted primarily of $384,893 in selling and marketing professional fees, $405,474 in salaries, $81,587 in advertising, and $92,349 in patient collection kits provided to physicians without charge. Selling expenses increased as a result of increased sales and marketing expenses paid to one of our distributors, and increased salaries and other selling and marketing expenses related to the national launch of ForeCYTE.
 
Liquidity and Capital Resources
 
We have a history of operating losses as we have focused our efforts on raising capital and building the MASCT System. The report of our independent auditors issued on our consolidated financial statements as of and for the years ended December 31, 2012 and 2011 expresses substantial doubt about our ability to continue as a going concern. In 2011, we were successful in raising net proceeds of $5.7 million through a private placement in order to fund the growth of our operations and product development. In November 2012 we were successful in our initial public offering and raising net proceeds of approximately $3.5 million.
 
On March 27, 2013 we entered into a stock purchase agreement with Aspire Capital Fund, LLC, which provides that, upon the terms and subject to the conditions and limitations set forth therein, Aspire is committed to purchase up to an aggregate of $30 million of shares of our common stock over the three-year term of the agreement. Under the agreement, Aspire purchased $1,000,000 of our common stock on March 27, 2013 for $12 per share and since that date through November 7, 2013 Aspire has purchased an additional 2,150,000 shares of our common stock for a total aggregate purchase price of $10,303,745.  On November 8, 2013, we terminated this stock purchase agreement and entered into a new agreement with Aspire which provides that we may sell common stock to Aspire under the terms and subject to the conditions and limitations set forth therein.  Under the new agreement, Aspire is committed to purchase up to an aggregate of $25 million of shares of our common stock over the 30 month term of the new agreement.  One condition to utilizing the new agreement and selling stock to Aspire is that we file a registration statement with the SEC covering the resale of the shares to be sold to Aspire and that the registration statement be declared and remain effective.
 
Our ability to continue as a going concern is dependent on our obtaining additional adequate capital to fund additional operating losses until we become profitable. If we are unable to obtain adequate capital, we could be forced to cease operations.
 
Cash Flows
 
For the nine months ended September 30, 2013, we incurred a net loss of $8,026,984. Net cash used in operating activities was $6,182,060, net cash used in investing activities was $400,674 and net cash provided by financing activities was $12,551,098. For the for the nine months ended September 30, 2012, we incurred a net loss of $3,374,249, net cash used in operating activities was $1,967,626, net cash used in investing actives was $0 and net cash used by financing activities was $475,375.
 
Funding Requirements
 
We expect to incur substantial expenses and generate ongoing operating losses for the foreseeable future as we prepare for the scale-up manufacturing and ongoing launch of the MASCT System, complete the development of and launch the FullCYTE and NextCYTE Tests, and build and operate our planned diagnostics laboratory in the Fred Hutchinson Cancer Research Center. We expect our existing capital resources as of the date of this report to be sufficient to fund our planned operations for at least the next six to ten months. To fund our operations for at least the next 12 months under our current business plan, we estimate that we would need between $2 million and $5 million of additional capital. If we are unable to raise this amount of capital, however, we could be forced to curtail or cease operations. Our future capital uses and requirements depend on numerous forward-looking factors. These factors include the following:
 
 
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·
the time and funds needed to complete our recall, receive an additional 510(k) clearance from the FDA and to re-launch our ForeCYTE Test;
 
 
 
 
·
the time and funds needed to complete the development and manufacturing of the ForeCYTE Test devices and Microcatheter Systems and any necessary regulatory clearances;
  
 
·
the expense associated with building a network of  sales representatives to market the ForeCYTE System and ArgusCYTE Test; and
 
 
·
the degree and speed of patient and physician acceptance of our products and the degree to which third-party payors approve the ForeCYTE and ArgusCYTE Tests for reimbursement.
 
Since inception (April 30, 2009) through September 30, 2013, we have generated $1,068,687 in revenue. We do not expect to generate significant revenue until we are able to manufacture and launch the MASCT System more broadly. We expect our continuing operating losses to result in increases in cash used in operations over at least the next year. Although we expect our existing resources as of the date of this report, to be sufficient to fund our planned operations for at least the next six to ten months, we may require additional funds earlier than we currently expect to successfully commercialize the ForeCYTE System. Because of the numerous risks and uncertainties associated with the development and commercialization of the ForeCYTE Test and our services, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated research and development activities and commercialization efforts.
 
Additional funding may not be available to us on acceptable terms or at all. In addition, the terms of any financing may adversely affect the holdings or the rights of our stockholders. For example, if we raise additional funds by issuing equity securities or by selling debt securities, if convertible, further dilution to our existing stockholders would result. To the extent our capital resources are insufficient to meet our future capital requirements, we will need to finance our future cash needs through public or private equity offerings, collaboration agreements, debt financings or licensing arrangements.
 
If adequate funds are not available, we may be required to terminate, significantly modify or delay our development programs, reduce our planned commercialization efforts, or obtain funds through collaborators that may require us to relinquish rights to our technologies or product candidates that we might otherwise seek to develop or commercialize independently. Further, we may elect to raise additional funds even before we need them if we believe the conditions for raising capital are favorable.
 
Off-Balance Sheet Arrangements
 
We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts.
 
Recent Accounting Pronouncements
 
The Company has adopted all recently issued accounting pronouncements that management believes to be applicable to the Company. The adoption of these accounting pronouncements, including those not yet effective, is not anticipated to have a material effect on the financial position or results of operations of the Company.
 
 
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ITEM 3. QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
Not applicable.
 
ITEM 4. CONTROLS AND PROCEDURES
 
Our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2013. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of September 30, 2013, our principal executive officer and principal financial officer concluded that, as of such date, the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
 
No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended September 30, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
PART II OTHER INFORMATION
 
ITEM 1. LEGAL PROCEEDINGS
 
On June 30, 2011, Robert Kelly, the Company’s former President, filed a counterclaim against the Company in an arbitration proceeding, alleging breach of contract in connection with the termination of a consulting agreement between Mr. Kelly (dba Pitslayer LLC) and the Company that was entered into in July 2010 in connection with his resignation from the Company as President and a director. The consulting agreement was terminated by the Company in September 2010. Mr. Kelly seeks $450,000 in compensatory damages, which is the amount he claims would have been earned had the consulting agreement been fulfilled to completion.
 
On December 11, 2012, Mr. Kelly filed a complaint in the United States District Court, Western Division of Washington seeking compensatory damages, interest and attorneys’ fees related to the termination of Mr. Kelly’s consulting contract and the rescission of shares issued to him in July 2010 in connection with his resignation from the Company as President and a director. The specific amount of damages sought is to be proven at trial and is not specified. On July 8, 2013 the court granted the Company’s motion to compel arbitration of these claims and therefore this action was dismissed.
 
On February 26, 2013, Mr. Victor Cononi filed a complaint in the United States District Court, Western Division of Washington seeking compensatory damages, interest and attorneys’ fees related to the rescission of shares issued to him in July 2010 in connection with Mr. Kelly’s resignation from the Company as President and a director. The specific amount of damages sought is to be proven at trial and is not specified.  In August 2013, the court granted the Company’s motion to compel arbitration of these claims and therefore this action was dismissed.
 
A hearing in the arbitration has been postponed pending certain procedures in the above Western Division action and may be delayed further to accommodate other third party civil and federal criminal proceedings alleging securities and wire fraud that have been brought against Mr. Kelly with respect to his prior employment and predating his service with the Company.
 
The Company is reasonably confident in its defenses to Mr. Kelly’s and Mr. Cononi’s claims. Consequently, no provision or liability has been recorded for these claims as of September 30, 2013. However, it is at least reasonably possible that the Company’s estimate of liability may change in the near term. Any payments by reason of an adverse determination in this matter will be charged to earnings in the period of determination.
 
 
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On October 10, 2013, a putative securities class action complaint was filed in the United States District Court for the Western District of Washington against us, certain of our directors and officers and the underwriters of our November 2012 initial public offering.  The complaint alleges that all defendants violated Sections 11 and 12(a)(2), and that we and certain of our directors and officers violated Section 15, of the Securities Act by making false and misleading statements and omissions in the offering’s registration statement, and that we and certain of our directors and officers violated Sections 10(b) and 20A of the Exchange Act and SEC Rule 10b-5 promulgated thereunder by making false and misleading statements and omissions in the registration statement and in certain of our subsequent press releases and SEC filings with respect to our NAF specimen collection process, our ForeCYTE Breast Health Test and our MASCT device.   This action seeks, on behalf of persons who purchased our common stock between November 8, 2012 and October 4, 2013, inclusive, damages of an unspecific amount. 
 
We believe this complaint is without merit and plan to defend ourselves vigorously.   Failure by us to obtain a favorable resolution of the claims set forth in the complaint could have a material adverse effect on our business, results of operations and financial condition.  Currently, the amount of such material adverse effect cannot be reasonably estimated, and no provision or liability has been recorded for these claims as of September 30, 2013. The costs associated with defending and resolving the complaint and ultimate outcome cannot be predicted.  These matters are subject to inherent uncertainties and the actual cost, as well as the distraction from the conduct of our business, will depend upon many unknown factors and management’s view of these may change in the future.
 
 
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ITEM 1A.  RISK FACTORS 
 
RISK FACTORS
 
A purchase of our shares of Common Stock is an investment in our securities and involves a high degree of risk. You should carefully consider the following information about these risks, together with the other information contained in this report, before purchasing our securities. If any of the following risks actually occur, our business, financial condition and results of operations would likely suffer. In that case, the market price of the Common Stock could decline, and you may lose part or all of your investment in our company. Additional risks of which we are not presently aware or that we currently believe are immaterial may also harm our business and results of operations.
 
Risks Relating to our Business
 
We have only a limited operating history, and, as such, an investor cannot assess our profitability or performance based on past results.
 
We are a development stage company, with operations beginning in December 2008 around acquiring the MASCT System patent rights and assignments and the FDA clearance for marketing, which was completed in January 2009. We were incorporated in Delaware in April 2009 and our operations to date have consisted primarily of securing manufacturing for the MASCT and the Duct Microcatheter Systems, establishing our CLIA-certified laboratory, validating the laboratory developed tests we use in the ForeCYTE and ArgusCYTE tests, conducting research and development on the FullCYTE and NextCYTE tests, securing distribution partners and beginning the commercialization of our products. We did not begin the national launch of the ForeCYTE test until January 2013 and we subsequently recalled that product in October 2013. We will require significant additional capital to achieve our business objectives, and the inability to obtain such financing on acceptable terms or at all could lead to closure of the business.
 
Our revenue and income potential is uncertain. Any evaluation of our business and prospects must be considered in light of these factors and the risks and uncertainties often encountered by companies in the development stage. Some of these risks and uncertainties include our ability to:
 
 
·
execute our business plan and commercialization strategy, including with respect to the assets we acquired from Acueity Healthcare, Inc.;
 
·
work with contract manufacturers to produce the MASCT and Microcatheter Systems in commercial quantities;
 
·
create brand recognition;
 
·
respond effectively to competition;
 
·
manage growth in operations;
 
·
respond to changes in applicable government regulations and legislation;
 
·
access additional capital when required;
 
·
obtain regulatory clearances in a timely manner and maintain those clearances, including for our lead product the ForeCYTE Breast Health Test which was recalled in October 2013 and for which we plan to seek an additional regulatory clearance;
 
·
sell our products and service at the prices currently expected; and
 
·
attract and retain key personnel.
 
Our independent auditors have issued a report questioning our ability to continue as a going concern.
 
The report of our independent auditors contained in our consolidated financial statements explains that we have not yet established an ongoing source of revenue sufficient to cover operating costs and allow us to continue as a going concern. Our ability to continue as a going concern is dependent on obtaining adequate capital to fund operating losses until we become profitable. If we are unable to obtain adequate capital, we may be unable to expand our product offerings or geographic reach and we could be forced to cease operations.
 
 
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Anticipated liquidity issues in the next six to ten months.
 
For the year ended December 31, 2012, we generated $483,342 in revenue from the sale of our products and services and we incurred a net loss of $5,079,851.  For the nine months ended September 30, 2013, we generated $585,345 in revenue from the sale of our products and services and incurred a net loss of $8,026,984.  Through September 30, 2013, we had an accumulated deficit of approximately $17,758,642. As of the date of this report, we expect that our existing resources will be sufficient to fund our planned operations for at least the next six to ten months. We have not yet established an ongoing source of revenue sufficient to cover our operating costs and allow us to continue as a going concern. Our only source of revenue has historically been from our ForeCYTE Test, which was recalled commencing in October 2013 and will not be re-launched without an additional regulatory clearance. Our ability to continue as a going concern is dependent on obtaining adequate capital to fund operating losses until we become profitable. We may not achieve profitability from the sale of our products and services in the next six to ten months and other sources of capital may not be available when we need them or on acceptable terms. For example, we may not be able to raise capital by selling Common Stock to Aspire because our stock price may not be at the minimum $0.25 price per share required under our agreement with Aspire, or the Aspire registration statement may not become and remain effective. If we are unable to raise in a timely fashion the amount of capital we anticipate needing, from Aspire or otherwise, we would be forced to curtail or cease operations.
 
If we are not successful in obtaining, or are delayed in obtaining, a new 510(k) clearance from the FDA for our ForeCYTE Test, our operations will be significantly and adversely affected.
 
On October 4, 2013, we announced that we commenced a voluntary recall of our ForeCYTE Breast Health Test devices (also known as the Mammary Aspiration Specimen Cytology Test (MASCT)) and that we are planning to pursue an additional 510(k) clearance from the FDA before we market, sell or distribute this test.  We do not expect to generate revenue unless and until we obtain this clearance from the FDA.  We may not obtain clearance from the FDA in a timely manner or at all for a number of reasons, including:
 
 
·
we may be required to submit additional clinical data that we do not have and cannot obtain in a timely manner;
 
 
 
 
·
the FDA may not agree with the scope or content of our proposed protocol and study design, including our identification and analysis of the devices and processes we are using as predicates;
 
 
 
 
·
the FDA may request that we submit additional information, data and studies, either prospectively or retrospectively, related to the collection and preparation of NAF samples, or the processing and analysis of NAF samples at our laboratory or at other laboratories, which we may not be able to obtain in a timely manner or at all.  For example, in connection with a previous 510(k) that we submitted the FDA requested that we provide data on NAF processing by multiple third party laboratories and we were not able to provide that information;
 
 
 
 
·
although we plan to have a meeting with the FDA before submitting our 510(k) to them, any input from the FDA at that meeting is not binding on the FDA and the FDA can raise objections to our 510(k) submission that were not raised at the pre-submission meeting;
 
 
 
 
·
review by the FDA of our proposed 510(k) submission could be delayed because the FDA has up to 90 days to review the application, which time period is extended while we are responding to any FDA questions;
 
 
 
 
·
if we conclude that the FDA is likely not to clear our 510(k) submission for any reason we may decide to withdraw the submission and file a new 510(k) notification.  For example, we previously filed a 510(k) for the MASCT System which we withdrew on the 89th day of its pendency because the FDA requested information that we could not provide in a timely fashion;
 
 
 
 
·
the FDA might conclude that we need to submit a pre-market application, or PMA, rather than a 510(k), which would require significantly more time and expense;
 
 
 
 
·
our responses to the warning letter we received by the FDA in February 2013 could raise questions by the FDA that could impact their review of our 510(k) submission;
 
 
 
 
·
the FDA has indicated that the processing of NAF samples by our laboratory constitutes an in-vitro diagnostic testing service rather than a laboratory developed test and is subject to their regulatory authority.  We have therefore included our laboratory processing within the scope of our 510(k) submission; however, the FDA could require additional information, data and studies related to this processing by our laboratory or other laboratories which we may not be able to provide in a timely or cost effective manner;
 
 
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·
we anticipate that the FDA will again inspect our facilities in connection with the warning letter we received in February 2013 and they could make observations resulting from that inspection that could adversely impact our 510(k) submission.
 
If we don’t obtain the additional 510(k) clearance for the ForeCYTE test in a timely manner for the above or any other reasons, our operations will be significantly and adversely affected.