TENAX THERAPEUTICS, INC. - Quarter Report: 2006 January (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

For the quarterly period ended January 31, 2006

For the transition period from              to             

Commission File Number: 2-31909

SYNTHETIC BLOOD INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

3189 Airway Avenue, Building C, Costa Mesa, California 92626

(Address of Principal Executive Office)

714-427-6363

(Registrant’s telephone number, including area code)

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 (the “Exchange Act”) 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  x    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨                Accelerated filer ¨                Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES  ¨    NO  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of March 14, 2006: 135,299,723 shares of common stock, par value $0.01.

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FORM 10-Q

SYNTHETIC BLOOD INTERNATIONAL, INC.

INDEX

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Part I-Financial Information

SYNTHETIC BLOOD INTERNATIONAL, INC.

(A Development Stage Company)

BALANCE SHEETS

See accompanying condensed notes to financial statements.

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SYNTHETIC BLOOD INTERNATIONAL, INC.

(A Development Stage Company)

STATEMENTS OF OPERATIONS

See accompanying condensed notes to financial statements.

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SYNTHETIC BLOOD INTERNATIONAL, INC.

(A Development Stage Company)

STATEMENTS OF CASH FLOWS

See accompanying condensed notes to financial statements.

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SYNTHETIC BLOOD INTERNATIONAL, INC.

(A Development Stage Company)

STATEMENTS OF CASH FLOWS - CONTINUED

Non-cash financing activities during the nine months ended January 31, 2006:

See accompanying condensed notes to financial statements.

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SYNTHETIC BLOOD INTERNATIONAL, INC.

(A Development Stage Company)

CONDENSED NOTES TO FINANCIAL STATEMENTS

The accompanying unaudited financial statements contain all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary to present fairly the financial position of the Company as of January 31, 2006, and the results of its operations for the three months and the nine months ended January 31, 2006 and 2005, and for the period from May 26, 1967 (inception) to January 31, 2006, and its cash flows for the nine months ended January 31, 2006 and 2005, and for the period from May 26, 1967 (inception) to January 31, 2006. Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to rules and regulations of the U.S. Securities and Exchange Commission (the “Commission”). The Company believes that the disclosures in the financial statements are adequate to make the information presented not misleading. However, the financial statements included herein should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended April 30, 2005 filed with the Commission on August 15, 2005.

The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the accompanying financial statements, the Company is in the development stage and, at January 31, 2006, has an accumulated deficit of $26,772,697, continues to sustain operating losses on a monthly basis, and expects to incur operating losses for the foreseeable future. Since the Company is in the pre-clinical and clinical trial stages of its products, these products must undergo considerable development and testing prior to submission to the FDA for approval to market the products. The Company’s continuation as a going concern is dependent on its ability to obtain additional financing sufficient to fund the required additional development and testing and to meet its obligations on a timely basis. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern for a reasonable period of time.

The Company accounts for stock-based employee compensation as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and has adopted Statement of Financial Accounting Standards 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”), that amends certain aspects of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). APB 25 provides that compensation expense relative to the Company’s employee stock options is measured based on the intrinsic value of stock options granted. SFAS 123 and 148 require pro forma disclosures of net income (loss) and net income (loss) per share as if the fair value based method of accounting for stock-based awards had been applied for employee grants. They also require disclosure of option status on a more

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prominent and frequent basis. The Company accounts for stock options and warrants issued to non-employees based on the fair value method, but has not elected this treatment for grants to employees and board members. Under the fair value based method, compensation cost is recorded based on the value of the award at the grant date and is recognized over the service period.

The fair value of each option grant was estimated at the grant date using the Black-Scholes option-pricing model. The Black–Scholes option-pricing valuation model was developed for use in estimating the fair value of traded options and warrants that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s stock options and warrants have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options and warrants.

The Company’s calculations are based on a single option valuation approach and forfeitures are recognized as they occur. The following table illustrates the effect on net loss and net loss per share if the fair value based method had been applied to all outstanding and unvested employee awards:

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (Revised), Share-Based Payment. This standard revises SFAS No. 123, APB Opinion No. 25 and related accounting interpretations, and eliminates the use of the intrinsic value method for employee stock-based compensation. SFAS No. 123(R) requires compensation costs related to share-based payment transactions to be recognized in the financial statements over the period that an employee provides service in exchange for the award. Currently, the Company uses the intrinsic value method of APB Opinion No. 25 to value share-based options granted to employees and board members. The new standard requires the expensing of all share-based compensation, including options, using the fair value-based method. The effective date of this standard for the Company will be May 1, 2006. Management is currently assessing the impact that this new standard will have on the Company’s financial statements and expects that non-cash stock-based compensation charges will increase upon adoption of this standard.

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On July 13, 2005, the Company closed on a financing transaction with three private investors. In the transaction, the Company issued to the investors unsecured convertible debentures in the principal amount of approximately $1.85 million payable over a term of three years beginning 120 days following the closing of the financing discounted on the date of issue at 10 percent. Proceeds to the Company after commissions, investors’ professional fees, and original issue discount of $555,000, were approximately $1,130,500.

The principal amount of the debentures is convertible to common stock at any time at the election of the holder at a rate of one common share for each $0.22 of principal. The Company may, at its option and subject to certain conditions, make monthly payments on the debentures in common stock priced at the lower of $0.22 or 80 percent of the volume weighted average price for the common stock over the five trading days prior to the payment date. The Company also issued to the investors warrants to purchase up to 8,409,083 of shares of common stock exercisable during a term of three years at an exercise price of $0.242 per share.

In accordance with the provisions of Accounting Principles Board Opinion No. 14, the Company allocated the net proceeds received in this transaction to each of the convertible debentures and common stock purchase warrants based on their relative estimated fair values. As a result, the Company allocated $770,000 to the convertible debentures and $525,000 to the common stock purchase warrants, which was recorded in additional paid-in-capital. In accordance with the consensus of EITF issues 98-5 and 00-27, management determined that the convertible debentures contained a beneficial conversion feature based on the effective conversion price after allocating proceeds of the convertible debentures to the common stock purchase warrants. Because the calculated beneficial conversion amount exceeded the remaining net carrying value of the convertible debentures, the beneficial conversion was recorded in an amount equal to the remaining net carrying value of the convertible debentures of $770,000 with a corresponding amount recorded as additional paid-in-capital. The amounts recorded for the original issue discount, common stock purchase warrants and the beneficial conversion feature will be amortized as interest expense over the terms of the convertible debentures.

During the quarter ended January 31, 2006, the private investors elected to convert $26,000 of the convertible debentures into 118,182 shares of common stock at $0.22 per share. In addition, the Company made principal payments of $132,369 through the issuance of 1,616,352 shares of common stock. For the nine months ended January 31, 2006, the private investors elected to convert $839,357 of the convertible debentures into 3,815,260 shares of common stock at $0.22 per share and the Company made principal payments of $219,000 through the issuance of 2,120,900 shares of common stock.

Interest charges associated with the convertible debentures, including amortization of the original issue discount, common stock purchase warrant value and the beneficial conversion feature, aggregated $220,324 and $1,236,976 during the three months and nine months ended January 31, 2006, respectively.

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During the three months ended January 31, 2006 and 2005, the Company paid $17,334 and $24,075, respectively, and during the nine months ended January 31, 2006 and 2005, the Company paid $49,434 and $77,235, respectively, to a specialty contract manufacturer of pharmaceutical products to manufacture Oxycyte, the Company’s perfluorocarbon-based blood substitute and therapuetic oxygen carrier, for upcoming clinical trials. An officer of the Company is a minority shareholder and director of this specialty manufacturer. At January 31, 2006, the Company had no outstanding purchase orders with this specialty manufacturer.

Synthetic Blood International, Inc., is a New Jersey corporation that, since 1990, has pursued the development of medical products based on perfluorocarbon technology. Since 1993, Synthetic Blood has also pursued development of a glucose biosensor implant on a limited basis.

Perfluorocarbons are biologically inert compounds containing carbon and fluorine. The chemical composition of perfluorocarbons allows them to readily absorb and give up oxygen and carbon dioxide. This property creates opportunities for developing blood substitutes that act as oxygen carriers for human tissue and fluids that carry oxygen to the lungs for remedial uses.

Synthetic Blood developed Oxycyte as a synthetic blood substitute and therapeutic oxygen carrier. We received approval of our Investigational New Drug application filed with the U.S. Food and Drug Administration (FDA) in 2003 and completed a Phase I safety study in normal volunteers in December 2003. The results of the Phase I study were in line with our expectations for the performance of Oxycyte.

Enrollment started last year in a Phase II orthopedic surgery trial, and five study sites have been qualified and approved to participate in this study. In this first Phase II trial we are evaluating both efficacy and safety in the prevention of tissue hypoxia (the effects of reduced oxygen levels) in hip surgery patients who experience mild to moderate blood loss during surgery. While blood transfusions are typically not given during such procedures, blood loss may result in postoperative complications caused by tissue hypoxia. Three study sites have enrolled 12 patients in this study. This is less than expected, so enrollment has been temporarily put on hold so resources can be refocused on shorter term Phase II trials.

An eight patient proof of concept Phase II Oxycyte study in patients with brain ischemia due to severe head injury has been approved and enrollment is expected to start in the first quarter of 2006. A 20 patient proof of concept Phase II Oxycyte trial in patients in sickle cell crisis has been started but was put on clinical hold by the FDA for requested protocol changes. Enrollment in this trial is expected to start in the second quarter of 2006. The results of these studies are expected to be available in the second or third quarter of 2006. In addition to these studies, our future clinical development plans include testing Oxycyte in acute myocardial ischemia, high blood loss surgery, coronary bypass surgery, stroke, myocardial infarction, malignant tumors and decompression sickness.

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We expect to commit a substantial portion of our financial and business resources over the next 3 years to testing Oxycyte and advancing this product to licensing and commercial distribution.

Fluorovent is an oxygen exchange fluid and surfactant for facilitating the treatment of lung conditions, which is currently under development. We have not filed any applications on this product with the FDA and do not expect we will do so while we are focusing on Oxcyte clinical trials.

Our biosensor product uses an enzyme process for measuring the glucose level in the blood stream. It is a subcutaneous implant programmed to measure the glucose level and transmit the results to a wearable receiver. This product is also under development and we do not expect we will file any applications with the FDA for at least the next 2 years.

RESULTS OF OPERATIONS

Three months ended January 31, 2006 and 2005

Research and Development expenses for the three months ended January 31, 2006 were $327,361, compared to $304,987 for the same period in the prior year. During the quarter ended January 31, 2006, we continued to concentrate our research activities on our Oxycyte product that included Phase II clinical trials. Phase II expenses totaled $97,991 for the quarter ended January 31, 2006, compared to $22,500 for the quarter ended January 31, 2005. Because of the nature of our ongoing research and development activities, accounting periods may reflect significant changes in expenses resulting from the timing of research related to our developmental products.

General and Administrative expenses for the three months ended January 31, 2006 were $333,559, compared to $588,308 for the same period in the prior year. General office and operating expenses have remained relatively constant for the quarters ended January 31, 2006 and 2005, with the exception of decreased investor relations expenses of $312,000 related to the granting of stock warrants in consideration for a delayed registration of stock in the previous year, offset by increases in amortization of bond issue costs of $14,100 and the acceleration of $31,100 of unamortized costs related to the termination of a patent agreement in the current quarter.

The net loss for the three months ended January 31, 2006 was $860,537 compared to a net loss of $888,496 for the same period in the prior year. Total expenses decreased $12,051 during the three months ended January 31, 2006 over the comparable period in 2005. In addition to the items noted above, interest expense increased $220,324 due to the accelerated conversions of the convertible notes payable and the related amortization of associated debt discounts, as discussed in Note 3 to the Condensed Notes to the Financial Statements. Additionally, other income, consisting principally of sub-rental income of $17,600 and interest income of $3,000, increased $15,908 from the quarter ended January 31, 2005.

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Nine months ended January 31, 2006 and 2005

Research and Development expenses for the nine months ended January 31, 2006 were $957,897, compared to $834,068 for the same period in the prior year. During the nine months ended January 31, 2006, we continued to concentrate our research activities on our Oxycyte product that included Phase II clinical trials. Phase II expenses totaled $292,317 for the nine months ended January 31, 2006, compared to $93,480 for the nine months ended January 31, 2005. Because of the nature of our ongoing research and development activities, accounting periods may reflect significant changes in expenses resulting from the timing of research related to our developmental products.

General and Administrative expenses for the nine months ended January 31, 2006 were $1,004,926, compared to $1,135,210 for the same period in the prior year. General office and operating expenses have remained relatively constant for the nine months ended January 31, 2006 and 2005, with the exception of decreased investor relations expenses of $184,000 related principally to the granting of stock warrants in consideration for a delayed registration of stock in the previous year, offset by increases in amortization of bond issue costs of $28,200 and the acceleration of $65,400 of unamortized costs related to the termination of a patent agreement in the current period.

The net loss for the nine months ended January 31, 2006 was $3,149,966, compared to a net loss of $1,961,877 for the same period in the prior year. Total expenses increased $1,230,521 during the nine months ended January 31, 2006 over the comparable period in 2005. In addition to the items noted above, interest expense increased $1,236,976 due to the accelerated conversions of the convertible notes payable and the related amortization of associated debt discounts, as discussed in Note 3 to the Condensed Notes to the Financial Statements. Other income, consisting of sub-rental income of $35,400 and interest income of $14,500, increased $42,432 from the nine months ended January 31, 2005.

LIQUIDITY AND CAPITAL RESOURCES

Synthetic Blood has financed its operations since September 1990 through the issuance of debt and equity securities and loans from stockholders. As of January 31, 2006, we had $292,395 of total current assets and working capital of $142,307. Our practice is to invest excess cash in short-term money market investment instruments.

We have had and continue to have difficulty raising additional capital for research and development activities.

On July 13, 2005, the Company closed on a financing transaction with three private investors. In the transaction, the Company issued to the investors unsecured convertible debentures in the principal amount of approximately $1.85 million payable over a term of three years beginning 120 days following the closing of the financing, discounted on the date of issue at 10 percent. Proceeds to the Company after the original issue discount, commissions, and the investors’ professional fees were approximately $1,130,500.

Management believes that this new funding together with the Company’s cash and cash equivalents at January 31, 2006, will be sufficient to fund the Company’s clinical studies and general and administrative expenses until the first quarter of 2006. Currently, the

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Company has not obtained funding beyond the first quarter of 2006. The Company has received a financing term sheet and is currently negotiating with the investors. There can, however, be no assurance that a new financing agreement will result from these negotiations. If funding is not obtained, the Company will have to curtail or cease operations until additional capital is secured.

We are in the pre-clinical and clinical trial stages in the development of our products. Under an Investigational New Drug application filed with the FDA, we completed Phase I clinical studies on Oxycyte in December 2003. The results of the Phase I study were in line with our expectations for the performance of Oxycyte. Phase II clinical testing started earlier this year. We estimate the additional cost of pursuing our Phase II clinical trials in 2006 and 2007 to approximate $8,000,000. Even if we are successful with our Phase II studies, we must then conduct Phase III clinical studies and, if they are successful, file with the FDA and obtain approval of a Biologics License Application to begin commercial distribution, all of which will take more time and funding to complete. Our other products, Fluorovent and the glucose biosensor, must undergo further development and testing prior to submission to the FDA for approval to initiate clinical trials, which also requires additional funding. Management is actively pursuing private and institutional financing, as well as strategic alliances and/or joint venture agreements to obtain the necessary additional financing and reduce the cost burden related to the development and commercialization of our products. We expect our primary focus will be on funding the continued testing of Oxycyte, since this product is the furthest along in the regulatory review process. Our ability to continue to pursue testing and development of our products beyond the end of the first quarter of 2006 depends on obtaining outside financial resources, and there is no assurance we will succeed in obtaining the necessary resources.

Cash used in operating activities during the nine months ended January 31, 2006 was $1,834,618, compared to $1,389,671 for the comparable period of the prior year. Operating activities consisted primarily of product research and development and the general operation of our corporate office. Cash used in operating activities is primarily dependent on the timing and extent of our research and development activities.

Cash used in investing activities during the nine months ended January 31, 2006 was $53,896, compared to $106,285 for the comparable period of the prior year. Investing activities consisted primarily of the purchase of laboratory equipment and expenditures related to the Company’s patent rights. Synthetic Blood does not anticipate significant future capital expenditures in the near term.

Cash provided by financing activities during the nine months ended January 31, 2006 was $1,452,404 compared to cash provided by financing activities of $2,244,500 for the comparable period of the prior year. Cash provided by financing activities consists primarily of the sale of our common stock to outside investors and proceeds from the sale of convertible debentures. As discussed earlier in this quarterly report, Synthetic Blood is attempting to raise additional funds that may take the form of equity or debt securities.

CRITICAL ACCOUNTING POLICIES

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements:

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Stock-Based Compensation - We account for stock-based employee compensation as prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and, effective April 30, 2003, we adopted Statement of Financial Accounting Standards (“SFAS”) 148, Accounting for Stock-Based Compensation-Transition and Disclosure (“SFAS 148”) that supercedes Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). SFAS 148 requires pro forma disclosures of net income and net income per share as if the fair value based method of accounting for stock-based awards had been applied for both employee and non-employee grants. It also requires disclosure of option status on a more prominent and frequent basis. We account for stock options and warrants issued to non-employees based on the fair value method, but have not elected this treatment for grants to employees and board members. Under the fair value based method, compensation cost is recorded based on the value of the award at the grant date and is recognized over the service period.

The fair value of each option grant was estimated at the grant date using the Black-Scholes option-pricing model. The Black–Scholes option valuation model was developed for use in estimating the fair value of traded options and warrants that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because our employee stock options and warrants have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options.

In December 2004, the FASB issued SFAS No. 123 (Revised), Share-Based Payment. This standard revises SFAS No. 123, APB Opinion No. 25 and related accounting interpretations, and eliminates the use of the intrinsic value method for employee stock-based compensation. SFAS No. 123(R) requires compensation costs related to share-based payment transactions to be recognized in the financial statements over the period that an employee provides service in exchange for the award. Currently, the Company uses the intrinsic value method of APB Opinion No. 25 to value share-based options granted to employees and board members. The new standard requires the expensing of all share-based compensation, including options, using the fair value-based method. The effective date of this standard for the Company will be May 1, 2006. Management is currently assessing the impact that this new standard will have on the Company’s financial statements.

Long-Lived Assets - Our intangible assets consist of patents related to our various technologies. These assets are amortized on a straight-line method over their estimated useful life, which ranges from eight to ten years. We review these intangible assets for impairment on a quarterly basis in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). At January 31, 2006, management believes no indications of impairment existed.

FORWARD LOOKING STATEMENTS

Except for the historical information contained herein, the discussion and information presented in this report contain forward-looking statements that involve risks and

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uncertainties. The Company’s actual results could differ materially from those presented in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section and those discussed in the Company’s Annual Report on Form 10-K for the year ended April 30, 2005 and subsequent filings made with the Securities and Exchange Commission.

Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, the Company cannot guarantee future results, levels of performance or achievements. Moreover, neither the Company nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. The Company is under no obligation to update any of the forward-looking statements after the filing of this report to conform such statements to actual results or changes in expectations.

The Company has no derivative financial instruments and no exposure to foreign currency exchange rates or interest rate risk. Our convertible debentures that are described elsewhere in this report bear a fixed interest rate, and therefore, are not subject to interest rate risk.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Principal Executive Officer and our Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Our management, including our Principal Executive Officer and our Principal Financial Officer, does not expect that our disclosure controls or procedures will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation or controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

We carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and our Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarterly period covered by this report. Based on the foregoing, our Principal Executive Officer and our Principal Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

There has been no change in the Company’s internal controls over financial reporting during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect the Company’s internal controls over financial reporting.

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Part II-Other Information

During the quarter ended January 31, 2006, the Company issued warrants for the purchase of 2,000,000 shares of the Company’s common stock to a foreign individual in with connection capital raising services to be provided to the Company. The warrants have an exercise price of $0.242 per share and expire in December 2006. Based on a Black-Scholes analysis, the warrants had an estimated fair value of $31,000 on the date of grant, which has been recorded as Deferred Expenses to be deducted from the proceeds of the capital raised. The warrants were issued in reliance on the exemption from registration provided for in Regulation S adopted under the Securities Act of 1933.

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

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