CEO Corner

StemCells, Inc. CEO Martin McGlynn shares his thoughts…

May 6, 2011

Letter to Investors

In November 2010, I posted an investor newsletter on our website, which was designed to give the investment community a more in-depth perspective on StemCells, Inc., where we've come from, what we've accomplished to date, and what we are focusing on going forward.

This week’s announcement of a 30% reduction in our US-based headcount is one element of a much bigger corporate agenda for the Company over the next three to four years, and is designed to significantly reduce the trajectory of our operating cash burn, while at the same time harvesting the fruits of our investments in our technology in the form of human clinical data in spinal cord injury, age-related macular degeneration (AMD), and myelination disorders.

Shortly after I joined StemCells, Inc. in January 2001 as CEO, the Company embarked on a very exciting, but nonetheless long, tough, and expensive journey to translate the exciting discovery that had been made by our Company's scientists the previous year of a highly purified and expandable population of human neural stem cells. Our annual operating cash burn in 2001 was approximately $10 million. Since then, our operating cash burn has grown to $24.5 million as reported in 2010.

During that time, since 2001, we have invested heavily in research designed to characterize our neural stem cells both in vitro and in vivo, including assays and methods development, as well as in process development and validation of those processes, preclinical safety and efficacy studies, and the production of a sufficient number of cGMP-compliant cell banks to meet our clinical trial supply needs for the foreseeable future. We also made the successful transition from lab to the clinic, in that we initiated and completed our first human neural stem cell safety study. We have also since completed dosing in a separate and very exciting myelination disorder study at UCSF, and we recently initiated a clinical trial in spinal cord injury in Switzerland. In addition, we are well on our way to filing an IND later this year for the use of these same human neural stem cells in age-related macular degeneration.

I can tell you today that management is committed to quickly reducing our operating cash burn from last year's peak of $24.5 million to an annual run rate of approximately $18 million.

How do we plan to achieve such a significant reduction in our cash burn run rate?

There are a number of initiatives we are undertaking to achieve this objective:

• This summer, our lease for our current headquarters location in Palo Alto will terminate, and we will move to a smaller, less expensive, corporate facility across the bay in Newark, California. This facility will house our executive and administrative functions along with our core R&D activities and laboratories. The annualized effect of this move will be approximately $1 million in savings.
• We now have banked sufficient cGMP cell banks for our clinical trial agenda for the foreseeable future, so we have reduced our cell manufacturing run rate accordingly. The annualized effect of this will be approximately $1.1 million in savings.
• As a result of the reduction in force announced earlier this week, our spending on research will be reduced and focused primarily on supporting development activities, and we are also reducing our general and administration expenses. The annualized effect of this will be on the order of $2.3 million in savings.
• You may recall that we completed, in 2009, an acquisition of the operating assets of Stem Cell Sciences (SCS), a publicly traded company. Since that time, we have taken initiatives to consolidate the SCS Australia and the UK activities, and the net effect of that is approximately $1.3 million in annual savings compared to the previous run rate.
• Our obligations under a lease for what used to be the corporate headquarters and labs in Lincoln, Rhode Island, when we were doing business as CytoTherapeutics, Inc., will terminate mid-2013. The annualized effect of that will be $1.8 million in savings.
• We also have plans underway to liquidate non-essential corporate assets. For example, we plan to list for sale number 1 and number 6 Court Drive in Rhode Island, which was a facility that was used by CytoTherapeutics to manufacture products, as well as to do research and development. We also have advanced-staged discussions underway with regard to commercializing our rat embryonic stem (ES) cell technology platform. These discussions are underway with a number of third parties, and are focused on out-licensing the technology and securing a global commercial partner for a very exciting technology that we believe has significant commercial potential. We believe the outcome of successful negotiations will yield a combined one-time effect this year of $3 million to $5 million. In addition, we would anticipate receiving significant milestone payments going forward from such a transaction.
• We have been invited by the California Institute of Regenerative Medicine, also known as CIRM, to apply for a disease team planning grant, which is, if approved, a precursor to seeking approval for up to $20 million, or approximately $5 million per year over a four-year period, to fund our AMD clinical trials, which, if successful, would be awarded in the summer of next year.
• We also have a number of other initiatives underway aimed at further significantly reducing our operating cash burn, some of which we believe will also start to kick in next year, but we are unable to disclose details of those initiatives at this time.

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What clinical data will we have, and when?

First out of the block will be the results of the four-patient Phase I PMD trial being conducted at UCSF. The final patient in this trial was transplanted with our cells in February of this year. We are hoping to see evidence, by direct imaging, that the transplanted neural stem cells have produced myelin and have re-myelinated the nerve axons in the brains of these patients. Clinical data from the six-month time point will be available in the third quarter of this year, and the 12-month data will be available by the end of the first quarter next year. If we can detect such evidence, it could have great significance not only for the PMD patients involved in the study and around the world, but for a whole range of myelination disorders, including more common disorders like cerebral palsy and multiple sclerosis.

Next up should be data from our Phase I/II spinal cord injury trial that is currently underway in Zurich, Switzerland. We expect to dose the first cohort of patients, characterized as ASIA A patients, this year, and in keeping with the progressive nature of the trial design, quickly progress to the second cohort, known as ASIA B, and the third cohort, known as ASIA C, as soon as possible thereafter. The beauty of our spinal cord injury trial design is that we will have the opportunity to periodically evaluate and assess trial data beginning in the second quarter of 2012 all the way through the expected trial completion date in 2014.

Finally, we plan to file an IND in the fourth quarter of this year to initiate a Phase I/II trial in AMD, and we would anticipate data will start to flow from that trial in 2013, with trial completion targeted for 2014.

In summary, we believe we can aggressively advance our clinical trial agenda, complete our current and planned Phase I/II trials in the period 2012 to 2014, report data from those trials in the same timeframe, and do so with a significantly reduced operating cash burn run rate versus prior years. The driving force behind our strategy is to obtain evidence in the most timely and cost-efficient manner possible that our cells are having a favorable biological effect on patients. In doing so, we will not only reward our shareholders for their support and for helping us get to that critical milestone, but such data will greatly enhance the prospect that we will attract a partner on favorable terms to help fund the pivotal studies and get this medicine to the market where it's so badly needed by so many.

Sincerely,

Martin McGlynn
President and CEO

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November 2010

Letter to Investors

Driven by years of pioneering research and scientific achievement, StemCells, Inc. (NASDAQ: STEM) is a world leader in the development and commercialization of cell-based therapeutics and enabling technologies for cell-based research and drug discovery.

In this letter, I will outline the following reasons why I believe StemCells is not just a great company, but also substantially undervalued:

• Our approach to cell-based therapeutics could offer the best opportunity for durable, long-term clinical benefit
• Our clinical-stage CNS Program leads the field with demonstrated human safety data, multiple indications in the clinic, and a growing preclinical pipeline
• Our Liver Program offers a second therapeutic category and has shown significant preclinical promise for the treatment of liver disease
• Our enabling tools and technologies further broaden and diversify our business prospects and provide immediate commercial revenue opportunities
• Our distinguished team includes accomplished business leaders and some of the foremost experts in the fields of stem cell biology, biotechnology, regenerative medicine, and cGMP manufacturing
• Our comprehensive IP portfolio is among the most extensive in the field
• Our stock is significantly undervalued based on our achievements to date, the strength of our assets and our future prospects
• Our near-term target milestones, including our goal to initiate a spinal cord injury trial in 2011, offer significant value-creating opportunities

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Our Approach to Cell-based Therapeutics

StemCells was founded with one purpose in mind – to discover, develop and commercialize breakthrough cell-based therapies to treat a broad range of intractable human diseases. Our clinical approach is quite distinct from those of many other companies in the field:

• We aim to restore or protect organ function by transplanting stem cells into the patient in order to provide a durable, long-term therapeutic benefit. This is why we are so focused on cells that can engraft (i.e., take up residence in the patient) and survive. In fact, given the capacity of stem cells to self renew, there is the potential that a one-time transplant could restore function for the life of the patient, which in some diseases would essentially be a “cure.”  Our approach is in direct contrast to other approaches that use cells that only survive for short periods of time in the patient’s body and may only produce a transient, short-term therapeutic benefit.
• The development of a life-long treatment should be enhanced by using the “right” cell in the “right” way. We are focused on identifying tissue-derived adult stem cells and transplanting them back into the organ from which they were derived (e.g., the use of CNS-derived neural stem cells for the treatment of CNS disorders and liver-derived cells for the treatment of liver disorders). We believe transplanting cells derived from a particular organ back into the same organ (often referred to as “homologous” use) provides a better prospect for therapeutic benefit because these cells are already naturally pre-programmed to become the mature functional cells of that organ.
• Our high purity, tissue-derived cells are directly transplantable without further programming or modification. In contrast, pluripotent stem cells, such as embryonic stem (ES) cells or induced pluripotent stem (iPS) cells, are generated from other tissues and require artificial programming outside of the body before being put into the patient.
• Our studies in thousands of animal models have shown that our tissue-derived cells do not grow into tumors or teratomas when transplanted in vivo. This is contrast to pluripotent stem cells that have been observed to form tumors and teratomas when transplanted into animals.
• For all of the reasons highlighted above, our use of tissue-derived cells presents fewer scientific, technical and regulatory challenges.

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Clinical-stage CNS Program

At StemCells, we are pioneering the clinical translation of neural stem cells for use in treating central nervous system (CNS) disorders. Our proprietary HuCNS-SC^® product candidate (purified human neural stem cells) is being evaluated in the broadest and most advanced neural stem cell clinical development program in the CNS field.

Below is a summary scorecard of our significant progress to date:

• In 2009, we completed the first FDA-authorized clinical trial for the transplant of human neural stem cells into the brain for treatment of children afflicted with the fatal neurodegenerative disorder Nerounal Ceroid Lipofuscinosis (NCL, also often referred to as Batten disease).
• In 2009, we secured FDA authorization for a clinical trial of human neural stem cells in the fatal myelination disorder Pelizaeus-Merzbacher Disease (PMD), now underway.
• In 2010, we secured FDA authorization for a second clinical trial in NCL with preliminary efficacy endpoints, now underway.
• We are preparing to initiate a planned clinical trial in spinal cord injury in 2011.
• We are preparing to initiate a planned clinical trial in the retinal disorder age-related macular degeneration (AMD) in 2012.
• We have research collaborations underway to evaluate our cells in preclinical models for other CNS conditions such as Alzheimer’s disease and stroke.

With the above clinical and preclinical programs underway, we believe we are the only company in the stem cell field addressing all three regions of the CNS – the brain, the spinal cord and the eye. We are also the only company presently authorized by the FDA to conduct clinical trials involving transplantation of human neural stem cells directly into the brain, and the only company to date with established human safety data for these cells, positioning us to be among the first to market with a stem cell-based therapeutic product for CNS disorders.

While clinical success is not guaranteed in any of these endeavors, we are encouraged by the demonstrated safety profile of our HuCNS-SC product candidate to date, and we are enthusiastic about the prospect that we will be able to replicate in patients the very compelling and robust efficacy results observed in animal models of the various diseases evaluated in preclinical testing.

You might ask why we chose NCL and PMD for our initial studies.

First, well-characterized animal models existed for each of these diseases. Availability of these models allowed us to demonstrate the ability of our cells to protect neurons (in the case of NCL) and to form myelin around nerve axons (in the case of PMD), which in turn enabled us to secure FDA authorization for the first clinical trials to test human neural stem cells in patients.

Second, both NCL and PMD are fatal genetic disorders that, today, have no effective treatments or cures. Therefore, the need is great. The potential for orphan drug status exists, and the likelihood of showing efficacy is simpler because the diseases are not systemic or multi-factored, such as in ALS or in Parkinson’s disease.

Third, in both indications we are asking our HuCNS-SC cells to protect the existing cells within patients before irreversible damage or loss occurs due to disease progression, rather than the potentially more difficult task of cell replacement. This “neuroprotection” strategy utilizes our HuCNS-SC cells to preserve neurological function by providing what the patient’s own cells cannot — a missing enzyme in the case of NCL and myelin formation in the case of PMD.

Furthermore, although NCL and PMD are rare diseases, they both represent doorways to larger groups of CNS diseases and disorders. Demonstration of a therapeutic benefit in NCL, for example, could open the door to treatments for more than 20 CNS-mediated lysosomal storage disorders that cannot be treated with enzyme replacement therapy because enzymes are too large to cross the blood-brain barrier. In the case of PMD, the outcome of our current studies may reveal important information for the treatment of other, more common myelination disorders, such as Multiple Sclerosis and certain forms of Cerebral Palsy.

All of the data being accumulated in these initial trials should also facilitate our planned clinical testing of HuCNS-SC cells in spinal cord injury and retinal degenerative diseases such as AMD. Spinal cord injury is the second leading cause of paralysis in the United States, affecting an estimated 1.3 million Americans. AMD is the number one cause of legal blindness for those over age 55, and currently afflicts as many as 15 million Americans. Today there are no curative treatment options for either of these indications. Strong preclinical data demonstrate that our HuCNS-SC cells restore lost motor function in sub-acute and chronic spinal cord injury, and preserve visual function long-term in animal models of retinal degeneration, and we now look forward to the prospect of demonstrating these exciting results in the clinic.

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Promising Liver Program

We have also made excellent progress in our Liver Program, which started with our discovery of a cell subset isolated from human liver tissue. Since then, our scientists and process development experts have isolated a purified population of these human liver engrafting cells (hLEC^™) and created a pilot process to extract them from livers of all ages, including those deemed unusable for liver transplantation.

Promising preclinical data supports the use of our proprietary hLEC cells for the potential treatment of a variety of liver disorders. The use of hLEC cells to restore liver function in diseased or damaged livers would have numerous advantages over whole organ transplantation, which is the only current definitive treatment option for patients with severe liver disease.

While we had obtained Institutional Review Board (IRB) approval to initiate a clinical study at Saint Luc Hospital in Belgium, we subsequently made the decision to defer initiation of the proposed trial pending the completion of changes to our manufacturing process. We believe such changes could greatly improve the potential for use of the cells in clinical trials as well as in drug toxicology screening. Furthermore, the process improvements underway have helped us isolate a rarer, more purified subset of hLEC, which we believe may represent a more ideal candidate for clinical development. We are currently working to purify and characterize this subset.

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Enabling Tools and Technologies

While the pursuit of cell-based therapeutics remains our central mission, we are seizing opportunities for immediate revenue generation by leveraging our resources and capabilities to commercialize tools and technologies for use in stem cell-based research and drug discovery. Such opportunities leverage our cell biology expertise, extensive inventory of proprietary cells, in-vitro and in vivo assays, cell culture media and reagents, and broad intellectual property (IP) portfolio. This strategy balances and diversifies our business prospects and positions us to offset our capital requirements as we pursue our long-term goals.

By way of background, it is estimated that only one out of every 10,000 drug candidates entering the development process will be commercialized utilizing conventional technology. On average, the process of drug development takes approximately 12 years from lead identification to market approval and costs nearly $1 billion. According to the FDA, a 10% improvement in predicting failures before clinical trials could save approximately $100 million in development costs per drug. For these reasons, the pharmaceutical industry is increasingly interested in the use of cells to reduce the time and cost associated with drug discovery, screening and development.

Our drug discovery and development platform is modeled on the successful preclinical programs that have advanced our own therapeutic candidates into clinical trials, and includes the tools, technologies, core competencies and infrastructure needed to help pharmaceutical and biotechnology partners realize a faster, more reliable and more efficient process for identifying, characterizing and validating safe and effective lead candidates in vitro and in vivo.

Our tools and technologies include:

Drug Toxicity Testing – We are pursuing the potential use of hLEC and other liver-derived cells for use in drug toxicology screening and development. To date, a number of third parties have expressed interest in the biological properties of hLEC and have begun evaluating them for use in liver toxicity assays. Liver toxicity continues to be one of the primary causes of clinical trial failures and market withdrawals of drug products. Withdrawing compounds from the market is a very embarrassing and expensive process for pharmaceutical companies, and that’s before factoring in the subsequent costs of product liability law suits. Our hLEC cells have been shown to exhibit metabolic and detoxification enzyme activities and could have significant utility in testing new drug candidates to detect adverse drug reactions before the start of clinical trials.

CNS Drug Screening – Cell-based assays to evaluate the effect of CNS-active compounds on neurotoxicity are also high on the pharmaceutical industry shopping list. We are engaged in discussions with a number of pharmaceutical companies to ascertain how best to harness the power of our neural stem cells and stem cell biology expertise to help these prospective partners reduce the number of toxic compounds that are brought into preclinical and clinical testing. In addition, we are exploring the potential for our human neural cells to predict the neurogenic potential of small molecules and to see if the molecules might be used to stimulate a patient’s existing cells to behave in a certain way, or perhaps even to grow new neurons.

Rat ES Cell Technology – We are also excited about the potential to generate significant revenues from our proprietary embryonic stem cell technology that is now being used to derive novel genetically engineered rats for the study of human disease. This technology opens the door to the types of genetic manipulations previously only possible in mice, and paves the way for modeling a broader range of human disease using the rat. Currently, rats and mice are used as animal models of human disease; however, certain aspects of the rat’s physiology, behavior and metabolism are closer to the human, making rats the preferred species for drug development and for studying human disease, such as Parkinson’s, Alzheimer’s and Diabetes. We have begun discussions with a number of motivated third parties who are anxious to partner with us to fully commercialize this technology.

SC Proven^® Cell Culture Products – Unlike most clinical-stage biotechnology companies, we already have a revenue-generating commercial business selling specialty cell culture products to researchers on a worldwide basis. Under the SC Proven brand, we market a range of specialty cell culture products to enable the standardized and reproducible production and propagation of human and rodent pluripotent and tissue-specific stem cells. We continue to grow sales in this business and broaden our product offerings as demonstrated by the launch of three new products in 2010 to date, and the planned launch of three more before year-end. For 2011 and beyond, we foresee continued rapid evolution in the field and are developing a series of pipeline products to address the expected demand.

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Distinguished Team of Experts

We believe that StemCells is the scientific leader in the field of stem cell technology. The people behind our groundbreaking work, namely our directors, Scientific Advisory Board members, officers, employees and consultants, include world-renowned experts in stem cell biology credited with significant breakthroughs in the field. The strength of our assembled team gives StemCells a distinct and unparalleled advantage. Of our 82 employees today, 19 have advanced scientific or medical degrees, and 62 are dedicated to a myriad of research and development programs—from the development of release assays for our therapeutic programs to collaborations with academic researchers on new technologies to the in vivo testing of new cell types – as well as process development, manufacturing and quality control to ensure the highest standards and manufacturing control over our therapeutic product candidates. Additionally, both our CNS and Liver Programs are led by surgeons who formerly headed up, respectively, the Pediatric Neurosurgery and Pediatric Transplant Programs at Stanford University School of Medicine.

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Comprehensive IP Portfolio

Our extensive expertise in stem cell biology and long track record of scientific achievement in the field has enabled us to build a formidable and leading IP position. We have spent more than a decade systematically assembling one of the broadest IP portfolios in the world in the field of stem cell biology and related technology. Our patent portfolio consists of dozens of U.S. patents, hundreds of foreign equivalents and active patent prosecution in over 14 distinct patent families claiming different types of stem and progenitor cells, cell culture media, stem cell research tools and techniques, and similar technologies. This includes seminal technology in cell biology including three patents identified by Nature Biotechnology as being among the five most fundamental neural stem cell patents as well as four patents identified as being among the top 20 most significant patents in stem cell research.¹ In the neural area specifically, our neural stem cell patent portfolio is unsurpassed, with broad claims covering compositions of matter, methods of manufacture, and methods of use of these cells both as therapeutics and as tools for drug screening.

Much of our patented technology is home-grown. StemCells scientists are the named inventors on 18 of our U.S. patents and patent applications. Key among these are various antibody enrichment patents and our patents claiming the use of leukemia inhibitory factor (LIF) to improve the proliferation of neural stem cells. Another significant home-grown technology is our recently filed patent application claiming an oligodendrocyte progenitor cell, which claims an enriched population of these prospectively isolated cells as well as their use as either therapeutics or as drug screening tools.

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Achieving Recognition for Our True Valuation

Despite all that we have achieved to date, the significant value of our assets, and our future prospects, our market cap has declined from over $200 million in January 2005, when we were still a preclinical-stage company, to approximately $113 million. Like many of our peers in the stem cell space, our stock price is trading closer to our low than to our 52-week high. This decline in market cap and the low trading price are not the result of any clinical setbacks.

Since January 2000, the Company has raised $165 million in the capital markets (net of commissions) and has invested the vast majority of this capital to lay the ground work necessary for clinical testing of our candidate neural and liver cell products.

In the Biotech world, this period is often referred to as the “Valley of Death.”  It is the period that begins after the discovery of the molecule (in our case the cell) and typically ends with a demonstration of clinical proof-of-principle. During this period, companies must invest heavily in very important, but often unexciting and un-newsworthy preclinical development activities essential to gaining the regulatory approvals necessary to begin clinical testing. For example, we have invested approximately $30 million to ramp up our manufacturing capabilities in order to meet the FDA’s current Good Manufacturing Practices (cGMP) for our cells to be used in clinical trials. As a result of this investment, we have established human safety data for our cells based on a completed clinical trial and other studies now underway, the importance of which cannot be overstated. And, we have also now successfully banked sufficient GMP-quality HuCNS-SC cells to support our clinical trial agenda for the foreseeable future. We believe this investment in the characterization and manufacturing of our cells has significantly “de-risked” our HuCNS-SC product development program, and we expect this investment will pay handsome dividends in the future as we expand our clinical trial activities.

Sadly, many companies do not survive this so-called Valley of Death as investors often lose hope and the willpower to stay the course. Our journey through this Valley began in 2000, shortly after we isolated and purified the human neural stem cell, and to date we have successfully navigated this challenging period. Although we recognize that we will surely need to raise additional capital to reach proof-of-principle in the clinic, we believe we are currently in the process of emerging from the Valley as we have multiple clinical studies underway with our HuCNS-SC cells. In fact, some of our current and planned clinical trials are beginning to focus more on efficacy measures and demonstrating clinical benefit, which we believe will be a key inflection point. In addition, we have a revenue-generating cell culture products business that we intend to grow substantially, along with real opportunities to monetize some of our investments including the commercialization of genetically engineered rats and potential partnerships with the pharmaceutical industry for drug discovery assays.

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Near-term Target Milestones

For all of the reasons expressed herein, combined with our near-term, value-creating target milestones outlined below, the entire management team and I firmly believe that in the months just ahead, the investment community will concur with us that now is a good time to take a look at StemCells.

Significant 2010-2012 target milestones include:

• Complete second NCL trial, with a focus on additional safety data and measuring clinical benefit in less affected patients
• Complete Phase I PMD trial to further expand safety database and look for initial efficacy
• Initiate and complete enrollment of a spinal cord injury trial
• Initiate clinical trial in age-related macular degeneration
• Announce partnerships for one or more of – 
  • SC Proven distribution
  • hLEC for drug toxicity testing
  • CNS Drug Screening and Development
  • Commercialization of rat ES cell technologies

Conclusion

The next five years will be a time of transformation for StemCells, Inc. as we advance multiple development programs that could bring about extraordinary, fundamental changes in both healthcare delivery and drug discovery. As our therapeutic programs progress through clinical trials, and as we bring new tools and technologies to market, we look forward to the growth and development of our business.

We are prepared to meet the challenges of the years ahead as we strive to realize the full potential of stem cells to offer better treatments and cures, and are excited and optimistic about what the future holds.

Thank you for your interest in our Company. I look forward to reporting on our continued progress.

Sincerely,

Martin McGlynn
President and CEO

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Cautionary Statement. All statements in the CEO Corner, whether or not individually framed in terms of belief, express the opinions of our CEO and include forward-looking statements regarding the Company’s current status, events and trends that may affect us and our scientific, clinical and business prospects. All of these forward-looking statements are subject to substantial risks and uncertainties which are summarized here and further described in the Company’s SEC filings on Forms 10-K and 10-Q, available here. Investors should carefully consider these risks before making any investment in the Company. Each statement speaks only as of its date and we assume no responsibility to update or revise any forward-looking statement to reflect future events, trends or circumstances.

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