**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K**

 

| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|-------------------------------------------------------------------------------------------|

** **

**Forthe fiscal year ended December 31, 2001**

 

| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

** **

**Forthe transition period from        to        **

 

**CommissionFile Number 0-22229**

** **

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** **

**VITALIMAGES, INC.**

(Exact name ofRegistrant as specified in its charter)

 

| **Minnesota**                                              |   | **42-1321776**                        |
|------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of                           |   | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)                            |   |                                  |
|                                                       |   |                                  |
| **3300 Fernbrook Lane, N., Suite 200**                     |   | **55447**                             |
| **Plymouth, Minnesota**                                    |   | (Zip Code)                            |
| (Address of principal                                      |   |                                  |
| executive offices)                                         |   |                                  |
|                                                       |   |                                  |
| **(763) 852-4100**                                         |
| (Registrant’s telephone  number, including area code) |

 

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Securitiesregistered pursuant to Section 12(b) of the Act: None

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

Common Stock, $.01par value

Preferred StockPurchase Rights

 

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Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes   ý  No   o

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to the Form 10-K.  o

 

The aggregatemarket value of the voting stock held by non-affiliates of the registrant as ofFebruary 28, 2002 was $54,543,000.

 

The number ofshares outstanding of the issuer’s classes of common stock as of February 28,2002: Common stock, $.01 Par Value - 8,706,113.

 

DOCUMENTSINCORPORATED BY REFERENCE

 

Portions ofregistrant’s definitive Proxy Statement in connection with the Annual Meetingof Shareholders to be held May 8, 2002 (“2002 Proxy Statement”) areincorporated by reference into Part III.

 

 

VITAL IMAGES, INC.

FORM 10-K

 

TABLE OF CONTENTS

 
| PART I    |
|-----------|
|      |   |
| Item 1.   | Business |
| Item 2.   | Properties |
| Item 3.   | Legal Proceedings |
| Item  4.  | Submission  of Matters to a Vote of Security Holders |
|      |   |
| PART II   |
|      |   |
| Item 5.   | Market  for Registrant’s Common Equity and Related Stockholder Matters |
| Item 6.   | Selected Financial  Data |
| Item 7.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item  8.  | Financial  Statements and Supplementary Data |
| Item 9.   | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure |
|      |   |
| PART III  |
|      |   |
| Item  10. | Directors  and Executive Officers of the Registrant |
| Item 11.  | Executive Compensation |
| Item  12. | Security  Ownership of Certain Beneficial Owners and Management |
| Item  13. | Certain  Relationships and Related Transactions |
|      |   |
| PART IV   |
|      |   |
| Item  14. | Exhibits,  Financial Statement Schedules and Reports on Form 8-K |
|      |   |
|      | Signatures |

 

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FORWARD-LOOKING STATEMENTS

 

This Annual Report onForm 10-K contains certain forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995.  For this purpose, any statements contained in this Form 10-K thatare not statements of historical fact may be deemed to be forward-lookingstatements.  Without limiting theforegoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,”“estimate,” or “continue” or the negative or other variations thereof orcomparable terminology are intended to identify forward-looking statements.  These statements by their nature involvesubstantial risks and uncertainties, and actual results may differ materiallydepending on a variety of factors, including those set forth in the sectionbelow entitled “Important Factors.”

 

Item 1.            BUSINESS

 

Vital Images, Inc.(“Vital Images” or the “Company”) was incorporated in Iowa in September1988.  In March 1997, the Companyre-incorporated under the laws of the state of Minnesota.  The Company’s principal executive officesare located at 3300 Fernbrook Lane N., Suite 200, Plymouth, MN 55447 (telephone(763) 852-4100, facsimile (763) 852-4110, e-mail — info@vitalimages.com ).  From May 24, 1994 through May 11, 1997, theCompany was a wholly-owned subsidiary of Bio-Vascular, Inc. (“Bio-Vascular”).

 

Business Description

 

Vital Images develops,markets and supports 3D medical imaging software for use primarily in diseasescreening, clinical diagnosis and therapy planning.  The Company’s software applies proprietary computer graphics andimage processing technologies to a wide variety of data supplied by computedtomography (“CT”) scanners and magnetic resonance (“MR”) imaging devices.  Vital Images’ products allow clinicians tocreate both two- and three-dimensional views of human anatomy and to non-invasivelynavigate within these images to better visualize and understand internalstructures and pathologies.  The Companybelieves that its high-speed visualization technology and customized protocolscost-effectively bring 3D visualization and analysis into the routine,day-to-day practice of medicine.  TheCompany, which operates in a single business segment, markets its products tohealthcare providers and to manufacturers of diagnostic imaging systems througha direct sales force in the United States and independent distributors ininternational markets.

 

*Vitrea®*, Vital Images’ advanced 3D medicalimaging product for radiological and surgical applications, received FDAclearance in November 1996 and was released for sale in October 1997.  Due to its speed and ease-of-use, managementbelieves that *Vitrea*wasthe first 3D medical imaging product with the ability to appeal primarily tothe clinical market.  Historically, 3Dmedical imaging software was slow, difficult to use, and operated only onexpensive workstations.  Consequently,the functionality of such software was appealing only for researchapplications.  The Company’s *Vitrea*softwarecombined speed with ease-of-use to enable a physician to access, manipulate andanalyze 3D images, typically in less than five minutes.  The Company has released several updates to *Vitrea*each year, and in December 2001released *Vitrea2 Version 2.6*, which has improved quality, reliability and usabilityfeatures to meet the diagnostic and treatment planning needs of busy radiologydepartments. The Company offers *Vitrea 2* both as an integrated softwareand hardware system, consisting of *Vitrea 2* software installed on a computerworkstation, and as a stand-alone software package.  To date, the Company has licensed approximately 550 copies of *Vitrea*and*Vitrea 2* to hospitals,clinics, imaging centers and other sites, including 12 of the nation’s top 16hospitals.

 

The Company believes thatgrowing acceptance of 3D medical imaging offers Vital Images numerous marketexpansion opportunities.  Research anddevelopment efforts are currently focused on using the Company’s base ofvisualization technology to expand to other imaging modalities, such as x-rayangiography, as well as expanding the features and functions in the current modalities.  Vital Images is also developing 3D medicalimaging software tools for non-invasive screening applications, such as CTcolonography for colon cancer screening, surgical planning, intra-operativevisualization and real-time interventional 3D visualization.

 

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The diagnostic medicalimaging market continues to expand both its geographic boundaries and itsdefinitive boundaries.  Long defined asthe market for CT, MR, ultrasound and other imaging modalities, the diagnosticimaging market has grown to include both picture archive and communicationssystems (“PACS”) and 3D imaging systems, which have become integraltechnologies for many radiology practices around the world.

 

According to Frost & Sullivan, the estimated U.S. market for 3Ddiagnostic imaging was $382 million in 2001 and will grow to approximately $1billion by 2006, a compound annual growth rate of over 21%.  Today, only a minority of hospitals, clinicsand imaging centers has purchased 3D medical imaging products for use indiagnostic imaging.  Recenttechnological advances in both computer hardware and software development havedramatically improved the cost-to-performance ratio, bringing the prices for 3Dmedical imaging products into the reach of most healthcare providers.  In addition, increasing clinical awareness,improving utility of applications and an exponential increase in CT slicevolumes are driving demand for 3D medical imaging products.

 

Based on an increasing number of 3D procedures being performed as aresult of the growing use of imaging technology, new 3D screening proceduresand broader acceptance of 3D applications, Vital Images estimates that thepotential worldwide market for 3D medical imaging software and workstationswill grow to $2 billion in five years.

 

Technology

 

The two core technologies underlying the Company’s products are“customized protocols” which make *Vitrea 2* simple to use and a visualizationtechnique known as “volume rendering.” A feature critical to *Vitrea 2’s* speed and ease-of-use are itscustomized protocols, which provide automated 2D and 3D renderings of scannerdata, optimized for individual clinical applications.  Vital Images’ engineers and clinical collaborators have selectedspecific views for each type of exam *Vitrea 2* supports, in order to provideimmediate, useful 2D and 3D views for the user.  After the selected patient data has been retrieved, *Vitrea 2*provides the clinician with six views with all visualization parameters pre-setfor the specific type of clinical exam. The visualization settings for these views are stored in *Vitrea 2’s*software and are automatically and adaptively applied to each patient study,optimizing the views displayed.  Byapplying this proprietary protocol technique, the system anticipates theclinician’s needs and provides immediately useful views of the patientdata.  The use of customized protocolsautomates the complex and time-consuming approaches inherent in many competing3D medical imaging products and eliminates the need for the user to beproficient in operating complex graphics programs.  The Company has been issued Patent No. 5,986,662 from the U.S.Patent and Trademark Office for its mechanism for automated protocol selection,Patent No. 6,130,671 for the mechanism to calculate simulated lighting in 3Dimages and Patent No. 6,219,059 for the user interface and mechanism used tocontrol the relative transparency of 3D data in volume renderings of medicalimages.

 

Volume rendering is an advanced technique for displaying two- orthree-dimensional views on a computer monitor that the Company believes hassignificant advantages over the alternative technique, known as “surfacerendering.”  Volume rendering permits thedirect display of all of the imaging data without mathematical modeling andallows interactive control of the level of “transparency” of the data.  By comparison, surface rendering requiresthe creation of artificial surfaces based on selected imaging data, and theusefulness of the resulting visual image is largely dependent on where thesesurfaces are “set” by the clinical technician. Volume rendering is not dependent on the creation of artificial surfacesand allows visualization of varying components that might otherwise beeliminated from a surface rendered image due to surface approximation.  Because volume rendering uses all of thedata and information collected by the imaging equipment, the Company believesvisualization processes that use volume rendering provide clinicians withbetter images to define and display pathology and anatomy in a more usefulmanner.

 

Until recently, medical imaging companies largely overlooked volumerendering because the computer power necessary to perform volume rendering wassignificantly more expensive and intensive than the requirements for surfacerendering.  The Company’s experiencewith volume rendering has its basis in the efforts of Vincent

 

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J. Argiro, Ph.D., the founder of the Company, who developedthree-dimensional visualization software using volume rendering as an aid inhis research in developmental neuroscience. Dr. Argiro focused on accelerating the performance of volume renderingon standard computer platforms.  As aresult of his work, he developed expertise in accelerated volume rendering,which forms the core of the Company’s volume rendering technology.  Because the performance of standard computerplatforms has increased while the relative cost of such performance hasdecreased, the Company believes that volume rendering has become a moreaccessible imaging solution for routine clinical applications.

 

The Company believes thecombination of customized protocols and accelerated volume rendering offered by*Vitrea 2,*together with improved computer performance, allows it to deliver a simple,fast and affordable 3D medical imaging product.

 

Industry Background

 

Medical practices in theareas of diagnostic imaging, surgery and cancer treatment have changeddramatically over the past 20 years, due in part to the introduction of avariety of new imaging, visualization, analysis, computer, networking, catheterand navigation technologies.  The resulthas been the rapid adoption and increased use of CT and MR scanners and theincorporation of new physician-care practices based on the imaging informationprovided by these devices.

 

Both of these imagingtechnologies capture data that provide a physician with a graphicalrepresentation of the inside of the human body.  These images have traditionally been viewed as a series oftwo-dimensional, cross-sectional slices on x-ray-type film.  As computer processing speed increased,software performance improved and networking technologies developed,manufacturers of scanning equipment began offering integrated systems thatallowed clinicians to view, analyze and manipulate these medical images in adigital environment.  These systemsfirst visualized individual slices, or pictures, on a computer monitor andlater provided views of multiple slices. More recently, medical imaging systems began to permit viewing andmanipulation of large, multiple slice data sets as a single, three-dimensionalimage on a computer workstation.  Today,the 3D medical imaging industry involves the creation, visualization, manipulation,analysis and communication of medical images in two and three dimensions.

 

The 3D medical imagingindustry and the markets for 3D medical imaging products have historicallylagged the market for imaging devices due to the lack of industry standards forthe generation, transmission and storage of medical imaging data and due tocomputer costs and performance considerations. Over the past several years, a number of technical and cost barriers togrowth in the 3D medical imaging industry and the PACS industry have begun toerode.  In particular, the medicalindustry has embraced an image transmission and archiving standard calledDICOM, promulgated by the American College of Radiology and the NationalElectronic Manufacturer’s Association. This standard permits imaging, visualization, networking and archivingsystems from different vendors to work cooperatively within a singlenetwork.  In addition, thecost-to-performance ratio of computer products used in visualization and PACShas improved dramatically, bringing the prices for 3D medical imagingcapabilities and PACS within the grasp of most healthcare providers.  The Company believes that the increasingacceptance of industry standards such as DICOM and the improvements in thecost-to-performance ratio for clinical workstations will support continuedmarket growth in the 3D medical imaging and PACS industries.

 

Vital Images also expects that a number of other advantages of 3Dmedical imaging products will support growth in the 3D medical imaging industry:

 

•                  Diagnoses based on 2D images, or“slices,” require the clinician to “assemble” a 3D view mentally to understandthe true anatomy and pathology.  Giventhe industry pressure on cost-effective outcomes, 3D imaging is a valuable toolfor accelerating diagnoses, potentially eliminating unnecessary tests andtreatment, optimizing the use of minimally invasive surgery and therapies, andgaining additional insight needed for clinical decisions.

 

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•                  Spatial relationships are of paramountimportance in surgery, and 3D views displaying anatomy and pathology cangreatly aid in surgical planning.  3Dmedical imaging has the potential to promote improved surgical outcomes bygiving surgeons a better “road map” from which to plan their operativeprocedures.  Interactive navigation ofvolume data from scanners may also have the capability to spare patients frominvasive procedures like endoscopy or conventional angiography.

 

•                  Recent technology improvements in CT and MRscanners enable them to generate an increasing number of slices per exam,resulting in over 1500 images, which is more than 10 times as many images asthe same study less than five years ago. This makes the viewing of printed images on x-ray film, rather than in amedical imaging system, logistically impractical and expensive.

 

•                  Increased use of 3D medical imagingtechnology has the potential to enhance radiologists’ ability to communicatetheir findings to fellow clinicians, referring physicians and patients.  In addition, the integration of theseclinical disciplines through electronic visualization, networking and theInternet has the potential to provide the opportunity for greatercross-discipline coordination due to increased speed, access to information andthe resulting ability to perform consultative, interactive planning andexamination on computer workstations.

 

Markets

 

The Company participates in the rapidly growing 3D medical imagingmarket.  The 3D medical imaging marketalso interrelates with a number of other markets such as the diagnostic imagingequipment market, the PACS market and the hospital and clinical informationsystems markets.  3D medical imagingsoftware and systems have application and/or potential in diagnostic screeningand radiology, remote diagnosis and consultation (e.g., telemedicine), surgicalassessment, planning, navigation and follow-up, and radiation and chemotherapytreatment planning and medical education. The customers for these applications include radiology, surgery andoncology departments of hospitals and research centers, diagnostic imaging andscreening centers, outpatient surgery centers, clinics and physician groups.

 

The diagnostic medical imaging market continues to expand itsboundaries.  Long defined as the marketfor CT, MR, ultrasound and other imaging modalities, the diagnostic imagingmarket has grown to include both PACS and 3D imaging systems, which have becomeintegral technologies for many radiology practices around the world.

 

According to Frost & Sullivan, the estimated U.S. market for 3Ddiagnostic imaging was $382 million in 2001 and will grow to approximately $1billion by 2006, a compound annual growth rate of over 21%.  Today, only a minority of hospitals, clinicsand imaging centers has purchased 3D medical imaging products for use indiagnostic imaging.  Recenttechnological advances in both computer hardware and software development havedramatically improved the cost-to-performance ratio, bringing the prices for 3Dmedical imaging products into the reach of most healthcare providers.  In addition, increasing clinical awareness,improving utility of applications and an exponential increase in CT slicevolumes are driving demand for 3D medical imaging products.

 

Based on an increasing number of 3D procedures being performed as aresult of the growing use of imaging technology, new 3D screening proceduresand broader acceptance of 3D applications, Vital Images estimates that thepotential worldwide market for 3D medical imaging software and workstationswill grow to $2 billion in five years.

 

As discussed above, the overall market for 3D medical imaging softwareand systems is developing rapidly, as the related technology and products thatdefine this market are relatively new and undergoing rapid change.  Medical imaging software and systemsolutions for diagnostic radiology have existed for the last severalyears.  The use of medical imagingsoftware and systems to assist in surgical planning and navigation has onlybegun

 

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to emerge in clinical practice in the last few years.  While medical imaging software and systemshave been used in these applications and to support cancer treatment planningin the past, the Company believes that perspective, three-dimensional volumerendering represents an underutilized resource to practitioners for diagnosticscreening and radiology, surgical planning and navigation and cancer treatmentplanning.

 

Strategy

 

The Company’s goal is to be a leading provider of 3D medical imagingsoftware that improves clinical outcomes and reduces costs.  To achieve this goal, Vital Images intendsto implement the following key strategies:

 

•                  Develop and maintain leading-edgetechnology*.* The Company intends to continue its overall strategy of developing andmarketing leading-edge medical 3D medical imaging software for a variety ofmedical applications.  As part of thisstrategy, the Company will continue to improve the speed and performance of its*Vitrea 2*software.  In particular, the Companywill be focused on developing additional protocols that enhance the ease-of-useof *Vitrea2*, as well as increasing the number of platforms on which *Vitrea 2*will operate.

 

•                  Further develop applications for theCompany’s 3D medical imaging technology.  The Companyintends to leverage its core competencies in volume rendering, computergraphics and clinical applications.  TheCompany plans to develop and offer a full range of 3D medical imaging softwaretools for disease screening, radiological diagnosis, therapy planning andintra-operative visualization.  TheCompany believes that significant new opportunities exist for the applicationof its innovative technologies for the diagnosis and treatment ofcardiovascular disease, cancer and orthopedics.

 

•                  Further penetrate the 3D medical imagingmarket.  The Company intends to expand its sales andmarketing staff and increase its marketing efforts in order to continuebuilding momentum for the acceptance and purchase of *Vitrea 2* and its otherproducts.  A key challenge for theCompany involves reaching and educating physicians and clinicians as to thebenefits of the *Vitrea 2* software. By convincing the ultimate users of the benefits of its system, theCompany believes that it can successfully influence purchasing decisions formedical institutions purchasing or upgrading their imaging technology.  In addition, the Company will work to expandits appeal by implementing additional 2D capability as well as ensuring thatits technology will easily integrate into hospital networks.

 

•                  Continue to seek collaborativepartnerships with leading medical institutions.  The Companyhas historically sought out and developed collaborative relationships withseveral prestigious medical institutions to develop and test the Company’svisualization tools.  The Company willcontinue to pursue collaborations to focus on developing products that willimprove clinical outcomes and reduce costs for the practices of medical imagingand surgery.

 

•                  Continue to seek collaborativepartnerships with leading medical technology companies. In addition to collaborations with medical institutions, the Companyintends to selectively pursue relationships with leading medical technologycompanies to expand the Company’s clinical, distribution, financial and/ortechnical capability for its 3D medical imaging software products.  Examples of such relationships include theCompany’s development, marketing and/or distribution agreements with ToshibaAmerica Medical Systems (“TAMS”), the Surgical Navigation Technologies divisionof Medtronic, Inc., E-Z-EM, Inc. and A.L.I. Technologies, Inc. (“ALI”). See“Business-Marketing and Distribution.” 

 

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 Products andProduct Development

* *

*Vitrea**.*  In December 1995, the Company assessed itsbusiness strategy and determined that to optimize its dedicated participationin the medical field, it needed to create a new product for direct clinicalapplication.  The objective for this newproduct effort was to produce an easy-to-use, clinical software tool to allowradiologists and other clinicians to use two- and three-dimensionalvisualization in their routine clinical processes.  Unlike its predecessor software, *VoxelView®*, the Company setout to design this new software product for users with clinical knowledge,rather than computer graphics expertise. Specifications for this new product, called *Vitrea,* were developed inearly 1996, with software development beginning in late spring of thatyear.  The Company submitted 510(k)documentation in September 1996 for *Vitrea* and was granted marketing clearanceby the U.S. Food and Drug Administration (the “FDA”) in November 1996 for useas a clinical diagnostic and surgical planning device when used with CT and MRmedical imaging data.  *Vitrea*was first released for sale to customers in October 1997.  In December 1999, the Company released *Vitrea 2*,a Microsoft® Windows NT compatible version of its *Vitrea* software for 2D/3Dvisualization and analysis of medical image data.  *Vitrea 2* was Vital Images’ first 3D-volume medical imagingsoftware product available for Windows NT and provides the speed andease-of-use the medical community demands for diagnosis and treatment planningin a clinical environment.  In December2001, the Company released *Vitrea 2 Version 2.6*, which has improvedquality, reliability and usability features to meet the diagnostic andtreatment planning needs of busy radiology departments.

 

*Vitrea2* capitalizes onthe Company’s experience in 3D medical imaging and provides clinicians with aneasy-to-use tool for disease screening, radiological diagnosis and therapyplanning.  It represents the Company’smost important step to date as a provider of a range of clinical tools forbroad distribution to the 3D medical imaging market.  *Vitrea 2’s* primary features are its high-speed renderingcapability and the ability to provide two- and three-dimensional viewing forroutine diagnosis and therapy planning, without requiring the user to betrained in computer graphics techniques. The Company believes that both of these features, speed and ease-of-use,now make it possible to use three-dimensional medical imaging in daily clinicalroutines.  A *Vitrea 2* user, following abuilt-in clinical workflow, can view the image data in two or three dimensionsusing visualization settings based on specific clinical applications storedwithin the system as dedicated visualization protocols.  The user may then interactively navigatearound, or “fly through,” the image to view clinically relevant anatomies andpathologies.  *Vitrea 2*software alsoallows the user to capture views by taking “snapshots,” which can be integratedinto customized reports for electronic transmission and archiving through aDICOM network or sent to another location via the Internet.

 

*Vitrea2* softwareconforms to the latest medical imaging and computer industry standards, such as*OpenGL*TMcomputer graphics application programming interface (API) and DICOM.

 

The Company offers *Vitrea 2* primarily as an integratedsoftware and hardware system, consisting of *Vitrea 2*software installed on a personalcomputer (“PC”).  Pursuant to purchasingarrangements between the Company and computer resellers, the Company purchasespersonal computers at a nominal discount, installs its *Vitrea 2*software, andmarkets the package as an integrated 3D medical imaging solution, therebyimplementing the Company’s strategy to develop, market, sell and support anintegrated 3D medical imaging workstation. Currently *Vitrea 2* operates on PC workstations from Omni Tech, Inc.,Hewlett-Packard Company and Dell Computer Corporation.  The Company also sells software licenseswithout the related workstation hardware. The list price for a base model integrated workstation and softwarepackage is approximately $99,000, and the list price for the *Vitrea 2*software without a workstation is approximately $81,000.

 

In addition to its immediate clinical applications, *Vitrea 2*softwarealso incorporates a number of additional technological advances, thereby makingit adaptable to routine clinical use in surgical navigation and cancertreatment planning and for integration into diagnostic imaging equipmentmanufactured by other companies.  Inparticular, *Vitrea2* software was written using advanced programming techniques, amodular, object-oriented design, C++ programming language, and a sharedmessaging structure.  The Companybelieves these characteristics make it practical to modify *Vitrea 2* software to suitthe clinical needs of surgical navigation and

 

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oncology, as well as allowing diagnostic equipment manufacturers tointegrate *Vitrea2*software or its components into imaging system consoles andoff-line review stations, thereby providing the Company with the opportunity toleverage the *Vitrea 2* software development investment into new commercialareas.

 

Software options.  In additionto *Vitrea 2*, the Company has alsodeveloped a number of value-added software options that work with the base *Vitrea 2* software platform.  These options provide a variety of clinicalinformation and have list prices ranging from $20,000 to $40,000 each.

 

*VScoreTM*.  In August1999, the Company introduced its *VScore*software for coronary arterycalcium scoring.  The *VScore*software product was the Company’s first add-on option to the Company’s *Vitrea 2*3D medical imaging software product. The *VScore*option adds the functionality to non-invasively quantify calcium in the fourmajor coronary arteries using CT image data. In August 2000, the Company introduced *VScorewith EKG Gate**Ô*,which allows physicians and technologists to select the images with the leastamount of motion by matching the EKG signal with the images.  In February 2001, the Company introduced *VScore with AutoGate**Ô*, which allows users to create high quality cardiacimages using existing helical CT scanners without the use of EKG recordingdevices.

 

CT Brain Perfusion. In October 2001, the Company introduced its CT Brain Perfusion softwareoption to assist radiologists in analyzing blood flow of stroke victims wherethe speed of diagnosis and treatment is often the primary factor in determiningthe extent of recovery.

 

CT Colonography. In October 2001, the Company introduced its CT Colonography softwareoption, which generates two- and three-dimensional images of the entire colon,increasing the speed and ease of locating and analyzing polyps.  The option provides a less invasive, morecomfortable diagnostic procedure than previously possible, improving patientcompliance for screening

 

Automated VesselMeasurements.  In October 2001, the Company introduced itsAutomated Vessel Measurements software option to assist physicians incharacterizing the course and dimensions of diseased blood vessels.  The Automated Vessel Measurements option isdesigned to support activities such as pre-surgical diagnosis, evaluation andstent planning in the abdominal aorta, carotid arteries, coronary arteries andrenal arteries.

 

Maintenance and Support. In addition to its system and software products, the Company also offersmaintenance and support services to its customers, as well as certain otherservices such as installation and training. In connection with the licensing of *Vitrea 2*software, the Company marketsannual maintenance services for both *Vitrea 2* software and the integrated *Vitrea 2*system, pursuant to which the Company provides software updates, minor featureenhancements, error correction, telephone support and general maintenanceservices for an annual fee of approximately $7,000.  Outside of these maintenance services, the Company is required byFDA regulations to provide certain levels of support to end users as a resultof the use of its products as medical devices. Maintenance services currently marketed by the Company do not includeinstallation, training and other services, whether on- or off-site, as suchservices are charged separately by the Company.

 

License fees accounted for 66%, 66% and 63% of total revenue in each ofthe fiscal years ended December 31, 2001, 2000 and 1999, respectively.  Maintenance and services comprised 16%, 13%and 13% of total revenue for the years ended December 31, 2001, 2000 and 1999,respectively, while hardware accounted for 18%, 21% and 24% of total revenuefor the years ended December 31, 2001, 2000 and 1999, respectively.

 

The Company expensed $3,419,000, $3,036,000 and $2,525,000 incurred inits research and development efforts in each of the fiscal years ended December31, 2001, 2000 and 1999, respectively.

 

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Collaborative Relationships

 

Vital Images has formed collaboration relationships with some of theleading universities and physicians in medicine and medical imaging to developwhat it believes to be the most innovative and clinically relevant medicalimaging solutions.  Vital Images hasentered into clinical collaboration agreements with universities and physiciansto:

 

•                  Identify new clinical applications where3D medical imaging can improve clinical outcomes and reduce costs;

 

•                  Develop clinical routines thatincorporate Vital Images’ 3D medical imaging software in normal diagnostic,screening and therapy planning practices;

 

•                  Develop new features that facilitate andimprove diagnosis and therapy planning for Vital Images’ future products;

 

•                  Assess the clinical value of VitalImages’ 3D medical imaging software for given applications; and

 

•                  Develop automated rendering protocols for3D CT or MR data.

 

The following universities and physicians have entered into agreementswith Vital Images for the purpose of forming collaborative relationships:

 

•                  UCLA Medical Center

 

•                  Duke University Medical Center

 

•                  University of Iowa Hospital and Clinics

 

•                  Mallinckrodt Institute of Radiology atthe Washington University School of Medicine

 

•                  University of Minnesota-FairviewUniversity Medical Center

 

•                  Northwestern University Medical Center

 

•                  Massachusetts General Hospital

 

•                  Stanford University Medical Center

 

•                  Yale University School of Medicine

 

In general, the Company’s agreements with its collaborative partners donot provide such collaborators with any ownership of technology developed bythe Company in connection with the collaboration and do not provide for thepayment of any fees or royalties to such collaborators.  However, the Company was obligated to pay aroyalty to the Stanford University Medical Center equal to one-half of onepercent of the Company’s software license revenue from the sale of *Vitrea*and *Vitrea 2*through September2000.

 

Competition

 

The 3D medical imaging market is developing and growing rapidly.  It is intensely competitive, subject torapid change and significantly affected by new product introductions and othermarket activities of industry participants. The Company’s primary competitors are the various diagnostic imagingsystem suppliers, which are typically large, multinational companies, havingfar greater financial and technical resources than the Company, and which alsohave well-established sales and distribution networks for their products. Thesecompanies, including GE Medical Systems, Siemens Medical Systems, Inc. andPhilips Medical Systems, are engaged in the business of developing andmarketing medical imaging systems, such as CT and MR equipment.  These competitors offer 3D medical imagingcapabilities integrated into their products in addition

 

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to the 2D medical imaging capabilities typically provided as a part ofthe operator’s console on the imaging equipment itself.  This medical imaging capability may beinternally developed by these companies, or may be licensed from independentvendors.  In order to competeeffectively with these companies, Vital Images must convince customers to separatetheir purchasing decisions regarding the imaging equipment itself from theselection and purchase of the 3D medical imaging workstations instead ofpurchasing an entire integrated system manufactured by one entity.  To a lesser extent, the Company also facescompetition from other medical imaging systems and software suppliers, PACSvendors, hospital, radiology and clinical system suppliers, and internaldevelopment projects sponsored by hospital radiology departments.

 

Other medical imaging systems and software suppliers compete on the basisof volume rendering or other visualization technologies, specific applicationsor market niches.  These suppliers,including Voxar Ltd., Viatronix, Inc. and TeraRecon, Inc., are generallysmaller companies than Vital Images. PACS companies sometimes provide medical imaging capability in additionto their image archiving and networking products.  Vendors of hospital, clinical and radiology information systemshave also diversified into the PACS and medical imaging product lines, eitherthrough internal development or business development.  These companies, which may be large or small, attempt to offer anintegrated system covering a full range of administrative, clinical andradiology information management capabilities to healthcare providers.  Finally, some research and universityhealthcare institutions may attempt to develop their own 3D medical imagingsystems.  These institutions have in thepast, and may in the future, attempt to secure FDA clearance for such systemsand to license such systems or technology for general commercial sale.

 

The Company’s competitive strength is based on its ability to: (i)provide differentiated 3D medical imaging products that operate in multi-vendornetwork and image source environments; (ii) provide clinical quality,three-dimensional images, volume rendered at high speed with interactivenavigation on a relatively low-cost standard computer; (iii) integrate clinicalknowledge from its collaborative clinical partners into its products; (iv)leverage its visualization technology across multiple clinical disciplines,including disease screening, clinical diagnosis and therapy planning; (v) offera “DICOM client” product which can operate on any DICOM network, independent ofthe imaging system and network provider; and (vi) serve both original equipmentmanufacturers (“OEM”) and end-user customers through the development of amodular end-user product that can easily be segmented for OEM customers.

 

The Company believes that product quality, performance, functionalityand features, quality of support and service, reputation and price are alsoimportant competitive factors.  TheCompany believes that customers will prefer *Vitrea 2* because it is simple, fast andaffordable.  While price has been lesssignificant than other factors, increasing competition in the 3D medicalimaging market may result in price reductions and reduced gross margins.  In particular, should one or more of thediagnostic imaging system suppliers choose to provide or distribute morecompetitive medical imaging products than those offered by the Company, theCompany’s business, financial condition and results of operations could bematerially adversely affected.

 

Marketing and Distribution

 

The Company markets *Vitrea 2* both as a software package and aspart of an integrated software and hardware system to radiologists, surgeons,primary care physicians and medical researchers.  The Company markets its products directly to end-user customers,such as hospitals and clinics, as well as to select diagnostic imagingcompanies, digital imaging equipment manufacturers and PACS companies forresale as a Vital Images’ branded product. In November 2001, the Company signed a joint venture agreement to workcollaboratively on products and services in image-guided surgery and surgicalplanning with the Surgical Navigation Technologies (SNT) division of Medtronic,Inc. Under this agreement, the Company’s advanced visualization technology willbe integrated into Medtronic SNT’s image-guided surgery products and the two companieswill collaborate on new surgical planning software and service offerings.  In October 2001, the Company signed anexclusive agreement with E-Z-EM, Inc. to develop and distribute a dedicated CTcolonography product.  In September2000, the Company signed a marketing and distribution agreement with TAMS,which named *Vitrea 2* as TAMS’primary 3D software for use with their CT scanners in the United States.  In

 

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February 2002, the Company announced that it had entered into amarketing and distribution agreement with Toshiba Corporation, Medical SystemsCompany to offer *Vitrea 2* to**its subsidiaries and distributors,including TAMS, in more than 50 countries in North and South America, Europe,the Middle East, Africa, Australia and Asia, except Japan. The new agreementruns through September 30, 2002.  InDecember 1999, the Company established a strategic marketing alliance with ALI,a leader in the management of clinical data. Both Vital Images and ALI can now offer an integrated solution for thedata management requirements of the new generation of CT and MR scanners.  See “Business — Dependence on MajorCustomers.”

 

In addition, the Company markets its products directly to select OEMson either a standard basis or, in the case of Medtronic SNT, a customizedbasis.  In connection with its OEMopportunities, the Company will either provide complete systems for resale bysuch OEMs or will provide elements of its technology for incorporation into theproducts and systems of such OEMs.

 

The Company markets its products both domestically andinternationally.  In the United States,the Company markets its products through its direct sales force as well asthrough OEMs and resellers. Internationally, the Company markets its products through OEMs andresellers.  See Note 9 to the FinancialStatements - “Major Customers and Geographic Data” for information regardingthe Company’s export sales.  As ofDecember 31, 2001, the Company had 18 direct salespeople in the U.S., oneinternational reseller salesperson, one OEM customer and 13 internationalresellers.

 

Customers and Customer Support

 

Through December 31, 2001, the Company has sold approximately 550separate software licenses for *Vitrea*and *Vitrea 2* for use in approximately 450different sites, including hospitals, clinics, imaging centers and othersites.  The Company’s customers includeAmerica’s most renowned hospitals, including the following 12 of the top 16hospitals listed in *U.S. News and World Report’s* honor roll oftop hospitals:

 
| •     Mayo Clinic                    |   | •     Barnes-Jewish Hospital                      |
|---------------------------------------------------------------|--------|----------------------------------------------------------------------------|
| •     Massachusetts General Hospital |   | •     Stanford University Hospital                |
| •     Cleveland Clinic               |   | •     Hospital of the University of  Pennsylvania |
| •     UCLA Medical Center            |   | •     UCSF Medical Center                         |
| •     Duke University Medical Center |   | •     University of Washington Medical Center     |
| •     Johns Hopkins Hospital         |   | •     New York Presbyterian Hospital              |

 

In addition, the advantages of *Vitrea 2* software — simple, fast andaffordable — have also appealed to hospitals and clinics in smaller populationareas including:

 

•                  Hays Medical Center - Hays, Kansas

•                  Antelope Valley Hospital - Lancaster,California

•                  Olean Medical Group - Olean, New York

•                  Memorial Hospital of Union County -Marysville, Ohio

•                  Sumner Regional Hospital - Gallatin,Tennessee

 

The Company is committed to rapid response to customer servicerequests.  Customer supportrepresentatives are available during the Company’s business hours to answerquestions about the operation, maintenance and repair of the Company’s products.

 

Intellectual Property

 

Although the Company has filed patent applications with respect tocertain aspects of its technology, it generally does not rely on patentprotection with respect to its products and technologies.  Instead, the Company relies primarily on acombination of trade secret and copyright law, employee and third-party

 

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nondisclosure agreements and other protective measures to protectintellectual property rights pertaining to its products and technologies.  Because of the rapid pace of technologicalchange in the 3D medical imaging industry, the Company believes that patent,trade secret and copyright protection are less significant to its competitiveposition than factors such as the knowledge, ability and experience of itspersonnel; new product developments and enhancements; and ongoing, reliableproduct maintenance and support.

 

The Company has been issued Patent No. 5,986,662 from the U.S. Patentand Trademark Office for its mechanism for automated protocol selection.  The use of automated protocol selectionwithin *Vitrea2* allows the user to view image data in two or three dimensionsusing visualization settings based on specific clinical applications storedwithin the software.  This uniquetechnology adds significantly to the simplicity of use of the software — a keyadvantage over competing technologies. The Company has been issued Patent No. 6,130,671 for the mechanism tocalculate simulated lighting in 3D images. The mechanism for calculating simulated lighting in 3D images permits“two-sided lighting” in volume-rendered images, which is crucial for viewingimage data that represents edges of bright as well as dark regions.  These include producing simulated endoscopicimages of contrast-filled blood vessels, the gastrointestinal tract and theurinary system.  The Company has beenissued Patent No. 6,219,059 for the user interface and mechanism used tocontrol the relative transparency of 3D data in volume renderings of medicalimages.  Volume rendering is an advancedtechnique for displaying two- or three-dimensional views on a computerscreen.  It permits the direct displayof all of the imaging data without mathematical modeling and allows interactivecontrol of the level of “transparency” of the data.  All of the patents listed above are utilized in the *Vitrea 2*software.

 

The Company does not own all of the software and other technologiesused in its products, but has the licenses from third parties that the Companybelieves are necessary for using that technology in its current products. Itmay be necessary to renegotiate with such third parties for inclusion in anynew versions of the Company’s current products or any new products. Such thirdparty licenses may not be available on reasonable terms, or at all.

 

Manufacturing and Service

 

The Company’s manufacturing efforts are limited to the production,quality assurance and distribution of its software, which is distributed onCD-ROM.  The software is sent to thecustomer site and loaded into a personal computer.  The software for *Vitrea 2* is loaded into the computer byCompany personnel, as part of the Company’s installation services, which arepriced and billed incrementally to the software license billing, or by an authorizedreseller’s personnel as part of their installation services.  In addition to the loading of software intothe computer, installation services generally include integrating *Vitrea 2*workstations into customers’ computer networks, configuring the networkrequirements and verifying software operability on site.

 

The Company relies primarily on its own software development as itscore competence.  The Company sourcescertain utility software from third parties, see “Intellectual Property” above,and the operating system for integrated computer workstations from otherparties.  In addition, the Companysources systems components, computers and computer peripherals from third partysuppliers.

 

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Governmental Regulation

 

As medical devices, the Company’s 3D medical imaging software productsare subject to extensive and rigorous regulation by numerous governmentalauthorities, principally the FDA and corresponding foreign agencies.  In the United States, the FDA administersthe Federal Food, Drug and Cosmetic Act and its amendments.  These regulations classify medical devicesas either Class I, II or III devices, which are subject to general controls,special controls or pre-market approval requirements, respectively.  Most Class I and II devices, as well as someClass III devices, can be cleared for marketing pursuant to a 510(k) pre-marketnotification. The process of obtaining a 510(k) clearance typically can take severalmonths to a year or longer.

 

Class III devices generally require more stringent clinicalinvestigation and pre-market clearance requirements.  In such cases, the FDA will require that the manufacturer submita pre-market approval (“PMA”) application that must be reviewed and approved bythe FDA prior to the sale and marketing of the device in the UnitedStates.  The process of obtaining a PMAcan be expensive, uncertain and lengthy, frequently requiring anywhere from oneto several years from the date of FDA submission, if approval is obtained atall.  Moreover, a PMA, if granted, mayinclude significant limitations on the indicated uses for which a product maybe marketed.

 

*Vitrea2* is classifiedas a Class II medical device and has received marketing clearance from the FDAas the result of a 510(k) submission. Specifically, *Vitrea 2* has been cleared to be marketedfor use with CT and MR scanners, the Company’s *VScore* software options havebeen cleared for use in coronary artery calcium scoring and the Company’s CTBrain Perfusion option has been cleared for analyzing blood flow of strokevictims.  Future products, add-onoptions to existing software, and expanded claims of efficacy will likelyrequire additional 510(k) applications.

 

In the early 1990s, the review time by the FDA to clear medical devicesfor commercial release lengthened and the number of clearances, both of 510(k)submissions and PMA’s, decreased.  Inresponse to public and congressional concern, the FDA Modernization Act of 1997was adopted with the intent of bringing better definition to the clearanceprocess.  Although this Act has resultedin improved cycle times for product clearance, there can be no assurance thatthe FDA review process will not involve delays or that certain clearances willbe granted on a timely basis.

 

The Company is also increasingly becoming subject to regulation inthose foreign countries in which it sells its products.  Many of the regulations applicable to theCompany’s products in such countries are similar to those of the FDA.  The Company’s ability to successfully marketand sell its products internationally depends in large part on its ability tocomply with such foreign regulatory requirements. *Vitrea 2* software has beenConformitee Europeene (“CE”) marked, indicating conformance with applicablesections of the Medical Device Directive 93/42/EEC, which allows the product tobe marketed in the member countries of the European Communities.

 

The Company is also subject to periodic inspections by the FDA, whoseprimary purpose is to audit the Company’s compliance with quality systemregulations established by the FDA and other applicable governmentstandards.  Regulatory action may beinitiated in response to audit deficiencies or to product performance problems.  The Company believes that its manufacturingand quality control procedures are in essential compliance with therequirements of the FDA regulations.

 

In January 2001, the Company announced that it had received ISO 9001Certification and an upgraded Class I Measurement CE Mark for its medicalimaging software products.

 

The financial arrangements through which the Company markets, sells anddistributes its products may be subject to certain federal and state laws andregulations in the United States with respect to the provision of services orproducts to patients who are Medicare or Medicaid beneficiaries.  Violations of these laws and

 

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regulations may result in civil and criminal penalties, includingsubstantial fines and imprisonment.  Ina number of states, the scope of these laws and regulations have been extendedto include the provision of services or products to all patients, regardless ofthe source of payment, although there is variation from state to state as tothe exact provisions of such laws or regulations.  In other states, and, on a national level, several health carereform initiatives have been proposed which would have a similar impact.  The Company believes that its operations andits marketing, sales and distribution practices currently comply with allcurrent fraud and abuse and physician anti-referral laws and regulations, tothe extent they are applicable.

 

Third Party Reimbursement and Cost Containment

 

The Company’s products are purchased primarily by hospitals, clinics,imaging centers and other users that bill various third party payers for theservices provided to the patients. These payers, which include Medicare, Medicaid, private insurancecompanies and managed care organizations, reimburse part or all of the costsand fees associated with the procedures utilizing the Company’s products.  The medical imaging services performed usingthe Company’s software are covered by current CPT codes (Current ProceduralTerminology, as defined by the Centers for Medicare & MedicaidServices).  As such, hospitals providingservices on the Company’s 3D medical imaging workstations can seekreimbursement by using existing, approved CPT codes.  Medicare and Medicaid reimbursement for hospitals is based on afixed amount for admitting a patient with a specific diagnosis.  Because of this fixed reimbursement method,hospitals have incentives to use less costly methods in treating Medicare andMedicaid patients, and will frequently make capital expenditures to takeadvantage of less costly treatment technologies.  Frequently, reimbursement is reduced to reflect the availabilityof a new procedure or technique and, as a result, hospitals are generallywilling to implement new cost-saving technologies before these downwardadjustments take effect.  Likewise,because the rate of reimbursement for certain physicians who perform certainprocedures has been, and may in the future, be reduced in the event of changesin the resource-based relative value scale method of payment calculation, physiciansmay seek greater cost efficiency in treatment to minimize any negative impactof reduced reimbursement.  Anyamendments to existing reimbursement rules and regulations which restrict orterminate the reimbursement eligibility (or the extent or amount of coverage)of medical procedures using the Company’s products or the eligibility (or theextent or amount of coverage) of the Company’s products could have a materialadverse impact on business.

 

In response to the focus of national attention on rising health carecosts, a number of changes to reduce costs have been proposed or have begun toemerge.  There have been, and maycontinue to be, proposals by legislators and regulators and third party payersto reduce these costs.  There has alsobeen a significant increase in the number of Americans enrolling in some formof managed care plan and, in addition, many hospitals participate in or haveagreements with HMOs.  It has become atypical practice for hospitals to affiliate themselves with as many managedcare plans as possible.  Higher managedcare penetration typically drives down the prices of healthcare procedures,which in turn places pressure on medical supply prices.  This causes hospitals to implement tightervendor selection and certification processes by reducing the number of vendorsused, purchasing more products from fewer vendors and trading discounts onprice for guaranteed higher volumes to vendors.  Hospitals have also sought to control and reduce costs over thelast decade by joining group purchasing organizations or purchasingalliances.  The Company cannot predictwhat continuing or future impact these practices, the existing or proposedlegislation, or such third party payer measures may have on its futurebusiness.

 

Employees

 

As of February 28, 2002, the Company had 79 full-time employees, with26 involved in research and development, 26 in sales and marketing, 12 intechnical support functions and 15 in administrative functions.  The Company is not a party to any collectivebargaining agreement involving its employees and believes its relationship withits employees is good.

 

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EXECUTIVE OFFICERSOF THE REGISTRANT

 

Set forth below are thenames of the executive officers of the Company as of March 1, 2002, their ages,the year first elected as an executive officer of the Company and employmentfor the past five years.

** **
| **NAME**                 |   | **AGE** |   | **TITLE**                                                                    |
|--------------------------|--------|---------|--------|------------------------------------------------------------------------------|
| Jay D. Miller            |   | 42      |   | President, Chief Executive Officer  and Director                             |
|                     |   |    |   |                                                                         |
| Vincent J. Argiro, Ph.D. |   | 46      |   | Chief Technology Officer, Founder  and Director                              |
|                     |   |    |   |                                                                         |
| Steven P. Canakes        |   | 46      |   | Vice President - Sales                                                       |
|                     |   |    |   |                                                                         |
| David M. Frazee          |   | 41      |   | Vice President - Engineering                                                 |
|                     |   |    |   |                                                                         |
| Gregory S. Furness       |   | 47      |   | Vice President - Finance, Chief  Financial Officer, Treasurer  and Secretary |

 

*Jay D.Miller.*  Mr. Miller was named President & CEO inFebruary 2002 and served as the Company’s General Manager and Vice President -Business Development from August 1998 to February 2002 and as its VicePresident - Marketing and Business Development from February 1997 to August1998.  From 1989 until his employment bythe Company, Mr. Miller was employed by GE Medical Systems, Inc. in positionsof increasing responsibility in the marketing area, including serving asproduct manager and global product line strategy for MR imaging products andmarketing manager for the cardiology market segment.  Prior to 1989, Mr. Miller was employed by Siemens Medical Systemsin technical marketing.

 

*VincentJ. Argiro, Ph.D.*  Dr. Argiro, the Founder of the Company, wasnamed Chief Technology Officer of Vital Images in October 1995.  From May 1994 until May 1997, Dr. Argiroalso served as a Vice President of Bio-Vascular, the former parent company ofVital Images.  Dr. Argiro served as adirector of Bio-Vascular from May 1994 until March 1996.  Following the acquisition of the Company byBio-Vascular in May 1994, Dr. Argiro served as President of the Company untilOctober 1995.  Dr. Argiro served asChairman of the Board of the Company from 1988 until May 1994.  From 1988 to 1990 and from September 1991 toJune 1992, Dr. Argiro also served as President of the Company.

 

*Steven P. Canakes.*  Mr. Canakeswas named Vice President - Sales in March 2000.  Prior to that he was the Company’s Vice President - U.S. Salesfrom August 1998 to March 2000 and its Director of U.S. Sales from March 1998to August 1998.  From July 1996 to March1998, Mr. Canakes was Vice President of Business Development for MedManagement,LLC in Plymouth, Minnesota.  FromFebruary 1994 to July 1996, Mr. Canakes served as Vice President of Sales forMedintell Systems and Value Health Corporation, a Medintell SystemsDivision.  Prior to February 1994, Mr.Canakes was a CT Product Sales Manager for Picker International, Inc.

 

*David M. Frazee.* Mr. Frazee was named VicePresident - Engineering in March 1999. From July 1998 to March 1999, Mr. Frazee served as a Manager in theSolution Strategies Practice of Whittman-Hart, Inc.  From April 1997 to July 1998, Mr. Frazee was Director of ProgramManagement and Internet Products at LodgeNet Entertainment, Inc.  Prior to April 1997, Mr. Frazee held severalsystems and software development and management positions at GE MedicalSystems, Inc., most recently as Manager of the Global Software Applications Operation.

 

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*GregoryS. Furness*.  Mr. Furness was named Vice President —Finance, Chief Financial Officer, Treasurer and Secretary of Vital Images inFebruary 1997.  From December 1987 toDecember 1996, Mr. Furness served as Executive Vice President and ChiefFinancial Officer of CAMAX Manufacturing Technologies, Inc., a computer-aidedmanufacturing software developer, which was acquired by Structural DynamicsResearch Corporation in June 1996. Prior to December 1987, Mr. Furness was employed as Vice President,Finance and Chief Financial Officer of Mizar, Inc., and as an audit manager atDeloitte and Touche LLP.  Mr. Furness isa Certified Public Accountant.

 

ITEM 1A - IMPORTANT FACTORS

 

The following factors areimportant and should be considered carefully in connection with any evaluationof the Company’s business, financial condition, results of operations andprospects.  Additionally, the followingfactors could cause the Company’s actual results to materially differ fromthose reflected in any forward-looking statements of the Company.

 

Historical Operating Losses

 

The Company had operating losses of $1,055,000, $2,787,000 and$3,303,000 for the years ended December 31, 2001, 2000 and 1999, respectively,and, with the exception of the fiscal year ended October 31, 1995, has incurredoperating losses each year since 1990. As of December 31, 2001, the Company’s accumulated deficit was$20,878,000.  The Company’s ability toattain and maintain annual profitability will depend on, among other things,its ability to successfully market its products, make new product offerings,respond to competitive developments and attract and retain qualified sales,technical and management employees. There can be no assurance that the Company will achieve profitableoperations on an annual basis.  See“Management’s Discussion and Analysis of Financial Condition and Results ofOperations.”

 

New Product Acceptance

 

The Company’s success depends on its ability to successfully market its*Vitrea 2*software for clinical use, and the ability and willingness of physicians to usetwo- and three-dimensional medical imaging software in disease screening,clinical diagnosis and therapy planning and other diagnosis, surgical, andtreatment protocols.  The three–dimensionalmedical imaging software offered by *Vitrea 2* represents a new alternative tothe conventional methods traditionally used for viewing medical images in theclinical setting.  The acceptance of *Vitrea 2*by physicians and other clinicians will depend on the Company’s ability toeducate those users as to the speed, ease-of-use and benefits offered by the *Vitrea 2*system, as well as the timely introduction of new features and functions by theCompany.  There can be no assurance thatusers will prefer three-dimensional medical imaging software over lessexpensive two-dimensional medical imaging software, or that the Company willsucceed in its efforts to further develop, commercialize, and achieve marketacceptance for its *Vitrea 2* product, or for any other productin the clinical setting.  See“Business—Technology,” “—Industry Background,” “—Markets” and “—Competition.”

 

Substantial Reliance on a Single Product

 

Revenue from sales of the *Vitrea 2* system constituted 96% of the Company’stotal revenue for the year ended December 31, 2001, 96% of the Company’s totalrevenue for the year ended December 31, 2000 and 85% of the Company’s totalrevenue for the year ended December 31, 1999. Further, the Company anticipates that revenue from the sale of *Vitrea 2*will continue to account for a substantial portion of the Company’s revenue forthe foreseeable future.  As such, thefailure of physicians to accept *Vitrea 2* would have a material adverseimpact on the Company’s results of operations and financial condition.

 

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Dependence on Market Growth 

 

The 3D medical imaging industry in which the Company markets itsproducts is still developing due to the fairly recent availability of high performancecomputers at reduced prices, the recent adoption of industry standards for thegeneration, transmission and storage of medical imaging data, and changingmedical practices. Historically, there has been a perception thatthree-dimensional imaging was too slow or difficult for clinical use.  This perception was due largely to therelatively slower processing speed of workstations available in the past.  Although the Company believes that therecent advances in the affordability of high performance computers and in thedevelopment of industry standards for the generation, transmission, and storageof imaging data will provide opportunities for growth in the 3D medical imagingindustry, given the uncertainties associated with the developing stage of thisindustry, there can be no assurance that it will continue to develop in themanner anticipated by the Company. Accordingly, there can be no assurance that the 3D medical imagingindustry will provide growth opportunities for the Company and its softwareproducts or that the Company’s business strategies will be successful as the 3Dmedical imaging industry continues to evolve. Ultimately, if the 3D medical imaging industry fails to develop as theCompany expects, the Company’s business, results of operations and financialcondition will be materially and adversely affected.

 

Need for Additional Capital

 

If the Company’s operations progress as anticipated, of which there canbe no assurance, the Company believes that its existing cash balances, togetherwith cash flows from operations, should be sufficient to satisfy its cashrequirements for at least the next 12 months.

 

The timing of the Company’s future capital requirements will depend ona number of factors, including, but not limited to, the ability of Vital Imagesto successfully market its products; the ability and willingness of physiciansto use two- and three-dimensional medical imaging software in diseasescreening, clinical diagnosis and therapy planning and other diagnosis,surgical, and treatment protocols; the impact of competition in the 3D medicalimaging business; the ability of the Company to differentiate its products fromcompeting products; the capital equipment budget constraints of some potentialpurchasers; the ability of the Company to build an effective sales anddistribution force; and the ability to enhance existing products and developnew products on a timely basis.  To theextent that the Company’s operations do not progress as anticipated, additionalcapital may be required.  There can beno assurance that any required additional capital will be available onacceptable terms, or at all, and the failure to obtain any such requiredcapital would have a material adverse effect on Vital Images’ business.  The issuance of additional equity securitiesmay result in dilution of current shareholder voting and ownershipinterests.  See “Management’s Discussionand Analysis of Financial Condition and Results of Operations.”

 

Highly Competitive Industry

 

The Company faces intense competition in the 3D medical imagingindustry.  The Company expectstechnology to continue to develop rapidly, and the Company’s success willdepend to a large extent on its ability to maintain a competitive position withits products.  Companies competing with theCompany in the 3D medical imaging industry include large, establishedmanufacturers of CT and MR imaging equipment. Companies such as GE Medical Systems, Siemens Medical Systems, Inc. andPhilips Medical Systems typically offer their own medical imaging software andworkstations as part of their integrated imaging and scanner systems.  The Company’s ability to successfully marketand sell its current 3D medical imaging products to prospective customersdepends, in part, on its ability to persuade such customers to separate thepurchase of CT or MR equipment from the selection and purchase of 3D medicalimaging workstations.  In addition tohaving significantly greater capital and staffing resources for research anddevelopment that are critical to success in the rapidly changing 3D medicalimaging industry, such companies also have well-established marketing anddistribution networks and have a competitive advantage in marketing 3D medicalimaging tools as an integrated part of their imaging products.  While price has been less significant thanother factors, increasing competition may result in price reductions andreduced gross margins.  Additionally,the

 

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Company faces competition from other entities, such as other softwaresuppliers, information storage and retrieval vendors, hospital, radiology andclinical systems suppliers and internal development projects sponsored byhospital radiology departments.  Therecan be no assurance that the Company will be able to compete effectively withsuch manufacturers or competing entities. See “Business—Technology,” “—Industry Background” and “—Competition.”

 

Risk of Technological Obsolescence

 

The 3D medical imaging market is characterized by rapid innovation andtechnological change.  There can be noassurance that the Company will be able to compete effectively in themarketplace or that products developed by its competitors will not render itsproducts obsolete or non-competitive. Similarly, there can be no assurance that the Company’s competitors willnot succeed in developing or marketing products that are viewed as providingsuperior clinical performance or are less expensive than the Company’s productscurrently marketed or to be developed.

 

Dependence on Major Customers

 

One of the Company’s principal distribution channels is to sell its *Vitrea 2*medical imaging software for inclusion with the delivery of medical imagingequipment being sold by Toshiba Corporation, Medical Systems Company(“Toshiba”).  Sales by the Company toToshiba accounted for approximately 27%, 27% and 21% of the Company’s totalrevenue for the years ended December 31, 2001, 2000 and 1999, respectively.Management believes a limited number of large customers may continue to accountfor a significant portion of the Company’s revenue during any given period forthe foreseeable future.  Except for itsmarketing and distribution agreements with Toshiba, Medtronic SNT and E-Z-EM,Inc., the Company currently has no long-term purchase or other agreements withany of its customers and sales are generally made pursuant to purchaseorders.  A reduction, delay, orcancellation of orders from one or more of its significant customers likelywould have a material adverse effect on the Company’s operating results.  See “Business-Marketing and Distribution.”

 

Fluctuations in Operating Results

 

The Company may experience significant fluctuations in future annualand quarterly operating results.  Ifthese fluctuations occur, they may result in volatility in the price of theCompany’s common stock.  Quarterlyrevenue and operating results may fluctuate as a result of a variety of factorsincluding, but not limited to, the timing of significant orders, the timing ofproduct enhancements and new product introductions by the Company, itscompetitors and its customers, the pricing of the Company’s products, changesin customers’ budgets, and competitive conditions, many of which are beyond thecontrol of the Company.

 

Government Regulation

 

The Company’s products are subject to regulation by the FDA and bycomparable agencies in foreign countries. In the United States, the FDA regulates the development, introduction,manufacturing, labeling and record keeping procedures for medical devices,including 3D medical imaging software and systems.  The process of obtaining marketing clearance from the FDA for newproducts and new applications for existing products can be time-consuming andexpensive.  All of the current productsactively marketed by the Company have received marketing clearance from the FDApursuant to 510(k) pre-market notifications. *Vitrea2* has been approved to be marketed for use with CT and MR scanners,the Company’s *VScore*options havebeen approved for use in coronary artery calcium scoring and theCompany’s CT Brain Perfusion option has been cleared for analyzing blood flowof stroke victims.  There can be noassurance, however, that clearance will be granted with respect to futureproducts or enhancements, or that FDA review will not involve delays that wouldadversely affect the Company’s ability to market such future products orenhancements.  In addition, there can beno assurance that future products or enhancements will not be subject to themore lengthy and expensive pre-market approval process with the FDA.

 

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Even if regulatory approvals to market a product are obtained from theFDA, these approvals may entail limitations on the indicated uses of theproduct.  Product approvals by the FDA canalso be withdrawn due to failure to comply with regulatory standards or theoccurrence of unforeseen problems following initial approval.  The FDA could also limit or prevent thedistribution of the Company’s products and has the power to require the recallof such products.  FDA regulationsdepend heavily on administrative interpretation, and there can be no assurancethat future interpretations made by the FDA or other regulatory bodies will notadversely affect the Company.  The FDAmay inspect the Company and its facilities from time to time to determinewhether the Company is in compliance with various regulations relating tospecification, development, documentation, validation, testing, quality controland product labeling.  A determinationthat the Company is in violation of such regulations could lead to impositionof civil penalties, including fines, product recalls or product seizures and,in extreme cases, criminal sanctions.

 

The Company markets its products both domestically and internationally.  International regulatory bodies haveestablished varying regulations governing product standards, packagingrequirements, labeling requirements, import restrictions, tariff regulations,duties and tax requirements.  Theinability or failure of the Company to comply with the varying regulations orthe imposition of new regulations could restrict its ability to sell itsproducts internationally and could thereby adversely affect the Company’sbusiness.  See “Business—GovernmentalRegulation.”

 

Uncertain Protection for Intellectual Property;Possible Claims of Others

 

Although the Company has filed patent applications with respect tocertain aspects of its technology, it generally does not rely on patentprotection with respect to its products and technologies.  Instead, the Company relies primarily on acombination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to its products and technologies.  There can be no assurance that thesemeasures will provide meaningful protection of the Company’s trade secrets,know-how or other intellectual property in the event of any unauthorized use,misappropriation or disclosure or that others will not independently developsimilar technologies or duplicate any technology developed by the Company.  In addition, to the extent that any patentsare applied for, there can be no assurance that such applications will resultin issued patents or, if issued, that such patents will be held to be valid orwill otherwise be of value.  While theCompany does not believe that its products and technologies infringe anyexisting patents or intellectual property rights of third parties, there can beno assurance that such infringement does not exist.  The costs of defending an intellectual property claim could besubstantial and could adversely affect the Company, even if it was ultimatelysuccessful in defending any such claims. If the Company’s products or technologies were found to infringe therights of a third party, the Company could be required to pay significantdamages or license fees or cease production, any of which could have a materialadverse effect on the Company’s business. See “Business—Intellectual Property.”

 

Product Liability Risk; Limited Insurance Coverage

 

The manufacture and sale of products used in the practice of medicineentail significant risk of product liability claims.  While the Company currently maintains product liability insurancein the amount of $6,000,000 per occurrence and $7,000,000 in total and alsomaintains errors and omissions coverage in the amount of $6,000,000 peroccurrence and in total, there can be no assurance that its coverage limitswill be adequate to protect the Company from any liabilities it might incur inconnection with the sale of its products, or that the Company will be able tomaintain this level of coverage in the future. The Company also may require increased product liability coverage asadditional products and updates are released. Such insurance is expensive and in the future may not be available onacceptable terms, if at all.  Asuccessful product liability claim or series of such claims against the Companyin excess of the Company’s insurance coverage could have a material adverseeffect on its business.

 

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Dependence on Key Employee; Need to Hire AdditionalPersonnel

 

The Company depends upon the continued active participation of Dr.Vincent J. Argiro, its Chief Technology Officer and Founder.  Loss of the services of Dr. Argiro couldhave a material adverse effect on the Company’s future business.  Dr. Argiro does not have an employmentagreement with the Company, but does have a confidentiality and non-competitionagreement with the Company.** **TheCompany maintains key person life insurance coverage on Dr. Argiro’s life inthe amount of $500,000.

 

The Company’s ability to enhance and develop markets for its currentproducts as well as to introduce new products to the marketplace also dependson its ability to attract and retain qualified scientific and managementpersonnel.  The Company competes forsuch personnel with other companies, academic institutions, government entitiesand organizations, many of which have substantially greater capital resources,name recognition, and research and development capabilities than theCompany.  There can be no assurance thatthe Company will be successful in recruiting or retaining such personnel.  The inability of the Company to recruit andretain such personnel would have a material adverse effect on the Company’sbusiness.

 

Management of Growth

 

The execution of the Company’s business plan will place increasingdemands on the Company’s existing management and resources.  There can be no assurance that the Companywill be able to effectively manage any expansion of its business, which couldhave a material adverse effect on the Company’s business, financial conditionand results of operations.

 

Dependence on Third-Party Reimbursement

 

The Company’s products are purchased by hospitals, clinics, imagingcenters and other users, which bill various third party payers, such asgovernment health programs, private health insurance plans, managed careorganizations and other similar programs, for the health care goods andservices provided to their patients. There is currently a Current Procedural Terminology (CPT) reimbursementcode for procedures, which utilize the Company’s products.  However, the amount of such reimbursementvaries by location and is subject to change. Payers may deny reimbursement if they determine that a product used in aprocedure was not used in accordance with established payer protocol regardingcost-effective treatment methods or was used for an unapproved indication.  Third party payers are increasinglychallenging the prices charged for medical services and, in some instances,have put pressure on service providers to lower their prices or reduce theirservices.  The Company is unable topredict what changes will be made in the reimbursement methods used by thirdparty healthcare payers.  There can beno assurance that procedures in which the Company’s products are used will beconsidered cost effective by third party payers, that reimbursement for suchprocedures will be available or, if available, that payers’ reimbursementlevels will not adversely affect the Company’s ability to sell its products ona profitable basis.  In addition, therehave been and may continue to be proposals by legislators, regulators and thirdparty payers to curb further these costs in the future.  Failure by hospitals and other users of theCompany’s products to obtain reimbursement from third party payers, changes inthird party payers’ policies toward reimbursement for procedures using theCompany’s products or legislative action could have a material adverse effecton the Company’s business.  See“Business—Third Party Reimbursement and Cost Containment.”

 

Uncertainty of Health Care Reform

 

The levels of revenue and profitability of medical technology companiesmay be affected by the efforts of government and third party payers to containor reduce the costs of health care through various means.  In the United States there have been, andthe Company expects that there will continue to be, a number of federal, state,and private proposals to control health care costs.  These proposals may contain measures intended to control publicand private spending on health care as well as to provide universal publicaccess to the health care system.  Ifenacted, these proposals may result in a substantial restructuring of thehealth care delivery

 

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system.  Significant changes inthe nation’s health care system could have a substantial impact on the mannerin which the Company conducts its business and could have a material adverseeffect on the Company’s business, financial condition and results ofoperations.

 

Possible Issuances of Preferred Stock; CertainAnti-Takeover Considerations

 

The Company’s Articles of Incorporation authorize the Company’s Boardof Directors, without any action by its shareholders, to establish the rightsand preferences of up to 5,000,000 shares of currently undesignated preferredstock.  Such shares of preferred stock could possess voting and conversion rights,which could adversely affect the voting power of the holders of the commonstock and may have the effect of delaying, deferring or preventing a change incontrol of the Company.  Noshares of preferred stock or other senior equity securities are currentlydesignated and currently there is no plan to designate or to issue any suchsecurities.

The Company is also subject to certain “anti-takeover” provisions ofthe Minnesota Business Corporation Act. In addition, the Company has adopted a Shareholder Rights Plan (the“Rights Agreement”) designed to protect the Company and its shareholders fromunsolicited attempts to acquire the Company. These measures may, in certain circumstances, deter or discourage takeoverattempts and other changes in control of the Company not approved by its Boardof Directors and may have a depressive effect on any market for the Company’sstock.  As a result, the Company’sshareholders may lose opportunities to dispose of their shares at the higherprices typically available in takeover attempts or that may be available undera merger proposal.  In addition, thesemeasures may have the effect of permitting the Company’s current directors toretain their positions and place them in a better position to resist changesthat the Company’s shareholders may wish to make if they are dissatisfied withthe conduct of the Company’s business.

 

No Dividends

 

The Company has not paid cash dividends on itscommon stock in the past and does not intend to do so in the foreseeablefuture.

 

Limitations on Director Liability

 

As permitted by Minnesota law, the Company’s Articles of Incorporationprovide that a director of the Company shall not be personally liable to theCompany or its shareholders for monetary damages for breach of fiduciary dutyas a director, with certain exceptions. These provisions may discourage shareholders from bringing suit againsta director for breach of fiduciary duty and may reduce the likelihood ofderivative litigation brought by shareholders on behalf of the Company againsta director.  In addition, the Company’sBylaws provide for mandatory indemnification of directors and officers to thefullest extent permitted by Minnesota law.

 

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Item 2.     PROPERTIES

 

The Company’s principal office is located in Plymouth, Minnesota, wherethe Company currently occupies approximately 24,000 square feet under a leasethat expires July 31, 2005. Under certain conditions contained in the lease,the Company has the option to expand its facilities.

 

The Company considers its current facilities adequate for its currentneeds and believes that suitable additional space will be available as and ifneeded.

 

Item 3.     LEGAL PROCEEDINGS

 

The Company is not engaged in any legal proceedings at this time.

 

Item 4.     SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

 

There was no matter submitted to the vote of security holders duringthe fourth quarter of 2001.

 

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PART II

 
| Item 5. | MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED |
|---------|--------------------------------------------------------|
|    | STOCKHOLDER MATTERS                                    |

 

Effective September 29, 2000 the Company’s common stock began tradingon the Nasdaq SmallCap Market under the symbol “VTAL.”  Prior to September 29, 2000, the Company’scommon stock traded on the OTC Bulletin Board under the symbol “VTAL.”  The table below reflects the high and lowper share closing sale prices of the Company’s common stock as reported by TheNasdaq Stock Market for the fourth quarter 2000 and all of 2001, and for eachof the periods indicated prior to the fourth quarter of 2000, the high and lowclosing bid quotations for the Company’s common stock as reported by the OTCBulletin Board.  Such prices reflectinter-dealer prices, do not include adjustments for retail mark-ups, markdownsor commissions and may not necessarily represent actual transactions.

 
|           |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
| 2001           |   |     |   |    |   |
| Fourth Quarter |   | $        | 10.32  |    | $      | 5.00 |   |
| Third Quarter  |   | 7.35     |   | 4.40    |   |
| Second Quarter |   | 6.95     |   | 3.63    |   |
| First Quarter  |   | 5.25     |   | 3.25    |   |
|           |   |     |   |    |   |
| 2000           |   |     |   |    |   |
| Fourth Quarter |   | $        | 5.94   |    | $      | 3.44 |   |
| Third Quarter  |   | 6.88     |   | 4.94    |   |
| Second Quarter |   | 8.63     |   | 5.38    |   |
| First Quarter  |   | 10.94    |   | 4.63    |   |

 

The Company has never paid or declared any cashdividends on its common stock and does not intend to pay dividends on itscommon stock in the near future.  Todate, the Company has incurred losses and presently expects to retain itsfuture anticipated earnings to finance development and expansion of itsbusiness.  As of February 28, 2002, therewere approximately 4,000 beneficial owners and approximately 1,100 registeredholders of record of the Company’s common stock.

 

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Item 6.     SELECTEDFINANCIAL DATA

 

The following selectedfinancial data for each of the fiscal years in the five-year period endedDecember 31, 2001 is derived from the audited financial statements of theCompany and the notes thereto.  Theinformation set forth below should be read in conjunction with the Company’sfinancial statements, including the notes thereto, and “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” which areincluded elsewhere in this Annual Report on Form 10-K.

 
|                                                              |   | **For the  Years Ended  or As of  December 31,** |   |
|-------------------------------------------------------------------|--------|--------------------------------------------------|--------|
|                                                              |   | **2001**                                         |   | **2000** |   | **1999** |   | **1998** |   | **1997(1)** |   |
|                                                              |   | **(In thousands, except per share data)**        |
| **Statement of Operations Data:**                                 |   |                                             |   |   |   |   |   |   |   |   |   |
| Revenue                                                           |   | $                                                | 15,196 |   | $ | 10,628 |   | $ | 6,623 |   | $ | 4,527 |   | $ | 1,218 |   |
| Gross margin                                                      |   | 11,886                                           |   | 8,110 |   | 5,080 |   | 3,302 |   | 915 |   |
|                                                              |   |                                             |   |   |   |   |   |   |   |   |   |
| Operating  expenses:                                              |   |                                             |   |   |   |   |   |   |   |   |   |
| Selling, general  and administrative                              |   | 9,523                                            |   | 7,861 |   | 5,858 |   | 4,954 |   | 3,871 |   |
| Research and  development                                         |   | 3,418                                            |   | 3,036 |   | 2,525 |   | 1,815 |   | 2,255 |   |
| Operating loss                                                    |   | (1,055                                           | )      | (2,787 | ) | (3,303 | ) | (3,467 | ) | (5,211 | ) |
|                                                              |   |                                             |   |   |   |   |   |   |   |   |   |
| Net loss                                                          |   | $                                                | (1,012 | ) | $ | (2,637 | ) | $ | (3,218 | ) | $ | (3,209 | ) | $ | (4,774 | ) |
|                                                              |   |                                             |   |   |   |   |   |   |   |   |   |
| Net loss per  share - basic and diluted (2)                       |   | $                                                | (0.14  | ) | $ | (0.39 | ) | $ | (0.64 | ) | $ | (0.66 | ) | $ | (1.00 | ) |
|                                                              |   |                                             |   |   |   |   |   |   |   |   |   |
| Weighted average  common sharesoutstanding - basic and diluted(2) |   | 7,075                                            |   | 6,760 |   | 5,046 |   | 4,841 |   | 4,772 |   |
|                                                              |   |                                             |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                           |   |                                             |   |   |   |   |   |   |   |   |   |
| Working capital                                                   |   | $                                                | 6,094  |   | $ | 2,344 |   | $ | 5,409 |   | $ | 3,360 |   | $ | 6,415 |   |
| Total assets                                                      |   | 13,269                                           |   | 7,287 |   | 8,666 |   | 5,938 |   | 8,296 |   |
| Long-term debt                                                    |   | —                                           |   | — |   | — |   | — |   | — |   |
| Total  shareholders’ equity                                  |   | 8,051                                            |   | 3,765 |   | 6,098 |   | 4,134 |   | 7,253 |   |

 

(1)                                  Includes Vital Images’ results as awholly-owned subsidiary of Bio-Vascular from January 1, 1997 through May 12,1997.  Vital Images was merged withBio-Vascular in May 1994 in a transaction accounted for as apooling-of-interests and subsequently spun-off as an independent,publicly-owned company in May 1997. Results of operations during the period from January 1, 1997 through May12, 1997 include allocations of certain general corporate expenses ofBio-Vascular.

 

(2)                                  For periods after and including May 12,1997, basic and diluted net loss per share is computed using the weightedaverage common shares outstanding during the period.  Common share equivalents are not included in the net loss pershare calculations since they are anti-dilutive.

 

For periods prior to May 12, 1997, the weightedaverage common shares outstanding used in the net loss per share calculation isone-half of the weighted average of Bio-Vascular common shares outstandingbased on the distribution of one share of the Company’s common stock for eachtwo shares of Bio-Vascular’s common stock.

 

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| Item 7. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND |
|---------|-----------------------------------------------------------------------|
|    | RESULTS OF OPERATIONS                                                 |

 

**Overview**

 

Vital Images develops, markets and supports 3D medical imaging softwarefor use primarily in disease screening, clinical diagnosis and therapyplanning.  The Company’s softwareapplies proprietary computer graphics and image processing technologies to awide variety of data supplied by computed tomography (“CT”) scanners andmagnetic resonance (“MR”) imaging devices. Vital Images’ products allow clinicians to create both two- andthree-dimensional views of human anatomy and to non-invasively navigate withinthese images to better visualize and understand internal structures andpathologies.  The Company believes thatits high-speed visualization technology and customized protocolscost-effectively bring 3D visualization and analysis into the routine,day-to-day practice of medicine.  TheCompany, which operates in a single business segment, markets its products tohealthcare providers and to manufacturers of diagnostic imaging systems througha direct sales force in the United States and independent distributors ininternational markets.

 

On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.(“Bio-Vascular”), the former parent company of Vital Images, approved a plan tospin off and establish Vital Images as an independent, publicly-ownedcompany.  On May 12, 1997, Bio-Vasculardistributed all of the shares of Vital Images to the shareholders ofBio-Vascular, and on that date Vital Images began operating as an independentpublic company.  All Bio-Vascular shareholdersof record as of May 5, 1997 received one share of Vital Images common stock foreach two shares of Bio-Vascular stock held on that date, and cash in lieu offractional shares.  Vital Images’ commonstock is currently traded on The Nasdaq SmallCap Market under the symbol VTAL.

 

**CriticalAccounting Policies and Estimates**

 

Management’s discussion and analysis of its financial position andresults of operations are based upon the Company’s consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America. The preparation of thesefinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities as of the date of the financial statementsand the reported amounts of revenue and expenses during the reportingperiods.  Actual results could differfrom those estimates.  The followingrepresents those critical accounting policies and estimates where materiallydifferent amounts would be reported under different conditions or usingdifferent assumptions.

 

*Allowancefor doubtful accounts.*  The Company maintainsallowances for doubtful accounts for estimated losses resulting from theinability of its customers to make required payments. If the financialcondition of the Company’s customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.

 

*Deferredtax asset.* The Company records a valuation allowance toreduce its deferred tax assets to the amount that is more likely than not to berealized. While the Company has considered future taxable income and ongoingprudent and feasible tax planning strategies in assessing the need for thevaluation allowance, in the event the Company were to determine that it wouldbe able to realize its deferred tax assets in the future in excess of its netrecorded amount, an adjustment to the deferred tax asset would increase incomein the period such determination was made. Likewise, should the Companydetermine that it would not be able to realize all or part of its net deferredtax asset in the future, an adjustment to the deferred tax asset would becharged to income in the period such determination was made.

 

*Long-Lived Assets.*The Company periodically reviews the carrying amountsof property and equipment and intangible assets purchased in the normal courseof business, to determine whether current events or circumstances, as definedin Statement of Financial Accounting Standard No 121, “Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,”warrant adjustments to such

 

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carryingamounts.  In reviewing the carryingvalues of property and equipment and intangible assets, the Company considers,among other things, the future cash flows expected from the use of the asset.

 

*Revenue Recognition. *The Company recognizes revenue in accordance withAICPA Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” asamended by SOP 98-4 and SOP 98-9. License fees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale ofsystem hardware including peripheral equipment.  Maintenance and service revenue is derived from hardware andsoftware maintenance and from services consisting of installation, training andengineering services.

 

In software arrangements that include the rights tomultiple software products, system hardware, specified upgrades, maintenance orservices, the Company allocates the total arrangement fee among eachdeliverable based on the relative fair value of each of the deliverablesdetermined based on vendor-specific objective evidence. In softwarearrangements in which the Company does not have vendor-specific objectiveevidence, revenue is deferred until the earlier of when vendor-specificobjective evidence is determined for the undelivered elements (residual method)or when all elements have been delivered.

 

Revenue from license fees is recognized whenpersuasive evidence of an agreement exists, shipment of the product hasoccurred, no significant Company obligations with regard to implementationremain, the fee is fixed and determinable and collection is probable.  Revenue allocable to maintenance isrecognized on a straight-line basis over the periods in which it isprovided.  The Company evaluatesarrangements that include services to determine whether those services areessential to the functionality of other elements of the arrangement.  Generally, the Company’s services are notconsidered essential to the functionality of other elements, and accordingly,revenue allocable to services is recognized as the services are performed.  In arrangements where the Company isperforming significant customization or modification of software, revenue fromthe arrangements are recognized using contract accounting, generally on apercentage-of-completion basis.  Hardwarerevenue is recognized upon shipment when all other revenue recognition criteriain the arrangement have been met.

 

**Revenue**

 

Total revenue increased 43% to $15,196,000 in 2001 from total revenueof $10,628,000 in 2000.  Total revenueincreased 60% to $10,628,000 in 2000 compared with $6,623,000 in 1999.  The revenue growth was driven by theincrease in the Company’s core revenue components of software license fees andmaintenance and service revenue. License fee revenue increased 43% to $10,083,000 in 2001 from $7,037,000in 2000.  The increase in softwarelicense fee revenue was driven primarily by an increase in the number of Vitreaâ 2licenses sold as well as an increase in the number of Vitrea add-on optionssold.  License fee revenue increased 68%to $7,037,000 in 2000 from $4,182,000 in 1999. The increase in software license fee revenue from 1999 to 2000 wasprimarily due to an increase in the number of Vitrea licenses sold.

 

Maintenance and services revenue increased 74% to $2,450,000 in 2001from $1,412,000 in 2000 and increased 70% to $1,412,000 in 2000 from $831,000in 1999.  The increases were primarilydue to increases in maintenance revenue as the Company added new customers tothe installed base and increases in training revenue due to an increase in thenumber of training sessions sold with customer purchases of software.  The Company recorded an additional $348,000in service revenue in 2001 for the development of a CT colonography product,InnerviewGITM, for E-Z-EM, Inc.

 

Hardware revenue increased 22% to $2,663,000 in 2001from $2,179,000 in 2000 and increased 35% to $2,179,000 in 2000 from $1,610,000in 1999.  The increase in hardwarerevenue was due to an increase in the number of hardware systems sold with the *Vitrea*software licenses.  The hardware revenue growth was lower in2001 than in 2000 due to a change in the sales model with Toshiba AmericaMedical Systems, Inc. (“TAMS”). Previously, all of the Company’s sales to TAMS were complete systemssales.  During the third quarter and fourthquarter 2001, most of the revenue resulting from sales to TAMS was derived fromsoftware-only sales, which generate higher margins than complete system sales.

 

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Royalties received from the Company’s license agreement with ParadigmGeophysical Corporation (“Paradigm”) decreased in 2001 as compared to 2000 anddecreased in 2000 compared to 1999 due to a decrease in the royalty percentagereceived.  Revenue received under thelicense agreement with Paradigm was $106,000, $210,000 and $462,000 in 2001,2000 and 1999, respectively.  Theagreement expired in January 2001.

 

As a result of the Company focusing its efforts on its *Vitrea 2*software, revenue from *VoxelView**Ò*software, the Company’s predecessor software product to *Vitrea*, decreased from $269,000 in 1999 to$89,000 in 2000 and $25,000 in 2001.

 

**Gross Margin**

 

The Company’s gross margin percentage was 78% in 2001,up from 76% in 2000. The gross margin percentage was 77% in 1999.  The increase in gross margin for 2001 wasprimarily attributable to a change in the sales model with TAMS as discussedabove.

 

The *Vitrea 2* system, consisting of *Vitrea 2*software and third-party hardware and peripherals, is designed to offer endusers an integrated 3D medical imaging system. The Company receives only a nominal discount in purchasing thethird-party hardware and peripheral components of the *Vitrea 2*system, and theCompany’s gross margin on the resale of these system components approximatesits discount.  The Company anticipatesthat software license fee revenue as a percentage of the Company’s totalrevenue will increase modestly in future periods and, therefore, the overallgross margin percentage will increase modestly in future periods.

 

**Sales and Marketing**

 

Sales and marketing expenses were $6,865,000, or 45%of total revenue, $5,651,000, or 53% of total revenue, and $3,886,000, or 59%of total revenue, for 2001, 2000 and 1999, respectively.  The increase in expenses from 2000 to 2001was primarily due to increased compensation costs as a result of additionalpersonnel and increased sales commissions as a result of increasedrevenue.  The increase in expenses from1999 to 2000 was primarily due to additional personnel, increased compensationcosts as a result of increased sales commissions and increased travel expensesrelated to selling and promoting the *Vitrea 2* product.  There were also advertising and promotionalcosts during 2000 that increased the marketing expenses over 1999.  Depreciation expense also increased in 2001as compared with 2000 and in 2000 as compared with 1999, primarily due toequipment purchases used for the additional personnel, upgrades of computerequipment and equipment for tradeshows and, in 2000, the addition of furnitureand fixtures at the Company’s new leased facilities. During these periods,sales and marketing expenses as a percentage of revenue declined primarily dueto the Company’s ability to generate revenue growth without proportionatelyincreasing sales and marketing costs. The Company expects sales and marketing costs to increase in futureperiods primarily as a result of the cost of additional sales and customersupport personnel, but decline as a percentage of total revenue.

 

**Researchand Development**

 

Research and development expenses were up 13% to$3,419,000 or 22% of total revenue in 2001 from $3,036,000, or 29% of totalrevenue, in 2000.  The increase wasprimarily due to increased compensation costs resulting from additionalpersonnel supporting the development of *Vitrea2*, the amortization of licensed technology and increases in expensesto support clinical collaboration sites. Research and development expenses were $2,525,000, or 38% of totalrevenue, in 1999.  The increase from1999 to 2000 was primarily due to increased compensation costs as a result ofadditional personnel.  There were alsoconsecutive increases in annual depreciation expense between 1999 and 2001,primarily as the result of equipment purchases to support the additionalpersonnel and to upgrade computer equipment. The decreases in research and development expenses as a percentage ofrevenue during these periods reflect the Company’s ability to generateincreasing revenue resulting from its product development efforts.  The Company anticipates that

 

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research and development costs will increase in futureperiods as the Company develops software tools for applications with largepotential markets, such as cardiovascular disease, disease screeningapplications such as colon cancer, and surgical and therapy planning, butdecline as a percentage of total revenue.

 

**General and Administrative**

 

General and administrative expenses were $2,658,000,or 17% of total revenue, $2,210,000, or 21% of total revenue and $1,971,000, or30% of total revenue, in 2001, 2000 and 1999, respectively. The increase from2000 to 2001 was primarily due to compensation costs increasing due toadditional personnel and increases in professional fees incurred inestablishing partnering agreements.  Theincrease from 1999 to 2000 was primarily due to increases in compensationcosts, legal fees for patent work and additional SEC filings, and shareholdercommunication costs and, in 2000, higher depreciation expense due to the additionof furniture and equipment at the Company’s new leased facilities.  The decreases in general and administrativeexpenses as a percentage of revenue during these periods reflect the Company’sability to limit operating costs while increasing revenue. The Company believesthat general and administrative expenses will increase in future periods due toincreased infrastructure costs as the business grows, but that they willcontinue to decrease as a percentage of total revenue.

 

**Results of Operations**

 

The increasing revenue from *Vitrea 2* and add-on softwareoptions and related service revenues, net of the increased expensesattributable to the development of the Company’s infrastructure and thedevelopment and promotion of the *Vitrea 2*product, resulted in an operatingloss of $1,055,000 for 2001 compared with an operating loss of $2,787,000 for2000 and an operating loss of $3,303,000 for 1999.

 

**Interest Income**

 

There was $55,000 of interest income for 2001,compared with $162,000 in 2000 and $91,000 in 1999. The decrease in interestincome from 2000 to 2001 was primarily due to a lower balance of cash and cashequivalents throughout the year as a result of the use of cash to fund theCompany’s operations.  The increase ininterest income from 1999 to 2000 was primarily due to an increase in cash fromthe Company’s private placement of securities in December 1999.

 

**Income Taxes**

 

The income tax provisions for 2001, 2000 and 1999consist solely of certain state minimum fees. As a result of the Company’s history of generating net operating losses,the Company has established a valuation allowance to completely reserve for thedeferred tax assets of the Company.

 

**Liquidityand Capital Resources**

 

As of December 31, 2001, the Company had $6,831,000 incash and cash equivalents, working capital of $6,094,000 and noborrowings.  The Company’s line ofcredit agreement with a bank expired on September 30, 2001.  The Company is in the process of reviewingvarious options for working capital borrowings.

 

Cash provided by operations was $771,000 for 2001compared with cash used in operations of $1,961,000 for 2000 and $3,064,000 for1999. The primary provider of cash from operations for 2001 was an increase indeferred revenue and accrued payroll and other liabilities and non-cashexpenses for depreciation and amortization, which was partially offset by cashflow usages to fund operating losses. Cash flow usages for the years 2000 and1999 were primarily to fund operating losses, which were partially offset bynon-cash expenses for depreciation and amortization.  Increases in accounts receivable reduced cash flows in each ofthe years 2001, 2000 and 1999. Increases in deferred revenue and accrued payroll and other liabilitiesresulted in increased cash flows in 2001, 2000 and 1999.

 

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The increases in deferred revenue in 2001 wereprimarily due to volume increases in *Vitrea2*sales and renewals of annual maintenance.  The increases in accounts receivable weredue primarily to volume increases in *Vitrea 2* sales.  The increases in accrued payroll and other liabilities in 2001were primarily due to increases in incentive bonuses and sales commissions fromincreased revenue.  The increases inaccrued payroll and other liabilities in 2000 and 1999 were primarily due toincreases in accrued vacation due to increases in headcount and in salescommissions as a result of increased revenue.

 

Net investing activities used $1,519,000 of cash in2001, of which $769,000 was used for purchases of property and equipment,primarily for new computer equipment. In July 2001, the Company entered into an agreement to licensetechnology from a third party and paid $500,000 to the licensor and wasobligated to pay an additional $250,000 plus interest at 8%.  The $250,000 plus interest was paid in fullin December 2001.  Net investingactivities used $1,384,000 of cash in 2000 due to additions of property andequipment primarily from the move to new office facilities in 2000 andequipment for additional headcount.  Netinvesting activities provided $1,474,000 of cash in 1999 primarily due to theconversion of marketable securities into cash. The Company added property andequipment of $512,000 in 1999 primarily for computer equipment to accommodatethe increases in employee headcount.

 

Cash provided by financing activities totaled$5,288,000, $303,000 and $5,171,000 in 2001, 2000 and 1999, respectively.  In December 2001, the Company called theoutstanding warrants issued as part of the private placement in December 1999and all of the warrant holders elected to exercise the warrants rather thanallowing the Company to redeem them. Purchases of common stock resulting from the exercise of these stockwarrants generated $4,491,000 in 2001. During October 2001, the Company sold 82,332 shares of newly issuedcommon stock of Vital Images, Inc. to E-Z-EM, Inc. for approximately$552,000.  A private placement of theCompany’s common stock and warrants completed by the Company in December 1999was primarily responsible for the cash provided by financing activities in1999. During 2001, 2000 and 1999, net cash of $245,000, $303,000 and $426,000,respectively, was provided by proceeds from the exercise of stock options.

 

The Company has never paid or declared any cashdividends and does not intend to pay dividends in the near future.

 

The following summarizes our contractual obligations,including purchase commitments at December 31, 2001, and the effect suchobligations are expected to have on our liquidity and cash flow in futureperiods.

 
|             |   | **2002** |    | **2003** |   | **2004** |   | **2005** |    | **2006** |   |
|------------------|--------|----------|---------|----------|--------|----------|--------|----------|---------|----------|--------|
| Operating leases |   | $        | 330,000 |     | $      | 347,000  |   | $        | 349,000 |     | $      | 203,000 |   | $ | — |   |
|                  |        |          |         |          |        |          |        |          |         |          |        |  |  |  |  |  |

 

Management believes that its cash and cash equivalentsshould be sufficient to satisfy its cash requirements for at least the nexttwelve months.

 

**Foreign Currency Transactions**

 

Substantially all of the Company’s foreigntransactions are negotiated, invoiced and paid in U.S. dollars.

 

**Inflation**

 

Management believes inflation has not had a materialeffect on the Company’s operations or on its financial condition.

 

**Recent Accounting Pronouncements**

 

In June 2001, the Financial Accounting Standards Boardapproved Statements of Financial Accounting Standards (“SFAS”) No. 141,“Business Combinations” and No. 142, “Goodwill and Other Intangible Assets.”

 

30

----

 

The statements eliminate the pooling-of-interestsmethod of accounting for business combinations and require that goodwill andcertain intangible assets not be amortized. Instead, these assets will be reviewed for impairment at least annuallywith any related losses recognized when incurred.  SFAS No. 141 is generally effective for business combinationscompleted after June 30, 2001.  SFAS No.142 is effective January 1, 2002 for existing goodwill and intangible assetsand July 1, 2001 for business combinations completed after June 30, 2001.  TheCompany is currently evaluating the impact of these standards on its financialposition and results of operations.

 

In October 2001, the FinancialAccounting Standards Board issued SFAS No. 144, “Accounting for the Impairmentor Disposal of Long-Lived Assets.”  Thisstatement addresses financial accounting and reporting for the impairment oflong-lived assets and for long-lived assets to be disposed of and supersedesSFAS No. 121 and APB Opinion No. 30. SFAS No. 144 is effective for the Company beginning January 1,2002.  The Company is currentlyevaluating the impact of this standard on its financial position and results ofoperations.

 

**Market Risk**

 

The Company is exposed to market risk related tochanges in the fair value of its financial instruments due to changes ininterest rates.  The Company does nothave any foreign subsidiaries and substantially all of the Company’stransactions are denominated in U.S. dollars.

 

**Forward-Looking Statements**

 

This Annual Report on Form 10-K contains certainforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995 and information that is based on management’sbeliefs as well as on assumptions made by, and upon information currentlyavailable to, management.  When used inthis Annual Report on Form 10-K, the words “expect,” “anticipate,” “intend,”“plan,” “believe,” “seek,” and “estimate,” or similar expressions are intendedto identify such forward-looking statements. However, this Annual Report on Form 10-K also contains otherforward-looking statements. Forward-looking statements are not guarantees of future performance andare subject to certain risks, uncertainties and assumptions, including, but notlimited to, the following factors, which could cause the Company’s futureresults and shareholder values to differ materially from those expressed in anyforward-looking statements made by or on behalf of the Company: the dependenceon market growth of the industry in which the Company operates; the extent towhich the Company’s products gain market acceptance; the need for andavailability of additional capital; the potential for litigation regardingpatent and other intellectual property rights; the introduction of competitiveproducts by others; dependence on major customers; fluctuations in quarterlyresults; the progress of product development; the availability of third partyreimbursement; and the receipt and timing of regulatory approvals and otherfactors detailed from time to time in the Company’s filings with the Securitiesand Exchange Commission, including those set forth under the heading “ImportantFactors” included in Item 1A of this Annual Report on Form 10-K.

 

Item 8.    FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

The Company’s financialstatements, supplemental schedule and Report of Independent Accountantsthereon, all of which are included in this Annual Report on Form 10-K, arelisted in Item 14 (a) (1) of this Form 10-K.

 
| Item 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND |
|---------|------------------------------------------------------------------|
|    | FINANCIAL DISCLOSURE                                             |

 

None.

 

31

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PART III

 

Item 10.        DIRECTORSAND EXECUTIVE OFFICERS OF REGISTRANT

 

(a) Directors of the Registrant.

 

The information under thecaption “Election of Directors” in the Company’s 2002 Proxy Statement isincorporated herein by reference.

 

(b)    Executive Officers of the Registrant.

 

Information concerningExecutive Officers of the Company is included in this Report under Item 1,“Executive Officers of the Registrant.”

 

(c) Compliance with 16(a) of the SecuritiesExchange Act of 1934.

 

The information under thecaption “Compliance with Section 16 (a)” in the Company’s 2002 Proxy Statementis incorporated herein by reference.

 

Item 11.        EXECUTIVECOMPENSATION

 

The information under thecaption “Executive Compensation” and “Director Compensation” in the Company’s2002 Proxy Statement is incorporated herein by reference.

 

Item 12.        SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The information under thecaption “Beneficial Ownership of Common Stock” in the Company’s 2002 ProxyStatement is incorporated herein by reference.

 

Item 13.        CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

 

There are no reportabletransactions.

 

32

----

 

PART IV

 

Item 14.        EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

 

(a) (1)  The following financial statements andsupplemental schedule of Vital Images, Inc. and Report of IndependentAccountants thereon are included herein:

 
| Report of  Independent Accountants                                                            |
|-----------------------------------------------------------------------------------------------|
| Balance Sheets as of December 31, 2001  and 2000                                              |
| Statements of Operations for  the years ended December 31, 2001, 2000 and 1999                |
| Statements of  Shareholders’ Equity for the years ended December 31, 2001, 2000 and 1999 |
| Statements  of Cash Flows for the years ended December 31, 2001, 2000 and 1999                |
| Notes  to Financial Statements                                                                |
|                                                                                          |
| Schedule II. Valuation and Qualifying  Accounts                                               |

 

(a) (2) Included in Item14 (a) (1) above

 

All other schedules tothe financial statements required by Article 12 of Regulation S-X are notrequired under the related instructions or are inapplicable and therefore havebeen omitted.

 

(a) (3)  LISTING OF EXHIBITS

 

The Exhibits required tobe a part of this Report are listed in the Index to Exhibits, which follows theFinancial Statement Schedule on page 53.

 

(b)  REPORTS ON FORM 8-K

 

The Company had noCurrent Reports on Form 8-K during the year ended December 31, 2001 or duringthe period from December 31, 2001 to the date of this Annual Report on Form10-K.

 

(c)  EXHIBITS

 

Included in Item 14 (a)(3) above.

 

33

----

 

SIGNATURES

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this Report to be signed on its behalf by theundersigned, thereunto duly authorized, in Minneapolis, Minnesota, on the 29thday of March 2002.

 
|   |   | VITAL IMAGES, INC.          |
|--------|--------|-----------------------------|
|   |   |                        |
|   | By:    | /s/ Gregory S. Furness      |   |
|   |   | Gregory S. Furness          |
|   |   | Chief Financial Officer and |
|   |   | Vice  President-Finance     |
|   |   | (Chief  Accounting Officer) |

 

Pursuant to the requirement of the Securities Exchange Act of 1934,this Report has been signed by the following persons in the capacities and onthe dates indicated.

 
| **Signature**            |                               | **Title**                          |           | **Date** |   |
|--------------------------|------------------------------------|------------------------------------|----------------|----------|--------|
| /s/ Jay D. Miller        |                               | President, Chief Executive Officer | March 29, 2002 |
| Jay D. Miller            | and Director                       |                               |
|                     | (Principal  Executive Officer)     |                               |
|                     |                               |                               |
| /s/ Gregory S. Furness   |                               | Chief Financial Officer,           | March 29, 2002 |
| Gregory S. Furness       | Vice  President-Finance, Treasurer |                               |
|                     | and Secretary                      |                               |
|                     | (Chief  Accounting Officer)        |                               |
|                     |                               |                               |
| /s/ Douglas M.  Pihl     |                               | Chairman of the Board and Director | March 29, 2002 |
| Douglas M. Pihl          |                               |                               |
|                     |                               |                               |
| /s/ Vincent J. Argiro    |                               | Chief Technology Officer, Founder  | March 29, 2002 |
| Vincent J. Argiro        | and Director                       |                               |
|                     |                               |                               |
| /s/ James B. Hickey, Jr. |                               | Director                           | March 29, 2002 |
| James B. Hickey, Jr.     |                               |                               |
|                     |                               |                               |
| /s/ Richard W. Perkins   |                               | Director                           | March 29, 2002 |
| Richard W. Perkins       |                               |                               |
|                     |                               |                               |
| /s/ Michael W. Vannier   |                               | Director                           | March 29, 2002 |
| Michael W. Vannier       |                               |                               |
|                     |                               |                               |
| /s/ Sven A. Wehrwein     |                               | Director                           | March 29, 2002 |
| Sven A. Wehrwein         |                               |                               |
|                          |                                    |                                    |                |          |        |  |

 

34

----

 

**REPORTOF INDEPENDENT ACCOUNTANTS**

 

To the Board ofDirectors and Shareholders of

Vital Images,Inc.:

 

In our opinion,the financial statements listed in the index appearing under Item 14(a)(1)present fairly, in all material respects, the financial position of VitalImages, Inc. (the Company) at December 31, 2001 and 2000, and the results ofits operations and its cash flows for each of the three years in the periodended December 31, 2001 in conformity with accounting principles generallyaccepted in the United States of America. In addition, in our opinion, the financial statement schedule listed inthe index appearing under Item 14(a)(1) presents fairly, in all materialrespects, the information set forth therein when read in conjunction with therelated financial statements.  Thesefinancial statements and financial statement schedule are the responsibility ofthe Company’s management; our responsibility is to express an opinion on thesefinancial statements and financial statement schedule based on our audits. Weconducted our audits of these statements in accordance with auditing standardsgenerally accepted in the United States of America, which require that we planand perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

PricewaterhouseCoopersLLP

Minneapolis,Minnesota

February 6, 2002

 

35

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**VITAL IMAGES, INC.**

**BALANCESHEETS**

** **
|                                                                                                                                                               |   | **As of  December 31,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                                                                                                               |   | **2001**                | ** ** | **2000** | ** ** |
| **ASSETS**                                                                                                                                                         |   |                    |       |   |   |
| Current assets:                                                                                                                                                    |   |                    |       |   |   |
| Cash and cash  equivalents                                                                                                                                         |   | $                       | 6,830,906  |   | $ | 2,291,107 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $185,000 and $215,000  as of December 31, 2001 and 2000, respectively                              |   | 3,637,954               |       | 3,024,299 |   |
| Prepaid expenses  and other current assets                                                                                                                         |   | 557,833                 |       | 441,500 |   |
| Total current  assets                                                                                                                                              |   | 11,026,693              |       | 5,756,906 |   |
| Property and  equipment, net                                                                                                                                       |   | 1,552,116               |       | 1,529,688 |   |
| Licensed  technology, net                                                                                                                                          |   | 690,000                 |       | — |   |
|                                                                                                                                                               |   |                    |       |   |   |
| TOTAL ASSETS                                                                                                                                                       |   | $                       | 13,268,809 |   | $ | 7,286,594 |   |
|                                                                                                                                                               |   |                    |       |   |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                     |   |                    |       |   |   |
| Current  liabilities:                                                                                                                                              |   |                    |       |   |   |
| Accounts payable                                                                                                                                                   |   | $                       | 864,385    |   | $ | 1,019,898 |   |
| Accrued payroll                                                                                                                                                    |   | 1,326,214               |       | 799,975 |   |
| Deferred revenue                                                                                                                                                   |   | 2,199,465               |       | 1,238,344 |   |
| Accrued  royalties                                                                                                                                                 |   | 362,637                 |       | 80,557 |   |
| Other current  liabilities                                                                                                                                         |   | 179,610                 |       | 273,793 |   |
| Total current  liabilities                                                                                                                                         |   | 4,932,311               |       | 3,412,567 |   |
| Deferred revenue                                                                                                                                                   |   | 285,709                 |       | 109,353 |   |
| Total  liabilities                                                                                                                                                 |   | 5,218,020               |       | 3,521,920 |   |
|                                                                                                                                                               |   |                    |       |   |   |
| Commitments  (Note 6)                                                                                                                                              |   |                    |       |   |   |
|                                                                                                                                                               |   |                    |       |   |   |
| Shareholders’  equity:                                                                                                                                        |   |                    |       |   |   |
| Preferred stock:  $0.01 par value; 5,000,000 shares authorized; none issued or outstanding as  of December 31, 2001 and 2000                                       |   | —                  |       | — |   |
| Common stock:  $0.01 par value; 20,000,000 shares authorized; 8,186,092 and 6,823,106 shares  issued and outstanding as of December 31, 2001 and 2000,respectively |   | 81,861                  |       | 68,231 |   |
| Additional  paid-in capital                                                                                                                                        |   | 28,846,906              |       | 23,562,444 |   |
| Accumulated  deficit                                                                                                                                               |   | (20,877,978             | )          | (19,866,001 | ) |
| Total  shareholders’ equity                                                                                                                                   |   | 8,050,789               |       | 3,764,674 |   |
|                                                                                                                                                               |   |                    |       |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                   |   | $                       | 13,268,809 |   | $ | 7,286,594 |   |

 

(The accompanyingnotes are an integral part of the financial statements.)

 

36

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**VITAL IMAGES, INC.**

**STATEMENTSOF OPERATIONS**

** **
|                                                           |   | **For the  Years Ended December 31,** |       |
|----------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                           |   | **2001**                              |       | **2000** |   | **1999** |   |
| Revenue:                                                       |   |                                  |       |   |   |   |   |
| License fees                                                   |   | $                                     | 10,082,897 |   | $ | 7,037,227 |   | $ | 4,181,750 |   |
| Maintenance and  services                                      |   | 2,450,037                             |       | 1,411,583 |   | 831,196 |   |
| Hardware                                                       |   | 2,662,702                             |       | 2,179,381 |   | 1,610,414 |   |
| Total revenue                                                  |   | 15,195,636                            |       | 10,628,191 |   | 6,623,360 |   |
|                                                           |   |                                  |       |   |   |   |   |
| Cost of revenue:                                               |   |                                  |       |   |   |   |   |
| License fees                                                   |   | 643,593                               |       | 238,775 |   | 139,025 |   |
| Maintenance and  services                                      |   | 552,861                               |       | 385,950 |   | 197,705 |   |
| Hardware                                                       |   | 2,112,982                             |       | 1,893,075 |   | 1,206,846 |   |
| Total cost of  revenue                                         |   | 3,309,436                             |       | 2,517,800 |   | 1,543,576 |   |
|                                                           |   |                                  |       |   |   |   |   |
| Gross margin                                                   |   | 11,886,200                            |       | 8,110,391 |   | 5,079,784 |   |
|                                                           |   |                                  |       |   |   |   |   |
| Operating  expenses:                                           |   |                                  |       |   |   |   |   |
| Sales and  marketing                                           |   | 6,864,762                             |       | 5,651,333 |   | 3,886,295 |   |
| Research and  development                                      |   | 3,418,506                             |       | 3,036,016 |   | 2,524,670 |   |
| General and  administrative                                    |   | 2,657,998                             |       | 2,209,999 |   | 1,971,435 |   |
| Total operating  expenses                                      |   | 12,941,266                            |       | 10,897,348 |   | 8,382,400 |   |
|                                                           |   |                                  |       |   |   |   |   |
| Operating loss                                                 |   | (1,055,066                            | )          | (2,786,957 | ) | (3,302,616 | ) |
|                                                           |   |                                  |       |   |   |   |   |
| Interest income,  net                                          |   | 55,089                                |       | 161,726 |   | 90,991 |   |
| Loss before  income taxes                                      |   | (999,977                              | )          | (2,625,231 | ) | (3,211,625 | ) |
|                                                           |   |                                  |       |   |   |   |   |
| Income taxes                                                   |   | 12,000                                |       | 12,000 |   | 6,000 |   |
|                                                           |   |                                  |       |   |   |   |   |
| Net loss                                                       |   | $                                     | (1,011,977 | ) | $ | (2,637,231 | ) | $ | (3,217,625 | ) |
|                                                           |   |                                  |       |   |   |   |   |
| Net loss per  share - basic and diluted                        |   | $                                     | (0.14      | ) | $ | (0.39 | ) | $ | (0.64 | ) |
|                                                           |   |                                  |       |   |   |   |   |
| Weighted average  common shares outstanding -basic and diluted |   | 7,074,906                             |       | 6,760,233 |   | 5,045,530 |   |

 

(The accompanyingnotes are an integral part of the financial statements.)

 

37

----

 

**VITAL IMAGES,INC.**

**STATEMENTS OF SHAREHOLDERS’ EQUITY**

 
|                                                                                  |   |             |   |       |   | **Additional  Paid- In  Capital** |   | **Accumulated  Deficit** |   | **Total  Shareholder's****Equity** |         |
|---------------------------------------------------------------------------------------|--------|------------------|--------|------------|--------|-----------------------------------|--------|--------------------------|--------|------------------------------------|--------------|
|                                                                                  |   | **Common Stock** |
|                                                                                  |   | **Shares**       |   | **Amount** |
| Balances as of December 31, 1998                                                      |   | 4,870,497        |   | $          | 48,705 |                              | $      | 18,096,707               |   | $                                  | (14,011,145) |   | $ | 4,134,267 |   |
|                                                                                  |   |             |   |       |   |                              |   |                     |   |                               |         |
| Cancellation of restricted stock                                                      |   | (1,881           | )      | (19        | )      | 19                                |   |                     |   |                               |         |
| Stock-based compensation                                                              |   |             |   |       |   | 10,781                            |   |                     |   | 10,781                             |         |
| Issuance of common stock upon exercise of stock options                               |   | 153,484          |   | 1,535      |   | 358,306                           |   |                     |   | 359,841                            |         |
| Issuance of common stock under Employee Stock Purchase Plan                           |   | 23,767           |   | 238        |   | 66,407                            |   |                     |   | 66,645                             |         |
| Issuance of common stock in connection with private placement, net of  offering costs |   | 1,650,000        |   | 16,500     |   | 4,728,007                         |   |                     |   | 4,744,507                          |         |
| Net and comprehensive loss                                                            |   |             |   |       |   |                              |   | (3,217,625               | )      | (3,217,625                         | )            |
| Balances as of December 31, 1999                                                      |   | 6,695,867        |   | 66,959     |   | 23,260,227                        |   | (17,228,770              | )      | 6,098,416                          |         |
|                                                                                  |   |             |   |       |   |                              |   |                     |   |                               |         |
| Issuance of common stock upon exercise of stock options                               |   | 105,650          |   | 1,056      |   | 216,468                           |   |                     |   | 217,524                            |         |
| Issuance of common stock under Employee Stock Purchase Plan                           |   | 21,589           |   | 216        |   | 85,749                            |   |                     |   | 85,965                             |         |
| Net and comprehensive loss                                                            |   |             |   |       |   |                              |   | (2,637,231               | )      | (2,637,231                         | )            |
| Balances as of December 31, 2000                                                      |   | 6,823,106        |   | 68,231     |   | 23,562,444                        |   | (19,866,001              | )      | 3,764,674                          |         |
|                                                                                  |   |             |   |       |   |                              |   |                     |   |                               |         |
| Stock-based compensation                                                              |   |             |   |       |   | 10,447                            |   |                     |   | 10,447                             |         |
| Issuance of common stock upon exercise of stock options                               |   | 49,520           |   | 495        |   | 153,073                           |   |                     |   | 153,568                            |         |
| Issuance of common stock under Employee Stock Purchase Plan                           |   | 25,487           |   | 255        |   | 91,397                            |   |                     |   | 91,652                             |         |
| Issuance of common stock upon exercise of stock warrants                              |   | 1,205,647        |   | 12,057     |   | 4,478,744                         |   |                     |   | 4,490,801                          |         |
| Issuance of common stock (Note 12)                                                    |   | 82,332           |   | 823        |   | 550,801                           |   |                     |   | 551,624                            |         |
| Net and comprehensive loss                                                            |   |             |   |       |   |                              |   | (1,011,977               | )      | (1,011,977                         | )            |
| Balances as of December 31, 2001                                                      |   | 8,186,092        |   | $          | 81,861 |                              | $      | 28,846,906               |   | $                                  | (20,877,978  | ) | $ | 8,050,789 |   |

 

(The accompanyingnotes are an integral part of the financial statements.)

 

38

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**VITAL IMAGES, INC.**

**STATEMENTSOF CASH FLOWS**

** **
|                                                                                       |   | **For the  Years Ended December 31,** |       |
|--------------------------------------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                                                       |   | **2001**                              |       | **2000** |   | **1999** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                     |   |                                  |       |   |   |   |   |
| Net loss                                                                                   |   | $                                     | (1,011,977 | ) | $ | (2,637,231 | ) | $ | (3,217,625 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |   |                                  |       |   |   |   |   |
| Depreciation and  amortization                                                             |   | 746,727                               |       | 718,978 |   | 563,420 |   |
| Stock-based  compensation                                                                  |   | 10,447                                |       | — |   | 10,781 |   |
| Provision for  uncollectible accounts receivable                                           |   | 114,000                               |       | 122,000 |   | 15,000 |   |
| Amortization of  licensed technology                                                       |   | 60,000                                |       | — |   | — |   |
| Changes in  operating assets and liabilities:                                              |   |                                  |       |   |   |   |   |
| Accounts  receivable                                                                       |   | (727,655                              | )          | (1,141,185 | ) | (871,005 | ) |
| Prepaid expenses  and other current assets                                                 |   | (116,333                              | )          | 21,809 |   | (328,192 | ) |
| Accounts payable                                                                           |   | (155,513                              | )          | 188,157 |   | 326,481 |   |
| Deferred revenue                                                                           |   | 1,137,477                             |       | 414,227 |   | 411,004 |   |
| Accrued expenses  and other current liabilities                                            |   | 714,136                               |       | 352,165 |   | 26,518 |   |
| Net cash  provided by (used in) operating activities                                       |   | 771,309                               |       | (1,961,080 | ) | (3,063,618 | ) |
|                                                                                       |   |                                  |       |   |   |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                     |   |                                  |       |   |   |   |   |
| Additions to  property and equipment                                                       |   | (769,155                              | )          | (1,384,187 | ) | (511,661 | ) |
| Payment for  licensed technology                                                           |   | (750,000                              | )          | — |   | — |   |
| Investments in  marketable securities                                                      |   | —                                |       | — |   | (1,014,444 | ) |
| Maturities of  marketable securities                                                       |   | —                                |       | — |   | 3,000,000 |   |
| Net cash (used  in) provided by investing activities                                       |   | (1,519,155                            | )          | (1,384,187 | ) | 1,473,895 |   |
|                                                                                       |   |                                  |       |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                     |   |                                  |       |   |   |   |   |
| Proceeds from  sale of common stock                                                        |   | 551,624                               |       | — |   | 4,744,507 |   |
| Proceeds from  sale of common stock under stock plans                                      |   | 245,220                               |       | 303,489 |   | 426,486 |   |
| Proceeds from  sale of common stock under stock warrants                                   |   | 4,490,801                             |       | — |   | — |   |
| Net cash  provided by financing activities                                                 |   | 5,287,645                             |       | 303,489 |   | 5,170,993 |   |
|                                                                                       |   |                                  |       |   |   |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                      |   | 4,539,799                             |       | (3,041,778 | ) | 3,581,270 |   |
|                                                                                       |   |                                  |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OFYEAR                                               |   | 2,291,107                             |       | 5,332,885 |   | 1,751,615 |   |
|                                                                                       |   |                                  |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, END OF YEAR                                                    |   | $                                     | 6,830,906  |   | $ | 2,291,107 |   | $ | 5,332,885 |   |
|                                                                                       |   |                                  |       |   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                       |   |                                  |       |   |   |   |   |
| Cash paid during  the year for interest                                                    |   | $                                     | 17,730     |   | $ | 5,204 |   | $ | 12,526 |   |

 

(The accompanyingnotes are an integral part of the financial statements.)

 

39

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**VITAL IMAGES, INC.**

**NOTESTO FINANCIAL STATEMENTS**

** **

**(1) Business Description andBackground**

 

*Business Description*

 

Vital Imagesdevelops, markets and supports 3D medical imaging software for use primarily indisease screening, clinical diagnosis and therapy planning.  The Company’s software applies proprietarycomputer graphics and image processing technologies to a wide variety of datasupplied by computed tomography (“CT”) scanners and magnetic resonance (“MR”)imaging devices.  Vital Images’ productsallow clinicians to create both two- and three-dimensional views of humananatomy and to non-invasively navigate within these images to better visualizeand understand internal structures and pathologies.  The Company believes that its high-speed visualization technologyand customized protocols cost-effectively bring 3D visualization and analysisinto the routine, day-to-day practice of medicine.  The Company, which operates in a single business segment, marketsits products to healthcare providers and to manufacturers of diagnostic imagingsystems through a direct sales force in the United States and independentdistributors in international markets.

 

*Background*

 

On October 28, 1996, theBoard of Directors of Bio-Vascular, Inc. (“Bio-Vascular”), the former parentcompany of Vital Images, approved a plan to spin off and establish Vital Imagesas an independent, publicly owned company. On May 12, 1997 (the “Distribution Date”), Bio-Vascular distributed allof the shares of Vital Images to the shareholders of Bio-Vascular (the“Distribution”), and on that date Vital Images began operating as anindependent public company.  AllBio-Vascular shareholders of record as of May 5, 1997 received one share ofVital Images common stock for each two shares of Bio-Vascular stock held onthat date, and cash in lieu of fractional shares.

 

**(2) Summary of Significant Accounting Policies**

 

*Use of Estimates*

 

The preparation of the Company’s financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities as of the date of the financial statements and the reported amountsof revenues and expenses during the reporting periods.  Actual results could differ from thoseestimates.

 

*Financial Instruments*

 

The Company considers all highly liquid investments acquired with anoriginal maturity of three months or less to be cash equivalents.  Investments having original maturities inexcess of three months are classified as marketable securities.  Investments are classified as short-term orlong-term on the balance sheet based on their maturity date.  All of the Company’s marketable securitiesare classified as available-for-sale and all mature in one year or less.  Available-for-sale investments are recordedat market value, which is based on quoted market prices, with unrealizedholding gains and losses included as a separate component of shareholders’equity.  The Company uses a specificidentification cost method to determine the gross realized gains and losses onthe sale of its securities.

 

40

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*Concentration of Credit Risk*

 

Cash is held primarily by one financial institution.  Cash equivalents and marketable securitiesare invested in money market accounts. Carrying values approximate market values for all money market funds,accounts receivable and accounts payable because of their short maturities andliquidity.  Realized gains and losses onmarketable securities were not significant for the years ended December 31,2001 and 2000.  The Company’s customerbase is generally concentrated with a small base of customers.  The Company reviews the creditworthiness ofits customers prior to product shipment and generally does not requirecollateral.

 

*Property and Equipment*

 

Property and equipment are stated at cost.  Depreciation is computed using thestraight-line method over the related asset’s estimated useful life, generallythree to seven years.  Leaseholdimprovements are amortized over the shorter of their estimated useful lives orthe remaining terms of the related leases. The asset cost and related accumulated depreciation or amortization areadjusted for asset retirement or disposal with the resulting gain or loss, ifany, credited or charged to results of operations.

 

*Impairment of Long-Lived Assets*

 

The Company periodically reviews the carrying amountsof property and equipment and intangible assets purchased in the normal courseof business, to determine whether current events or circumstances, as definedin Statement of Financial Accounting Standard No 121, “Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,”warrant adjustments to such carrying amounts. In reviewing the carrying values of property and equipment andintangible assets, the Company considers, among other things, the future cashflows expected from the use of the asset.

 

*Revenue Recognition*

 

The Company recognizes revenue in accordance withAICPA Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” asamended by SOP 98-4 and SOP 98-9. License fees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale ofsystem hardware including peripheral equipment.  Maintenance and service revenue is derived from hardware andsoftware maintenance and from services consisting of installation, training andengineering services.

 

In software arrangements that include the rights tomultiple software products, system hardware, specified upgrades, maintenance orservices, the Company allocates the total arrangement fee among eachdeliverable based on the relative fair value of each of the deliverablesdetermined based on vendor-specific objective evidence. In softwarearrangements in which the Company does not have vendor-specific objectiveevidence, revenue is deferred until the earlier of when vendor-specificobjective evidence is determined for the undelivered elements (residual method)or when all elements have been delivered.

 

Revenue from license fees is recognized whenpersuasive evidence of an agreement exists, shipment of the product hasoccurred, no significant Company obligations with regard to implementationremain, the fee is fixed and determinable and collection is probable.  Revenue allocable to maintenance isrecognized on a straight-line basis over the periods in which it isprovided.  The Company evaluatesarrangements that include services to determine whether those services are essentialto the functionality of other elements of the arrangement.  Generally, the Company’s services are notconsidered essential to the functionality of other elements, and accordingly,revenue allocable to services is recognized as the services are performed.  In arrangements where the Company isperforming significant customization or modification of software (i.e.development agreements — Note 12), revenue from the arrangements are recognizedusing contract accounting,

 

41

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generally on a percentage-of-completion basis.  Hardware revenue is recognized upon shipmentwhen all other revenue recognition criteria in the arrangement have been met.

 

*Research and Development Costs*

 

Costs related to research, design and development ofproducts are charged to research and development expense as incurred.  Software development costs are capitalizedbeginning when a product’s technological feasibility has been established andending when a product is available for general release to customers.  The Company uses the working model approachto determine technological feasibility. Generally, the Company’s products are released soon after technologicalfeasibility has been established.  As aresult, the Company has not capitalized any software development costs, sincesuch costs have not been significant.

 

*Income Taxes*

 

The Company accounts for income taxes using the assetand liability method.  Deferred incometax assets and liabilities are determined based on differences betweenfinancial reporting and tax bases of assets and liabilities and are measuredusing the enacted tax rates and laws that will be in effect when thedifferences are expected to reverse. Valuation allowances are established when necessary to reduce deferredtax assets to the amounts expected to be realized.

 

*Net Loss Per Share*

 

Net loss per share is computed using the weightedaverage common shares outstanding during the period.  Common share equivalents are not included in the net loss pershare calculations since they are anti-dilutive.  Warrants and options to purchase 2,891,604 shares, 3,889,675shares and 3,624,561 shares of the Company’s common stock were outstanding asof December 31, 2001, 2000 and 1999, respectively, and could potentially dilutebasic earnings per share in future periods, if the Company generates netincome.

 

*Stock-Based Compensation*

 

The Company has chosen to continue to account forstock options granted to employees and directors using the intrinsic valuemethod prescribed by APB Opinion No. 25, *Accounting for Stock Issued to Employees,*and related interpretations. Accordingly, compensation cost for stock options granted is measured asthe excess, if any, of the value of the Company’s stock as of the date of thegrant over option exercise price.  Suchcompensation cost is amortized on a straight-line basis over the underlyingvesting term of the option.

 

*Recent Accounting Pronouncements*

 

In June 2001, the Financial Accounting Standards Boardapproved Statements of Financial Accounting Standards (“SFAS”) No. 141,“Business Combinations” and No. 142, “Goodwill and Other IntangibleAssets.”  The statements eliminate thepooling-of-interests method of accounting for business combinations and requirethat goodwill and certain intangible assets not be amortized.  Instead, these assets will be reviewed forimpairment at least annually with any related losses recognized whenincurred.  SFAS No. 141 is generallyeffective for business combinations completed after June 30, 2001.  SFAS No. 142 is effective January 1, 2002for existing goodwill and intangible assets and July 1, 2001 for businesscombinations completed after June 30, 2001. The Company is currentlyevaluating the impact of these standards on its financial position and resultsof operations.

 

In October 2001, the Financial Accounting Standards Board issued SFAS No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement addresses financialaccounting and reporting

 

42

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for the impairment of long-lived assets and for long-lived assets to bedisposed of and supersedes SFAS No. 121 and APB Opinion No. 30.  SFAS No. 144 is effective for the Companybeginning January 1, 2002.  The Companyis currently evaluating the impact of this standard on its financial positionand results of operations.

 

**(3) Supplemental Financial StatementInformation**

 

*Cash and Cash Equivalents*

* *
| ** **                  | ** ** | **December  31,** | ** ** |
|-----------------------------|------------|-------------------|------------|
| ** **                  | ** ** | **2001**          |       | **2000** |   |
| Cash and cash  equivalents: |       |              |       |   |   |
| Cash                        |       | $                 | 265,291    |   | $ | 1,192,633 |   |
| Money market  funds         |       | 6,565,615         |       | 1,098,474 |   |
| Cash and cash  equivalents  |       | $                 | 6,830,906  |   | $ | 2,291,107 |   |
|                             |            |                   |            |  |  |  |  |  |

 

*Property and Equipment*

** **
| ** **                                      | ** ** | **December  31,** | ** ** |
|-------------------------------------------------|------------|-------------------|------------|
|                                            |       | **2001**          | ** ** | **2000** |   |
| Equipment                                       |       | $                 | 3,262,566  |   | $ | 2,730,272 |   |
| Furniture and  fixtures                         |       | 869,920           |       | 795,726 |   |
| Computer  software                              |       | 540,910           |       | 393,260 |   |
| Leasehold  improvements                         |       | 79,861            |       | 79,861 |   |
| Total property  and equipment                   |       | 4,753,257         |       | 3,999,119 |   |
| Less accumulated  depreciation and amortization |       | (3,201,141        | )          | (2,469,431 | ) |
| Property and  equipment, net                    |       | $                 | 1,552,116  |   | $ | 1,529,688 |   |
|                                                 |            |                   |            |  |  |  |  |  |

 

**(4) Line of Credit**

 

The Company’s line ofcredit agreement for short-term line of credit borrowings of up to $1,000,000expired on September 30, 2001.  Therewere no amounts outstanding under the credit agreement as of December 31, 2001.

 

**(5) Deferred Revenue**

 

Deferred revenue consistsprimarily of service revenue, which is recognized as the services are performedand maintenance revenue, which is recognized on a straight-line basis over theterm of the arrangement.

 

**(6) Operating Lease Commitments**

 

In October 1999, theCompany entered into a non-cancelable office facilities lease in Plymouth,Minnesota commencing on February 1, 2000 and expiring on July 31, 2005.  Under the terms of the lease the Company isalso required to pay a portion of the lessor’s operating costs.

 

Total rent expense,including an allocation of operating costs, was $554,000, $476,000 and $417,000for the years ended December 31, 2001, 2000 and 1999, respectively.

 

43

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Scheduled minimum leasepayments for the next five years are approximately as follows:

 

| **Year  Ending  December 31,** |   |
|--------------------------------|--------|
| 2002                           |   | $ | 330,000 |   |
| 2003                           |   | 347,000 |   |
| 2004                           |   | 349,000 |   |
| 2005                           |   | 203,000 |   |
| Total                          |   | $ | 1,229,000 |   |

 

**(7) Shareholders’ Equity**

 

*Stock Option Plans*

 

In connection with theDistribution, Bio-Vascular, as the sole shareholder of the Company, approvedand adopted several option plans and stand-alone option grants, which coveredemployees of both Vital Images and Bio-Vascular.  The adopted plans include the Incentive Stock Option AdjustmentPlan, the 1990 Management Incentive Stock Option Plan, the 1992 Director StockOption Adjustment Plan, the 1992 Stock Option Plan, and the 1995 StockIncentive Adjustment Plan (collectively, the “Mirror Plans”).  Each of these plans is intended to mirrorthe provisions of a corresponding Bio-Vascular plan that was in effect at thetime of the Distribution.  As eachBio-Vascular option plan generally provided for the termination of optionsfollowing termination of employment, each of the Mirror Plans, as well as eachof the stand-alone option grants (the “Mirror Grants”), were approved andadopted to provide that the Distribution would not cause a termination of anyVital Images employee for the purposes of such plans or option grant, and thatBio-Vascular options held by Vital Images employees following the Distributionwould remain exercisable following the Distribution, so long as such employeesremain employed by Vital Images or any subsidiary.  Similar provisions were also adopted with respect to Vital Imagesoptions held by Bio-Vascular employees. On the Distribution Date, 608,534 options were issued in connection withthe Mirror Plans and the Mirror Grants (collectively, the “MirrorOptions”).  These options had vestingperiods ranging from less than one year up to four years and terms ranging fromless than one year up to ten years.  Noadditional grants may be made pursuant to any of the Mirror Plans.

 

In May 1997,Bio-Vascular, as the sole shareholder of the Company, approved and adopted theVital Images, Inc. 1997 Stock Option and Incentive Plan (the “Stock OptionPlan”), which became effective on the Distribution Date.  Under the terms of the plan, the Board ofDirectors may grant options and other stock-based awards to key employees topurchase shares of the Company’s common stock at an option exercise price equalto or greater than 85% of the fair market value on the date of grant.  The options are exercisable at such times,in installments or otherwise, as the Board of Directors may determine.  Generally, these options are incentive stockoptions with a term of eight years and are exercisable to 28% of the totalgrant one year after the date of grant and 2% per month thereafter.  In May 2001, the shareholders of the Companyapproved an increase of 575,000 common shares, bringing the total number ofshares of common stock that may be issued or awarded under the Stock OptionPlan to 2,500,000.  As of December 31,2001, there were 778,821 shares available for grant under the Stock OptionPlan.

 

Also in May 1997,Bio-Vascular, as the sole shareholder of the Company, approved and adopted theVital Images, Inc. 1997 Director Stock Option Plan (the “Director Plan”)(together with the Stock Option Plan, the “1997 Plans”), which became effectiveon the Distribution Date.  The DirectorPlan provides non-employee directors with automatic grants of stock options,and allows the Board of Directors to make additional discretionary option grantsto any or all directors.  Options thatare granted under the Director Plan are 

 

44

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generally granted with anoption price equal to the fair market value on the date of grant, with a termof eight years, are non-qualified options and become exercisable in three equalannual installments beginning on the first occurring December 31 after the dateof grant.  In May 1999, the shareholdersof the Company approved an increase of 105,000 common shares, bringing thetotal number of shares of common stock that may be issued or awarded under theDirector Plan to 210,000.  In May 2000,the shareholders of the Company approved an increase to the number of sharessubject to automatic option grant to current and future non-employee directorsfrom 15,000 shares to 18,000 shares. As of December 31, 2001, there were 25,000shares available for grant under the Director Plan.

 

Certain non-plan optionswere granted to certain officers of the Company in 1998 and 1999.  In February 1998, the Company reserved and granted300,000 non-qualified, non-plan options to an officer of the Company.  These non-plan options have a term of eightyears, vest over a two year period and were granted at exercise prices at leastequal to fair market value of the Company’s common stock on the date ofgrant.  In December 1999, 100,000 ofthese non-plan options were canceled. In December 1999, the Company granted an additional 175,000non-qualified, non-plan options to another officer of the Company.  These non-plan options have a term of eightyears, are exercisable to 28% of the total grant one year after the date ofgrant and 2% per month thereafter and were granted at exercise prices at leastequal to fair market value of the Company’s common stock on the date of grant.

 

*Non-Employee Options*

 

In December 2000, the Company granted 10,000 options to a non-employeeconsultant. These non-plan options have a term of eight years and were grantedat exercise prices at least equal to fair market value of the Company’s commonstock on the date of grant. 5,000 of the options vest over a four-year periodand the remaining 5,000 options will vest immediately when a specifiedmilestone is achieved. The Company records compensation expense related to thisarrangement based upon the fair values of the options during the periods theconsultant provides services. Such fair values are measured using theBlack-Scholes option-pricing model. The fair value of the options wasapproximately $42,000 at December 31, 2001. The Company recorded $10,000 ofcompensation expense related to these options for the year ended December 31,2001.

 

In December 2001, the Company granted a total of 4,000 options to twonon-employee consultants. These non-plan options have a term of eight years andwere granted at exercise prices at least equal to fair market value of theCompany’s common stock on the date of grant. The options vest over a four-yearperiod.  The Company recordscompensation expense related to this arrangement based upon the fair values ofthe options during the periods the consultants provide services. Such fairvalues are measured using the Black-Scholes option-pricing model. The fairvalue of the options was approximately $31,000 at December 31, 2001.

 

45

 

The following table summarizes stock option activity for 2001, 2000 and1999:

 
|                                       |   | **Shares  Under  Option** |   | **Weighted-  Average  Exercise Price  Per Share** |   |
|--------------------------------------------|--------|---------------------------|--------|---------------------------------------------------|--------|
| Total  outstanding as of December 31, 1998 |   | 1,440,318                 |   | $                                                 | 2.44   |   |
|                                       |   |                      |   |                                              |   |
| Options granted                            |   | 693,750                   |   | 4.22                                              |   |
| Options  exercised                         |   | (153,484                  | )      | 2.34                                              |   |
| Options canceled                           |   | (169,674                  | )      | 3.60                                              |   |
|                                       |   |                      |   |                                              |   |
| Total  outstanding as of December 31, 1999 |   | 1,810,910                 |   | 3.02                                              |   |
|                                       |   |                      |   |                                              |   |
| Options granted                            |   | 482,750                   |   | 6.83                                              |   |
| Options  exercised                         |   | (105,650                  | )      | 2.06                                              |   |
| Options canceled                           |   | (111,986                  | )      | 4.56                                              |   |
|                                       |   |                      |   |                                              |   |
| Total  outstanding as of December 31, 2000 |   | 2,076,024                 |   | 3.87                                              |   |
|                                       |   |                      |   |                                              |   |
| Options granted                            |   | 323,250                   |   | 5.43                                              |   |
| Options  exercised                         |   | (50,013                   | )      | 3.07                                              |   |
| Options canceled                           |   | (60,805                   | )      | 4.93                                              |   |
|                                       |   |                      |   |                                              |   |
| Total  outstanding as of December 31, 2001 |   | 2,288,456                 |   | $                                                 | 4.08   |   |
|                                       |   |                      |   |                                              |   |
| Options  exercisable as of:                |   |                      |   |                                              |   |
|                                       |   |                      |   |                                              |   |
| December 31,  1999                         |   | 847,640                   |   | $                                                 | 2.41   |   |
| December 31,  2000                         |   | 1,125,409                 |   | $                                                 | 2.87   |   |
| December 31,  2001                         |   | 1,462,761                 |   | $                                                 | 3.41   |   |

 

Various price ranges and weighted average information for options outstandingas of December 31, 2001 are as follows:

** **
|                           |        | **Outstanding  Options**                    |    | **Exercisable  Options**                           |       |
|--------------------------------|-------------|---------------------------------------------|---------|----------------------------------------------------|------------|
| **Range of   Exercise Prices** |        | **Number  Outstanding as of  Dec 31, 2001** |    | **Weighted  Average  Remaining  Contractual Life** |       | **Weighted****Average  Exercise  Price** |   | **Number  Exercisable as of  Dec 31, 2001** |   | **Weighted****Average****Exercise  Price** |   |
| $                              | 1.13 - 2.25 |                                        | 399,050 |                                               | 3.85 years |   | $ | 1.57 |   | 386,130 |   | $ | 1.57 |   |
| 2.31 - 2.75                    |        | 414,497                                     |    | 3.67 years                                         |       | 2.41 |   | 400,797 |   | 2.41 |   |
| 3.50 - 3.56                    |        | 276,702                                     |    | 5.99 years                                         |       | 3.56 |   | 143,982 |   | 3.56 |   |
| 3.87 - 4.75                    |        | 495,536                                     |    | 5.18 years                                         |       | 4.61 |   | 348,436 |   | 4.61 |   |
| 5.13 - 5.81                    |        | 334,399                                     |    | 6.89 years                                         |       | 5.25 |   | 33,069 |   | 5.55 |   |
| 6.22 - 8.70                    |        | 368,272                                     |    | 6.51 years                                         |       | 7.31 |   | 150,347 |   | 7.36 |   |
|                           |        | 2,288,456                                   |    | 5.23 years                                         |       | $ | 4.08 |   | 1,462,761 |   | $ | 3.41 |   |
|                                |             |                                             |         |                                                    |            |  |  |  |  |  |  |  |  |  |

 

46

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*Employee Stock Purchase Plan*

 

The 1997 Employee Stock Purchase Plan (the “ESPP”) was approved andadopted by Bio-Vascular, as the sole shareholder of the Company, in May1997.  The ESPP, which became effectiveon July 1, 1997, enables eligible employees to purchase the Company’s commonstock at 85% of the fair market value of the stock on the date an offeringcommences or on the date an offering terminates, whichever is lower.  The ESPP covers an aggregate of up to250,000 shares of common stock that can be issued and sold to participatingemployees of the Company through a series of three-month offerings, beginningJuly 1, 1997.  The ESPP coverssubstantially all employees, subject to certain limitations.  Each employee may elect to have up to 10% ofhis or her base pay withheld and applied toward the purchase of shares in eachsuch offering.  Purchases under the ESPPfor 2001 were 25,487 shares generating proceeds to the Company of $91,652 at anaverage purchase price of $3.60; for 2000 there were 21,589 shares purchased,generating proceeds to the Company of $85,965 at an average purchase price of$3.99; and for 1999 there were 23,767 shares purchased, generating proceeds tothe Company of $66,645 at an average purchase price of $2.80.  As of December 31, 2001, there are 138,987shares of common stock reserved for purchases under the ESPP.

 

*Stock-Based Compensation*

 

If compensation cost for the ESPP, the Stock Option Plan, the DirectorPlan and the non-plan options granted to employees had been determined based onthe fair values on the grant dates for awards in 2001, 2000 and 1999 consistentwith the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,”the Company’s net loss and net loss per share for 2001, 2000 and 1999 wouldhave been increased to the pro forma amounts indicated below:

 
|                                                       |   |        |       | **For the  Years Ended December 31,** |       |
|------------------------------------------------------------|--------|-------------|------------|---------------------------------------|------------|
|                                                       |   |        | ** ** | **2001**                              |       | **2000** |   | **1999** | ** ** |
| Net loss                                                   |   | As reported |       | $                                     | (1,011,977 | ) | $ | (2,637,231 | ) | $ | (3,217,625 | ) |
|                                                       |   | Pro forma   |       | $                                     | (2,222,000 | ) | $ | (3,570,000 | ) | $ | (3,745,000 | ) |
|                                                       |   |        |       |                                  |       |   |   |   |   |
| Net loss per  share -                                      |   | As reported |       | $                                     | (0.14      | ) | $ | (0.39 | ) | $ | (0.64 | ) |
| basic and  diluted                                         |   | Pro forma   |       | $                                     | (0.31      | ) | $ | (0.53 | ) | $ | (0.74 | ) |
|                                                       |   |        |       |                                  |       |   |   |   |   |
| The weighted  average fair values of options granted were: |   |        |       |                                  |       |   |   |   |   |
|                                                       |   |        |       |                                  |       |   |   |   |   |
| Options under  the 1997 Plans                              |   |        |       | $                                     | 4.19       |   | $ | 5.43 |   | $ | 3.47 |   |
| Options under  ESPP                                        |   |        |       | $                                     | 0.64       |   | $ | 0.70 |   | $ | 0.50 |   |
| Non-plan options                                           |   |        |       | $                                     | 6.02       |   | $ | 3.66 |   | $ | 2.80 |   |
|                                                            |        |             |            |                                       |            |  |  |  |  |  |  |  |  |  |

 

The weighted average fair values for the 1997 Plans and the non-planoptions were based on the fair values on the dates of grant.  The fair values of options under the ESPPwere based on the 15 percent purchase discount.  The fair values for the 1997 Plans and the non-plan options werecalculated using the Black-Scholes option-pricing model with the followingweighted average assumptions:

 
|                        |   | **For the  Years Ended December 31,** |   |
|-----------------------------|--------|---------------------------------------|--------|
|                        |   | **2001**                              |   | **2000** |   | **1999** | ** ** |
| Expected option  life       |   | 6.0 years                             |   | 6.0 years |   | 6.0 years |   |
| Expected  volatility factor |   | 90.8                                  | %      | 92.6 | % | 91.7 | % |
| Expected  dividend yield    |   | 0                                     | %      | 0 | % | 0 | % |
| Risk-free  interest rate    |   | 4.93                                  | %      | 6.40 | % | 5.97 | % |

 

47

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The pro forma effects onthe net losses for 2001, 2000 and 1999 are not necessarily representative ofthe pro forma effect that may occur on the net income (loss) in future periods.

 

*Warrants*

 

In December 1999, theCompany completed a private placement of 1,650,000 units at $3.25 perunit.  Each unit consisted of one shareof the Company’s common stock and a redeemable, five-year warrant to purchasean additional share of common stock at $3.75 per share.  The warrants were immediately exercisableand expired in December 2004.  Thewarrants could have been redeemed by the Company at any time before December2004 at a redemption price of $.01 per warrant, upon notice of such redemption,provided that (i) the closing bid price of the Company’s common stock exceeded$5.75 per share for any thirty consecutive trading days prior to such noticeand (ii) a registration statement covering the resale of the warrant shares hadbeen filed by the Company with the Securities and Exchange Commission and waseffective as of the date of such notice. The Company satisfied the conditionsfor redemption of the warrants as of December 7, 2000. In December 2001, theCompany called for redemption of all outstanding warrants.  As of December 31, 2001, approximately1,192,000 warrants had been exercised generating approximately $4,468,000 inproceeds.  All remaining warrants wereexercised in January 2002 generating approximately $1,719,000 in proceeds.  None of the warrants were exercised prior to2001.

 

The Company also issuedwarrants to the underwriter in the private placement to purchase 163,651 sharesof the Company’s common stock at $3.25 per share.  The warrants were immediately exercisable and expire in December2004.  As of December 31, 2001, 18,940of these warrants have been exercised and converted to 14,084 shares of commonstock.  4,856 shares were forfeited aspart of cashless exercises.  None of thewarrants were exercised prior to 2001.

 

*Restricted Stock*

 

Under certain compensation agreements, an arrangement which providesfor awards of restricted common stock to key management was adopted byBio-Vascular in 1992.  Pursuant to theagreement governing the Company’s spin-off from Bio-Vascular (the “DistributionAgreement”), Vital Images assumed its proportionate share of obligationsrepresented by such restricted shares such that the Company issued 25,375restricted shares on the Distribution Date in connection with the spin-off fromBio-Vascular.  As of December 31, 2001,no shares of restricted stock remain unearned by certain key Bio-Vascularemployees.

 

*Rights Plan*

 

In April 1997, theCompany declared a dividend distribution of one Preferred Stock Purchase Rightfor each outstanding share of the Company’s common stock (the “Rights”).  With certain exceptions, the Rights becomeexercisable only in the event that (i) an acquiring party accumulates 15% ormore of the Company’s common stock, (ii) a party announces an offer to acquire15% or more of the Company’s common stock, or (iii) the acquisition of asubstantial amount of the Company’s common stock by a person whom the Board ofDirectors has determined is an Adverse Person as defined in the underlyingRights Agreement.  Each Right entitlesthe holder to purchase one-thousandth of a share of the Company’s Series AJunior Preferred Stock at a price of $20.00 (the “Exercise Price”).  If a person or group becomes the beneficialowner of 15% or more of the Company’s common stock or the Board of Directors determinesthat a person is an Adverse Person, each holder of a Right shall thereafterhave the right to receive preferred stock having a fair market value equal totwo times the Exercise Price.  Upon theoccurrence of certain mergers, combinations or acquisitions of the Company’sassets, each holder of a Right shall thereafter have the right to receive thatnumber of shares of common stock of the acquiring company which equals theExercise Price of the Right divided by one-half of the current market price ofsuch common stock as of the date of the occurrence of the event.  The Company is

 

48

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generally entitled toredeem the Right at $.001 per Right at any time until ten days following theacquisition of 15% or more of the Company’s common stock or ten days after thepoint at which the Company’s Board of Directors determines that a person is anAdverse Person, as defined by the Rights Agreement.  The Rights expire on April 30, 2007, if not previously redeemed orexercised.

 

**(8) Income Taxes**

 

The income tax provisionfor each of the periods presented represents state minimum taxes.  As of December 31, 2001, the Company has netoperating loss carryforwards of approximately $17,300,000 for federal income taxreporting purposes and unused research and development credits of approximately$809,000, which expire in varying amounts from 2004 to 2021.  For financial reporting purposes, avaluation allowance has been established to completely reserve for theCompany’s deferred tax assets related to those carryforwards.  The utilization of these carryforwards maybe subject to limitations based on future changes in ownership of the Company,pursuant to Internal Revenue Code Section 382 (the “Code”).

 

As a result of Bio-Vascular’sacquisition of the Company in May 1994, the Company experienced an ownershipchange as defined by Section 382 of the Code. Under the Code, the amount of pre-acquisition net operating losscarryforwards and research and development credits that can be used to offsetfuture taxable income and income taxes will be limited.  As of the date of the Company’s acquisitionby Bio-Vascular, the Company had approximately $1,600,000 of net operating losscarryforwards and approximately $137,000 of research and experimentationcredits, both of which will be subject to limitation under the Code.

 

The significantcomponents of the Company’s tax-effected net deferred tax assets, based on anassumed effective tax rate of 40%, are:

 
|                                                |   | **December 31,** |       |
|-----------------------------------------------------|--------|------------------|------------|
|                                                |   | **2001**         |       | **2000** | ** ** |
| Net operating  loss carryforwards                   |   | $                | 6,920,000  |   | $ | 6,600,000 |   |
| Research and  development tax credit carryforwards  |   | 809,000          |       | 662,000 |   |
| Deferred  compensation                              |   | 230,000          |       | 230,000 |   |
| Depreciation                                        |   | 284,000          |       | 229,000 |   |
| Other, net                                          |   | 197,000          |       | 153,000 |   |
| Net deferred tax  assets before valuation allowance |   | 8,440,000        |       | 7,874,000 |   |
| Less valuation  allowance                           |   | (8,440,000       | )          | (7,874,000 | ) |
| Net deferred tax  assets                            |   | $                | **—** |   | $ | — |   |

 

**(9) Major Customers and GeographicData**

 

Customers accounting for more than 10 percent of the Company’s totalrevenue are as follows:

 
|                          |   | **Significant  Customer**                    |   | **Revenue** |      | **Percentage  of  Total Revenue** |   |
|-------------------------------|--------|----------------------------------------------|--------|-------------|-----------|-----------------------------------|--------|
| Year ended  December 31, 2001 |   | Toshiba Corporation, Medical Systems Company |   | $           | 4,163,000 |                              | 27     | % |
|                          |   |                                         |   |        |      |                              |   |   |
| Year ended  December 31, 2000 |   | Toshiba Corporation, Medical Systems Company |   | $           | 2,819,000 |                              | 27     | % |
|                          |   |                                         |   |        |      |                              |   |   |
| Year ended  December 31, 1999 |   | Toshiba Corporation, Medical Systems Company |   | $           | 1,377,000 |                              | 21     | % |

 

49

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The Company’saccounts receivable are generally concentrated with a small base ofcustomers.  As of December 31, 2001,there was one customer accounting for 18% of accounts receivable, while as ofDecember 31, 2000, two customers, each accounting for more than 10% of accountsreceivable, accounted for 27% of accounts receivable.

 

Export revenueaccounted for 8%, 7% and 8% of total revenue for the years ended December 31,2001, 2000 and 1999, respectively. Substantially all of the Company’s export sales are negotiated, invoicedand paid in U.S. dollars.

 

Export sales bygeographic area are summarized as follows:

 
|           |   | **For the Years Ended December 31,** | ** ** |
|----------------|--------|--------------------------------------|------------|
|           |   | **2001**                             |       | **2000** |   | **1999** | ** ** |
| Europe         |   | $                                    | 706,000    |   | $ | 389,000 |   | $ | 312,000 |   |
| Asia-Pacific   |   | 300,000                              |       | 195,000 |   | 133,000 |   |
| Canada         |   | 207,000                              |       | 26,000 |   | 22,000 |   |
| Latin  America |   | 14,000                               |       | 108,000 |   | 42,000 |   |
| Other          |   | —                               |       | 36,000 |   | — |   |
|                |        |                                      |            |  |  |  |  |  |  |  |

 

**(10) Employee Benefit Plan**

 

The Companymaintains the Vital Images, Inc. Salary Savings Plan (the “Plan”), which isintended to qualify under Section 401(k) of the Internal Revenue Code, as amended.  The Plan covers substantially allemployees.  Each employee may elect tocontribute to the Plan through payroll deductions of up to 25% of his or hersalary, subject to certain limitations. At the discretion of the Board of Directors, the Company may makematching contributions equal to a percentage of the salary reductioncontributions or other discretionary amounts. There were no contributions to the Plan by the Company in 2001, 2000 and1999.

 

**(11) Licensed Technology**

 

In July 2001, theCompany entered into an agreement to license technology from a thirdparty.  The Company paid $500,000 to thelicensor and was obligated to pay an additional $250,000 in two installments of$125,000 plus interest at 8% on each of the first two anniversary dates of theagreement.  The $250,000 plus interestwas paid in full in December 2001.  TheCompany recorded this $750,000 purchase as licensed technology and isamortizing it over the estimated useful life of the technology of 75months.  As part of this agreement, theCompany is also obligated to pay the licensor royalties on the sales of certainproducts as defined in the agreement. During 2001, $211,000 of such royalties was incurred.

 

50

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**(12) Development Agreements**

 

During the fourth quarterof 2001, the Company entered into an agreement with E-Z-EM, Inc.  Under the agreement, the Company developed asingle application CT Colonography product called InnerviewGITM, which will be marketedand sold through E-Z-EM, Inc.  During2001, the Company recorded service revenue totaling $348,000 under thisagreement.  In addition, E-Z-EM, Inc.purchased 82,332 shares of newly issued common stock of Vital Images, Inc. forapproximately $552,000 cash.

 

In November 2001, the Companyentered into a development and license agreement with Surgical NavigationTechnologies, Inc., a division of Medtronic, Inc. (“MSNT”), to integratecertain Company technology into MSNT’s image-guided surgery products and todevelop products and services for surgical planning which will be marketed andsold through MSNT.  The Company received$250,000 upon execution of the agreement, which is included in deferred revenuein the current liabilities section of the balance sheet as of December 31,2001.

 

**(13) Quarterly Financial Data**

 

The following summarized unaudited quarterly financial data has beenprepared using the consolidated financial statements of Vital Images, Inc.

 
|                                           |   | **First  Quarter** |      | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |      |
|------------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|---------------------|-----------|
| **2001:**                                      |   |               |      |                |   |               |   |                |      |
| Total revenue                                  |   | $                  | 3,331,000 |                | $      | 3,682,000          |   | $                   | 3,633,000 |   | $ | 4,550,000 |   |
| Gross margin                                   |   | 2,529,000          |      | 2,769,000           |   | 2,899,000          |   | 3,689,000           |      |
| Net income  (loss)                             |   | (622,000           | )         | (402,000            | )      | (132,000           | )      | 144,000             |      |
| Earnings (loss)  per share - basic and diluted |   | (0.09              | )         | (0.06               | )      | (0.02              | )      | 0.02                |      |
|                                           |   |               |      |                |   |               |   |                |      |
| **2000:**                                      |   |               |      |                |   |               |   |                |      |
| Total revenue                                  |   | $                  | 2,270,000 |                | $      | 2,513,000          |   | $                   | 2,829,000 |   | $ | 3,016,000 |   |
| Gross margin                                   |   | 1,744,000          |      | 1,984,000           |   | 2,191,000          |   | 2,191,000           |      |
| Net loss                                       |   | (665,000           | )         | (802,000            | )      | (525,000           | )      | (645,000            | )         |
| Loss per share -  basic and diluted            |   | (0.10              | )         | (0.12               | )      | (0.08              | )      | (0.09               | )         |

 

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**SCHEDULE II**

 

VITAL IMAGES, INC.

VALUATION ANDQUALIFYING ACCOUNTS

 
| **Description**                   |   | **Balance as  of  Beginning  of Period** |    | **Charges  to  Cost and  Expenses** |   | **Deductions/  Write-Offs** |   | **Balance  as of End  of Period** |    |
|-----------------------------------|--------|------------------------------------------|---------|-------------------------------------|--------|-----------------------------|--------|-----------------------------------|---------|
| Allowance for  doubtful accounts: |   |                                     |    |                                |   |                        |   |                              |    |
|                              |   |                                     |    |                                |   |                        |   |                              |    |
| Year ended  December 31, 2001     |   | $                                        | 215,000 |                                | $      | 114,000                     |   | $                                 | 144,000 |   | $ | 185,000 |   |
|                              |   |                                     |    |                                |   |                        |   |                              |    |
| Year ended  December 31, 2000     |   | $                                        | 93,000  |                                | $      | 122,000                     |   | $                                 | —  |   | $ | 215,000 |   |
|                              |   |                                     |    |                                |   |                        |   |                              |    |
| Year ended  December 31, 1999     |   | $                                        | 78,000  |                                | $      | 15,000                      |   | $                                 | —  |   | $ | 93,000 |   |

 

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**VITAL IMAGES, INC.**

**FORM 10-K**

 

**INDEXTO EXHIBITS**

** **
| **Item No.** |   |                                                                                                                                                                                                                                                                                                         | **Description** |   |
|--------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------|--------|
| 3.1          |   | Articles of Incorporation of the Company  (incorporated by reference to Exhibit 3.1 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 3.2          |   | By-laws of the Company (incorporated by reference to  Exhibit 3.2 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                                                                                                              |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.1          |   | Form of common stock Certificate of the Company  (incorporated by reference to Exhibit 4.3 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                                                                     |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.2          |   | Rights Agreement, dated effective as of May 1, 1997  between the Company and American Stock Transfer and Trust Company, which  includes as Exhibit B the form of Rights Certificate (incorporated by  reference to Exhibit 4.4 to the Company’s registration statement on Form 10  (File No. 0-22229)). |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.3          |   | Certificate of Designation, Preferences and Rights  of Series A Junior Preferred Stock of the Company (incorporated by reference  to Exhibit 4.5 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                               |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.1         |   | Form of Distribution Agreement, effective as of May  2, 1997 between Bio-Vascular, Inc. and the Company (incorporated by reference  to Exhibit 10.1 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.2         |   | Form of Employee Benefits Agreement, effective as of  May 2, 1997, between Bio-Vascular, Inc. and the Company** (incorporated by  reference to Exhibit 10.2 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                    |

 

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| 10.3   |   | Form of Tax Sharing Agreement, effective as of May  2, 1997, between Bio-Vascular, Inc. and the Company (incorporated by  reference to Exhibit 10.3 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                   |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                |
| 10.4   |   | Form of Transition Services Agreement, effective as  of May 2, 1997 between Bio-Vascular, Inc. and the Company (incorporated by  reference to Exhibit 10.4 to the Company’s registration statement on Form 10  (File No. 0-22229)).                            |
|   |   |                                                                                                                                                                                                                                                                |
| 10.5   |   | Incentive Stock Option Adjustment Plan**  (incorporated by reference to Exhibit 10.5 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                |
| 10.6   |   | 1990 Stock Option Plan** (incorporated by reference  to Exhibit 10.6 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                |
| 10.7   |   | 1992 Stock Option Plan** (incorporated by reference  to Exhibit 10.7 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                |
| 10.8   |   | 1992 Director Stock Option Adjustment Plan**  (incorporated by reference to Exhibit 10.8 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                              |
|   |   |                                                                                                                                                                                                                                                                |
| 10.9   |   | 1995 Stock Incentive Adjustment Plan** (incorporated  by reference to Exhibit 10.9 to the Company’s registration statement on Form  10 (File No. 0-22229)).                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                |
| 10.10  |   | Employee Stock Purchase Plan** (incorporated by  reference to Exhibit 10.10 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                |
| 10.11  |   | 1997 Stock Option and Incentive Plan** (incorporated  by reference to Exhibit 10.11 to the Company’s registration statement on Form  10 (File No. 0-22229)).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                |
| 10.12  |   | 1997 Director Stock Option Plan** (incorporated by  reference to Exhibit 10.12 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                |
| 10.13  |   | License Agreement dated August 25, 1995 between the  Company and Paradigm Geophysical Corporation (formerly CogniSeis Development,  Inc.) (incorporated by reference to Exhibit 10.14 to the Company’s  registration statement on Form 10 (File No. 0-22229)). |

 

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| 10.14  |   | Lease agreement dated May 14, 1993, as amended April  15, 1997, between Vital Images, Inc. and Douglas Green IRA Trust  (incorporated by reference to Exhibit 10.15 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                         |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.15  |   | Lease Agreement dated January 31, 1997 between ACKY  -s 3100 Lake Limited Partnership and the Company (incorporated by reference  to Exhibit 10.16 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                          |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.16  |   | Form of Change in Control Agreement between the  Company and Andrew M. Weiss, Vincent J. Argiro, Ph.D., David A. Davis,  Gregory S. Furness and Jay D. Miller** (incorporated by reference to Exhibit  10.17 to the Company’s registration statement on Form 10 (File No. 0-22229)). |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.17  |   | Joint Development Agreement dated August 14, 1996  between the Company and ATL Ultrasound, Inc.* (incorporated by reference to  Exhibit 10.18 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                               |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.18  |   | Sales and Marketing Agreement dated August 14, 1996  between the Company and ATL Ultrasound, Inc.* (incorporated by reference to  Exhibit 10.19 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                             |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.19  |   | Software License Agreement dated August 1, 1997  between the Company and Duke University (incorporated by reference to Exhibit  10.20 to the Company’s Annual Report on Form 10-K for the year ended December  31, 1997 (File No. 0-22229)).                                         |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.20  |   | Severance Agreement dated February 13, 1998 between  the Company and Mr. Weiss** (incorporated by reference to Exhibit 10.21 to  the Company’s Annual Report on Form 10-K for the year ended December 31, 1997  (File No. 0-22229)).                                                 |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.21  |   | Employment Agreement dated February 1, 1998 between  the Company and Douglas M. Pihl** (incorporated by reference to Exhibit 10.22  to the Company’s Annual Report on Form 10-K for the year ended December 31,  1997 (File No. 0-22229)).                                           |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.22  |   | Non-qualified Stock Option  Agreement dated February 24, 1998 between the Company and Douglas M. Pihl**  (incorporated by reference to Exhibit 10.23 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 1997 (File No. 0-22229)).                          |
|   |   |                                                                                                                                                                                                                                                                                      |
| 10.23  |   | Loan Agreement dated March 19, 1999 between the  Company and Riverside Bank (incorporated by reference to Exhibit 10.24 to the  Company’s Form 10-Q for the quarter ended March 31, 1999 (File No. 0-22229)).                                                                        |

 

 

55

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| 10.24     |   | Promissory Note dated  March 19, 1999 between the Company and Riverside Bank (incorporated by  reference to Exhibit 10.25 to the Company’s Form 10-Q for the quarter ended  March 31, 1999 (File No. 0-22229)).                                                                                                         |
|-----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                                                                                                                                                                                                                                         |
| 10.25     |   | Commercial Security  Agreement dated March 19, 1999 between the Company and Riverside Bank  (incorporated by reference to Exhibit 10.26 to the Company’s Form 10-Q for  the quarter ended March 31, 1999 (File No. 0-22229)).                                                                                           |
|      |   |                                                                                                                                                                                                                                                                                                                         |
| 10.26     |   | Lease agreement dated  October 19, 1999 between St. Paul Properties, Inc. and the Company  (incorporated by reference to Exhibit 10.27 to the Company’s Form 10-Q for  the quarter ended September 30, 1999 (File No. 0-22229)).                                                                                        |
|      |   |                                                                                                                                                                                                                                                                                                                         |
| **10.27** |   | **Vital Images, Inc. and Toshiba  America Medical Systems, Inc. Reseller Agreement * (incorporated by reference  to Exhibit 10.27 to the Company’s Form 10-Q for the quarter ended September  30, 2000 (File No. 0-22229)).**                                                                                           |
|      |   |                                                                                                                                                                                                                                                                                                                         |
| **10.28** |   | **Employment Agreement dated  December 27, 1999 between the Company and Albert Emola** (incorporated by  reference to Exhibit 10.28 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2000 (File No. 0-22229)).**                                                                            |
|      |   |                                                                                                                                                                                                                                                                                                                         |
| 10.29     |   | Non-qualified Stock Option  Agreement dated December 28, 1999 between the Company and Albert Emola**  (incorporated by reference to Exhibit 10.29 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2000 (File No. 0-22229)).                                                                |
|      |   |                                                                                                                                                                                                                                                                                                                         |
| 10.30     |   | Form of Change in Control  Agreement between the Company and Albert Emola and Gregory S. Furness**  (incorporated by reference to Exhibit 10.30 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2000 (File No. 0-22229)).                                                                  |
|      |   |                                                                                                                                                                                                                                                                                                                         |
| **10.31** |   | **Form of Change in Control  Agreement between the Company and Vincent J. Argiro, Ph.D., Steven P.  Canakes, David M. Frazee, Jay D. Miller and Robert C. Samec** (incorporated  by reference to Exhibit 10.31 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2000 (File No. 0-22229)).** |
|      |   |                                                                                                                                                                                                                                                                                                                         |
| **10.32** |   | **Technology License Agreement  between PointDX, Inc. and Vital Images, Inc.* (incorporated by reference to  Exhibit 10.32 to the Company’s Form 10-Q for the quarter ended September 30,  2001 (File No. 0-22229)).**                                                                                                  |

 

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| **10.33** |   | **Development, Supply, Marketing  and Distribution Agreement between Vital Images, Inc. and E-Z-EM, Inc.* (incorporated  by reference to Exhibit 10.33 to the Company’s Form 10-Q for the quarter  ended September 30, 2001 (File No. 0-22229)).** |
|-----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                                                                                                                                                                    |
| **10.34** |   | **Development and License  Agreement between Vital Images, Inc. and Surgical Navigation Technologies,  Inc. (filed herewith electronically).**                                                                                                          |
|      |   |                                                                                                                                                                                                                                                    |
| 23.1      |   | Consent of PricewaterhouseCoopers LLP (filed  herewith electronically).                                                                                                                                                                                 |

 
| *      |   | Portions of such  exhibit are subject to a request for confidential treatment filed with the  Commission |
|--------|--------|----------------------------------------------------------------------------------------------------------|
|   |   |   by the Registrant.                                                                                |
|   |   |                                                                                                     |
| **     |   | Indicates a management contract or compensatory plan  or arrangement.                                    |

 

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