**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K/A**

 

**(AmendmentNo. 1)**

 

| **ý**                                                                                                                                                         | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**     |
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| **For the  fiscal year ended December 31, 2003**                                                                                                              |
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| **o**                                                                                                                                                              | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
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| **For the  transition period from             to            ** |
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| **Commission  File Number 0-22229**                                                                                                                                |

 

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**VITAL IMAGES, INC.**

(Exact name ofRegistrant as specified in its charter)

 

| **Minnesota**                                                              | ** ** | **42-1321776**                        |
|----------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)           |       | (I.R.S. Employer  Identification No.) |
|                                                                       |       |                                  |
| **3300  Fernbrook Lane, N., Suite 200  Plymouth, Minnesota**               | ** ** | **55447**                             |
| (Address of  principal  executive offices)                                 |       | (Zip Code)                            |
|                                                                       |       |                                  |
| **(763)  852-4100**                                                        |
| (Registrant’s  telephone number, including area code)                 |
|                                                                       |       |                                  |
| Securities  registered pursuant to Section 12(b) of the Act: **None** |
|                                                                       |       |                                  |
| Securities  registered pursuant to Section 12(g) of the Act:          |
|                                                                       |       |                                  |
| **Common  Stock, $.01 par value  Preferred Stock Purchase Rights**         |
| (Title of Class)                                                           |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.  Yes o  No ý

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained 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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theact).  Yes ýNo o

 

The aggregate marketvalue of the common stock held by non-affiliates of the registrant computed byreference to the price at which the common stock was last sold as of June 30,2003, the last business day of the registrant’s most recently completed secondfiscal quarter, was $172,873,000.  Thecommon stock is the registrant’s only class of voting stock.

 

The number of sharesoutstanding of the issuer’s classes of common stock as of February 28,2004: Common stock, $.01 Par Value – 11,545,258.

DOCUMENTSINCORPORATED BY REFERENCE

 

Portions of registrant’sdefinitive Proxy Statement in connection with the Annual Meeting ofShareholders held May 12, 2004 (“2004 Proxy Statement”) are incorporated byreference into Part III.

 

 

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**EXPLANATORYNOTE**

 

Vital Images,Inc. (the *“Company”*) is filingthis Amendment No. 1 to its Annual Report on Form 10-K for the fiscal yearended December 31, 2003, which was originally filed on March 15, 2004(the *“Form 10-K”*), to restate the2003 financial statements and related footnote disclosures to (1) correct theaccounting for unrecognized deferred maintenance and service revenue in 2003from certain maintenance and service arrangements and (2) change theclassification of certain non-trade accounts receivable from accountsreceivable to prepaid expenses and other current assets.  The adjustment for the deferred maintenanceand service revenue (a) increased maintenance and service revenue, totalrevenue and operating income by $524,471, (b) reduced the net tax benefit forthe tax effect of the additional revenue by $194,000 and (c) increased netincome by $330,471 and net income per diluted share by $0.02.  The change in classification for thenon-trade accounts receivable of $104,486 had no effect on the Company’spreviously reported revenue, operating income, net income, and net income pershare.  The Company also restated thedisclosures to the financial statements to correct the computation of pro formastock-based employee compensation expense by $92,167 for the year endedDecember 31, 2003.  The impact of thepreviously unrecognized deferred maintenance and service revenue adjustment andthe pro forma stock-based compensation expense adjustment increased pro forma netincome per diluted share by $0.06.  Inaddition, the Company has revised Item 9A to include information about theimpact of the restatements on its internal controls.  This Amendment No. 1 amends only thefollowing portions of the Form 10-K; the remainder of the Form 10-K isunchanged and is not reproduced in this Amendment No. 1.  This Amendment No. 1 does not reflect eventsoccurring after the original filing date of the Form 10-K.

 

This Amendment No. 1contains changes to the following disclosures:

 

•                  PartI – Item 1.  Business

•                  “—Maintenance and Support”

•                  “—Important Factors”

 

•                  PartII – Item 6.  Selected Financial Data

 

•                  PartII – Item 7.  Management’s Discussion andAnalysis of Financial Condition and Results of Operations

 

•                  PartII – Item 8.  Financial Statements andSupplementary Data 

 

•                  PartII – Item 9A.  Controls and Procedures

 

•                  PartIV – Item 15.  Exhibits, FinancialStatement Schedules and Reports on Form 8-K

 

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VITAL IMAGES, INC.

FORM 10-K/A

 

TABLE OF CONTENTS

 
| PART I   |
|----------|
|     |   |   |
| Item 1.  | Business |   |
|     |   |   |
| PART II  |
|     |   |   |
| Item 6.  | Selected Financial Data  (Restated) |   |
| Item  7. | Management’s  Discussion and Analysis of Financial Condition and Results of Operations  (Restated) |   |
| Item  8. | Financial  Statements and Supplementary Data (Restated) |   |
| Item 9A. | Controls and  Procedures |   |
|     |   |   |
|     |   |   |
| PART IV  |
|     |   |   |
| Item 15. | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K |   |
|     |   |   |
|     | Signatures |   |

 

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Item 1.                                     BUSINESS

 

Vital Images, Inc. (“VitalImages” or the “Company”) was incorporated in Iowa in September 1988.  In March 1997, the Companyre-incorporated under the laws of the state of Minnesota.  The Company’s principal executive offices arelocated 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., now known asSynovis Life Technologies, Inc.

 

The Company files annualreports, quarterly reports, current reports, proxy statements, and otherdocuments with the Securities and Exchange Commission (SEC) under theSecurities Exchange Act of 1934 (Exchange Act). The public may read and copy any materials that the Company files withthe SEC at the SEC’s Public Reference Room at 450 Fifth Street N.W.,Washington, D.C. 20549.  The public mayobtain information on the operation of the Public Reference Room by calling theSEC at 1-800-SEC-0330.  Also, the SECmaintains an Internet website that contains reports, proxy and informationstatements, and other information regarding issuers, including the Company,that file electronically with the SEC. The public can obtain any documents that the company files with the SECat http://www.sec.gov.

 

The Company also makesavailable free of charge through its Internet website(http://www.vitalimages.com) the Company’s Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Proxy Statementsand, if applicable, amendments to those reports filed or furnished pursuant tothe Exchange Act as soon as reasonably practicable after the Companyelectronically files such material with, or furnishes it to, the SEC.

 

Business Description

 

Vital Images develops,markets and supports 3D medical imaging software for use primarily in clinicaldiagnosis, disease screening and therapy planning.  The Company’s software applies proprietarycomputer graphics and image processing technologies to a wide variety of datasupplied by computed tomography (“CT”) and magnetic resonance (“MR”)scanners.  Vital Images’ products allowclinicians to create 2D, 3D and 4D 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 andpicture archive and communication systems (“PACS”) through a direct sales forcein the United States and independent distributors in international 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*was the first 3D medical imaging product with the ability toappeal primarily to the clinical market. Historically, 3D medical imaging software was slow, difficult to use,and operated only on expensive workstations. Consequently, the functionality of such software was appealing only forresearch applications.  The Company’s *Vitrea*software combined speed with ease-of-use to enable aphysician to access, manipulate and analyze 3D images, typically in less thanfive to ten minutes.  The Company hasreleased several updates to *Vitrea*eachyear, and in December 2003 released *Vitrea 2 Version 3.4*,which has improved quality, reliability and usability features to meet thediagnostic and treatment planning needs of busy radiology departments. TheCompany offers *Vitrea 2* both as an integratedsoftware and hardware system, consisting of *Vitrea 2*software installed on a computer workstation, and as a stand-alone softwarepackage.  To date, the Company haslicensed over 1,300 copies of *Vitrea*and*Vitrea 2*to hospitals, clinics, imaging centers and other sites.

 

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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 currentmodalities.  Vital Images is alsodeveloping and enhancing its 3D medical imaging software tools for less-invasivescreening applications, such as CT colonography for colon cancer screening andCT cardiac for diagnosis of heart disease.

 

The Company has amarketing and distribution agreement with Toshiba Medical Systems Corporation (“Toshiba”),which names *Vitrea 2* as Toshiba’sprimary 3D software for use with their CT scanners in the United States and inmore than 50 countries in North and South America, Europe, the Middle East,Africa, Australia and Asia, except Japan. The agreement runs through December 31,2004.  Sales by the Company to Toshiba accountedfor approximately 42%, 34% and 27% of the Company’s total revenue for the yearsended December 31, 2003, 2002 and 2001, respectively.  See “Business – Marketing and Distribution”and “– Dependence on Major Customers.”

 

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 PACS and 3D imaging systems, whichhave become integral technologies for many radiology practices around theworld.

 

Today, only a minority ofhospitals, clinics and imaging centers use 3D medical imaging products indiagnostic imaging.  Technologicaladvances over the last several years in both computer hardware and softwaredevelopment have dramatically improved the cost-to-performance ratio, bringingthe prices for 3D medical imaging products into the reach of most healthcareproviders.  In addition, increasingclinical awareness, improving utility of applications and an exponentialincrease in CT slice volumes are driving demand for 3D medical imagingproducts.

 

Based on an increasingnumber of 3D procedures being performed as a result of the growing use ofimaging technology, new 3D screening procedures and broader acceptance of 3Dapplications, Vital Images estimates that the potential worldwide market for 3Dmedical imaging software and workstations, including the U.S. market, will growto $2 billion in less than four years.

 

Technology

 

The two core technologiesunderlying the Company’s products are “customized protocols,” which make*Vitrea 2* simple to use, and a visualization technique knownas “volume rendering.”  A featurecritical to *Vitrea 2’s* speed and ease-of-use is itscustomized protocols, which provide automated 2D, 3D and 4D renderings ofscanner data, optimized for individual clinical applications.  Vital Images’ engineers and clinicalcollaborators have selected specific views for each type of exam *Vitrea 2* supports in order to provide immediate, useful 2D,3D and 4D views for the user.  4D isdefined as 3D images showing changes over time, such as images of a beatingheart.  After the selected patient datahas been retrieved, *Vitrea 2*provides the clinician with up to six views with all visualization parameterspre-set for the specific type of clinical exam. The visualization settings for these views are stored in *Vitrea 2’s* software and are automatically and adaptivelyapplied to each patient study, optimizing the views displayed.  By applying this proprietary protocoltechnique, the system anticipates the clinician’s needs and providesimmediately useful views of the patient data. The use of customized protocols automates the complex and time-consumingapproaches inherent in many competing 3D medical imaging products andeliminates the need for the user to be proficient in operating complex graphicsprograms.  The Company has been issuedPatent No. 5,986,662 from the U.S. Patent and Trademark Office for its mechanismfor automated protocol selection, Patent No. 6,130,671 for the mechanism tocalculate simulated lighting in 3D images, and Patent No. 6,219,059 for theuser interface and mechanism used to control the relative transparency of 3Ddata in volume renderings of medical images.

 

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Volume rendering is anadvanced technique for displaying three-dimensional views on a computer monitorthat the Company believes has significant advantages over the alternativetechnique, known as “surface rendering.” Volume rendering permits the direct display of all of the imaging datawithout mathematical modeling and allows interactive control of the level of “transparency”of the data.  By comparison, surfacerendering requires the creation of artificial surfaces based on selectedimaging data, and the usefulness of the resulting visual image is largelydependent on where these surfaces are “set” by the clinical technician.  Volume rendering is not dependent on thecreation of artificial surfaces and allows visualization of varying componentsthat might otherwise be eliminated from a surface rendered image due to surfaceapproximation.  Because volume renderinguses all of the data and information collected by the imaging equipment, theCompany believes visualization processes that use volume rendering provideclinicians with better images to define and display pathology and anatomy in amore useful manner.

 

In the early years ofmedical imaging, most 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 experience withvolume rendering has its basis in the efforts of Vincent J. Argiro, Ph.D., thefounder of the Company, who developed three-dimensional visualization softwareusing volume rendering as an aid in his research in developmentalneuroscience.  Dr. Argiro focused onaccelerating the performance of volume rendering on standard computerplatforms.  As a result of his work, hedeveloped expertise in accelerated volume rendering, which forms the core ofthe Company’s volume rendering technology. Because the performance of standard computer platforms has increasedwhile the relative cost of such performance has decreased, the Company believesthat volume rendering has become a more accessible imaging solution for routineclinical applications.

 

The Company believes thecombination of customized protocols and accelerated volume rendering offered by*Vitrea 2,* together with improvedcomputer performance, allows it to deliver a simple, fast and affordable 3Dmedical 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.

 

CT and MR imagingtechnologies capture data that provide a physician with a graphical representationof the inside of the human body.  Theseimages have traditionally been viewed as a series of two-dimensional,cross-sectional slices on x-ray-type film. As computer processing speed increased, software performance improvedand networking technologies developed, manufacturers of scanning equipmentbegan offering integrated systems that allowed clinicians to view, analyze andmanipulate these medical images in a digital environment.

 

Medical imaging 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, three andfour dimensions (collectively, “3D medical imaging software”).

 

Initially, the 3D medicalimaging industry and the markets for 3D medical imaging products lagged themarket for imaging devices due to the lack of industry standards for thegeneration, transmission and storage of medical imaging data and due tocomputer costs and performance considerations. After a time, many of the technical and cost barriers to growth in the3D medical imaging industry and the PACS industry began to erode.  In particular, the medical industry embracedan image transmission and archiving standard called

 

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DICOM, promulgated by theAmerican College of Radiology and the National Electronic Manufacturer’sAssociation.  This standard permitsimaging, visualization, networking and archiving systems from different vendorsto work cooperatively within a single network. In addition, the cost-to-performance ratio of computer products used invisualization and PACS has improved dramatically, bringing the prices for 3Dmedical imaging capabilities and PACS within the grasp of most healthcareproviders.  The Company believes that theacceptance 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 expectsthat a number of other advantages of 3D medical imaging products will supportgrowth in the 3D medical imaging industry:

 

•                        Recenttechnology improvements in CT and MR scanners enable them to generate anincreasing number of slices per exam, resulting in over 2,000 images, which ismore than 15 times as many images as the same study less than five yearsago.  This makes the viewing of printedimages on x-ray film, rather than in a medical imaging system, logisticallyimpractical and expensive.

 

•                        Recentreimbursement approvals by Medicare, Medicaid, private insurance companies andmanaged care organizations for procedures utilizing positron emissiontomography (“PET”) scanners have greatly increased the number of proceduresperformed.  In addition, recent advancesin integrating CT and PET technologies into a single scanner have alsocontributed to an increase in the number of procedures performed utilizing suchtechnology.  The Company has signed anagreement with Mirada Solutions Limited (“Mirada”) to integrate Mirada’s fusiontechnology into *Vitrea 2* to view images generatedby PET and PET/CT scanners.

 

•                        Thenumber of planning procedures is growing. Physicians are increasingly recognizing the clinical value of 3Dimaging.  In addition, the Baby Boomgeneration has a strong interest in screening procedures for the earlydetection of cancer and heart disease. Accordingly, these factors are driving a demand for an increased numberof scanning procedures.

 

•                        Drivenby a shortage of radiologists, hospital radiology departments are underpressure to perform as efficiently as possible. Thus, an increased workload must be completed with the same or fewerpeople.  Speed in interpreting images isessential for increasing workflow productivity. Thus, there is a clear need for a fast and efficient integrated 2D, 3Dand 4D visualization and analysis tools.

 

•                        Diagnosesbased on 2D images, or “slices,” require the clinician to “assemble” a 3D viewmentally to understand the true anatomy and pathology.  Given the industry pressure to producecost-effective outcomes, 3D imaging is a valuable tool for acceleratingdiagnoses, potentially eliminating unnecessary tests and treatment, optimizingthe use of minimally invasive surgery and therapies, and gaining additionalinsight needed for clinical decisions.

 

•                        Spatialrelationships are of paramount importance in surgery, and 3D views displayinganatomy and pathology can greatly aid in surgical planning.  3D medical imaging has the potential topromote improved surgical outcomes by giving surgeons a better “road map” withwhich to plan their operative procedures. Interactive navigation of volume data from scanners may also have thecapability to spare patients from invasive procedures like endoscopy orconventional angiography.

 

•                        Increaseduse of 3D medical imaging technology has the potential to enhance radiologists’ability to communicate their findings to fellow clinicians, referringphysicians and patients.  In addition,the integration of these clinical disciplines through electronic visualization,networking and the Internet has the potential to provide the opportunity forgreater cross-discipline coordination due to increased speed, access toinformation and the resulting ability to perform consultative, interactiveplanning and examination on computer workstations.

 

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Markets

 

The Company participatesin the rapidly growing 3D medical imaging market.  The 3D medical imaging market alsointerrelates 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 screening andradiology, remote diagnosis and consultation (e.g., telemedicine), surgicalassessment, planning, navigation and follow-up, radiation and chemotherapytreatment planning and medical education. The customers for these applications include radiology, surgery andoncology departments, as well as other clinical specialists, at hospitals andresearch centers, diagnostic imaging and screening centers, outpatient surgerycenters, clinics and physician groups.

 

The diagnostic medicalimaging market continues to expand its boundaries.  Long defined as the market for CT, MR,ultrasound and other imaging modalities, the diagnostic imaging market hasgrown to include both PACS and 3D imaging systems, which have become integraltechnologies for many radiology practices around the world.

 

Today, only a minority ofhospitals, clinics and imaging centers use 3D medical imaging products indiagnostic imaging.  Technologicaladvances over the last several years in both computer hardware and softwaredevelopment have dramatically improved the cost-to-performance ratio, bringingthe prices for 3D medical imaging products into the reach of most healthcareproviders.  In addition, increasingclinical awareness, improving utility of applications and an exponentialincrease in CT slice volumes are driving demand for 3D medical imagingproducts.

 

Based on an increasingnumber of 3D procedures being performed as a result of the growing use ofimaging technology, new 3D screening procedures and broader acceptance of 3Dapplications, Vital Images estimates that the potential worldwide market for 3Dmedical imaging software and workstations, including the U.S. market, will growto $2 billion in less than four years.

 

As discussed above, theoverall market for 3D medical imaging software and systems is developingrapidly, as the related technology and products that define this market arerelatively new and undergoing rapid change. Medical imaging software and system solutions for diagnostic radiologyhave existed for the last several years. The use of medical imaging software and systems to assist in surgicalplanning and navigation has only begun to emerge in clinical practice in thelast few years.  While medical imagingsoftware and systems have been used in these applications and to support cancertreatment planning in the past, the Company believes that perspective,three-dimensional volume rendering represents an underutilized resource topractitioners for diagnostic screening and radiology, surgical planning andnavigation and cancer treatment planning.

 

Strategy

 

The Company’s goal is tobe a leading provider of 3D medical imaging software that improves clinicaloutcomes and reduces costs.  To achievethis goal, Vital Images intends to implement the following key strategies:

 

•                        Developand maintain leading-edge technology*.*  The Company intends to continue its overallstrategy of developing and marketing leading-edge medical 3D medical imagingsoftware for a variety of medical applications. As part of this strategy, the Company will continue to improve the speedand performance of its *Vitrea 2*software.  In particular, the Companywill be focused on developing additional protocols that enhance the ease-of-useof *Vitrea 2*, as well as increasing thenumber of platforms on which *Vitrea 2* willoperate.

 

•                        Furtherdevelop applications for the Company’s 3D medical imaging technology.  The Company intends to leverage its corecompetencies in volume rendering, computer graphics and clinicalapplications.  The Company plans todevelop and offer a full range of 3D medical 

 

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imaging software toolsfor diagnostic imaging, disease screening and therapy planning.  The Company believes that significant newopportunities exist for the application of its innovative technologies for thediagnosis and treatment of cardiovascular disease, cancer and orthopedics.

 

•                        Furtherpenetrate the 3D medical imaging market. The Company intends to expand its sales and marketing staff and increaseits marketing efforts in order to continue building momentum for the acceptanceand 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 thebenefits of its system, the Company believes that it can successfully influencepurchasing decisions for medical institutions purchasing or upgrading theirimaging technology.  In addition, theCompany will work to expand its appeal by implementing additional 2D capabilityas well as ensuring that its technology will easily integrate into PACSnetworks.

 

•                        Continueto seek collaborative partnerships with leading medical institutions.  The Company has historically sought out anddeveloped collaborative relationships with several prestigious medicalinstitutions to develop and test the Company’s visualization and analysistools.  The Company will continue topursue collaborations to focus on developing products that will improve clinicaloutcomes and reduce costs for the practices of medical imaging and surgery.

 

•                        Continueto seek collaborative partnerships with leading medical technology companies.  In addition to collaborations with medicalinstitutions, the Company intends to selectively pursue relationships withleading medical technology companies to expand the Company’s clinical,distribution, financial and/or technical capability for its 3D medical imagingsoftware products.  Examples of suchrelationships include the Company’s development, marketing and/or distributionagreements with Toshiba; the Surgical Navigation Technologies division ofMedtronic, Inc.; E-Z-EM, Inc.; R2 Technology, Inc. (“R2”); McKesson InformationSolutions (“McKesson”) and Mirada. See “Business-Marketing and Distribution,” “–IntellectualProperty” and “–Manufacturing and Service.” 

 

Products and ProductDevelopment

 

*Vitrea**.*  In December 1995,the Company assessed its business strategy and determined that to optimize itsdedicated participation in the medical field, it needed to create a new productfor direct clinical application.  Theobjective for this new product effort was to produce an easy-to-use clinicalsoftware tool to allow radiologists and other clinicians to use two- andthree-dimensional visualization in their routine clinical processes.  Unlike its predecessor software, *VoxelView®*, the Company set out to design this new softwareproduct for users with clinical knowledge rather than computer graphicsexpertise.  Specifications for this new product,called *Vitrea,* were developed in early 1996,with software development beginning in late spring of that year.  The Company submitted 510(k) documentation inSeptember 1996 for *Vitrea* and wasgranted marketing clearance by the U.S. Food and Drug Administration (the “FDA”)in November 1996 for use as a clinical diagnostic and surgical planningdevice when used with CT and MR medical imaging data.  *Vitrea* wasfirst 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/3D visualization and analysis ofmedical image data.  *Vitrea 2*was Vital Images’ first 3D-volume medical imaging software product availablefor the Microsoft Windows operating system and provides the speed andease-of-use the medical community demands for diagnosis and treatment planningin a clinical environment.  In December 2003,the Company released *Vitrea 2 Version 3.4*,which has improved usability and networking features to meet the diagnostic,screening and therapy planning needs of busy radiology departments and operateson the Microsoft Windows XP operating system.

 

*Vitrea 2*capitalizes on the Company’s experience in 3D medical imaging and providesclinicians with an easy-to-use tool for disease screening, radiologicaldiagnosis and therapy planning.  Itrepresents the Company’s 

 

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most important step todate as a provider of a range of clinical tools for broad distribution to the3D medical imaging market.  *Vitrea 2’s* primary features are its high-speed renderingcapability and its ability to provide two- and three-dimensional viewing forroutine diagnosis and therapy planning without requiring the user to be trainedin computer graphics techniques.  TheCompany believes that both of these features - speed and ease-of-use - now makeit possible to use three-dimensional medical imaging in daily clinicalroutines.  A *Vitrea 2*user, following a built-in clinical workflow, can view the image data in two,three or four dimensions using visualization settings based on specificclinical applications stored within the system as dedicated visualizationprotocols.  The user may then interactivelynavigate around, or “fly through,” the image to view clinically relevantanatomies and pathologies.  *Vitrea 2*software also allows the user to capture views bytaking “snapshots,” which can be integrated into customized reports forelectronic transmission and archiving through a DICOM network or sent toanother location via the Internet.

 

*Vitrea 2*software conforms to the latest medical imaging and computer industrystandards, such as *OpenGL*TMcomputer graphics application programming interface and DICOM.

 

The Company offers *Vitrea 2* both as an integrated software and hardware system,consisting of *Vitrea 2*software installed on apersonal computer (“PC”) and as a stand-alone software package.  Pursuant to purchasing arrangements betweenthe Company and computer resellers, the Company purchases personal computers ata nominal discount, installs its *Vitrea 2*software,and markets the package as an integrated 3D medical imaging solution.  Some customers prefer to purchase their ownhardware.  For such customers, as well aswhen selling to its diagnostic imaging OEM and PACS partners, the Company sellssoftware licenses only for use on hardware qualified by the Company for usewith *Vitrea 2.*  Currently, *Vitrea 2*operates on PC workstations from Omni Tech, Inc., Hewlett-Packard Company andDell Computer Corporation.  The listprice for a base model integrated workstation and software package isapproximately $87,000, and the list price for the *Vitrea 2*software without a workstation is approximately $75,000.

 

In addition to itsimmediate clinical applications, *Vitrea 2*softwareincorporates a number of additional technological advances, thereby making itadaptable to routine clinical use in surgical navigation and cancer treatmentplanning and for integration into diagnostic imaging equipment and PACSnetworks manufactured and sold by other companies.  In particular, *Vitrea 2*software was written using advanced programming techniques, a modular,object-oriented design, C++ programming language, and a shared messagingstructure.  The Company believes thesecharacteristics make it practical to modify *Vitrea 2*software to suit the clinical needs of surgical navigation and oncology, aswell as allowing diagnostic equipment and PACS network manufacturers tointegrate *Vitrea 2*software into their product offerings,thereby providing the Company with the opportunity to leverage the *Vitrea 2* software development investment into new commercialareas.

 

Software options.  In addition to *Vitrea 2*, the Company has developed a number of value-addedsoftware options that work with the base *Vitrea2* software platform.  Theseoptions provide a variety of clinical information and have list prices rangingfrom $20,000 to $50,000 each.

 

*VScoreTM*.  In August 1999, the Company introducedits *VScore*software for coronary arterycalcium scoring.  The *VScore* software product was the Company’s first add-onoption to the Company’s *Vitrea 2* 3Dmedical imaging software product.  The *VScore* option adds the functionality to non-invasivelyquantify calcium in the four major coronary arteries using CT image data.

 

CT Brain Perfusion.  In October 2001, the Company introducedits CT Brain Perfusion software option to assist radiologists in analyzingblood flow of stroke victims where the speed of diagnosis and treatment isoften the primary factor in determining the extent of recovery.

 

CT Colonography.  Also, in October 2001, the Companyintroduced its CT Colonography software option, which generates two- andthree-dimensional images of the entire colon, increasing the speed and ease oflocating and analyzing polyps.  Theoption provides a less invasive, more comfortable diagnostic procedure thanpreviously possible, improving patient compliance for screening.

 

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Automated VesselMeasurements.  In October 2001,the Company introduced its Automated Vessel Measurements software option toassist physicians in characterizing the course and dimensions of diseased bloodvessels.  The Automated VesselMeasurements option is designed to support activities such as pre-surgicaldiagnosis, evaluation and stent planning in the abdominal aorta, carotidarteries, coronary arteries and renal arteries.

 

CT Cardiac.  In February 2003, the Company introducedits CT Cardiac software option, which defines the coronary anatomy and thedegree of luminal obstruction of the coronary arteries.  It is commonly used to determine the extentof obstructive coronary artery disease and to assess the feasibility andappropriateness of various forms of therapy or surgical interventions.

 

Vessel Probe.  In December 2003, the Company introducedits Vessel Probe option as a complementary product to its CT Cardiacoption.  It is used to define vascularanatomy and the degree of luminary obstruction in vessels other than the coronaryarteries.  With this option, physicianscan determine the extent of obstructive vascular disease and assess thefeasibility of various forms of therapy or surgical interventions.  

 

Concurrent License.  In December 2003, the Company introducedits Concurrent License option which gives multiple end users the ability toshare a single *Vitrea 2* license within afacility.  While limiting the number ofsimultaneous users to the number of *Vitrea 2*licenses purchased, the Concurrent License option allows *Vitrea 2*software to be accessed from multiple reading stations within an enterprise.

 

Lung Tools.  In December 2003, the Company introducedthe Lung Tools product developed by R2 for the visualization andcharacterization of lung nodules.  Nowintegrated into *Vitrea 2,*this option is designedto improve the efficiency of radiologists when reviewing chest CT exams.

 

Maintenance and Support.  In addition to its system and softwareproducts, the Company also offers maintenance and support services to itscustomers, as well as certain other services such as installation andtraining.  In connection with thelicensing of *Vitrea 2*software, the Companymarkets annual maintenance and support 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 other general supportservices for an annual fee of approximately $9,000.  Outside of these maintenance services, theCompany is required by FDA regulations to provide certain levels of support toend users as a result of the use of its products as medical devices.  Maintenance and support services currentlymarketed by the Company do not include installation, training and otherservices, whether on- or off-site, as such services are charged separately bythe Company.

 

License fees accountedfor 67%, 67% and 66% of total revenue in each of the fiscal years ended December 31,2003, 2002 and 2001, respectively. Maintenance and services comprised 25%, 19% and 16% of total revenue forthe years ended December 31, 2003, 2002 and 2001, respectively, whilehardware sales accounted for 8%, 14% and 18% of total revenue for the yearsended December 31, 2003, 2002 and 2001, respectively.

 

The Company charged $3.8million, $2.9 million and $1.7 million to cost of revenue for customer support,installation and training services and expensed $5.2 million, $4.1 million and$3.4 million incurred in its research and development efforts in each of thefiscal years ended December 31, 2003, 2002 and 2001, respectively.

 

CollaborativeRelationships

 

Vital Images has formedcollaborative relationships with some of the leading universities andphysicians in medicine and medical imaging to develop what it believes to be themost innovative and clinically relevant 

 

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medical imagingsolutions.  Vital Images has entered intoclinical collaboration agreements with universities and physicians to:

 

•                        Identifynew clinical applications where 3D medical imaging can improve clinicaloutcomes and reduce costs;

 

•                        Assistin the development of clinical routines that incorporate Vital Images’ 3Dmedical imaging software in normal diagnostic, screening and therapy planningpractices;

 

•                        Consultin the development of new features that facilitate and improve diagnosis andtherapy planning for Vital Images’ future products;

 

•                        Assessthe clinical value of Vital Images’ 3D medical imaging software for givenapplications; and

 

•                        Developautomated rendering protocols for 3D CT or MR data.

 

The Company’s agreementswith its collaborative partners do not provide such partners with any ownershipof technology developed by the Company in connection with the collaboration anddo not provide for the payment of any fees or royalties to such collaborators.

 

Competition

 

The 3D medical imagingmarket is developing and growing rapidly. It is intensely competitive, subject to rapid change and significantlyaffected by new product introductions and other market activities of industryparticipants.  The Company’s primarycompetitors are diagnostic imaging system suppliers, which are typically large,multinational companies, having far greater financial and technical resourcesthan the Company. They also have well-established sales and distributionnetworks for their products. These companies, including GE Medical Systems,Siemens Medical Systems, Inc. and Philips Medical Systems, are engaged in thebusiness of developing and marketing medical imaging systems, such as CT and MRequipment.  These competitors offer 3Dmedical imaging capabilities integrated with their products in addition to the2D medical imaging capabilities typically provided as a part of the operator’sconsole on the imaging equipment itself. This medical imaging capability may be internally developed by thesecompanies, or it may be licensed from independent vendors.  In order to compete effectively with thesecompanies, Vital Images must convince customers to separate their purchasingdecisions regarding the imaging equipment itself from the selection andpurchase of the 3D medical imaging workstations instead of purchasing an entireintegrated system manufactured by one entity.

 

The Company also facescompetition from other medical imaging systems and software suppliers and PACSvendors.  Other medical imaging systemsand software suppliers compete on the basis of volume rendering or othervisualization technologies, specific applications or market niches.  Most of these suppliers, including VoxarLtd., Viatronix, Inc. and TeraRecon, Inc., are similar in size or smallercompanies than Vital Images.  PACScompanies sometimes provide medical imaging capability in addition to theirimage archiving and networking products. Vendors of hospital, clinical and radiology information systems havealso 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 an integrated system covering a full range of administrative,clinical and radiology information management capabilities to healthcareproviders.

 

The Company’s competitivestrength is based on its ability to do the following:

 

•                  Providedifferentiated 3D medical imaging products that operate in multi-vendor networkand image source environments.

•                  Provideclinical quality, three-dimensional images, volume rendered at high speed withinteractive navigation on a relatively low-cost standard computer.

 

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•                  Integrateclinical knowledge from its collaborative clinical partners into its products.

•                  Leverageits visualization technology across multiple clinical disciplines, includingclinical diagnosis, disease screening and therapy planning.

•                  Offera “DICOM client” product, which can operate on any DICOM network, independentof the imaging system and network provider.

•                  Serveboth original equipment manufacturers (“OEMs”), PACS vendors and end-usercustomers through the development of a modular end-user product that can easilybe segmented for OEM customers or integrated into a PACS environment.

 

The Company believes thatproduct quality, performance, functionality and features, quality of supportand service, reputation and price are also important competitive factors.  The Company believes that customers willprefer *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 andDistribution

 

The Company markets *Vitrea 2* both as a software package and as part of anintegrated software and hardware system to radiologists, surgeons, primary carephysicians and medical researchers.  TheCompany markets its products directly to end-user customers, such as hospitalsand clinics, as well as to select diagnostic imaging companies, digital imagingequipment manufacturers and PACS companies for resale as a Vital Images brandedproduct.  In November 2001, theCompany signed a joint venture agreement to work collaboratively on productsand services in image-guided surgery and surgical planning with the SurgicalNavigation Technologies (“SNT”) division of Medtronic, Inc. Under thisagreement, the Company’s advanced visualization technology will be integratedinto Medtronic SNT’s image-guided surgery products, and the two companies willcollaborate 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 September 2000,the Company signed a marketing and distribution agreement with Toshiba AmericaMedical Systems (“TAMS”), which named *Vitrea2* as TAMS’ primary 3D software for use with its CT scanners in theUnited States.  In February 2002,the Company announced that it had entered into a marketing and distributionagreement with Toshiba Medical Systems Corporation to offer *Vitrea 2* to**its subsidiaries and distributors, including TAMS, in morethan 50 countries in North and South America, Europe, the Middle East, Africa,Australia and Asia, except Japan. The agreement has twice been amended. Mostrecently, in December 2003, the Company announced that it had renewed theagreement through December 31, 2004. In July 2003, the Company signed a joint distribution agreementwith McKesson where each company was granted the right to distribute the otherparty’s products.  See “Business –Dependence on Major Customers.”

 

In addition, the Companymarkets its products directly to select OEMs on either a standard basis or, inthe case of Medtronic SNT, on a customized basis.  In connection with its OEM opportunities, theCompany will either provide complete systems for resale by such OEMs or willprovide elements of its technology for incorporation into the products andsystems of such OEMs.

 

The Company markets itsproducts both domestically and internationally. In the United States, the Company markets its products through itsdirect sales force as well as through OEMs and resellers.  Internationally, the Company markets itsproducts through OEMs and resellers.  SeeNote 8 to the Financial Statements - “Major Customers and Geographic Data” forinformation regarding the Company’s export sales.  As of December 31, 2003, the Company had29 field salespeople in the U.S., one international reseller salesperson, oneOEM customer and 11 international resellers, many of whom are also Toshibaresellers.

 

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Customers and CustomerSupport

 

Through December 31,2003, the Company has sold over 1,300 separate software licenses for *Vitrea*,*Vitrea 2* and InnerviewGITMfor use in over 1,000 different sites, including hospitals, clinics, imagingcenters and other sites.  Due to theadvantages of the *Vitrea 2* software – fast andeasy-to-use - the Company’s customers include large teaching hospitals in majorcities in the United States as well as hospitals and clinics in smallerpopulation areas.

 

The Company is committedto rapid response to customer service requests. Customer support representatives are available during the Company’sbusiness hours to answer questions about the operation, maintenance and repairof the Company’s products.

 

Intellectual Property

 

Although the Company hasfiled patent applications with respect to certain aspects of its technology, itgenerally does not rely on patent protection with respect to its products andtechnologies.  Instead, the Companyrelies primarily on a combination of trade secret and copyright law, employeeand third-party nondisclosure agreements and other protective measures toprotect intellectual property rights pertaining to its products andtechnologies.  Because of the rapid paceof technological change in the 3D medical imaging industry, the Companybelieves that the knowledge, ability and experience of its personnel; newproduct developments and enhancements; and ongoing, reliable productmaintenance and support are also significant factors in its competitiveposition.

 

The Company has beenissued Patent No. 5,986,662 from the U.S. Patent and Trademark Office for itsmechanism for automated protocol selection. The use of automated protocol selection within *Vitrea 2*allows the user to view image data in two or three dimensions usingvisualization settings based on specific clinical applications stored withinthe software.  This unique technologyadds significantly to the simplicity of use of the software — a key advantageover competing technologies.  The Companyhas been issued Patent No. 6,130,671 for the mechanism to calculate simulatedlighting in 3D images.  The mechanism forcalculating simulated lighting in 3D images permits “two-sided lighting” involume-rendered images, which is crucial for viewing image data that representsedges of bright as well as dark regions. These include producing simulated endoscopic images of contrast-filledblood vessels, the gastrointestinal tract and the urinary system.  The Company has been issued Patent No.6,219,059 for the user interface and mechanism used to control the relativetransparency of 3D data in volume renderings of medical images.  Volume rendering is an advanced technique fordisplaying two- or three-dimensional views on a computer screen.  It permits the direct display of all of theimaging data without mathematical modeling and allows interactive control ofthe level of “transparency” of the data. All of the patents listed above are utilized in the *Vitrea 2*software.

 

The Company does not ownall of the software and other technologies used in its products, but it has thelicenses from third parties that the Company believes are necessary for usingthat technology in its current products. It may be necessary to renegotiatewith such third parties for any new versions of current products or any newproducts. Such third party licenses may not be available on reasonable terms,or at all.

 

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Manufacturing and Service

 

The Company’smanufacturing efforts are limited to the production, quality assurance anddistribution of its software, which is distributed on CD-ROM.  The software is sent to the customer site andloaded into a personal computer.  Thesoftware for *Vitrea 2* is loaded into thecomputer by Company personnel, as part of the Company’s installation services,which are priced and billed incrementally to the software license billing, byan authorized reseller’s personnel as part of their installation services or byqualified IT personnel from the customer. In addition to the loading of software into the computer, installationservices generally include integrating *Vitrea 2*workstations into customers’ computer networks, configuring the networkrequirements and verifying software operability on site.

 

The Company reliesprimarily on its own software development as its core competence.  The Company sources certain application andutility software from third parties (see “—Intellectual Property” above) andthe operating system for integrated computer workstations from otherparties.  In addition, the Companysources systems components, computers and computer peripherals from third partysuppliers.

 

The Company has alsosigned reseller distribution agreements that allow it to distribute productsfrom certain third parties.  The Companycurrently has agreements with R2 for R2’s ImageChecker® CT softwareapplications for the detection of lung nodules, Mindways Software, Inc. forMindways’ QCT PRO BMD software for measuring bone density, and Mirada forMirada’s Fusion 7D software application for the anatomical alignment of twodifferent image data sets from two different modalities.

 

Governmental Regulation

 

As medical devices, theCompany’s 3D medical imaging software products are subject to extensive andrigorous regulation by numerous governmental authorities, principally the FDAand corresponding foreign agencies.  Inthe United States, the FDA administers the Federal Food, Drug and Cosmetic Actand its amendments.  These regulationsclassify medical devices as either Class I, II or III devices, which aresubject to general controls, special controls or pre-market approval requirements,respectively.  Most Class I and IIdevices, as well as some Class III devices, can be cleared for marketingpursuant to a 510(k) pre-market notification. The process of obtaining a 510(k)clearance typically can take several months to a year or longer.

 

Class III devicesgenerally require more stringent clinical investigation and pre-marketclearance requirements.  In such cases,the FDA will require that the manufacturer submit a pre-market approval (“PMA”)application that must be reviewed and approved by the FDA prior to the sale andmarketing of the device in the United States. The process of obtaining a PMA can be expensive, uncertain and lengthy,frequently requiring anywhere from one to several years from the date of FDAsubmission, if approval is obtained at all. Moreover, a PMA, if granted, may include significant limitations on theindicated uses for which a product may be marketed.

 

*Vitrea 2* isclassified as a Class II medical device and has received marketing clearancesfrom the FDA as the result of 510(k) pre-market notifications.  Specifically, *Vitrea 2*and the Company’s add-on options have been cleared to be marketed for use withCT and MR scanners.  Future products,add-on options to existing software, and expanded claims of efficacy willlikely require additional 510(k) pre-market notifications.

 

There can be no assurancethat future FDA review processes will not involve delays or that certainclearances will be granted on a timely basis.

 

The Company is alsoincreasingly becoming subject to regulation in those foreign countries in whichit sells its products.  Many of theregulations applicable to the Company’s products in such countries are similarto those of the FDA.  The Company’sability to successfully market and sell its products in foreign markets dependsin large part on its ability to comply with such foreign regulatoryrequirements. *Vitrea 2* software has been 

 

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Conformitee Europeene (“CE”)marked, indicating conformance with applicable sections of the Medical DeviceDirective 93/42/EEC, which allows the product to be marketed in the membercountries of the European Communities.

 

The Company is alsosubject to periodic inspections by the FDA and similar foreign regulatoryagencies, whose primary purpose is to audit the Company’s compliance withquality system regulations established by the FDA and other applicablegovernment standards.  Regulatory actionmay be initiated in response to audit deficiencies or to product performanceproblems.  The Company believes that itsmanufacturing and quality control procedures are in essential compliance withthe requirements of the FDA regulations and foreign regulatory agencies incountries to which it sells its products.

 

The Company has receivedISO 9001 Certification that has been updated to include ISO 13485 complianceand also has an upgraded Class I Measurement CE Mark for its medical imagingsoftware products..

 

The financialarrangements through which the Company markets, sells and distributes itsproducts may be subject to certain federal and state laws and regulations inthe United States with respect to the provision of services or products topatients who are Medicare or Medicaid beneficiaries.  Violations of these laws and regulations mayresult in civil and criminal penalties, including substantial fines andimprisonment.  In a number of states, thescope of these laws and regulations have been extended to include the provisionof services or products to all patients, regardless of the source of payment,although there is variation from state to state as to the exact provisions ofsuch laws or regulations.  In otherstates and, on a national level, several health care reform initiatives havebeen 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 Reimbursementand Cost Containment

 

The Company’s productsare purchased primarily by hospitals, clinics, imaging centers and other usersthat bill various third party payers for the services provided to thepatients.  These payers, which includeMedicare, Medicaid, private insurance companies and managed care organizations,reimburse part or all of the costs and fees associated with the diagnosticprocedures utilizing the Company’s products. The medical imaging services performed using the Company’s software,except for disease screening procedures, are covered by current CPT codes(Current Procedural Terminology, as defined by the Centers for Medicare &Medicaid Services).  As such, hospitalsproviding services on the Company’s 3D medical imaging workstations can seekreimbursement by using existing approved CPT codes.  Medicare and Medicaid reimbursement forhospitals is based on a fixed amount for admitting a patient with a specificdiagnosis.  Because of this fixed reimbursementmethod, hospitals have incentives to use less costly methods in treatingMedicare and Medicaid patients, and they will frequently make capitalexpenditures to take advantage of less costly treatment technologies.  Often, reimbursement is reduced to reflectthe availability of a new procedure or technique and, as a result, hospitalsare generally willing to implement new cost-saving technologies before thesedownward adjustments take effect. Likewise, because the rate of reimbursement for certain physicians whoperform certain procedures has been, and may in the future, be reduced in theevent of changes in the resource-based relative value scale method of paymentcalculation, physicians may seek greater cost efficiency in treatment tominimize any negative impact of reduced reimbursement.  Any amendments to existing reimbursementrules and regulations which restrict or terminate the reimbursement eligibility(or the extent or amount of coverage) of medical procedures using the Company’sproducts or the eligibility (or the extent or amount of coverage) of theCompany’s products could have a material adverse impact on business.

 

In response to the focusof national attention on rising health care costs, a number of changes toreduce costs have been proposed or have begun to emerge.  There have been, and may continue to be, proposalsby legislators and regulators and third party payers to reduce thesecosts.  There has also been a significantincrease in the number of Americans enrolling in some form of managed care planand, in addition, many hospitals participate in or have agreements withHMOs.  It has become a typical practicefor hospitals to 

 

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affiliate themselves withas many managed care plans as possible. Higher managed care penetration typically drives down the prices ofhealthcare procedures, which in turn places pressure on medical supplyprices.  This causes hospitals toimplement tighter vendor selection and certification processes by reducing thenumber of vendors used, purchasing more products from fewer vendors and tradingdiscounts on price for guaranteed higher volumes to vendors.  Hospitals have also sought to control andreduce costs over the last decade by joining group purchasing organizations orpurchasing alliances.  The Company cannotpredict what continuing or future impact these practices, the existing orproposed legislation, or such third party payer measures may have on its futurebusiness.

 

Health InsurancePortability and Accountability Act of 1996 (“HIPAA”)

 

The HIPAA regulations arecausing customers of the Company to request that the Company sign “businessassociate” agreements with them.  A “businessassociate” is a person or entity that performs certain functions or activitiesthat involve the use or disclosure of protected health information on behalfof, or provides services to, a covered entity. By law, the HIPAA Privacy Rule applies only to covered entities – healthplans, health care clearinghouses, and certain health care providers.  However, most health care providers do notcarry out all of their health care activities and functions by themselves.  Instead, they often use the services of avariety of other persons or businesses. The Privacy Rule allows covered providers and health plans to discloseprotected health information to these “business associates” if the providers orplans obtain satisfactory assurances that the business associate will use theinformation only for the purposes for which it was engaged by the coveredentity, will safeguard the information from misuse, and will help the coveredentity comply with some of the covered entity’s duties under the PrivacyRule.  Covered entities may discloseprotected health information to an entity in its role as a business associate *only* to help the covered entity carry outits health care functions – not for the business associate’s independent use orpurposes, except as needed for the proper management and administration of thebusiness associate.

 

Employees 

 

As of February 29,2004, the Company had 134 full-time employees, with 46 involved in research anddevelopment, 45 in sales and marketing, 24 in technical support functions and19 in administrative functions.  TheCompany is not a party to any collective bargaining agreement involving itsemployees and believes its relationship with its employees is good.

 

Acquisition ofHInnovation, Inc.

 

On February 18,2004, the Company completed the acquisition of HInnovation, Inc. (“HInnovation”)in accordance with the terms and conditions of an Acquisition Agreement andPlan of Reorganization (the “Acquisition Agreement”) dated as of January 8,2004 by and among Vital Images, HInnovation Acquisition, Inc., a wholly-ownedsubsidiary of Vital Images (“HInnovation Acquisition”), HInnovation and Mr. HuiHu and JMS Co., Ltd., the principal stockholders of HInnovation.  Pursuant to the Acquistion Agreement,HInnovation was merged with and into HInnovation Acquisition, and HInnovationbecame a wholly-owned subsidiary of Vital Images.

 

The merger considerationincluded 376,262 newly-issued shares of common stock of Vital Images valued at$6 million and $6 million in cash.  Inaddition, the merger consideration includes contingent milestone paymentscomprised of newly-issued shares of Vital Images common stock with an aggregatevalue of $3 million and $3 million in cash. The Company expects the contingent milestone payments to be madeperiodically as the milestones are achieved over a 12 to 24 month periodfollowing the date of acquisition.  Themerger consideration was and any contingent consideration is to be paid to theformer stockholders of HInnovation.  Thetype and amount of merger consideration was determined by arm’s-lengthnegotiation among the parties.

 

HInnovation was aprivately-held company founded in June 2000 and is a provider of innovativeand cost-effective solutions to deliver medical imaging software applicationsand services online.  HInnovation’senabling technologies have been developed to help hospitals, clinics andindustry reach a new dimension in 

 

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optimizing workflow,improving productivity, enhancing service and increasing revenue.  It obtained 510(k) marketing clearance forits product, iConnectionTM, from the FDA in November 2001.  HInnovation was awarded U.S. Patent No.6,621,918, which protects a server-based MPR/3D/4D software system anddesign.  The iConnection software enablesphysicians to use existing ordinary Internet-connected PCs to access the same2D/3D/4D imaging applications and functionalities typically only available on3D diagnostic workstations.  WithiConnection software, users can review and analyze patients’ diagnostic imagesover the Internet whenever and wherever the need arises.

 

ImportantFactors

 

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*

 

For the years ended December 31,2003 and 2002, the Company had operating income of $1.9 million and$677,000.  However, the Company had anoperating loss of $1.1 million for the year ended December 31, 2001 and,with the exceptions of the fiscal years ended December 31, 2003 and 2002and October 31, 1995, has incurred operating losses each year since1990.  As of December 31, 2003, theCompany’s accumulated deficit was $11.6 million.  The Company’s ability to maintain annualprofitability will depend on, among other things, its ability to successfullymarket its products, make new product offerings, respond to competitivedevelopments and attract and retain qualified sales, technical and managementemployees.  The Company may not be ableto continue to achieve profitable operations on an annual basis.  See “Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”

 

*Market Acceptance*

 

The Company’s successdepends on its ability to successfully market its *Vitrea 2*software for clinical use, and on the ability and willingness of physicians touse 2D, 3D and 4D medical imaging software in disease screening, clinicaldiagnosis and therapy planning.  Thethree-dimensional medical imaging software offered by *Vitrea 2*represents a new alternative to the conventional methods traditionally used forviewing medical images in the clinical setting. The acceptance of *Vitrea 2* byphysicians and other clinicians will depend on the Company’s ability to educatethose users as to the speed, ease-of-use and other benefits offered by the *Vitrea 2* system, as well as the Company’s timelyintroduction of new features and functions. There can be no assurance that users will prefer three-dimensionalmedical imaging software over less expensive two-dimensional medical imagingsoftware or that the Company will succeed in its efforts to further develop,commercialize, and achieve market acceptance for its *Vitrea 2*product or for any other product in the clinical setting.  See “Business—Technology,” “—IndustryBackground,” “—Markets” and “—Competition.”

 

*Substantial Reliance on a SingleProduct*

 

Revenue from sales of the*Vitrea 2* system constituted 96% of theCompany’s total revenue for the year ended December 31, 2003, 98% of theCompany’s total revenue for the year ended December 31, 2002, and 96% ofthe Company’s total revenue for the year ended December 31, 2001.  The Company anticipates that revenue from thesale of *Vitrea 2* will continue to account for asubstantial portion of the Company’s revenue for the foreseeable future.  As such, the failure of physicians to accept *Vitrea 2* would have a material adverse impact on the Company’sresults of operations and financial condition.

 

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*Dependence on Market Growth*

 

The 3D medical imagingindustry in which the Company markets its products is still developing due tothe fairly recent availability of high performance computers at reduced prices,the recent adoption of industry standards for the generation, transmission andstorage of medical imaging data, and changing medical practices. Historically,there has been a perception that three-dimensional imaging was too slow ordifficult for clinical use.  Thisperception was due largely to the relatively slower processing speed ofworkstations available in the past.  TheCompany believes that the recent advances in the affordability of highperformance computers and in the development of industry standards for thegeneration, transmission, and storage of imaging data will provideopportunities for growth in the 3D medical imaging industry.  However, given the uncertainties associatedwith the developing stage of this industry, there can be no assurance that itwill continue to develop in the manner anticipated by the Company.  Accordingly, there can be no assurance that the3D medical imaging industry will provide growth opportunities for the Companyand its software products or that the Company’s business strategies will besuccessful as the 3D medical imaging industry continues to evolve.  Ultimately, if the 3D medical imagingindustry fails to develop as the Company expects, the Company’s business,results of operations and financial condition will be materially and adverselyaffected.

 

*Highly Competitive Industry*

 

The Company faces intensecompetition in the 3D medical imaging industry. The Company expects technology to continue to develop rapidly, and theCompany’s success will depend to a large extent on its ability to maintain acompetitive position with its products. The Company’s competitors in the 3D medical imaging industry includelarge, established manufacturers of CT and MR imaging equipment.  Companies such as GE Medical Systems, SiemensMedical Systems, Inc. and Philips Medical Systems typically offer their ownmedical imaging software and workstations as part of their integrated imagingand scanner systems.  The Company’sability to successfully market and sell its current 3D medical imaging productsto prospective customers depends, in part, on its ability to persuade suchcustomers to separate the purchase of CT or MR equipment from the selection andpurchase of 3D medical imaging workstations. In addition to having significantly greater capital and staffingresources for research and development that are critical to success in therapidly changing 3D medical imaging industry, such companies also havewell-established marketing and distribution networks and have a competitiveadvantage in marketing 3D medical imaging tools as an integrated part of theirimaging products.  While price has beenless significant than other factors, increasing competition may result in pricereductions and reduced gross margins. Additionally, the Company faces competition from other entities, such assoftware suppliers and PACS vendors.  TheCompany may not be able to compete effectively with such manufacturers orcompeting entities.  See “Business—Technology,”“—Industry Background” and “—Competition.”

 

*Risk of TechnologicalObsolescence*

 

The 3D medical imagingmarket is characterized by rapid innovation and technological change.  The Company may be unable to competeeffectively in the marketplace, and products developed by its competitors mayrender its products obsolete or non-competitive.  Similarly, the Company’s competitors maysucceed in developing or marketing products that are viewed as providingsuperior clinical performance or are less expensive than the Company’s currentor future products.

 

*Dependence on Major Customers*

 

One of the Company’sprincipal distribution channels is to sell its *Vitrea 2*medical imaging software for inclusion with the delivery of medical imagingequipment being sold by Toshiba.  Salesby the Company to Toshiba accounted for approximately 42%, 34% and 27% of theCompany’s total revenue for the years ended December 31, 2003, 2002 and2001, respectively.  Toshiba’s accountreceivable represented 7% of the Company’s accounts receivable at December 31,2003 and 21% at December 31, 2002. Management believes a limited number of large customers may continue toaccount for a significant portion of the Company’s

 

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revenue during any givenperiod for the foreseeable future. Except for its marketing and distribution agreements with Toshiba,Medtronic SNT, E-Z-EM, Inc. and McKesson, the Company currently has nolong-term purchase or other agreements with any of its customers, and itgenerally makes sales pursuant to purchase orders.  A reduction, delay, or cancellation of ordersfrom one or more of its significant customers, or its inability to collect accountsreceivable from these customers, likely would have a material adverse effect onthe Company’s operating results.  See “Business-Marketingand Distribution.”

 

*Impact of Purchase Commitments*

 

In November 2002,the Company entered into an agreement with R2 to distribute R2’s lung noduleCAD software product in conjunction with the Company’s products.  During the three-year period beginning withthe later of either the date R2 is able to meet CE certification requirementsand produce a “Declaration of Conformance” for the lung CAD product or thecompletion of milestones in the development plan for the lung CAD product thatwill be distributed in Europe, the Company is required to begin purchasing thelung CAD product from R2.  R2 met CEcertification requirements and produced a “Declaration of Conformance” for thelung CAD product in 2003, and the Company completed the milestones in thedevelopment plan in January 2004 with respect to the lung CAD product thatwill be distributed in Europe. Accordingly, the Company will be required to begin purchasing the lungCAD product in the first half of 2004. The total purchase commitment will be a maximum of $5.6 million ofproduct over the three-year commitment period. The purchase commitment price the Company has to pay will be reduced ifthe selling price of the lung CAD product when sold directly to end-users by R2falls below a specified price.  Thepurchase commitment units the Company is required to purchase will be reducedif R2 and its other distributors of the lung CAD product are unable to sell asmany units as the Company is required to purchase.  However, the Company must purchase theminimum amount under the agreement with R2 regardless of how much of the lungCAD product it sells.  If the cost of thelung CAD product the Company buys is greater than the price of the lung CADproduct it sells, or if the Company is unable to sell some or all of the lungCAD product it buys, its business could be adversely affected.

 

*Fluctuations in Operating Results*

 

The Company mayexperience significant fluctuations in future annual and quarterly operatingresults.  If these fluctuations occur,they may result in volatility in the price of the Company’s common stock.  Quarterly revenue and operating results mayfluctuate as a result of a variety of factors that are outside of our controlincluding, but not limited to, the timing of significant orders, the timing ofproduct enhancements and new product introductions by the Company or itscompetitors, the pricing of the Company’s products, changes in customers’budgets, and competitive conditions.

 

*Government Regulation*

 

The Company’s productsare subject to regulation by the FDA and by comparable agencies in foreigncountries.  In the United States, the FDAregulates the development, introduction, manufacturing, labeling and recordkeeping procedures for medical devices, including 3D medical imaging softwareand systems.  The process of obtainingmarketing clearance from the FDA for new products and new applications for existingproducts can be time-consuming and expensive. All of the current products actively marketed by the Company havereceived marketing clearance from the FDA pursuant to 510(k) pre-marketnotifications.  *Vitrea 2*and the Company’s add-on options have been cleared to be marketed for use withCT and MR scanners..  The FDA may notgrant clearance with respect to the Company’s future products or enhancements,or future FDA review may involve delays that could adversely affect the Company’sability to market such future products or enhancements.  In addition, the Company’s future products orenhancements may be subject to the more lengthy and expensive pre-marketapproval process with the FDA.

 

Even if the Companyobtains regulatory clearances and approvals to market a product from the FDA,these approvals may entail limitations on the indicated uses of theproduct.  Product clearances andapprovals by the

 

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FDA can also be withdrawndue to failure to comply with regulatory standards or the occurrence ofunforeseen problems following initial approval. The FDA could also limit or prevent the distribution of the Company’sproducts and has the power to require the recall of such products.  FDA regulations depend heavily onadministrative interpretation, and future interpretations made by the FDA orother regulatory bodies may adversely affect the Company.  The FDA may inspect the Company and itsfacilities from time to time to determine whether the Company is in compliancewith various regulations relating to specification, development, documentation,validation, testing, quality control and product labeling.  If the FDA determines that the Company is inviolation of such regulations, it could impose civil penalties, includingfines, recall or seize products and, in extreme cases, impose criminalsanctions.

 

The Company markets itsproducts both domestically and internationally. International regulatory bodies have established varying regulationsgoverning product standards, packaging requirements, labeling requirements,import restrictions, tariff regulations, duties and tax requirements.  The inability or failure of the Company tocomply with the varying regulations, or the imposition of new regulations,could restrict its ability to sell its products internationally and couldadversely affect the Company’s business. See “Business—Governmental Regulation.”

 

*Health Insurance Portability andAccountability Act of 1996 (“HIPAA”)*

 

The HIPAA regulations arecausing the Company’s customers to request that the Company sign “businessassociate” agreements with them.  A “businessassociate” is a person or entity that performs certain functions or activitiesthat involve the use or disclosure of protected health information on behalfof, or that provides services to, a covered entity.  By law, the HIPAA Privacy Rule applies onlyto covered entities – health plans, health care clearinghouses, and certainhealth care providers.  However, mosthealth care providers do not carry out all of their health care activities andfunctions by themselves.  Instead, theyoften use the services of a variety of other persons or businesses.  The Privacy Rule allows covered providers andhealth plans to disclose protected health information to these “businessassociates” if the providers or plans obtain satisfactory assurances that thebusiness associate will use the information only for the purposes for which itwas engaged by the covered entity, will safeguard the information from misuse,and will help the covered entity comply with some of the covered entity’sduties under the Privacy Rule.  Coveredentities may disclose protected health information to an entity in its role asa business associate only tohelp the covered entity carry out its health care functions – not for thebusiness associate’s independent use or purposes, except as needed for theproper management and administration of the business associate.  If the Company is not willing to or is unableto enter into a business associate agreement with current and potentialcustomers, such customers may not purchase products or services from theCompany, which would have a material adverse effect on the Company’s results ofoperations and financial condition.

 

*Uncertain Protection for IntellectualProperty; Possible Claims of Others*

 

Although the Company hasfiled patent applications with respect to certain aspects of its technology, itgenerally does not rely on patent protection with respect to its products andtechnologies.  Instead, the Companyrelies primarily on a combination of trade secret and copyright law, employeeand third-party nondisclosure agreements and other protective measures toprotect intellectual property rights pertaining to its products andtechnologies.  Such measures may notprovide meaningful protection of the Company’s trade secrets, know-how or otherintellectual property in the event of any unauthorized use, misappropriation ordisclosure.  Others may independentlydevelop similar technologies or duplicate any technology developed by theCompany.  In addition, to the extent thatthe Company applies for any patents, such applications may not result in issuedpatents or, if issued, such patents may not be valid or of value.  The Company does not believe that its productsand technologies infringe any existing patents or intellectual property rightsof third parties.  However, the Company’sproducts and technologies may infringe existing patents or intellectualproperty rights of third parties.  Thecosts of prosecuting or defending an intellectual property claim could besubstantial and could adversely affect the Company’s business, even if it wasultimately successful in prosecuting or defending any such claims.  If the Company’s products or technologieswere found to infringe the rights of a

 

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third party, the Companycould be required to pay significant damages or license fees or ceaseproduction, any of which could have a material adverse effect on the Company’sbusiness.  See “Business—IntellectualProperty.”

 

*Product Liability Risk; LimitedInsurance Coverage*

 

The manufacture and saleof products used in the practice of medicine entail significant risk of productliability claims.  The Company currentlymaintains product liability insurance in the amount of $11,000,000 peroccurrence and $12,000,000 in total and errors and omissions coverage in theamount of $11,000,000 per occurrence and in total.  However, the Company’s coverage limits maynot be adequate to protect the Company from any liabilities it might incur inconnection with the sale of its products. Further, the Company may not be able to maintain this level of coveragein the future.  The Company also may needincreased product liability coverage as it releases additional products andupdates.  Such insurance is expensive andmay not be available on acceptable terms, if at all.  A successful product liability claim orseries of such claims against the Company in excess of the Company’s insurancecoverage could have a material adverse effect on its business.

 

*Need to Hire Additional Personnel*

 

The Company’s ability toenhance and develop markets for its current products and to introduce newproducts to the marketplace also depends on its ability to attract and retainqualified scientific and management personnel. The Company competes for such personnel with other companies, academicinstitutions, government entities and organizations, many of which havesubstantially greater capital resources, name recognition, and research anddevelopment capabilities than the Company. There can be no assurance that the Company will be successful inrecruiting or retaining such personnel. The Company may not be able to recruit and retain such personnel, whichwould have a material adverse effect on the Company’s business.

 

*Management of Growth*

 

TheCompany’s ability to grow successfully requires an effective planning andmanagement process.  The expansion andgrowth of its business could place a significant strain on the Company’smanagement systems, infrastructure and other resources.  To manage its growth successfully, theCompany must continue to improve and expand its systems and infrastructure in atimely and efficient manner.  Inaddition, the success of any acquisition, including the Company’s acquisitionof HInnovation, will depend on the Company’s ability to successfully integratethe acquired business with the Company’s business.  The Company’s controls, systems, proceduresand resources may not be adequate to support a changing and growingcompany.  If the Company’s managementfails to respond effectively to changes and growth in its business, includingacquisitions, such failure could have a material adverse effect on itsbusiness.

 

*Dependence on Third-Party Reimbursement*

 

The Company’s productsare purchased by hospitals, clinics, imaging centers and other users, whichbill various third party payers, such as government health programs, privatehealth insurance plans, managed care organizations and other similar programs,for the health care goods and services provided to their patients.  There are currently Current ProceduralTerminology (CPT) reimbursement codes for most of the diagnostic proceduresthat use the Company’s products. However, the amount of such reimbursement varies by location and issubject to change.  Payers may denyreimbursement if they determine that a product used in a procedure was not usedin accordance with established payer protocol regarding cost-effectivetreatment 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 to predictwhat changes will be made in the reimbursement methods used by third partyhealthcare payers.  The procedures inwhich the Company’s products are used may not be considered cost effective bythird party payers.  Reimbursement forsuch procedures may not be available or, if

 

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available, payers’ lowreimbursement levels may adversely affect the Company’s ability to sell itsproducts on a profitable basis.  Inaddition, there have been and may continue to be proposals by legislators,regulators and third party payers to curb further these costs in thefuture.  A failure by hospitals and otherusers of the Company’s products to obtain reimbursement from third partypayers, changes in third party payers’ policies toward reimbursement forprocedures using the Company’s products or legislative action could have amaterial adverse effect on the Company’s business.  See “Business—Third Party Reimbursement andCost Containment.”

 

*Uncertainty of Health Care Reform*

 

The levels of revenue andprofitability of medical technology companies may be affected by the efforts ofgovernment and third party payers to contain or reduce the costs of health carethrough various means.  In the UnitedStates, there have been, and the Company expects that there will continue tobe, a number of federal, state, and private proposals to control health carecosts.  These proposals may containmeasures intended to control public and private spending on health care as wellas to provide universal public access to the health care system.  If enacted, these proposals may result in asubstantial restructuring of the health care delivery system.  Significant changes in the nation’s healthcare system could have a substantial impact on the manner in which the Companyconducts its business and could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

*Possible Issuances of PreferredStock*

 

The Company’s Articles ofIncorporation authorize its Board of Directors, without any action by itsshareholders, to establish the rights and preferences of up to 5,000,000 sharesof currently undesignated preferred stock. These shares of preferred stock could possess voting and conversionrights that could adversely affect the voting power of the holders of thecommon stock and may have the effect of delaying, deferring or preventing achange in control of the Company.  Noshares of preferred stock or other senior equity securities are currentlydesignated, and currently the Company has no plan to designate or issue anysuch securities.

 

*Anti-Takeover Considerations*

 

The Company is subject to“anti-takeover” provisions of the Minnesota Business Corporation Act.  In addition, the Company has adopted aShareholder Rights Plan (the “Rights Agreement”) designed to protect theCompany and its shareholders from unsolicited attempts to acquire theCompany.  These measures may deter ordiscourage takeover attempts and other changes in control of the Company thatare not approved by its Board of Directors, and they may have a depressiveeffect on any market for the Company’s stock. As a result, the Company’s shareholders may lose opportunities todispose of their shares at the higher prices typically available in takeoverattempts or that may be available under a merger proposal.  In addition, these measures may have theeffect of permitting the Company’s current directors to retain their positionsand place them in a better position to resist changes that the Company’s shareholdersmay wish to make if they are dissatisfied with the conduct of the Company’sbusiness.

 

*No Dividends*

 

The Company has not paidcash dividends on its common stock in the past, and it does not intend to do soin the foreseeable future.

 

*Limitations on Director Liability*

 

As permitted by Minnesotalaw, the Company’s Articles of Incorporation provide that directors of theCompany shall not be personally liable to the Company or its shareholders formonetary damages for breach of fiduciary duty as a director, with certainexceptions.  These provisions maydiscourage shareholders from bringing suit against a director for breach offiduciary duty and may reduce the likelihood of derivative 

 

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litigation brought byshareholders on behalf of the Company against a director.  In addition, the Company’s Bylaws provide formandatory indemnification of directors and officers to the fullest extentpermitted by Minnesota law.

 

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PART II

 

Item 6.     SELECTEDFINANCIAL DATA

 

The following selectedfinancial data for each of the fiscal years in the five-year period ended December 31,2003 is derived from the audited financial statements of the Company and thenotes thereto.  The information set forthbelow should be read in conjunction with the Company’s financial statements,including the notes thereto, and “Item 7. Management’s Discussion and Analysisof Financial Condition and Results of Operations,” which are included elsewherein this Annual Report on Form 10-K/A.

 
| ** **                                                 | ** ** | **2003**                                     | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                                 | ** ** | **(In thousands, except per share amounts)** | ** ** |
| ** **                                                 |       | **(Restated)(1)**                            |       |     |       |     |       |     |       |     |       |
| **Years ended December 31:**                          |       |                                         |       |     |       |     |       |     |       |     |       |
| Revenue                                                    |       | $                                            | 27,300     |     | $          | 21,116   |       | $        | 15,196     |     | $          | 10,628 |   | $ | 6,623 |   |
| Gross margin                                               |       | 20,229                                       |       | 14,808   |       | 10,723   |       | 7,168    |       | 4,303    |       |
|                                                       |       |                                         |       |     |       |     |       |     |       |     |       |
| Operating expenses:                                        |       |                                         |       |     |       |     |       |     |       |     |       |
| Selling, general and administrative                        |       | 13,125                                       |       | 9,988    |       | 8,420    |       | 6,919    |       | 5,081    |       |
| Research and development                                   |       | 5,169                                        |       | 4,143    |       | 3,358    |       | 3,036    |       | 2,525    |       |
| Operating income (loss)                                    |       | 1,935                                        |       | 677      |       | (1,055   | )          | (2,787   | )          | (3,303   | )          |
|                                                       |       |                                         |       |     |       |     |       |     |       |     |       |
| Net income (loss)                                          |       | $                                            | 8,462      | (2)      | $          | 790      |       | $        | (1,012     | )        | $          | (2,637 | ) | $ | (3,218 | ) |
|                                                       |       |                                         |       |     |       |     |       |     |       |     |       |
| Net income (loss) per share-basic                          |       | $                                            | 0.83       |     | $          | 0.09     |       | $        | (0.14      | )        | $          | (0.39 | ) | $ | (0.64 | ) |
|                                                       |       |                                         |       |     |       |     |       |     |       |     |       |
| Weighted average common shares outstanding – basic    |       | 10,189                                       |       | 8,861    |       | 7,075    |       | 6,760    |       | 5,046    |       |
|                                                       |       |                                         |       |     |       |     |       |     |       |     |       |
| Net income (loss) per share-diluted                        |       | $                                            | 0.71       |     | $          | 0.08     |       | $        | (0.14      | )        | $          | (0.39 | ) | $ | (0.64 | ) |
|                                                       |       |                                         |       |     |       |     |       |     |       |     |       |
| Weighted average common shares outstanding –  diluted |       | 11,848                                       |       | 9,822    |       | 7,075    |       | 6,760    |       | 5,046    |       |
|                                                       |       |                                         |       |     |       |     |       |     |       |     |       |
| **At December 31:**                                   |       |                                         |       |     |       |     |       |     |       |     |       |
| Working capital                                            |       | $                                            | 31,915     |     | $          | 9,219    |       | $        | 6,094      |     | $          | 2,344 |   | $ | 5,409 |   |
| Total assets                                               |       | 53,063                                       |       | 18,827   |       | 13,269   |       | 7,287    |       | 8,666    |       |
| Long-term debt                                             |       | —                                       |       | —   |       | —   |       | —   |       | —   |       |
| Total shareholders’ equity                            |       | 44,594                                       |       | 11,721   |       | 8,051    |       | 3,765    |       | 6,098    |       |
|                                                            |            |                                              |            |          |            |          |            |          |            |          |            |  |  |  |  |  |  |

 

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(1)   See Note 14 to the financial statements forinformation about the restatements of 2003 amounts.

(2)          Includes a net taxbenefit of $6,313 resulting from the reversal of the Company’s valuationallowance for its net deferred tax assets, net of other current year state andfederal income taxes.

 

 

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Item 7.                                     MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(RESTATED)

 

**ExecutiveSummary**

 

2003was a year of financial growth for Vital Images.  The Company reported revenue of $27.3million, a 29% increase over the prior year revenue of $21.1 million.  Core revenue components, that is, softwarelicense fees and maintenance and services, rose 38% in 2003 to $25.2 millionfrom $18.2 million in 2002.  In 2003,most of the Company’s revenue was generated from the U.S. CT market.  Going forward, the Company anticipates agrowing contribution from other sources, including an expanding picturearchive and communication systems (“PACS”) market, sales of Web-based products and the Company’s installed base.

 

VitalImages recorded net income of $8.5 million, or $0.71 per diluted share, in 2003versus $790,000 of net income, or $0.08 per diluted share, in 2002.  Full-year earnings for 2003 include a net taxbenefit of $6.3 million, or $0.53 per diluted share.

 

InJune 2003, the Company completed a private investment in public equityfinancing (“PIPE”) that netted $19.0 million from the sale of 1.5 millionshares of common stock.  The Companyplans to use the net proceeds to expand its business.  To that end, in early 2004, Vital Imagesacquired HInnovation, Inc., a privately-heldprovider of software solutions that allow physicians to use PCs or notebookcomputers to access 2D, 3D and 4D medical imaging applications securely overthe Internet, as a significant step towards expanding itspresence in the PACS and Web-based markets. The Company also generated $4.4 million in positive cash flow fromoperations in 2003.  The PIPE andpositive cash flow from operations helped increase cash, cash equivalents andmarketable securities to $34.2 million as of December 31, 2003, up from$10.6 million as of December 31, 2002.

 

The Company has restatedits financial statements and related footnote disclosures for the year endedDecember 31, 2003 to (1) correct the accounting for unrecognized deferredmaintenance and service revenue from certain maintenance and servicearrangements and (2) change the classification of certain non-trade accountsreceivable from accounts receivable to prepaid expenses and other currentassets.  The Company has made the appropriatemodifications to the balance sheet, statement of operations, statement ofshareholders’ equity and statement of cash flows to give effect to theadjustment and change in classification. The adjustment for the previously unrecognized deferred maintenance andservice revenue (a) increased maintenance and service revenue, total revenueand operating income by like amounts, (b) reduced the net tax benefit for thetax effect of the additional revenue and (c) increased net income and netincome per share by the net effect of (a) and (b).  The change in classification for thenon-trade accounts receivable had no effect on the Company’s previouslyreported revenue, operating income, net income or net income per share, nor didthe change in classification affect the Company’s statement of shareholders’equity.  The Company also restated thedisclosures to the financial statements to correct the computation of pro formastock-based employee compensation expense for the year ended December 31, 2003.  The effects of the restatements have beenreflected in the discussion of Management’s Discussion and Analysis ofFinancial Condition and Results of Operations in this Amendment No. 1.  This Amendment No. 1 to the Form 10-K doesnot reflect events occurring after the original filing of the Form 10-K.

 

**Overview**

 

Vital Images develops,markets and supports 3D medical imaging software for use primarily in clinicaldiagnosis, disease screening and therapy planning.  The Company’s software applies proprietarycomputer graphics and image processing technologies to a wide variety of datasupplied by computed tomography (“CT”) and magnetic resonance (“MR”)scanners.  Vital Images’ products allowclinicians to create 2D, 3D and 4D 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 PACS and diagnostic imagingsystems through a direct sales force in the United States and independentdistributors in international markets.

 

On October 28, 1996,the Board of Directors of Bio-Vascular, Inc. (“Bio-Vascular”), now known asSynovis Life Technologies, Inc., the former parent company of Vital Images,approved a plan to spin off and establish Vital Images as an independent,publicly-owned company.  On May 12, 1997,Bio-Vascular distributed all of the shares of Vital Images to the shareholdersof Bio-Vascular, 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.  Vital Images’ common stock is currentlytraded on The NASDAQ National Market under the symbol VTAL.

 

**Critical Accounting Policies andEstimates**

 

Management’sdiscussion and analysis of its financial position and results of operations arebased upon the Company’s financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these financial statements requires management

 

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tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities as of the dateof the financial statements and the reported amounts of revenue and expensesduring the reporting periods.  Actualresults could differ from those estimates. The following represents those critical accounting policies andestimates where materially different amounts could be reported under differentconditions or using different assumptions.

 

*Allowancefor doubtful accounts.*  The Company maintains an allowance fordoubtful accounts that reflects the Company’s estimate of losses that mayresult from the uncollectibility of accounts receivable.  The allowance for doubtful accounts is basedon an analysis of individual accounts for which the Company has informationindicating the customer may not be able to pay amounts owed to theCompany.  In these cases, based on theavailable facts and circumstances, the Company estimates the amount that willbe collected from such customers.  TheCompany also evaluates the collectibility of its accounts receivable in theaggregate based on factors such as the aging of receivable amounts, customerconcentrations, historical experience, and current economic trends andconditions.  The allowance for doubtfulaccounts is adjusted when additional information is received that impacts theamount reserved. If circumstances change, the Company’s estimates of therecoverability of accounts receivable could be reduced or increased by amaterial amount.  Such a change inestimated recoverability would be accounted for in the period in which thefacts that give rise to the change become known.  As of December 31, 2003, the Company hadan allowance for doubtful accounts of $235,000.

 

*Deferred tax asset.* TheCompany records a valuation allowance to reduce its deferred tax assets to theamount that is more likely than not to be realized.  During 2003, the Company concluded that it ismore likely than not that substantially all of its net deferred tax assets wouldbe realized and the Company reversed substantially all of its valuationallowance for net deferred tax assets, which resulted in the recording of a nettax benefit in 2003.  The reversal of thedeferred tax assets valuation allowance is based upon the Company’s historicaloperating performance and management’s expectation that the Company willgenerate taxable income of at least $25 million in future periods to allow itto realize its deferred tax assets resulting from the tax benefits associatedwith its net operating loss carryforwards and a significant portion of itsresearch and development tax credit carryforwards, as well as certain other taxbenefits related to book and tax income timing differences.  The Company recorded a net increase indeferred tax assets of $9.6 million, $6.4 million of which was recorded as atax benefit in the statement of operations and represents the tax benefit ofits net operating loss and tax credit carryforwards, as well as certain othertax benefits related to book and tax income timing differences.  The remaining $3.2 million increase indeferred tax assets was recorded as additional paid-in capital and representsthe amount of deferred tax assets generated from the exercise of stockoptions.  Should the Company determinethat it would not be able to realize all or part of its net deferred tax assetin the future, an adjustment to record a valuation allowance to reduce thedeferred tax assets would be charged to income in the period such adetermination was made.

 

*Long-Lived Assets.*The Company periodically reviews the carrying amounts of property andequipment and intangible assets purchased in the normal course of business todetermine whether current events or circumstances, as defined in Statement ofFinancial Accounting Standard No 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” warrant adjustments to such carryingamounts.  In reviewing the carryingvalues of property and equipment and intangible assets purchased in the normalcourse of business, the Company considers, among other things, the futureundiscounted cash flows expected from the use of the asset. To the extent thesefuture estimated undiscounted cash flows significantly change, an impairmentcould be identified.

 

*RevenueRecognition. *The Company licenses its software and sellsproducts and services to end-users and also indirectly through OEMs andindependent distributors. Terms offered by the Company do not generally differbased on whether the customer is an end-user, OEM or independentdistributor.  The Company offers termsthat require payment within 30 to 90 days after product delivery.  The Company does not offer rights of return,acceptance clauses or price protection to its customers.

 

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Licensefees 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 derivedfrom hardware and software maintenance and from services consisting oftelephone support, installation, training and engineering services. The Company’ssoftware licenses are always sold as part of an arrangement that includesmaintenance and support and often installation and training services.  Engineering services consist of softwaremodification or development services that are sold separately to OEMs.  The Company generally sells hardware as partof a system sale, but it occasionally sells hardware as part of a systemupgrade or additional product sale.

 

TheCompany recognizes revenue in accordance with AICPA Statement of Position (“SOP”)97-2,  Software Revenue Recognition,  as amended by SOP 98-4 and SOP 98-9, as wellas Technical Practice Aids issued from time to time by the American Instituteof Certified Public Accountants and Staff Accounting Bulletin (SAB) No.104.  The Company recognizes revenue whenit is realized or realizable and earned. The Company considers revenue realized or realizable and earned when ithas persuasive evidence of an arrangement, the product has been shipped or theservices have been provided to the customer, the sales price is fixed ordeterminable, and collectibility is probable.

 

TheCompany evaluates the credit worthiness of all customers.  In circumstances where the Company does nothave experience selling to a customer and lacks adequate credit information toconclude collection is probable, revenue is deferred until the arrangement feesare collected and all other revenue recognition criteria in the arrangementhave been met.

 

Inaddition to the aforementioned general policy, the following are the specificrevenue recognition policies for services and multiple-element arrangements.

 

*Software and Hardware*

Revenuefrom license fees and hardware is recognized when shipment of the product hasoccurred, no significant Company obligations with regard to implementationremain and the Company’s services are not considered essential to thefunctionality of other elements of the arrangement.  See also “— Multiple Element Arrangements” below forfurther information.

 

*Services*

Revenuefrom maintenance and support arrangements is deferred and recognized ratablyover the term of the maintenance and support arrangements.

 

Revenuefrom training and installation services is recognized as the services areprovided to customers.

 

Revenuefrom engineering services, where the Company is performing significantcustomization or modification of software, is recognized using contractaccounting on a percentage-of-completion basis. The Company records revenue by reference to actual hours incurred todate and the estimated hours remaining to complete the services.

 

*Multiple-ElementArrangements*

TheCompany enters into arrangements with customers that include a combination ofsoftware products, system hardware, specified upgrades, maintenance andsupport, or installation and training services. For such arrangements, the Company recognizes revenue using the residualvalue method.  The Company allocates thetotal arrangement fee among each element of the arrangement based on therelative fair value of each of the undelivered elements determined based onvendor-specific objective evidence. The fair value of maintenance and supportservices is based upon the renewal rate for continued servicearrangements.  The fair value ofinstallation and training services is established based upon separate pricingfor the services. In software arrangements for which the Company does not havevendor-specific objective evidence of fair value for all elements, revenue isdeferred until the earlier of when vendor-specific objective evidence isdetermined for the undelivered elements (residual method) or when all elementshave been delivered.

 

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The following table setsforth information from the Company’s Statements of Operations, expressed as apercentage of total revenue.

 
| ** **                                 | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                 | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                 | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                   |       |                                      |       |   |   |   |   |
| License  fees                              |       | 67.4                                      | %          | 67.3 | % | 66.4 | % |
| Maintenance  and services                  |       | 25.1                                      |       | 19.0 |   | 16.1 |   |
| Hardware                                   |       | 7.5                                       |       | 13.7 |   | 17.5 |   |
| Total  revenue                             |       | 100.0                                     |       | 100.0 |   | 100.0 |   |
|                                       |       |                                      |       |   |   |   |   |
| Cost  of revenue:                          |       |                                      |       |   |   |   |   |
| License  fees                              |       | 6.7                                       |       | 5.9 |   | 4.6 |   |
| Maintenance  and services                  |       | 13.8                                      |       | 13.6 |   | 10.9 |   |
| Hardware                                   |       | 5.4                                       |       | 10.4 |   | 13.9 |   |
| Total  cost of revenue                     |       | 25.9                                      |       | 29.9 |   | 29.4 |   |
|                                       |       |                                      |       |   |   |   |   |
| Gross  margin                              |       | 74.1                                      |       | 70.1 |   | 70.6 |   |
|                                       |       |                                      |       |   |   |   |   |
| Operating  expenses:                       |       |                                      |       |   |   |   |   |
| Sales  and marketing                       |       | 34.1                                      |       | 32.2 |   | 37.9 |   |
| Research  and development                  |       | 18.9                                      |       | 19.6 |   | 22.1 |   |
| General  and administrative                |       | 14.0                                      |       | 15.1 |   | 17.5 |   |
| Total  operating expenses                  |       | 67.0                                      |       | 66.9 |   | 77.5 |   |
|                                       |       |                                      |       |   |   |   |   |
| Operating  income (loss)                   |       | 7.1                                       |       | 3.2 |   | (6.9 | ) |
|                                       |       |                                      |       |   |   |   |   |
| Interest  income, net                      |       | 0.8                                       |       | 0.6 |   | 0.3 |   |
| Income  (loss) before income taxes         |       | 7.9                                       |       | 3.8 |   | (6.6 | ) |
|                                       |       |                                      |       |   |   |   |   |
| Provision  (benefit) for income taxes, net |       | (23.1                                     | )          | 0.1 |   | (0.1 | ) |
|                                       |       |                                      |       |   |   |   |   |
| Net  income (loss)                         |       | 31.0                                      | %          | 3.7 | % | (6.7 | )% |

 

**Revenue**

 

Total revenue increased 29%to $27,300,000 in 2003 from total revenue of $21,116,000 in 2002.  Total revenue increased 39% to $21,116,000 in2002 from total revenue of $15,196,000 in 2001. The revenue growth was driven by the increase in the Company’s corerevenue components of software license fees and maintenance and servicerevenue.  License fee revenue increased29% to $18,389,000 in 2003 and increased 41% to $14,212,000 in 2002 from$10,083,000 in 2001.  The increase insoftware license fee revenue was driven by an increase in the number of *Vitrea* 2 licenses sold, principally to Toshiba MedicalSystems Corporation (“Toshiba”), and an increase in the number of Vitrea add-onoptions sold.  The installed base ofVitrea customers increased from approximately 550 at December 31, 2001 toapproximately 850 at December 31, 2002 to approximately 1,300 at December 31,2003.  The number of Vitrea add-onmodules sold by the Company increased from approximately 70 in 2001, to 660 in2002 and 1,200 in 2003.

 

For2003, the Company generated 50% revenue growth from the sale of *Vitrea 2*options, including *VScoreTM*, CT Colonography, Automated VesselMeasurements and CT Cardiac.  The sale of*Vitrea 2* options totaled$9,035,000 for 2003 compared with $6,019,000 in 2002 and $2,448,000 in2001.  For 2003, software license feerevenue from sales to Toshiba totaled $8,323,000 compared with $6,013,000 for2002 and $3,190,000 for 2001.

 

Maintenanceand services revenue increased 70% to $6,844,000 for 2003 compared to$4,019,000 for 2002 and increased 64% to $4,019,000 in 2002 from $2,450,000 in2001.  Of the $2,825,000 increase for2003 compared

 

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to2002, $2,079,000 consisted of an increase in maintenance revenue and $793,000was an increase in training revenue.  Ofthe $1,569,000 increase for 2002 compared to 2001, $716,000 consisted of anincrease in maintenance revenue and $596,000 was an increase in trainingrevenue.  The increases in maintenancerevenue in both 2003 and 2002 were due to the Company adding new customers tothe installed base and renewing back maintenance from customers whose maintenancearrangements had lapsed.  The increasesin training revenue in both 2003 and 2002 were due to an overall increase inthe number of training sessions sold with the customers’ initial purchases ofsoftware.

 

Hardwarerevenue decreased 28% to $2,066,000 in 2003 from $2,885,000 in 2002 andincreased 8% to $2,885,000 in 2002 from $2,663,000 in 2001.  The decrease in hardware revenue from 2002 to2003 was due to a decrease in the number of complete system sales and lowerunit pricing for hardware platforms shipped in 2003.  Although total revenue grew 39% from 2001 to2002, hardware revenue grew only 8% due to a change in the sales model withToshiba.  Prior to the third quarter of2001, all of the Company’s sales to Toshiba were complete systems sales.  Beginning in the third quarter of 2001 andcontinuing thereafter, most of the revenue resulting from sales to Toshiba wasderived from software-only sales, which resulted in a decrease in hardwarerevenue.

 

**Gross Margin**

 

The Company’s grossmargin percentage was 74% in 2003, up from 70% in 2002. The gross marginpercentage was 71% in 2001.  Revenue in2003 included more higher margin software license fee revenue and less lowermargin hardware revenue than in 2002.  Inaddition, there was a 70% increase in maintenance and services revenue withonly a 32% increase in cost of revenue for maintenance and services.  The number of customer support employeesincreased from 17 at December 31, 2002 to 22 at December 31,2003.  The decrease in margin in 2002compared to 2001 was due to increasing costs for customer support resultingfrom the Company’s growth, which was partially offset by the favorable impactof sales mix.  Revenue in 2002 includedmore of higher margin software license fee revenue than in 2001.  The number of customer support employeesincreased from 11 at December 31, 2001 to 17 at December 31, 2002.

 

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 a nominal discount in purchasing the third-partyhardware and peripheral components of the *Vitrea 2*system,and the Company’s gross margin on the resale of these system componentsapproximates its discount.  During 2004, theCompany will begin selling more third party software products, including lungvisualization products from R2 Technology, Inc. (“R2”) and a fusion technologyproduct from Mirada Solutions, Limited. The Company will receive a discount when purchasing these third-partysoftware products, but such discounts will be considerably less than the grossmargins the Company earns on its own internally-developed softwareproducts.  Accordingly, the Companyanticipates that its gross margin on software license fee revenue, as well asthe overall gross margin for total revenue, will decrease in future periods.

 

**Sales and Marketing**

 

Sales and marketingexpenses were $9,318,000, $6,795,000 and $5,761,000 for 2003, 2002 and 2001,respectively.  The increases were mostly due to increases incompensation costs as a result of additional personnel required to supportrecent growth and increased sales commissions as a result of increasedrevenue.  Compensation costs, includingcommissions, increased $1,515,000 from 2002 to 2003 and $679,000 from 2001 to2002.  There were 40, 33 and 27 sales andmarketing personnel as of December 31, 2003, 2002 and 2001,respectively.  Due to the increase in thenumber of personnel from 2002 to 2003, travel and entertainment expensesincreased $280,000 and hiring costs increased $141,000.  There was a $356,000 increase in expensesrelated to utilizing outside consultants to help sell and promote *Vitrea 2* and related options for 2003 as compared to2002.  Tradeshow and marketingbrochure costs increased $65,000 and $147,000 from 2002 to 2003 and 2001 to2002, respectively, due to the Company purchasing more space at 

 

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tradeshows and attending additional tradeshows.  TheCompany expects sales and marketing costs to increase in future periods as aresult of the cost of additional sales and marketing personnel.

 

**Research and Development**

 

Researchand development expenses were up 25% to $5,169,000 in 2003 from $4,143,000 in2002.  Of the $1,026,000 expenseincrease, $492,000 was due to increased compensation costs resulting fromadditional personnel supporting the development of *Vitrea 2*.  Total research and development personnelincreased from 33 at December 31, 2002 to 38 at December 31,2003.  Due to the increase in personnel,hiring costs increased $41,000 in 2003 as compared to 2002.  Due to more training and increased personnel,training costs increased $64,000 from 2002 to 2003.  There was a $189,000 expense increase due toa decrease in expenses classified in cost of revenue in connection withengineering services provided to certain third parties under various productdevelopment agreements in 2003 as compared to 2002.  In addition, depreciation expense increasedby $68,000 from 2002 to 2003 as the result of equipment purchases to supportthe additional personnel and to upgrade computer equipment.

 

Totalresearch and development expenses increased from $3,359,000 in 2001 to$4,143,000 in 2002.  Of the $784,000increase in expense, $794,000 was due to increased compensation costs resultingfrom additional personnel supporting the development of *Vitrea 2*.  Total research anddevelopment personnel increased from 24 at December 31, 2001 to 33 at December 31,2002.  The compensation increase from2001 to 2002 was partially offset by a $211,000 increase in expenses classifiedin cost of revenue during 2002 in connection with engineering services providedto certain third parties under various product development agreements.  There was also a $59,000 increase in annualdepreciation expense from 2001 to 2002 as the result of equipment purchases tosupport the additional personnel and to upgrade computer equipment.

 

TheCompany anticipates that 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.

 

**General and Administrative**

 

General and administrativeexpenses were $3,807,000, $3,193,000 and $2,658,000 in 2003, 2002 and 2001,respectively.  Of the $614,000 increasefrom 2002 to 2003, $263,000 was due to an increase in compensation costsrelated to additional personnel.  Totalgeneral and administrative personnel increased from 17 at December 31,2002 to 21 at December 31, 2003. Legal fees increased $227,000 during 2003 as compared to 2002 due tobusiness development, patent work and SEC filings related to the registrationstatement covering the resale of shares from a private placement in June 2003.  In addition, registration and filing feesincreased $104,000 in 2003 as compared to 2002, which includes a $100,000NASDAQ National Market registration fee. This registration fee was paid for the first time in June 2003 whenthe Company qualified for listing on the NASDAQ National Market.  There was also a $54,000 increase in 2003 ascompared to 2002 due to higher audit costs, including assistance with SECfilings.  These increases were partiallyoffset by a $230,000 decrease due to severance costs paid in 2002 to theCompany’s former chief executive officer. The $535,000 increase from 2001 to 2002 was largely due to severancecosts of $230,000 for the Company’s former chief executive officer, an increasein consulting fees of $73,000, travel costs of $79,000 related to investorrelations and business development and a $52,000 increase in insurance costsdue to the growth of the Company and premium rate increases.  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 believes that general andadministrative expenses will increase in future periods due to increased infrastructurecosts as the business grows but that they will remain unchanged or decreasefrom the current percentage of total revenue.

 

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**Operating Income (Loss)**

 

The increasing revenuefrom *Vitrea 2* and add-on software options andrelated service revenues, net of the increased expenses attributable to thedevelopment of the Company’s infrastructure and the development and promotionof the *Vitrea 2*product, resulted in operatingincome of $1,935,000 for 2003 compared with $677,000 for 2002 and an operatingloss of $1,055,000 for 2001.

 

**Interest Income**

 

There was $214,000 ofinterest income for 2003, compared with $135,000 in 2002 and $55,000 in2001.  The increases in interest incomefrom 2001 to 2002 and from 2002 to 2003 were primarily due to increases incash, cash equivalents and marketable securities.  The increases in cash, cash equivalents andmarketable securities were due to the increased cash flows from operations from2001 to 2002 and from 2002 to 2003, the $18,991,000 of cash generated from theprivate placement in June 2003, and the exercise of warrants for thepurchase of common stock, which generated $1,725,000 and $4,491,000 in proceedsfor the years ended December 31, 2002 and 2001, respectively.

 

**IncomeTaxes**

 

During2003, the Company concluded that it is more likely than not that substantiallyall of its net deferred tax assets would be realized, and the Company reversedsubstantially all of its valuation allowance for net deferred tax assets, whichresulted in the recording of a net tax benefit in 2003.  The reversal of the deferred tax assetsvaluation allowance is based upon the Company’s historical operatingperformance and management’s expectation that the Company will generate taxableincome of at least $25 million in future periods to allow it to realize itsdeferred tax assets resulting from the tax benefits associated with its netoperating loss (“NOL”) carryforwards and a significant portion of its researchand development tax credit carryforwards, as well as certain other tax benefitsrelated to book and tax income timing differences. The reversal of thevaluation allowance resulted in a tax benefit of $7,171,000.  This reversal net of other current year stateand federal income taxes resulted in a net tax benefit of $6,313,000 in2003.  The Company has a valuationallowance of $147,000 as of December 31, 2003.

 

Asof December 31, 2003, the Company had available NOL carryforwards ofapproximately $22.6 million and research and development tax creditcarryforwards of approximately $1.1 million expiring in varying amounts from2004 through 2023.

 

Theincome tax provision for 2002 and 2001 consists solely of certain state minimumfees.  As a result of the Company’shistory of generating net operating losses, the Company had established avaluation allowance to completely reserve for the deferred tax asset of theCompany at December 31, 2002.

 

**Liquidityand Capital Resources**

 

As of December 31,2003, the Company had $30.1 million in cash and cash equivalents, $4.1 millionin marketable securities, working capital of $31.9 million and no borrowings.

 

Cash provided byoperations was $4.4 million for 2003 compared with cash provided by operationsof $2.4 million for 2002 and $771,000 for 2001. During 2003, $14.1 million of cash was generated from increases in netincome, deferred revenue, accounts payable and non-cash expenses fordepreciation and the tax benefit from stock option transactions.  These increases were partially offset by a$9.6 million increase in the deferred income tax benefit.  During 2002, $3.7 million of cash fromoperations was generated from increases in net income, deferred revenue,non-cash depreciation and accrued expenses and other current liabilities.  These increases were partially offset by a$1.4 million increase in accounts receivable. During 2001, $2.6 million of cash was generated from operations as aresult of increases in deferred revenue, non-cash depreciation expense 

 

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and accrued expenses andother current liabilities.  Theseincreases were offset by a combined $1.7 million increase in net loss andaccounts receivable.

 

Of the $699,000, $1.6million and $1.1 million increases in deferred revenue for the years ended2003, 2002 and 2001, respectively, $364,000, $841,000 and $605,000, respectively, were due to volume increasesin *Vitrea 2* sales and renewals of annualmaintenance.  For the years ended2003, 2002 and 2001, $335,000, $717,000 and $569,000, respectively, of theincrease in deferred revenue was due to volume increases in training andinstallation from increased sales of *Vitrea 2*.  The$500,000 increase in accounts payable for 2003 was due to the timing ofpayments and the increasing level of expenses.  The$1.4 million increase and $728,000 increase in accounts receivable for 2002 and2001, respectively, were due to revenue increases.  The days sales outstanding improved from 92days at December 31, 2001 to 86 days and 65 days at December 31, 2002and 2003, respectively.  The$384,000 and $714,000 increases in accrued expenses and other liabilities in2002 and 2001, respectively, were primarily due to increases in incentivebonuses and sales commissions directly related to increased revenue andprofitability.

 

The Company used $3.4million, $4.0 million and $1.5 million of cash in investing activities in 2003,2002 and 2001, respectively, of which $1.9 million, $1.5 million and $769,000, respectively, was usedfor purchases of property and equipment. The purchases for all periods were principally to upgrade computerequipment and to purchase computer equipment for new personnel.  In addition, the Company purchased furnitureand fixtures and leasehold improvements related to expansions of the Company’soffices in 2003 and 2002.  Managementanticipates that the Company will continue to purchase property and equipmentnecessary in the normal course of the Company’s business.  The amount and timing of these purchases andthe related cash outflows in future periods is difficult to predict and dependson a number of factors, including the hiring of employees and the rate ofchange of computer hardware.  The Companyused $6.8 million and $8.0 million to purchase investments in marketablesecurities during 2003 and 2002, respectively. The Company realized $5.2 million and $5.5 million of proceeds frommaturities of marketable securities during 2003 and 2002, respectively.  The marketable securities are invested inU.S. government obligations, U.S. government agency obligations, corporatecommercial obligations and certificates of deposits.

 

On February 18,2004, the Company completed the acquisition of HInnovation, Inc. in accordancewith the terms and conditions of an Acquisition Agreement and Plan ofReorganization dated as of January 8, 2004.  The merger consideration included 376,262newly-issued shares of common stock of Vital Images valued at $6 million and $6million in cash.  In addition, the mergerconsideration includes contingent milestone payments comprised of newly-issuedshares of Vital Images common stock with an aggregate value of $3 million and$3 million in cash.  The Company expectsthe contingent milestone payments to be made periodically as the milestones areachieved over a 12 to 24 month period following the date of the acquisition.

 

Cashprovided by financing activities totaled $21.1 million, $2.9 million and $5.3million for 2003, 2002 and 2001, respectively. Of the cash provided during 2003, $19.0 million consisted of netproceeds, after deducting offering costs of $1.3 million, from the Company’sprivate placement of 1.5 million shares of common stock at $13.50 pershare.  A registration statement coveringthe resale of these shares was declared effective on September 29, 2003 bythe Securities and Exchange Commission.

 

InDecember 2001, the Company announced its decision to exercise its right toredeem, if not exercised, its outstanding redeemable, five-year common stockwarrants issued in its December 1999 private placement. The warrant holdersexercised all of the outstanding warrants in December 2001 and January 2002.  Cash provided by financing activities fromthe purchases of common stock resulting from the exercise of warrants generated$1.7 million and $4.5 million in 2002 and 2001, respectively.  In addition, the exercise of the brokerwarrants issued in 1999 in connection with the private placement generated$248,000, $6,000 and $22,000 of cash, in 2003, 2002 and 2001, respectively.

 

DuringOctober 2001, the Company sold 82,332 shares of newly-issued common stockto E-Z-EM, Inc. for $552,000.

 

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Theremaining $1.8 million, $1.1 million and $245,000 of cash provided by financingactivities was generated from the sale of common stock upon the exercise ofstock options in 2003, 2002 and 2001, respectively.

 

The Company has neverpaid or declared any cash dividends and does not intend to pay dividends in thenear future.

 

The following summarizesour contractual obligations, including purchase commitments, at December 31,2003, and the effect such obligations are expected to have on our liquidity andcash flow in future periods.

 
| ** **                  | ** ** | **2004**   | ** ** | **2005**   | ** ** | **2006**   | ** ** | **2007**   | ** ** |
|-----------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating  leases           |       | $          | 434,000    |       | $          | 274,000    |       | $          | 19,000     |   | $ | — |   |
|                        |       |       |       |       |       |       |       |       |       |
| Purchase  commitment(1)     |       | $          | 1,050,000  |       | $          | 1,995,000  |       | $          | 2,030,000  |   | $ | 525,000 |   |
|                        |       |       |       |       |       |       |       |       |       |
| HInnovation  acquisition(2) |       | $          | 6,000 000  |       | $          | —     |       | $          | —     |   | $ | — |   |

 

----

(1) Assumes the R2’s lungnodule CAD software product will be available for sale in Europe in the firstquarter of 2004 and in the U.S. beginning in the fourth quarter of 2004. TheCompany completed its development work to integrate the lung nodule CADsoftware into *Vitrea**2* in January 2004.   The first purchase under the agreement isrequired on or before April 1, 2004. The total purchase commitment will bea maximum of $5.6 million worth of product over a three-year commitment period.The purchase commitment price the Company has to pay will be reduced if theselling price of the lung CAD product when sold directly to end-users by R2falls below a specified price. The purchase commitment units the Company isrequired to purchase will be reduced if R2 and its other distributors of thelung CAD product are unable to sell as many as the Company is required topurchase.

 

(2) The mergerconsideration of HInnovation includes contingent milestone cash payments of upto $3 million.  The Company expects thecontingent milestone cash payments to be made as certain milestones areachieved over a 12 to 24 month period following the date of the acquisition.

 

The Company had nosignificant outstanding purchase orders as of December, 31 2003.  The Company has entered into a number oftechnology licensing agreements that provide for the payment of royalties whenthe Company sells *Vitrea 2*.Except for the R2-purchase commitment discussed above, the Company is notobligated for any minimum payments under such agreements.

 

Management believes thatits cash and cash equivalents should be sufficient to satisfy the Company’s cashrequirements for at least the next 12 months.

 

**Foreign Currency Transactions**

 

Substantially all of theCompany’s foreign transactions are negotiated, invoiced and paid in U.S.dollars.

 

**Inflation**

 

Management believesinflation has not had a material effect on the Company’s operations or on itsfinancial condition.

 

**Recent Accounting Pronouncements**

 

InMay 2003, the FASB issued SFAS No. 150, Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity.  SFAS No.150 requires that an issuer classify certain financial instruments within itsscope as a liability (or an asset in some circumstances). Effective July 1,2003, the Company adopted SFAS No. 150. Adoption of this interpretation did not have an impact on the Company’sfinancial position or results of operations.

 

InMay 2003, Emerging Issues Task Force (EITF) No. 00-21, Accounting forRevenue Arrangements with Multiple Deliverables, was finalized.  This issue addresses certain aspects ofaccounting by a vendor for arrangements under which it will perform multiplerevenue-generating activities.  Theguidance in EITF 00-21 is effective for revenue arrangements entered into infiscal periods beginning after June 15, 2003.  In December 2003, the Securities andExchange Commission issued Staff Accounting Bulletin (SAB) No.104, Revenue Recognition, which codifies and rescinds certain sections ofSAB No. 101, Revenue Recognition, in order to make this interpretive guidanceconsistent with EITF No. 00-21.  Adoptionof this interpretation did not have an impact on the Company’s financialposition or results of operations.

 

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**Forward-Looking Statements**

 

This Annual Report onForm 10-K/A contains certain forward-looking statements within the meaning ofthe Private Securities Litigation Reform Act of 1995 and information that isbased on management’s beliefs as well as on assumptions made by, and uponinformation currently available to, management. When used in this Annual Report on Form 10-K/A, the words “expect,” “anticipate,”“intend,” “plan,” “believe,” “seek,” and “estimate” or similar expressions areintended to identify such forward-looking statements.  However, this Annual Report on Form 10-K/Aalso contains other forward-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 potential forlitigation regarding patent and other intellectual property rights; theintroduction of competitive products by others; dependence on major customers;fluctuations in quarterly results; the progress of product development; theavailability of third party reimbursement; and the receipt and timing ofregulatory approvals and other factors detailed from time to time in theCompany’s filings with the Securities and Exchange Commission, including thoseset forth under the heading “Important Factors” included in Item 1 of thisAnnual Report on Form 10-K/A.

 

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Item 8.                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA (RESTATED)

 

The Company’s financialstatements, supplemental schedule and Report of Independent RegisteredPublic Accounting Firm thereon, all of which are included in this Annual Reporton Form 10-K/A, are listed in Item 15(a) (1) of this Form 10-K/A.

 

**ITEM 9A.   CONTROLS AND PROCEDURES**

 

As of the end of the period covered by this report, an evaluation wasperformed by the Company’s management, including its principal executiveofficer and principal financial officer, of the effectiveness of the design andoperation of the Company’s disclosure controls and procedures.  Based on that evaluation, the Company’smanagement, including its principal executive officer and principal financialofficer, concluded that the Company’s disclosure controls and procedures wereeffective as of December 31, 2003. However, as described below in “— Compliance with Section 404 of theSarbanes-Oxley Act of 2002,” management later determined that the Company’sdisclosure controls and procedures were not effective as of December 31, 2003because the Company had a “material weakness” over the reporting of revenuefrom maintenance and services and a “material weakness” over the reporting ofpro forma stock-based employee compensation expense in Note 2 to the financialstatements.

 

There were no changes in the Company’s internal controls over financialreporting that occurred during the most recent fiscal quarter that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal controls over financial reporting.

 

**Compliance with the Sarbanes-Oxley Act of 2002**

 

Vital Images is in the process of documenting and testing its internalcontrol procedures in order to satisfy the requirements of Section 404 of theSarbanes-Oxley Act of 2002 (the “Act”). Beginning with the Company’s Annual Report on Form 10-K for the year endingDecember 31, 2004, Section 404 of the Act requires annual managementassessments of the effectiveness of the Company’s internal controls overfinancial reporting and a report by its independent registered publicaccounting firm addressing these assessments.

 

As part of the preparation and testing of controls, the Companydetermined that it had a “material weakness” over the reporting of revenue frommaintenance and services.  Due to themanual procedures for identifying maintenance and service activity, revenue wasnot recognized for some maintenance and services that had actually beenprovided.  In addition, there were notsufficient review procedures in place to identify older deferred revenuebalances and errors in the detailed schedules for deferred revenue.  The Company has designed new procedures andcontrols that it will immediately implement to improve the process forrecognizing revenue from services, and to review deferred revenue schedules ona timely basis.  By implementing itsplanned internal control improvements, the Company expects to remediate thismaterial weakness by December 31, 2004.

 

During its procedures for preparing this Form 10-K/A, the Companydetermined that it had a “material weakness” over the accounting for pro formastock-based employee compensation expense required to be disclosed underStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting forStock-Based Compensation.”  The amountpreviously disclosed by the Company in the notes to the financial statementswas in error due to a misapplication of SFAS No. 123.  The Company recently hired additional financeand accounting personnel that are experienced in applying the provisions ofSFAS No. 123 and implemented additional review procedures to properly accountfor pro forma stock-based employee compensation expense.  By implementing its planned internal controlimprovements, the Company expects to remediate this material weakness byDecember 31, 2004.

 

During the course of itsother documentation and testing, the Company may identify deficiencies that itmay not be able to remediate in time to meet the deadline imposed by the Actfor compliance with the requirements of Section 404 or it may identify one ormore material weaknesses such that it will be unable to assert its internalcontrol is effective.  If the Company isunable to assert that its internal control over financial reporting iseffective as of December 31, 2004, or if the Company is unable to complete itsevaluation on a timely enough basis for its independent registered publicaccounting firm to complete their assessment of the Company’s internal controlsover financial reporting by the due date for the Company’s 2004 Annual Reporton Form 10-K, the Company could lose investor confidence in its internalcontrols over financial reporting, which in turn could have an adverse effecton its stock price.

 

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PART IV

 

Item 15.                               EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

 

The following financialstatements and supplemental schedule of Vital Images, Inc. and Report ofIndependent Registered Public Accounting Firm thereon are included herein:

 

(a) (1)       FINANCIAL STATEMENTS

 
| Report  of Independent Registered Public Accounting Firm                                                       |   |
|----------------------------------------------------------------------------------------------------------------|--------|
| Balance Sheets as of December 31,  2003 (Restated) and 2002                                               |   |
| Statements  of Operations for the years ended December 31, 2003 (Restated), 2002 and  2001                |   |
| Statements of  Shareholders’ Equity for the years ended December 31, 2003 (Restated),  2002 and 2001 |   |
| Statements of Cash Flows for  the years ended December 31, 2003 (Restated), 2002 and 2001                 |   |
| Notes to Financial  Statements (Restated)                                                                      |   |

 

(a) (2)       SCHEDULE II.VALUATION AND QUALIFYING ACCOUNTS

 

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 65.

 

(c) REPORTS ON FORM 8-K

 

Duringthe quarter ended December 31, 2003, and during the period from December 31,2003 until the original filing date of this Report, the Company filed orfurnished the following Current Reports on Form 8-K:

 

OnOctober 21, 2003, the Company furnished the SEC with a Current Report onForm 8-K announcing the issuance of a press release on October 21, 2003regarding Vital Images’ financial results for the three and nine months ended September 30,2003.

 

OnDecember 15, 2003, the Company filed with the SEC with a Current Report onForm 8-K announcing the extension of the marketing and distribution agreementwith Toshiba Medical Systems Corporation.

 

OnJanuary 8, 2004, the Company filed with the SEC with a Current Report onForm 8-K announcing the acquisition of HInnovation, Inc. and furnished to the SEC information on thefinancial results for the fourth quarter and for the year ended December 31,2003.

 

OnJanuary 27, 2004, the Company furnished the SEC with a Current Report onForm 8-K announcing that Jay D. Miller, president and CEO, and Gregory S.Furness, vice president, finance and CFO, would be presenting at the PiperJaffray Health Care Conference on January 27, 2004.

 

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OnFebruary 11, 2004, the Company furnished the SEC with a Current Report onForm 8-K announcing the financial results for the fourth quarter and thefull-year 2003.

 

OnFebruary 26, 2004, the Company filed with the SEC with a Current Report onForm 8-K announcing the completion of the acquisition of Hinnovation, Inc.

 

OnMarch 3, 2004, the Company furnished the SEC with a Current Report on Form8-K announcing that Jay D. Miller, president and CEO, and Gregory S. Furness,vice president, finance and CFO, would be presenting at the Wall Street AnalystForum on March 3, 2004.

 

(c)           EXHIBITS

 

Included in Item 15(a)(3)above.

 

38

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SIGNATURES

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Form 10-K/A to be signed on itsbehalf by the undersigned, thereunto duly authorized, in Minneapolis,Minnesota, on the 22nd day of November, 2004.

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

 

39

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

To the Board of Directorsand Shareholders ofVital Images, Inc.:

 

In our opinion, thefinancial statements listed in the index appearing under Item 15(a)(1) presentfairly, in all material respects, the financial position of Vital Images, Inc.(the Company) at December 31, 2003 and 2002, and the results of itsoperations and its cash flows for each of the three years in the period ended December 31,2003 in conformity with accounting principles generally accepted in the UnitedStates of America.  In addition, in ouropinion, the financial statement schedule listed in the index appearingunder Item 15(a)(2) presents fairly, in all material respects, the informationset forth therein when read in conjunction with the related financialstatements.  These financial statementsand financial statement schedule are the responsibility of the Company’smanagement; our responsibility is to express an opinion on these financialstatements and financial statement schedule based on our audits. Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States), which require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

As discussed in Note 14to the financial statements, the Company has restated its financial statementsas of and for the year ended December 31, 2003.

 

 
| /s/  PricewaterhouseCoopers LLP                                                                                                                            |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                       |
| Minneapolis, Minnesota                                                                                                                                     |
| February 6, 2004,  except Note 16 as to which the date is February 18, 2004, and except

Note 14 as to which the  date is November 19, 2004 |

 

40

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**VITAL IMAGES, INC.BALANCE SHEETS**

 
| ** **                                                                                                                                                                 | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **2003**                    | ** ** | **2002** | ** ** |
| ** **                                                                                                                                                                 | ** ** | **(Restated)**              | ** ** | ** ** | ** ** |
| **ASSETS**                                                                                                                                                                 | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Current  assets:                                                                                                                                                           |       |                        |       |   |   |
| Cash  and cash equivalents                                                                                                                                                 |       | $                           | 30,111,613 |   | $ | 8,122,547 |   |
| Marketable  securities                                                                                                                                                     |       | 4,078,587                   |       | 2,508,113 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $235,000 and $240,000  as of December 31, 2003 and 2002, respectively                                 |       | 4,877,876                   |       | 4,971,079 |   |
| Deferred  income taxes                                                                                                                                                     |       | 275,000                     |       | — |   |
| Prepaid  expenses and other current assets                                                                                                                                 |       | 776,558                     |       | 498,692 |   |
| Total  current assets                                                                                                                                                      |       | 40,119,634                  |       | 16,100,431 |   |
| Property  and equipment, net                                                                                                                                               |       | 3,043,239                   |       | 2,156,835 |   |
| Licensed  technology, net                                                                                                                                                  |       | 450,000                     |       | 570,000 |   |
| Deferred  income taxes                                                                                                                                                     |       | 9,306,000                   |       | — |   |
| Other  assets                                                                                                                                                              |       | 144,346                     |       | — |   |
|                                                                                                                                                                       |       |                        |       |   |   |
| TOTAL  ASSETS                                                                                                                                                              |       | $                           | 53,063,219 |   | $ | 18,827,266 |   |
|                                                                                                                                                                       |       |                        |       |   |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                              | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Current  liabilities:                                                                                                                                                      |       |                        |       |   |   |
| Accounts  payable                                                                                                                                                          |       | $                           | 1,485,451  |   | $ | 757,715 |   |
| Accrued  payroll                                                                                                                                                           |       | 1,347,464                   |       | 1,486,654 |   |
| Deferred  revenue                                                                                                                                                          |       | 4,530,333                   |       | 3,870,958 |   |
| Accrued  royalties                                                                                                                                                         |       | 556,494                     |       | 546,593 |   |
| Other  current liabilities                                                                                                                                                 |       | 285,121                     |       | 219,036 |   |
| Total  current liabilities                                                                                                                                                 |       | 8,204,563                   |       | 6,880,956 |   |
| Deferred  revenue                                                                                                                                                          |       | 264,691                     |       | 225,539 |   |
| Total  liabilities                                                                                                                                                         |       | 8,469,554                   |       | 7,106,495 |   |
|                                                                                                                                                                       |       |                        |       |   |   |
| Commitments  (Notes 5, 13 and 15)                                                                                                                                          |       |                        |       |   |   |
|                                                                                                                                                                       |       |                        |       |   |   |
| Shareholders’  equity:                                                                                                                                                |       |                        |       |   |   |
| Preferred  stock: $0.01 par value; 5,000,000 shares authorized; none issued or  outstanding as of December 31, 2002 and 2001                                          |       | —                      |       | — |   |
| Common  stock: $0.01 par value; 20,000,000 shares authorized; 11,140,380 and  8,987,009 shares issued and outstanding as of December 31, 2003 and  2002, respectively |       | 111,404                     |       | 89,870 |   |
| Additional  paid-in capital                                                                                                                                                |       | 56,108,590                  |       | 31,719,371 |   |
| Accumulated  deficit                                                                                                                                                       |       | (11,626,329                 | )          | (20,088,470 | ) |
| Total  shareholders’ equity                                                                                                                                           |       | 44,593,665                  |       | 11,720,771 |   |
|                                                                                                                                                                       |       |                        |       |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                           |       | $                           | 53,063,219 |   | $ | 18,827,266 |   |

 

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

 

41

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**VITAL IMAGES, INC.STATEMENTS OF OPERATIONS**

 
| ** **                                                 | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                 | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                 | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                   |       |                                      |       |   |   |   |   |
| License  fees                                              |       | $                                         | 18,388,794 |   | $ | 14,211,640 |   | $ | 10,082,897 |   |
| Maintenance  and services                                  |       | 6,844,470                                 |       | 4,019,639 |   | 2,450,037 |   |
| Hardware                                                   |       | 2,066,454                                 |       | 2,884,795 |   | 2,662,702 |   |
| Total  revenue                                             |       | 27,299,718                                |       | 21,116,074 |   | 15,195,636 |   |
|                                                       |       |                                      |       |   |   |   |   |
| Cost  of revenue:                                          |       |                                      |       |   |   |   |   |
| License  fees                                              |       | 1,818,353                                 |       | 1,250,426 |   | 703,593 |   |
| Maintenance  and services                                  |       | 3,773,794                                 |       | 2,862,459 |   | 1,656,207 |   |
| Hardware                                                   |       | 1,478,914                                 |       | 2,195,182 |   | 2,112,982 |   |
| Total  cost of revenue                                     |       | 7,071,061                                 |       | 6,308,067 |   | 4,472,782 |   |
|                                                       |       |                                      |       |   |   |   |   |
| Gross  margin                                              |       | 20,228,657                                |       | 14,808,007 |   | 10,722,854 |   |
|                                                       |       |                                      |       |   |   |   |   |
| Operating  expenses:                                       |       |                                      |       |   |   |   |   |
| Sales  and marketing                                       |       | 9,317,766                                 |       | 6,795,377 |   | 5,761,416 |   |
| Research  and development                                  |       | 5,168,695                                 |       | 4,143,257 |   | 3,358,506 |   |
| General  and administrative                                |       | 3,806,914                                 |       | 3,192,735 |   | 2,657,998 |   |
| Total  operating expenses                                  |       | 18,293,375                                |       | 14,131,369 |   | 11,777,920 |   |
|                                                       |       |                                      |       |   |   |   |   |
| Operating  income (loss)                                   |       | 1,935,282                                 |       | 676,638 |   | (1,055,066 | ) |
|                                                       |       |                                      |       |   |   |   |   |
| Interest  income, net                                      |       | 213,859                                   |       | 134,870 |   | 55,089 |   |
| Income  (loss) before income taxes                         |       | 2,149,141                                 |       | 811,508 |   | (999,977 | ) |
|                                                       |       |                                      |       |   |   |   |   |
| Provision  (benefit) for income taxes, net                 |       | (6,313,000                                | )          | 22,000 |   | 12,000 |   |
|                                                       |       |                                      |       |   |   |   |   |
| Net  income (loss)                                         |       | $                                         | 8,462,141  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
|                                                       |       |                                      |       |   |   |   |   |
| Net  income (loss) per share – basic                  |       | $                                         | 0.83       |   | $ | 0.09 |   | $ | (0.14 | ) |
|                                                       |       |                                      |       |   |   |   |   |
| Weighted  average common shares outstanding – basic   |       | 10,189,114                                |       | 8,861,132 |   | 7,074,906 |   |
|                                                       |       |                                      |       |   |   |   |   |
| Net  income (loss) per share – diluted                |       | $                                         | 0.71       |   | $ | 0.08 |   | $ | (0.14 | ) |
|                                                       |       |                                      |       |   |   |   |   |
| Weighted  average common shares outstanding – diluted |       | 11,848,268                                |       | 9,821,798 |   | 7,074,906 |   |

 

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

 

42

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**VITAL IMAGES, INC.STATEMENTS OF SHAREHOLDERS’ EQUITY**

 
| ** **                                                                                      | ** ** | ** ** | ** ** | **Additional****   Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------|------------|--------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
| **Common Stock**                                                                                |
| **Shares**                                                                                      | ** ** | **Amount** |
|                                                                                            |       |       |       |                                       |       |                     |       |                                  |       |   |   |
| Balances as of December 31, 2000                                                           |       | 6,823,106  |       | $                                          | 68,231     |                     | $          | 23,562,444                            |       | $ | (19,866,001 | ) | $ | 3,764,74 |   |
|                                                                                            |       |       |       |                                       |       |                     |       |                                  |       |   |   |
| 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 11)                                                              |       | 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 |   |
|                                                                                            |       |       |       |                                       |       |                     |       |                                  |       |   |   |
| Stock-based compensation                                                                        |       |       |       |                                       |       | 18,279                   |       |                                  |       | 18,279 |   |
| Issuance of common stock upon exercise of stock  options                                        |       | 288,008    |       | 2,880                                      |       | 1,003,321                |       |                                  |       | 1,006,201 |   |
| Issuance of common stock under Employee Stock Purchase  Plan                                    |       | 24,539     |       | 245                                        |       | 130,363                  |       |                                  |       | 130,608 |   |
| Issuance of common stock upon exercise of stock  warrants                                       |       | 488,370    |       | 4,884                                      |       | 1,720,502                |       |                                  |       | 1,725,386 |   |
| Net and comprehensive income                                                                    |       |       |       |                                       |       |                     |       | 789,508                               |       | 789,508 |   |
| Balances as of December 31, 2002                                                           |       | 8,987,009  |       | 89,870                                     |       | 31,719,371               |       | (20,088,470                           | )          | 11,720,771 |   |
|                                                                                            |       |       |       |                                       |       |                     |       |                                  |       |   |   |
| Stock-based compensation                                                                        |       |       |       |                                       |       | 137,485                  |       |                                  |       | 137,485 |   |
| Issuance of common stock upon exercise of stock  options                                        |       | 559,006    |       | 5,590                                      |       | 1,690,005                |       |                                  |       | 1,695,595 |   |
| Tax benefit related to exercise of stock options                                                |       |       |       |                                       |       | 3,189,000                |       |                                  |       | 3,189,000 |   |
| Issuance of common stock under Employee Stock Purchase  Plan                                    |       | 12,995     |       | 130                                        |       | 150,437                  |       |                                  |       | 150,567 |   |
| Issuance of common stock upon exercise of stock  warrants                                       |       | 81,370     |       | 814                                        |       | 246,777                  |       |                                  |       | 247,591 |   |
| Issuance of common stock in connection with private  placement, net of offering costs (Note 12) |       | 1,500,000  |       | 15,000                                     |       | 18,975,515               |       |                                  |       | 18,990,515 |   |
| Net and comprehensive income (Restated)                                                         |       |       |       |                                       |       |                     |       | 8,462,141                             |       | 8,462,141 |   |
| Balances as of December 31, 2003 (Restated)                                                |       | 11,140,380 |       | $                                          | 111,404    |                     | $          | 56,108,590                            |       | $ | (11,626,329 | ) | $ | 44,593,665 |   |

 

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

 

43

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**VITAL IMAGES, INC.STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                | ** ** | **For the Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                    |       |                                      |       |   |   |   |   |
| Net  income (loss)                                                                        |       | $                                         | 8,462,141  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                                      |       |   |   |   |   |
| Depreciation                                                                              |       | 1,220,468                                 |       | 894,814 |   | 746,727 |   |
| Stock-based  compensation                                                                 |       | 137,485                                   |       | 18,279 |   | 10,447 |   |
| Provision  for uncollectible accounts receivable                                          |       | 46,000                                    |       | 64,000 |   | 114,000 |   |
| Tax  benefit from stock option transactions                                               |       | 3,189,000                                 |       | — |   | — |   |
| Deferred  income taxes                                                                    |       | (9,581,000                                | )          | — |   | — |   |
| Amortization  of licensed technology                                                      |       | 120,000                                   |       | 120,000 |   | 60,000 |   |
| Changes  in operating assets and liabilities:                                             |       |                                      |       |   |   |   |   |
| Accounts  receivable                                                                      |       | 47,203                                    |       | (1,397,125 | ) | (727,655 | ) |
| Prepaid  expenses and other current assets                                                |       | (277,866                                  | )          | 59,141 |   | (116,333 | ) |
| Other  assets                                                                             |       | (144,346                                  | )          | — |   | — |   |
| Accounts  payable                                                                         |       | 499,981                                   |       | (106,670 | ) | (155,513 | ) |
| Deferred  revenue                                                                         |       | 698,527                                   |       | 1,611,323 |   | 1,137,477 |   |
| Accrued  expenses and other current liabilities                                           |       | (63,204                                   | )          | 383,822 |   | 714,136 |   |
| Net  cash provided by operating activities                                                |       | 4,354,389                                 |       | 2,437,092 |   | 771,309 |   |
|                                                                                      |       |                                      |       |   |   |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                    |       |                                      |       |   |   |   |   |
| Purchases  of property and equipment                                                      |       | (1,879,117                                | )          | (1,499,533 | ) | (769,155 | ) |
| Payment  for licensed technology                                                          |       | —                                    |       | — |   | (750,000 | ) |
| Purchases  of marketable securities                                                       |       | (6,775,592                                | )          | (8,047,536 | ) | — |   |
| Sales  of marketable securities                                                           |       | 5,205,118                                 |       | 5,539,423 |   | — |   |
| Net  cash used in investing activities                                                    |       | (3,449,591                                | )          | (4,007,646 | ) | (1,519,155 | ) |
|                                                                                      |       |                                      |       |   |   |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                    |       |                                      |       |   |   |   |   |
| Proceeds  from sale of common stock, net of offering costs                                |       | 18,990,515                                |       | — |   | 551,624 |   |
| Proceeds  from sale of common stock under stock plans                                     |       | 1,846,162                                 |       | 1,136,809 |   | 245,220 |   |
| Proceeds  from sale of common stock under stock warrants                                  |       | 247,591                                   |       | 1,725,386 |   | 4,490,801 |   |
| Net  cash provided by financing activities                                                |       | 21,084,268                                |       | 2,862,195 |   | 5,287,645 |   |
|                                                                                      |       |                                      |       |   |   |   |   |
| NET  INCREASE IN CASH AND CASH EQUIVALENTS                                                |       | 21,989,066                                |       | 1,291,641 |   | 4,539,799 |   |
|                                                                                      |       |                                      |       |   |   |   |   |
| CASH  AND CASH EQUIVALENTS, BEGINNING OF YEAR                                             |       | 8,122,547                                 |       | 6,830,906 |   | 2,291,107 |   |
|                                                                                      |       |                                      |       |   |   |   |   |
| CASH  AND CASH EQUIVALENTS, END OF YEAR                                                   |       | $                                         | 30,111,613 |   | $ | 8,122,547 |   | $ | 6,830,906 |   |
|                                                                                      |       |                                      |       |   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                      |       |                                      |       |   |   |   |   |
| Cash  paid during the year for interest                                                   |       | $                                         | —     |   | $ | — |   | $ | 17,730 |   |
|                                                                                      |       |                                      |       |   |   |   |   |
| Cash  paid during the year for income taxes                                               |       | $                                         | 68,157     |   | $ | 57,974 |   | $ | 9,042 |   |
|                                                                                      |       |                                      |       |   |   |   |   |
| Purchases  of property and equipment with accounts payable                                |       | $                                         | 227,755    |   | $ | — |   | $ | — |   |

 

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

 

44

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**VITAL IMAGES, INC.NOTES TO FINANCIAL STATEMENTS**

 

**(1)Business Description and Background**

 

*BusinessDescription*

 

Vital Images develops,markets and supports 3D medical imaging software for use primarily in clinicaldiagnosis, disease screening and therapy planning.  The Company’s software applies proprietarycomputer graphics and image processing technologies to a wide variety of datasupplied by computed tomography (“CT”) and magnetic resonance (“MR”)scanners.  Vital Images’ products allow cliniciansto create 2D, 3D and 4D views of human anatomy and to non-invasively navigatewithin these 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 andpicture archive and communication systems (“PACS”) through a direct sales forcein the United States and independent distributors in international markets.

 

*Background*

 

On October 28, 1996,the Board of Directors of Bio-Vascular, Inc. (“Bio-Vascular”), now known asSynovis Life Technologies, Inc., the former parent company of Vital Images,approved a plan to spin off and establish Vital Images as an independent,publicly-owned company.  On May 12, 1997(the “Distribution Date”), Bio-Vascular distributed all of the shares of VitalImages to the shareholders of Bio-Vascular (the “Distribution”), and on thatdate Vital Images began operating as an independent public company.  All Bio-Vascular shareholders of record as ofMay 5, 1997 received one share of Vital Images common stock for each two sharesof Bio-Vascular stock held on that date and cash in lieu of fractional shares.

 

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

 

*Use ofEstimates*

 

The preparation of theCompany’s financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities as of the dateof the financial statements and the reported amounts of revenues and expensesduring the reporting periods.  Actualresults could differ from those estimates.

 

*CashEquivalents and Marketable Securities*

 

Cash equivalents consistprincipally of money market funds as well as corporate bonds and certificatesof deposits with original maturities of three months or less at the date ofpurchase. Marketable securities consist of U.S. government agency securitiesand certificates of deposit.

 

Management determines theappropriate classification of marketable securities at the time of purchase andreevaluates such designation at each balance sheet date.  Marketable securities as of December 31,2003 are classified as “available-for-sale.” Available-for-sale securities are carried at fair value, with theunrealized gains and losses reported in a separate component of shareholders’equity.  As of December 31, 2003 and2002, the Company had no unrealized gains and losses.  The cost of debt securities in this categoryis adjusted for amortization of premiums and accretion of discounts tomaturity. Such amortization and accretion is included in interest income.  Realized gains and losses and declines invalue judged to be other-than-temporary on available-for-sale securities areincluded in net income.  The cost ofsecurities sold is based on the specific identification method.  Interest and dividends on securitiesclassified as available-for-sale are included in interest income.

 

45

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*Concentrationof Credit Risk*

 

Cash and cash equivalentsare primarily maintained with one financial institution. Deposits with the bankmay exceed the amount of insurance provided on such deposits. Generally, thesedeposits may be redeemed upon demand and, therefore, bear minimal risk.Financial instruments that potentially subject the Company to concentrations ofcredit risk consist principally of marketable securities. Marketable securitiesconsist of U.S. government agency notes and certificates of deposits. TheCompany’s investment policy, approved by the Board of Directors, limits theamount the Company may invest in any one type of investment, thereby reducingcredit risk concentrations.

 

The Company’s customerbase is generally concentrated with a small number of customers.  The Company reviews the creditworthiness ofits customers prior to product shipment and generally does not requirecollateral.

 

*TradeAccounts Receivable and Allowance for Doubtful Accounts*

 

Trade accounts receivable are initially recorded at aselling price, which approximates fair value upon the sale of goods or servicesto customers.  They are stated net ofallowances for uncollectible accounts, which represent estimated lossesresulting from the inability of customers to make the required payments.  When determining the allowances foruncollectible accounts, management takes several factors into consideration,including the overall composition of accounts receivable aging, prior historyof accounts receivable write-offs, the type of customer and day-to-dayknowledge of specific customers.  The allowance for doubtful accounts isadjusted when additional information is received that impacts the amountreserved. If circumstances change, the Company’s estimates of therecoverability of accounts receivable could be reduced or increased by amaterial amount.  Such a change inestimated recoverability would be accounted for in the period in which thefacts that give rise to the change become known.  As of December 31, 2003, the Company hadan allowance for doubtful accounts of $235,000.  Changes in the allowances for uncollectibleaccounts are recorded as bad debt expense and are included in general andadministrative expense in the statements of operations.

 

*Propertyand Equipment*

 

Property and equipmentare recorded at cost.  Depreciation iscomputed using the straight-line method over the related asset’s estimateduseful life, generally three to seven years. Depreciation expense was $1,220,000, $895,000 and $747,000 for each ofthe years ended December 31, 2003, 2002 and 2001, respectively.  Leasehold improvements are amortized over theshorter of their estimated useful lives or the remaining terms of the relatedleases.  The asset cost and relatedaccumulated depreciation or amortization are adjusted for asset retirement ordisposal with the resulting gain or loss, if any, credited or charged toresults of operations.

 

*Impairmentof 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 Standards No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” warrant adjustments to suchcarrying amounts.  In reviewing thecarrying values of property and equipment and intangible assets, the Companyconsiders, among other things, the future undiscounted cash flows expected fromthe use of the asset.  The Company reviews its intangible assetspurchased in the normal course of business and other long-lived assets forimpairment whenever an event or change in circumstances indicates that thecarrying value of an asset may not be recoverable.  If such an event or change in circumstancesoccurs and potential impairment is indicated because the carrying values exceedthe estimated future undiscounted cash flows, the Company would measure theimpairment loss as the amount by which the carrying value of the asset exceedsits fair value.

 

46

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*Comprehensive Income (Loss)*

 

Comprehensiveincome (loss) as defined by SFAS No. 130, “Reporting Comprehensive Income”,includes net income (loss) and items defined as other comprehensive income. SFAS No. 130 requires that items defined as other comprehensive income,such as foreign currency translation adjustments and unrealized gains andlosses on certain marketable securities, be separately classified in the financialstatements.  Comprehensive income (loss) is equal to the net income (loss)for each of the three years in the period ended December 31, 2003.

 

*Revenue Recognition*

 

TheCompany licenses its software and sells products and services to end-users andalso indirectly through OEMs and independent distributors. Terms offered by theCompany do not generally differ based on whether the customer is an end-user,OEM or independent distributor.  TheCompany offers terms that require payment within 30 to 90 days after productdelivery.  The Company does not offerrights of return, acceptance clauses or price protection to its customers.

 

Licensefees 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 derivedfrom hardware and software maintenance and from services consisting oftelephone support, installation, training and engineering services. The Company’ssoftware licenses are always sold as part of an arrangement that includes amaintenance and support arrangement and often installation and trainingservices. Engineering services consist of software modification or developmentservices that are sold separately to OEMs. The Company generally sells hardware as part of a system sale, butoccasionally sells hardware as part of a system upgrade or additional productsale.

 

TheCompany recognizes revenue in accordance with AICPA Statement of Position (“SOP”)97-2,  Software Revenue Recognition,  as amended by SOP 98-4 and SOP 98-9, as wellas Technical Practice Aids issued from time to time by the American Instituteof Certified Public Accountants and Staff Accounting Bulletin (SAB) No. 104.  The Company recognizes revenue when it is realizedor realizable and earned.  The Companyconsiders revenue realized or realizable and earned when it has persuasiveevidence of an arrangement, the product has been shipped or the services havebeen provided to the customer, the sales price is fixed or determinable andcollectibility is probable.

 

TheCompany evaluates the credit worthiness of all customers.  In circumstances where the Company does nothave experience selling to a customer and lacks adequate credit information toconclude collection is probable, revenue is deferred until the arrangement feesare collected and all other revenue recognition criteria in the arrangementhave been met.

 

Inaddition to the aforementioned general policy, the following are the specificrevenue recognition policies for services and multiple-element arrangements.

 

*Software and Hardware. *Revenue fromlicense fees and hardware is recognized when shipment of the product hasoccurred, no significant Company obligations with regard to implementationremain and the Company’s services are not considered essential to thefunctionality of other elements of the arrangement.  See also “Multiple Element Arrangements”below for further information.

 

*Services. *Revenue from maintenance and supportarrangements is deferred and recognized ratably over the term of themaintenance and support arrangements.

 

Revenuefrom training and installation services is recognized as the services areprovided to customers.

 

47

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Revenuefrom engineering services, where the Company is performing significantcustomization or modification of software, is recognized using contractaccounting on a percentage-of-completion basis. The Company records revenue by reference to actual hours incurred todate and the estimated hours remaining to complete the services.

 

*Multiple-Element Arrangements. *The Company enters into arrangements with customers that include acombination of software products, system hardware, specified upgrades,maintenance and support or installation and training services.  For such arrangements, the Company recognizesrevenue using the residual value method. The Company allocates the total arrangement fee among each element ofthe arrangement based on the relative fair value of each of the undeliveredelements determined based on vendor-specific objective evidence. The fair valueof maintenance and support services is based upon the renewal rate forcontinued service arrangements.  The fairvalue of installation and training services is established based upon separatepricing for the services. In software arrangements for which the Company doesnot have vendor-specific objective evidence of fair value for all elements,revenue is deferred until the earlier of when vendor-specific objectiveevidence is determined for the undelivered elements (residual method) or whenall elements have been delivered.

 

*Researchand Development Costs*

 

Costs related toresearch, design and development of products are charged to research anddevelopment expense as incurred. Software development costs are capitalized beginning when a product’stechnological feasibility has been established and ending when a product isavailable for general release to customers. The Company uses the working model approach to determine technologicalfeasibility.  Generally, the Company’sproducts are released soon after technological feasibility has beenestablished.  As a result, the Companyhas not capitalized any software development costs, since such costs have notbeen significant.

 

*IncomeTaxes*

 

The Company accounts forincome taxes using the asset and liability method.  Deferred income tax assets and liabilitiesare determined based on differences between financial reporting and tax basesof assets and liabilities and are measured using the enacted tax rates and lawsthat will be in effect when the differences are expected to reverse.  Valuation allowances are established whennecessary to reduce deferred tax assets to the amounts expected to be realized.

 

*Computationof Net Income (Loss) Per Share*

 

Net income (loss) pershare - basic is computed using the weighted average common shares outstandingduring the period.  Net income (loss) pershare – diluted is computed using the weighted average common shares outstandingand common share equivalents shares outstanding during the period.  Common share equivalents are not included inthe net income (loss) per share calculations if they are anti-dilutive.  Common share equivalents consist of warrantsand options.

 

48

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The computations forbasic and diluted net income (loss) per share for each year are as follows:

 
| ** **                                                                  | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                  | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                  | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                                  |       |                                      |       |   |   |   |   |
| Net  income (loss)                                                          |       | $                                         | 8,462,141  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
|                                                                        |       |                                      |       |   |   |   |   |
| Denominator:                                                                |       |                                      |       |   |   |   |   |
| Denominator  for weighted average common shares outstanding – basic    |       | 10,189,114                                |       | 8,861,132 |   | 7,074,906 |   |
|                                                                        |       |                                      |       |   |   |   |   |
| Dilution  associated with common stock warrants                             |       | 59,389                                    |       | 59,984 |   | — |   |
|                                                                        |       |                                      |       |   |   |   |   |
| Dilution  associated with the company’s stock based compensation plans |       | 1,599,765                                 |       | 900,682 |   | — |   |
|                                                                        |       |                                      |       |   |   |   |   |
| Denominator:                                                                |       |                                      |       |   |   |   |   |
| Denominator  for weighted average common shares outstanding – diluted  |       | 11,848,268                                |       | 9,821,798 |   | 7,074,906 |   |
|                                                                        |       |                                      |       |   |   |   |   |
| Net  income (loss) per share – basic                                   |       | $                                         | 0.83       |   | $ | 0.09 |   | $ | (0.14 | ) |
|                                                                        |       |                                      |       |   |   |   |   |
| Net  income (loss) per share – diluted                                 |       | $                                         | 0.71       |   | $ | 0.08 |   | $ | (0.14 | ) |

 

Options to purchase 172,000and 94,000 shares in 2003 and 2002, respectively, and options and warrants to purchase2,892,000 shares in 2001 were not included in the computation of earnings pershare assuming dilution because their effect on earnings per share would havebeen antidilutive.  All common share equivalents are antidilutive inperiods where the Company generates a net loss.

 

*Stock-Based Compensation*

 

The Company hasstock-based employee and director compensation plans, which are described morefully in Note 6. The Company accounts for these plans under the recognition andmeasurement principles of APB Opinion No. 25, *Accountingfor Stock Issued to Employees,* and related Interpretations. Nostock-based employee and director compensation cost is reflected in net income(loss), as all options granted under those plans had an exercise price equal tothe market value of the underlying common stock on the date of grant. Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share had the Company applied the fair value recognition provisionsof FASB Statement No. 123, *Accounting forStock-Based Compensation,* to stock-based employee and directorcompensation.

 

49

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| ** **                                                                                                                              | ** **  | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|-------------|-------------------------------------------|------------|
| ** **                                                                                                                              | ** **  | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                                                              | ** **  | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                              | ** **  | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  income (loss), as reported                                                                                                         |        | $                                         | 8,462,141  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
|                                                                                                                                    |        |                                      |       |   |   |   |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  method for all awards, net of related tax effects |        | (1,387,174                                | )          | (1,560,508 | ) | (1,210,023 | ) |
|                                                                                                                                    |        |                                      |       |   |   |   |   |
| Pro  forma net income (loss)                                                                                                            |        | $                                         | 7,074,967  |   | $ | (771,000 | ) | $ | (2,222,000 | ) |
|                                                                                                                                    |        |                                      |       |   |   |   |   |
| Net  income (loss) per share - basic                                                                                                    |        |                                      |       |   |   |   |   |
|                                                                                                                                    | As reported |                                      | $          | 0.83 |   | $ | 0.09 |   | $ | (0.14 | ) |
|                                                                                                                                    | Pro  forma  |                                      | $          | 0.69 |   | $ | (0.09 | ) | $ | (0.31 | ) |
|                                                                                                                                    |        |                                      |       |   |   |   |   |
| Net  income (loss) per share - diluted                                                                                                  |        |                                      |       |   |   |   |   |
|                                                                                                                                    | As reported |                                      | $          | 0.71 |   | $ | 0.08 |   | $ | (0.14 | ) |
|                                                                                                                                    | Pro  forma  |                                      | $          | 0.62 |   | $ | (0.09 | ) | $ | (0.31 | ) |

 

The pro formaeffects on the net income (loss) for 2003, 2002 and 2001 are not necessarilyrepresentative of the pro forma effect that may occur on the net income (loss)in future periods.

 

*Recent Accounting Pronouncements*

 

In May 2003, the FASB issued SFAS No. 150, Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 requires that an issuer classify certain financialinstruments within its scope as a liability (or an asset in somecircumstances). Effective July 1, 2003, the Company adopted SFAS No.150.  Adoption of this interpretation didnot have an impact on the Company’s financial position or results of operations.

 

In May 2003, Emerging Issues Task Force (EITF) No.00-21, Accounting for Revenue Arrangements with Multiple Deliverables, wasfinalized.  This issue addresses certainaspects of accounting by a vendor for arrangements under which it will perform multiplerevenue-generating activities.  Theguidance in EITF 00-21 is effective for revenue arrangements entered into infiscal periods beginning after June 15, 2003.  In December 2003, the Securities andExchange Commission issued Staff Accounting Bulletin (SAB) No.104, Revenue Recognition, which codifies and rescinds certain sections ofSAB No. 101, Revenue Recognition, in order to make this interpretive guidanceconsistent with EITF No. 00-21.  Adoptionof this interpretation did not have an impact on the Company’s financialposition or results of operations.

 

50

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**(3)Property and Equipment, net**

 

Property and Equipment consisted of the following at December 31:

 
| ** **                                      | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Equipment                                       |       | $          | 3,725,849  |       | $          | 4,361,806 |   |
| Furniture  and fixtures                         |       | 1,474,485  |       | 1,034,641  |       |
| Computer  software                              |       | 580,986    |       | 680,190    |       |
| Leasehold  improvements                         |       | 273,924    |       | 172,323    |       |
| Total  property and equipment                   |       | 6,055,244  |       | 6,248,960  |       |
| Less  accumulated depreciation and amortization |       | (3,012,005 | )          | (4,092,125 | )          |
| Property  and equipment, net                    |       | $          | 3,043,239  |       | $          | 2,156,835 |   |

 

**(4)Deferred Revenue**

 

Deferred revenueconsists primarily of service revenue, which is recognized as the services areperformed, and maintenance and support revenue, which is recognized on astraight-line basis over the term of the arrangement.

 

**(5)Commitments**

 

The Company leases itsoffice facilities in Plymouth, Minnesota pursuant to terms of a non-cancelableoperating lease, as amended, that expires on July 31, 2005 with theexception of a small portion of the space that is under lease until May2006.  Under the terms of the lease, theCompany is required to pay a portion of the lessor’s operating costs.

 

Total rent expense,including an allocation of the lessor’s operating costs, was $678,000, $596,000and $554,000 for the years ended December 31, 2003, 2002 and 2001,respectively.

 

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

 

| **Year  Ending  December 31,** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
|                                |       |       |       |
| 2004                                |       | 434,000    |       |
| 2005                                |       | 274,000    |       |
| 2006                                |       | 19,000     |       |
| Total                               |       | $          | 727,000    |   |
|                                     |            |            |            |  |

 

Under general contractterms, the Company includes an indemnification clause in its software licensingagreement that indemnifies the licensee against liability and damages arisingfrom any claims of patent, copyright, trademark or trade secret infringement bythe Company’s software.  The Company has incurred insignificant costs as aresult of this type of indemnification clause and the Company does not maintaina product warranty liability related to such indemnification clauses.

 

The Company has enteredinto various employment agreements with certain executives of the Company,which provide for severance payments subject to certain conditions and events.

 

51

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**(6)Shareholders’ Equity**

 

*StockOption 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 StockOption Adjustment Plan, the 1990 Management Incentive Stock Option Plan, the1992 Director Stock Option Adjustment Plan, the 1992 Stock Option Plan, and the1995 Stock Incentive Adjustment Plan (collectively, the “Mirror Plans”).  Each of these plans is intended to mirror theprovisions of a corresponding Bio-Vascular plan that was in effect at the timeof 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 withrespect to Vital Images options held by Bio-Vascular employees.  On the Distribution Date, options to purchase608,534 shares were issued in connection with the Mirror Plans and the MirrorGrants (collectively, the “Mirror Options”). These options had vesting periods ranging from less than one year up tofour years and terms ranging from less than one year up to ten years.  No additional grants may be made pursuant toany 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 Option Plan”),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, ininstallments or otherwise, as the Board of Directors may determine.  Generally, these options are incentive stockoptions with a term of eight years and are exercisable as to 28% of the totalgrant one year after the date of grant and 2% per month thereafter.  In May 2003, the shareholders of the Companyapproved an increase of 500,000 common shares, bringing the total number ofshares of common stock that may be issued or awarded under the Stock OptionPlan to 3,500,000.  As of December 31,2003, there were 920,051 shares available for the grant of awards under theStock Option Plan.

 

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 andallows the Board of Directors to make additional discretionary option grants toany or all directors.  Options that aregranted under the Director Plan are granted with an option price equal to thefair market value on the date of grant, with a term of eight years, arenon-qualified options and become exercisable in three equal annual installmentsbeginning on the first occurring December 31 after the date of grant.  In May 2002, the shareholders of the Companyapproved an increase of 90,000 common shares, bringing the total number ofshares of common stock that may be issued or awarded under the Director Plan to300,000.  As of December 31, 2003,there were 43,000 shares available for the grant of awards under the DirectorPlan.

 

Certain non-plan optionswere granted to certain officers of the Company in 1998, 1999 and 2002.  In February 1998, the Company reservedand granted non-qualified, non-plan options to purchase 300,000 shares to anofficer of the Company.  These non-planoptions had a term of eight years, vested over a two-year period and weregranted at exercise prices at least equal to fair market value of the Company’scommon stock on the date of grant.  Ofthese non-plan options, the Company cancelled options to purchase 100,000shares in December 1999, and the officer exercised the remaining optionsto purchase 200,000 shares in August 2003. In

 

52

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December 1999, theCompany granted non-qualified, non-plan options to purchase 175,000 shares toanother officer of the Company.  Thesenon-plan options had a term of eight years, were exercisable as to 28% of thetotal grant one year after the date of grant and 2% per month thereafter andwere granted at exercise prices at least equal to fair market value of theCompany’s common stock on the date of grant. Of these non-plan options, the Company cancelled options to purchase80,500 shares in February 2002, and the officer exercised the remainingoptions to purchase 94,500 shares in 2002. In March 2002, the Company granted non-qualified, non-plan optionsto purchase 165,000 shares to another officer of the Company.  These non-plan options have a term of eightyears, are exercisable as 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.  As of December 31, 2003, these optionswere still outstanding.

 

*Non-EmployeeOptions*

 

In December 2000,the Company granted options to purchase 10,000 shares to a non-employeeconsultant.  Options to purchase 5,000shares vest over a four-year period, and the remaining options vestedimmediately when a specified milestone was achieved, which occurred in May2003.  The options to purchase 5,000shares that vested in May 2003 were exercised in June 2003.  In December 2001, the Company grantedoptions to purchase a total of 4,000 shares to two non-employee consultants andin December 2002, the Company granted options to purchase an additional4,000 shares to two non-employee consultants. These options vest over a four-year period.  All of the non-plan options have a term ofeight years and were granted at exercise prices at least equal to fair marketvalue of the Company’s common stock on the date of grant. The Company recordscompensation expense related to these arrangements 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 Company recorded $137,000, $18,000 and$10,000 of compensation expense related to these options for each of the yearsended December 31, 2003, 2002 and 2001, respectively.

 

53

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The following tablesummarizes stock option activity for 2003, 2002 and 2001:

 
| ** **                                      | ** ** | **Shares  Underlying  Options** | ** ** | **Weighted-  Average  Exercise Price  Per Share** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|---------------------------------------------------|------------|
|                                            |       |                            |       |                                              |       |
| 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  granted                                |       | 677,750                         |       | 7.21                                              |       |
| Options  exercised                              |       | (288,008                        | )          | 3.49                                              |       |
| Options  canceled                               |       | (216,354                        | )          | 4.44                                              |       |
|                                            |       |                            |       |                                              |       |
| Total  outstanding as of December 31, 2002 |       | 2,461,844                       |       | 4.98                                              |       |
|                                            |       |                            |       |                                              |       |
| Options  granted                                |       | 618,750                         |       | 12.04                                             |       |
| Options  exercised                              |       | (574,381                        | )          | 3.55                                              |       |
| Options  canceled                               |       | (65,241                         | )          | 7.31                                              |       |
|                                            |       |                            |       |                                              |       |
| Total  outstanding as of December 31, 2003 |       | 2,440,972                       |       | $                                                 | 7.05       |   |
|                                            |       |                            |       |                                              |       |
| Options  exercisable as of:                     |       |                            |       |                                              |       |
|                                            |       |                            |       |                                              |       |
| December 31,  2001                         |       | 1,462,761                       |       | $                                                 | 3.41       |   |
| December 31,  2002                         |       | 1,505,069                       |       | $                                                 | 3.83       |   |
| December 31,  2003                         |       | 1,407,347                       |       | $                                                 | 5.09       |   |

 

Various price ranges andweighted average information for options outstanding and exercisable as of December 31,2003 are as follows:

 
| ** **                     | ** ** | **Options Outstanding**                     | ** ** | **Options Exercisable**                           | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|---------------------------------------------------|------------|
| **Range  of  Exercise Prices** | ** ** | **Number  Outstanding as of  Dec 31, 2003** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Number  Exercisable as of  Dec 31, 2003** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                           |       |                                        |       |                                              |       |   |   |   |   |   |   |
| $1.13                     | -          | 2.75                                        |       |                                              | 426,616    |   | 1.84 years |   | $ | 2.19 |   | 426,616 |   | $ | 2.19 |   |
| 3.51                           | -          | 5.70                                        |       |                                              | 543,573    |   | 4.19 years |   | 4.87 |   | 477,253 |   | 4.83 |   |
| 5.75                      | -          | 7.25                                        |       |                                              | 564,573    |   | 6.16 years |   | 7.12 |   | 237,878 |   | 7.13 |   |
| 7.34                      | -          | 9.24                                        |       |                                              | 299,210    |   | 4.75 years |   | 7.56 |   | 241,600 |   | 7.48 |   |
| 9.60                      | -          | 19.13                                       |       |                                              | 607,000    |   | 7.26 years |   | 12.09 |   | 24,000 |   | 17.52 |   |
|                           |       | 2,440,972                                   |       | 5.06 years                                        |       | $ | 7.05 |   | 1,407,347 |   | $ | 5.09 |   |

 

*EmployeeStock Purchase Plan*

 

The 1997 Employee StockPurchase Plan (the “ESPP”) was approved and adopted by Bio-Vascular, as thesole shareholder of the Company, in May 1997. The ESPP, which became effective on July 1, 1997, enables eligibleemployees to purchase the Company’s common stock at 85% of the fair marketvalue of the stock on the date an offering period commences or on the date anoffering period terminates, whichever is lower. The ESPP covers an aggregate of up to 250,000 shares of common stockthat can be issued and sold to participating employees of the Company through aseries of three-month offering periods, beginning July 1, 1997.  The 

 

54

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ESPP covers substantiallyall employees, subject to certain limitations. Each employee may elect to have up to 10% of his or her base paywithheld and applied toward the purchase of shares in each such offering period.  Purchases under the ESPP for 2003 were 12,995shares, generating proceeds to the Company of $151,000 at an average purchaseprice of $11.59; purchases for 2002 were 24,539 shares, generating proceeds tothe Company of $131,000 at an average purchase price of $5.32; and for 2001,there were 25,487 shares purchased, generating proceeds to the Company of$92,000 at an average purchase price of $3.60. As of December 31, 2003, there are 101,453 shares of common stockreserved for purchases under the ESPP.

 

*Stock-BasedCompensation*

 

For purposes ofcalculating the fair value of options under FASB Statement No. 123, theweighted average fair values of options granted were:

 
| ** **                    | ** ** | **For the Years Ended December 31,** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| ** **                    | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| Options  under the 1997 Plans |       | $                                         | 8.20       |   | $ | 5.03 |   | $ | 4.19 |   |
| Non-plan  options             |       | —                                    |       | $ | 5.13 |   | $ | 6.02 |   |
| Options  under ESPP           |       | $                                         | 2.04       |   | $ | 0.94 |   | $ | 0.64 |   |

 

The weighted average fairvalues for the 1997 Plans and the non-plan options were based on the fairvalues on the dates of grant.    The fair values for the 1997 Plans and thenon-plan employee options were calculated using the Black-Scholesoption-pricing model with the following assumptions:

 
| ** **                  | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| Expected  option life       |       | 5.0 years                                 |       | 5.0 years |   | 6.0 years |   |
| Expected  volatility factor |       | 84.7                                      | %          | 85.9 | % | 90.8 | % |
| Expected  dividend yield    |       | 0                                         | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 3.07                                      | %          | 4.69 | % | 4.93 | % |

 

The fair values for thenon-employee options were calculated using the Black-Scholes option-pricingmodel with the following assumptions:

 
| ** **                  | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| Expected  option life       |       | 5.9 years                                 |       | 8.0 years |   | 8.0 years |   |
| Expected  volatility factor |       | 84.5                                      | %          | 85.9 | % | 90.8 | % |
| Expected  dividend yield    |       | 0                                         | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 2.66                                      | %          | 2.81 | % | 5.00 | % |

 

The fair values ofshares under the ESPP were based on the 15 percent purchase discount.

 

*Warrants*

 

In December 1999,the Company 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 exercisablewith an expiration date in December 2004. The warrants could be redeemed by the Company at any time before December 2004at 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 on December 7, 2000. In 

 

55

----

 

December 2001, theCompany called for redemption of all outstanding warrants.  As of December 31, 2003, all 1,650,000warrants had been exercised, generating proceeds of $1,719,000 and $4,460,000during 2002 and 2001, respectively.

 

The Company also issuedwarrants to the selling agent for the December 1999 private placement topurchase 163,651 shares of the Company’s common stock at $3.25 per share.  The warrants were immediately exercisable andexpire in December 2004.  During2003, 2002 and 2001, 83,063, 42,492 and 18,940, respectively, of these warrantswere exercised and converted into a total of 125,387 shares of commonstock.  These warrant exercises generatedproceeds of $248,000, $6,000 and $22,000 for the years ended December 31,2003, 2002 and 2001, respectively.  Inconjunction with these exercises, during 2003, 2002 and 2001, 1,693, 12,559 and4,856 shares, respectively, were forfeited as part of cashless exercises.  As of December 31, 2003, 19,156 of thesewarrants remained outstanding.

 

*RightsPlan*

 

In April 1997,the Company declared a dividend distribution of one Preferred Stock PurchaseRight for each outstanding share of the Company’s common stock (the “Rights”).  With certain exceptions, the Rights becomeexercisable only if one of the following events occurs: (i) an acquiring partyaccumulates 15% or more of the Company’s common stock, (ii) a party announcesan offer to acquire 15% or more of the Company’s common stock, or (iii) theacquisition of a substantial amount of the Company’s common stock by a personwhom the Board of Directors has determined is an “Adverse Person” as defined inthe underlying Rights Agreement.  EachRight entitles the holder to purchase one-thousandth of a share of the Company’sSeries A Junior 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 Directorsdetermines that a person is an Adverse Person, each holder of a Right shallthereafter have the right to receive preferred stock having a fair market valueequal to two times the Exercise Price. Upon the occurrence of certain mergers, combinations or acquisitions ofthe Company’s assets, each holder of a Right shall thereafter have the right toreceive that number of shares of common stock of the acquiring company whichequals the Exercise Price of the Right divided by one-half of the currentmarket price of such common stock as of the date of the occurrence of theevent.  The Company is generally entitledto redeem 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, ifnot previously redeemed or exercised.

 

**(7) IncomeTaxes**

 

The income tax provision (benefit) for the years ended December 31,2003, 2002 and 2001 include the following components:

 
| ** **                           | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                           | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  income taxes:               |       |                                      |       |   |   |   |   |
| Federal                              |       | $                                         | —     |   | $ | — |   | $ | — |   |
| State                                |       | 79,000                                    |       | 22,000 |   | 12,000 |   |
|                                 |       |                                      |       |   |   |   |   |
| Deferred  income taxes:              |       |                                      |       |   |   |   |   |
| Federal                              |       | (7,657,000                                | )          | — |   | — |   |
| State                                |       | 1,265,000                                 |       | — |   | — |   |
| Provision (benefit) for income taxes |       | $                                         | (6,313,000 | ) | $ | 22,000 |   | $ | 12,000 |   |

 

56

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The significantcomponents of the Company’s tax-effected net deferred tax assets, based on anassumed effective tax rate of 37% in 2003 and 40% in 2002, are:

 
| ** **                                          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2003**              | ** ** | **2002** | ** ** |
| ** **                                          | ** ** | **(Restated)**        | ** ** | ** ** | ** ** |
| Net  operating loss carryforwards                   |       | $                     | 8,101,000  |   | $ | 6,830,000 |   |
| Research  and development tax credit carryforwards  |       | 1,063,000             |       | 995,000 |   |
| Depreciation                                        |       | 287,000               |       | 322,000 |   |
| Accrued  expenses and allowances                    |       | 276,000               |       | 246,000 |   |
| Deferred  compensation                              |       | —                |       | 230,000 |   |
| Other,  net                                         |       | 1,000                 |       | (25,000 | ) |
| Net  deferred tax assets before valuation allowance |       | 9,728,000             |       | 8,598,000 |   |
| Less  valuation allowance                           |       | (147,000              | )          | (8,598,000 | ) |
| Net  deferred tax assets                            |       | $                     | 9,581,000  |   | $ | — |   |

 

A reconciliation of the Company’s income tax provision (benefit) computedusing the federal statutory rate to the tax provision reported in the Company’sstatements of operations is as follows:

 
| ** **                                                      | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                      | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                      | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Tax  provision (benefit) computed at the federal statutory rate |       | $                                         | 726,000    |   | $ | 276,000 |   | $ | (340,000 | ) |
| State  taxes, net of federal benefit                            |       | 116,000                                   |       | 24,000 |   | (52,000 | ) |
| Increase  (decrease) in tax from:                               |       |                                      |       |   |   |   |   |
| Research  and development tax credits                           |       | (85,000                                   | )          | (186,000 | ) | (147,000 | ) |
| Business  meals and entertainment                               |       | 34,000                                    |       | 26,000 |   | 20,000 |   |
| Change  in valuation allowance (1)                              |       | (7,171,000                                | )          | (111,000 | ) | 545,000 |   |
| Other,  net                                                     |       | 67,000                                    |       | (7,000 | ) | (14,000 | ) |
| Provision (benefit) for income taxes                            |       | $                                         | (6,313,000 | ) | $ | 22,000 |   | $ | 12,000 |   |

 

----

(1)            Excludes $269,000 and$21,000 of valuation allowance established in 2002 and 2001, respectively,relating to certain stock option exercises that did not generate an income taxbenefit for financial reporting purposes.

 

During 2003, the Company concluded that it is more likely than not thatsubstantially all of its net deferred tax assets would be realized, and theCompany reversed substantially all of its valuation allowance for net deferredtax assets, which resulted in the recording of a net tax benefit in 2003.  The reversal of the deferred tax assetsvaluation allowance is based upon the Company’s historical operatingperformance and management’s expectation that the Company will generate taxableincome of at least $25 million in future periods to allow it to realize itsdeferred tax assets resulting from the tax benefits associated with its netoperating loss (“NOL”) carryforwards and a significant portion of its researchand development tax credit carryforwards, as well as certain other tax benefitsrelated to book and tax income timing differences. The reversal of thevaluation allowance resulted in a tax benefit of $7,171,000.  This reversal net of other current year stateand federal income taxes resulted in a net tax benefit of $6,313,000 in 2003.

 

The Company’s netoperating loss and research and development tax credit carryforwards of $22.4million and $1.1 million, respectively, will expire in varying amounts between2004 and 2023.

 

Under the InternalRevenue Code (“Code”) Section 382, certain stock transaction whichsignificantly change ownership, including sale of stock and the granting ofoptions to purchase stock, could limit the amount of net operating losscarryforwards that may be utilized on an annual basis to offset taxable incomein future periods.

 

As a result ofBio-Vascular’s acquisition of the Company in May 1994, the Company experiencedan ownership change as defined by Section 382 of the Code.  Under the Code, the amount of pre-acquisitionnet operating loss carryforwards and research and development credits that canbe used to offset future taxable 

 

57

----

 

income and incometaxes will be limited.  As of the date ofthe Company’s acquisition by Bio-Vascular, the Company had approximately$1,600,000 of net operating loss carryforwards and $137,000 of research andexperimentation credits, both of which will be subject to limitation under theCode.

 

**(8) MajorCustomers and Geographic Data (Restated)**

 

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, 2003 |       | Toshiba Medical Systems  Corporation |       | $           | 11,554,000 |                             | 42         | % |
|                               |       |                                 |       |        |       |                             |       |   |
| Year  ended December 31, 2002 |       | Toshiba Medical Systems  Corporation |       | $           | 7,246,000  |                             | 34         | % |
|                               |       |                                 |       |        |       |                             |       |   |
| Year  ended December 31, 2001 |       | Toshiba Medical Systems  Corporation |       | $           | 4,163,000  |                             | 27         | % |

 

The Company’s accountsreceivable are generally concentrated with a small base of customers.  As of December 31, 2003, no single customeraccounted for more than 10% of accounts receivable, while as of December 31,2002, Toshiba Medical Systems Corporation accounted for 21% of accountsreceivable.

 

All long-livedassets of the Company are located in the United States.

 

Export revenueaccounted for 13%, 10% and 8% of total revenue for the years ended December 31,2003, 2002 and 2001, 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,** | ** ** |
|--------------------------|------------|-------------------------------------------|------------|
| ** **               | ** ** | **2003**                                  | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **               | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | ** ** | ** ** |
|                     |       |                                      |       |   |   |   |   |
| Europe                   |       | $                                         | 2,421,000  |   | $ | 1,094,000 |   | $ | 706,000 |   |
| Asia-Pacific             |       | 846,000                                   |       | 709,000 |   | 300,000 |   |
| Canada                   |       | 75,000                                    |       | 161,000 |   | 207,000 |   |
| Other  foreign countries |       | 312,000                                   |       | 49,000 |   | 14,000 |   |
|                     |       | $                                         | 3,654,000  |   | $ | 2,013,000 |   | $ | 1,227,000 |   |

 

**(9)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, asamended.  The Plan covers substantiallyall employees.  Each employee may electto contribute 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 2003, 2002 and2001.

 

58

----

 

**(10)Licensed Technology**

 

In July 2001, theCompany entered into an agreement to license technology from a thirdparty.  The Company paid an aggregate of$750,000 to the licensor in 2001.  TheCompany recorded this $750,000 purchase as licensed technology and isamortizing it over the estimated useful life of the technology of 75months.  This amortization expense isreported as cost of revenue for license fees. As part of this agreement, the Company is also obligated to pay the licensorroyalties on the sales of certain products as defined in the agreement.  During 2003, 2002 and 2001, $772,000,$608,000 and $211,000, respectively, of such royalties were incurred and werereported as cost of revenue for license fees.

 

**(11) Development Agreements**

 

In November 2001,the Company entered into a development and license agreement with SurgicalNavigation Technologies, Inc., a division of Medtronic, Inc. (“SNT”), tointegrate certain Company technology into SNT’s image-guided surgery productsand to develop products and services for surgical planning which will bemarketed and sold through SNT.  TheCompany received $400,000 upon execution of the agreement, which was includedin deferred revenue on the balance sheet as of December 31, 2001.  During 2002, the Company completed allservices required under this agreement and recognized the entire $400,000 asservice revenue using the percentage of completion method.

 

In 2001, the Companyentered into an agreement with E-Z-EM, Inc. Under the agreement, the Company developed a single application CTColonography product called InnerviewGITM, which is marketed and sold throughE-Z-EM, Inc.  During 2001, the Companyrecorded service revenue totaling $348,000 under this agreement.  In addition, E-Z-EM, Inc. purchased 82,332shares of newly-issued common stock of Vital Images, Inc. for $552,000 cash.

 

**(12)Private Placement**

 

InJune 2003, the Company completed a private placement of 1,500,000 sharesof common stock at $13.50 per share for total gross proceeds of$20,250,000.  After deducting offeringcosts of $1,259,000, the Company received net proceeds of $18,991,000.  A registration statement covering the resaleof these shares was declared effective on September 29, 2003 by theSecurities and Exchange Commission.

 

**(13) Purchase Commitments**

 

In November 2002,the Company entered into an agreement with R2 Technology, Inc. (“R2”) todistribute R2’s lung nodule CAD software product in conjunction with theCompany’s products.  Upon the later ofeither the date on which R2 is able to meet CE certification requirements andproduce a “Declaration of Conformance” for the lung CAD product or thecompletion of the milestones in the development plan with respect to the lungCAD product that will be distributed in Europe, the Company is required tobegin purchasing the lung CAD product over the next three years.  R2 met CE certification requirements andproduced a “Declaration of Conformance” for the lung CAD product in 2003 and inJanuary 2004 the Company completed the milestones in the development planwith respect to the lung CAD product that will be distributed in Europe.  Accordingly, the Company will be required tobegin purchasing the lung CAD product in the first half of 2004.  The total purchase commitment will be amaximum of $5.6 million worth of product over the three-year commitmentperiod.  The purchase commitment pricethe Company has to pay will be reduced if the selling price of the lung CADproduct when sold directly to end-users by R2 falls below a specifiedprice.  The purchase commitment units theCompany is required to purchase will be reduced if R2 and its otherdistributors of the lung CAD product are unable to sell as many units as theCompany is required to purchase.

 

59

----

 

**(14)Restatements and Change in Classification**

 

The Company has restated itsfinancial statements and related footnote disclosures for the year ended December 31,2003 to (1) correct the accounting for unrecognized deferred maintenance andservice revenue from certain maintenance and service arrangements and (2)change the classification of certain non-trade accounts receivable fromaccounts receivable to prepaid expenses and other current assets.  The Company has made the appropriatemodifications to the balance sheet, statement of operations, statement ofshareholders’ equity and statement of cash flows to give effect to theadjustment and change in classification.  The adjustment for thepreviously unrecognized deferred maintenance and service revenue (a) increasedmaintenance and service revenue, total revenue and operating income by likeamounts, (b) reduced the net tax benefit for the tax effect of the additionalrevenue and (c) increased net income and net income per share by the net effectof (a) and (b).  As a result ofthe maintenance and service revenue restatement, the Company also restated thedisclosures to the financial statements to increase revenue from ToshibaMedical Systems by $354,000 and increase revenue from export sales by $101,000for the year ended December 31, 2003.  The change in classification for thenon-trade accounts receivable had no effect on the Company’s previouslyreported revenue, operating income, net income or net income per share, nor didthe change in classification affect the Company’s statement of shareholders’equity. The Company also restated the disclosures to the financial statementsto correct the computation of pro forma stock-based employee compensationexpense for the year ended December 31, 2003. The following statements presentthe effect of the adjustments and change in classification for the year ended December 31,2003:

 

BalanceSheet:

 
| ** **                                       | ** ** | **As of December 31, 2003** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **As Reported**                  | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
|                                             |       |                             |       |   |   |   |   |
| ASSETS                                           |       |                             |       |   |   |   |   |
| Current  assets:                                 |       |                             |       |   |   |   |   |
| Cash  and cash equivalents                       |       | $                                | 30,111,613 |   | $ | — |   | $ | 30,111,613 |   |
| Marketable  securities                           |       | 4,078,587                        |       | — |   | 4,078,587 |   |
| Accounts  receivable, net                        |       | 4,982,362                        |       | (104,486 | ) | 4,877,876 |   |
| Deferred  income taxes                           |       | 275,000                          |       | — |   | 275,000 |   |
| Prepaid  expenses and other current assets       |       | 672,072                          |       | 104,486 |   | 776,558 |   |
| Total  current assets                            |       | 40,119,634                       |       | — |   | 40,119,634 |   |
| Property  and equipment, net                     |       | 3,043,239                        |       | — |   | 3,043,239 |   |
| Licensed  technology, net                        |       | 450,000                          |       | — |   | 450,000 |   |
| Deferred  income taxes                           |       | 9,500,000                        |       | (194,000 | ) | 9,306,000 |   |
| Other  assets                                    |       | 144,346                          |       | — |   | 144,346 |   |
| TOTAL  ASSETS                                    |       | $                                | 53,257,219 |   | $ | (194,000 | ) | $ | 53,063,219 |   |
|                                             |       |                             |       |   |   |   |   |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY       |       |                             |       |   |   |   |   |
| Current  liabilities:                            |       |                             |       |   |   |   |   |
| Accounts  payable                                |       | $                                | 1,485,451  |   | $ | — |   | $ | 1,485,451 |   |
| Accrued  payroll                                 |       | 1,347,464                        |       | — |   | 1,347,464 |   |
| Deferred  revenue                                |       | 5,054,804                        |       | (524,471 | ) | 4,530,333 |   |
| Accrued  royalties                               |       | 556,494                          |       | — |   | 556,494 |   |
| Other  current liabilities                       |       | 285,121                          |       | — |   | 285,121 |   |
| Total  current liabilities                       |       | 8,729,334                        |       | (524,471 | ) | 8,204,863 |   |
| Deferred  revenue                                |       | 264,691                          |       | — |   | 264,691 |   |
| Total  liabilities                               |       | 8,994,025                        |       | (524,471 | ) | 8,469,554 |   |
|                                             |       |                             |       |   |   |   |   |
| Shareholders’  equity:                      |       |                             |       |   |   |   |   |
| Preferred  stock                                 |       | —                           |       | — |   | — |   |
| Common  stock                                    |       | 111,404                          |       | — |   | 111,404 |   |
| Additional  paid-in capital                      |       | 56,108,590                       |       | — |   | 56,108,590 |   |
| Accumulated  deficit                             |       | (11,956,800                      | )          | 330,471 |   | (11,626,329 | ) |
| Total  shareholders’ equity                 |       | 44,263,194                       |       | 330,471 |   | 44,593,665 |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY |       | $                                | 53,257,219 |   | $ | (194,000 | ) | $ | 53,063,219 |   |

 

60

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Statementof Operations:

 
| ** **                                                 | ** ** | **For the Year Ended December 31, 2003** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                 | ** ** | **As Reported**                               | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
|                                                       |       |                                          |       |   |   |   |   |
| Revenue:                                                   |       |                                          |       |   |   |   |   |
| License  fees                                              |       | $                                             | 18,388,794 |   | $ | — |   | $ | 18,388,794 |   |
| Maintenance  and services                                  |       | 6,319,999                                     |       | 524,471 |   | 6,844,470 |   |
| Hardware                                                   |       | 2,066,454                                     |       | — |   | 2,066,454 |   |
| Total  revenue                                             |       | 26,775,247                                    |       | 524,471 |   | 27,299,718 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Cost  of revenue:                                          |       |                                          |       |   |   |   |   |
| License  fees                                              |       | 1,818,353                                     |       | — |   | 1,818,353 |   |
| Maintenance  and services                                  |       | 3,773,794                                     |       | — |   | 3,773,794 |   |
| Hardware                                                   |       | 1,478,914                                     |       | — |   | 1,478,914 |   |
| Total  cost of revenue                                     |       | 7,071,061                                     |       | — |   | 7,071,061 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Gross  margin                                              |       | 19,704,186                                    |       | 524,471 |   | 20,228,657 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Operating  expenses:                                       |       |                                          |       |   |   |   |   |
| Sales  and marketing                                       |       | 9,317,766                                     |       | — |   | 9,317,766 |   |
| Research  and development                                  |       | 5,168,695                                     |       | — |   | 5,168,695 |   |
| General  and administrative                                |       | 3,806,914                                     |       | — |   | 3,806,914 |   |
| Total  operating expenses                                  |       | 18,293,375                                    |       | — |   | 18,293,375 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Operating  income                                          |       | 1,410,811                                     |       | 524,471 |   | 1,935,282 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Interest  income                                           |       | 213,859                                       |       | — |   | 213,859 |   |
| Income  before income taxes                                |       | 1,624,670                                     |       | 524,471 |   | 2,149,141 |   |
| Income  taxes                                              |       | (6,507,000                                    | )          | 194,000 |   | (6,313,000 | ) |
| Net  income                                                |       | $                                             | 8,131,670  |   | $ | 330,471 |   | $ | 8,462,141 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Net  income per share – basic                         |       | $                                             | 0.80       |   | $ | 0.03 |   | $ | 0.83 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Weighted  average common shares outstanding – basic   |       | 10,189,114                                    |       |   |   | 10,189,114 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Net  income per share – diluted                       |       | $                                             | 0.69       |   | $ | 0.02 |   | $ | 0.71 |   |
|                                                       |       |                                          |       |   |   |   |   |
| Weighted  average common shares outstanding – diluted |       | 11,848,268                                    |       |   |   | 11,848,268 |   |

 

61

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Statementof Cash Flows:

 
| ** **                                                                         | ** ** | **For  the Year Ended December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                         | ** ** | **As  Reported**                               | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
| ** **                                                                         | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                             |       |                                           |       |   |   |   |   |
| Net income                                                                         |       | $                                              | 8,131,670  |   | $ | 330,471 |   | $ | 8,462,141 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                           |       |   |   |   |   |
| Depreciation                                                                       |       | 1,220,468                                      |       | — |   | 1,220,468 |   |
| Stock-based  compensation                                                          |       | 137,485                                        |       | — |   | 137,485 |   |
| Provision for uncollectible  accounts receivable                                   |       | 46,000                                         |       | — |   | 46,000 |   |
| Tax benefit from stock  option transactions                                        |       | 3,189,000                                      |       | — |   | 3,189,000 |   |
| Deferred income taxes                                                              |       | (9,775,000                                     | )          | 194,000 |   | (9,581,000 | ) |
| Amortization of  licensed technology                                               |       | 120,000                                        |       | — |   | 120,000 |   |
| Changes in operating  assets and liabilities:                                      |       |                                           |       |   |   |   |   |
| Accounts receivable                                                                |       | (57,283                                        | )          | 104,486 |   | 47,203 |   |
| Prepaid expenses and  other current assets                                         |       | (173,380                                       | )          | (104,486 | )  | (277,866 | ) |
| Other assets                                                                       |       | (144,346                                       | )          | — |   | (144,346 | ) |
| Accounts payable                                                                   |       | 499,981                                        |       | — |   | 499,981 |   |
| Deferred revenue                                                                   |       | 1,222,998                                      |       | (524,471 | ) | 698,527 |   |
| Accrued expenses and  other current liabilities                                    |       | (63,204                                        | )          | — |   | (63,204 | ) |
| Net cash provided by  operating activities                                         |       | 4,354,389                                      |       | — |   | 4,354,389 |   |
|                                                                               |       |                                           |       |   |   |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                             |       |                                           |       |   |   |   |   |
| Purchases of property  and equipment                                               |       | (1,879,117                                     | )          | — |   | (1,879,117 | ) |
| Purchases of marketable  securities                                                |       | (6,775,592                                     | )          | — |   | (6,775,592 | ) |
| Sales of marketable  securities                                                    |       | 5,205,118                                      |       | — |   | 5,205,118 |   |
| Net cash used in  investing activities                                             |       | (3,449,591                                     | )          | — |   | (3,449,591 | ) |
|                                                                               |       |                                           |       |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                             |       |                                           |       |   |   |   |   |
| Proceeds from sale of  common stock, net of offering costs                         |       | 18,990,515                                     |       | — |   | 18,990,515 |   |
| Proceeds from sale of  common stock under stock plans                              |       | 1,846,162                                      |       | — |   | 1,846,162 |   |
| Proceeds from sale of  common stock under stock warrants                           |       | 247,591                                        |       | — |   | 247,591 |   |
| Net cash provided by  financing activities                                         |       | 21,084,268                                     |       | — |   | 21,084,268 |   |
|                                                                               |       |                                           |       |   |   |   |   |
| NET INCREASE IN CASH  AND CASH EQUIVALENTS                                         |       | 21,989,066                                     |       | — |   | 21,989,066 |   |
|                                                                               |       |                                           |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                    |       | 8,122,547                                      |       | — |   | 8,122,547 |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                          |       | $                                              | 30,111,613 |   | $ | — |   | $ | 30,111,613 |   |

 

 

ProForma Stock-Based Employee Compensation:

 
| ** **                                                                                                                              | ** **  | **As of  December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|-------------|-----------------------------------|------------|
| ** **                                                                                                                              | ** **  | **As  Reported**                  | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
| ** **                                                                                                                              | ** **  | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income, as reported                                                                                                                 |        | $                                 | 8,131,670  |   | $ | 330,471 |   | $ | 8,462,141 |   |
|                                                                                                                                    |        |                              |       |   |   |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value method  for all awards, net of related tax effects |        | (1,479,341                        | )          | 92,167 |   | (1,387,174 | ) |
|                                                                                                                                    |        |                              |       |   |   |   |   |
| Pro forma net income                                                                                                                    |        | $                                 | 6,652,329  |   | $ | 422,638 |   | $ | 7,074,967 |   |
|                                                                                                                                    |        |                              |       |   |   |   |   |
| Net income per share -  basic                                                                                                           |        |                              |       |   |   |   |   |
|                                                                                                                                    | As reported |                              | $          | 0.80 |   | $ | 0.03 |   | $ | 0.83 |   |
|                                                                                                                                    | Pro forma   |                              | $          | 0.65 |   | $ | 0.04 |   | $ | 0.69 |   |
|                                                                                                                                    |        |                              |       |   |   |   |   |
| Net income per share -  diluted                                                                                                         |        |                              |       |   |   |   |   |
|                                                                                                                                    | As reported |                              | $          | 0.69 |   | $ | 0.02 |   | $ | 0.71 |   |
|                                                                                                                                    | Pro forma   |                              | $          | 0.56 |   | $ | 0.06 |   | $ | 0.62 |   |

 

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**(15)Quarterly Financial Data (Unaudited) (Restated)**

 

The following summarizedunaudited quarterly financial data has been prepared using the financialstatements of Vital Images, Inc.

 
| ** **                                                       | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|------------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| **2003:**                                                        |       |               |       |                |       |               |       |                |       |
| Total revenue – As  previously reported                     |       | $                  | 6,791,000  |                | $          | 7,529,000          |       | $                   | 7,243,000  |   | $ | 5,212,000 |   |
| Total revenue – As  restated                                |       | 6,945,000          |       | 7,660,000           |       | 7,404,000          |       | 5,291,000           |       |
| Gross margin – As  previously reported                      |       | 5,176,000          |       | 5,496,000           |       | 5,466,000          |       | 3,566,000           |       |
| Gross margin – As  restated                                 |       | 5,330,000          |       | 5,627,000           |       | 5,627,000          |       | 3,645,000           |       |
| Net Income – As previously  reported                        |       | 654,000            |       | 666,000             |       | 6,805,000          |       | 7,000               |       |
| Net income – As  restated                                   |       | 801,000            |       | 790,000             |       | 6,814,000          |       | 57,000              |       |
| Earnings per share –  basic – As previously reported   |       | 0.07               |       | 0.07                |       | 0.62               |       | 0.00                |       |
| Earnings per share –  basic – As restated              |       | 0.09               |       | 0.08                |       | 0.62               |       | 0.01                |       |
| Earnings per share –  diluted – As previously reported |       | 0.06               |       | 0.06                |       | 0.53               |       | 0.00                |       |
| Earnings per share –  diluted – As restated            |       | 0.08               |       | 0.07                |       | 0.53               |       | 0.00                |       |
|                                                             |       |               |       |                |       |               |       |                |       |
| **2002:**                                                        |       |               |       |                |       |               |       |                |       |
| Total revenue                                                    |       | $                  | 4,443,000  |                | $          | 4,874,000          |       | $                   | 5,593,000  |   | $ | 6,206,000 |   |
| Gross margin                                                     |       | 3,094,000          |       | 3,331,000           |       | 4,034,000          |       | 4,349,000           |       |
| Net income (loss)                                                |       | (247,000           | )          | 201,000             |       | 419,000            |       | 417,000             |       |
| Earnings (loss) per  share – basic                          |       | (0.03              | )          | 0.02                |       | 0.05               |       | 0.05                |       |
| Earnings (loss) per  share – diluted                        |       | (0.03              | )          | 0.02                |       | 0.04               |       | 0.04                |       |

 

**(16)Subsequent Event**

 

OnFebruary 18, 2004, the Company completed the acquisition of HInnovation,Inc. (“HInnovation”) in accordance with the terms and conditions of anAcquisition Agreement and Plan of Reorganization (the “Acquisition Agreement”)dated as of January 8, 2004. HInnovation is a provider ofsoftware solutions that allow physicians to use PCs or notebook computers toaccess 2D, 3D and 4D medical imaging applications securely over theInternet.  The acquisition of HInnovationwas made to acquire products and technology that will enable the Company tomore effectively compete in the Web-enabled market for 3D medical imagingsoftware.

 

Themerger consideration included 376,262 newly-issued shares of common stock ofVital Images and $6 million in cash. Terms of the Acquisition Agreement provide for the payment of up to $6million of additional consideration contingent upon achievement of certainoperating milestones.  The Companyexpects the contingent milestone payments to be made periodically as themilestones are achieved over a 12 to 24 month period following the date of theacquisition.

 

TheCompany will account for this acquisition using the purchase method ofaccounting.  Accordingly, the purchaseprice will be allocated to the assets acquired and liabilities assumed basedupon their estimated fair values.  Theexcess of the purchase price over the fair value of the net assets acquiredwill be recorded as goodwill.  Thepurchase price allocation for this business combination has not been finalized.

 

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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, 2003 |       | $                                        | 240,000    |                                | $          | 46,000                      |       | $                                 | 51,000     |   | $ | 235,000 |   |
|                               |       |                                     |       |                                |       |                        |       |                              |       |
| Year  ended December 31, 2002 |       | $                                        | 185,000    |                                | $          | 64,000                      |       | $                                 | 9,000      |   | $ | 240,000 |   |
|                               |       |                                     |       |                                |       |                        |       |                              |       |
| Year  ended December 31, 2001 |       | $                                        | 215,000    |                                | $          | 114,000                     |       | $                                 | 144,000    |   | $ | 185,000 |   |

 

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**VITALIMAGES, INC.FORM 10-K/A**

 

**INDEX TOEXHIBITS**

 
| **Item  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                            |
|---------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       |                                                                                                                                                                                                                                                                                                                                                       |
| 2.1           |       | Acquisition Agreement  and Plan of Reorganization by and among Vital Images, Inc., HInnovation  Acquisition, Inc., HInnovation, Inc. and Hui Hu and JMS Co. Ltd. Dated as of January 8,  2004  (incorporated by reference to  Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on February 26,  2004 (File No. 0-22229)). |
|          |       |                                                                                                                                                                                                                                                                                                                                                       |
| 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)).                                                                                                                  |
|          |       |                                                                                                                                                                                                                                                                                                                                                       |
| 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)).                                                                                                                          |

 

65

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| 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)).                                                                                    |
|   |   |                                                                                                                                                                                                                                            |
| 10.26  |   | 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)).              |
|   |   |                                                                                                                                                                                                                                            |
| 10.30  |   | Form of Change in Control Agreement between the Company 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)). |

 

66

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| 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)).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 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. (incorporated by reference to Exhibit  10.34 to the Company’s Annual Report on Form 10-K for the year ended December 31,  2001 (File No. 0-22229)).                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.35  |   | Marketing and  Distribution Agreement between Vital Images, Inc. and Toshiba Corporation,  Medical Systems Company * (incorporated by reference to Exhibit 10.35 to the  Company’s Form 10-Q for the quarter ended March 31, 2002 (File No.  0-22229)).                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.36  |   | Severance Agreement  dated February 9, 2002 between the Company and Albert Emola  (incorporated by reference to Exhibit 10.36 to the Company’s Form 10-Q for  the quarter ended March 31, 2002** (File No. 0-22229)).                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.37  |   | Marketing and  Distribution Agreement between Vital Images, Inc. and Toshiba Corporation,  Medical Systems Company* (incorporated by reference to Exhibit 10.37 to the  Company’s Annual Report on Form 10-K for the year ended December 31,  2002 (File No. 0-22229)).                                             |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.38  |   | Product  Distribution Agreement between Vital Images, Inc. and R2 Technology, Inc.*  (incorporated by reference to Exhibit 10.38 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2002 (File No. 0-22229)).                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.39  |   | Employment Agreement  dated February 9, 2002 between the Company and Jay D. Miller**  (incorporated by reference to Exhibit 10.39 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2002 (File No. 0-22229)).                                                                       |

 

67

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| 10.40  |   | Form of Change in  Control Agreement between the Company and Jay D. Miller** (incorporated by  reference to Exhibit 10.40 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2002 (File No. 0-22229)).                                                                                                                 |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.41  |   | Non-qualified Stock  Option Agreement dated December 28, 2002 between the Company and Jay D.  Miller** (incorporated by reference to Exhibit 10.41 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2002 (File No.  0-22229)).                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.43  |   | Value  Added Reseller Agreement between Vital Images, Inc. and McKesson Information  Solutions LLC. (incorporated by reference to Exhibit 10.43 to the  Company’s Annual Report on Form 10-K for the year ended December 31,  2003 (File No. 0-22229)) (Confidential treatment has been requested for  portions of this exhibit).                |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.44  |   | Marketing and  Distribution Agreement between Vital Images, Inc. and Toshiba Corporation,  Medical Systems Company (incorporated by reference to Exhibit 10.44 to the  Company’s Annual Report on Form 10-K for the year ended December 31,  2003 (File No. 0-22229)) (Confidential treatment has been requested for  portions of this exhibit). |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 23.1   |   | Consent of  PricewaterhouseCoopers LLP (filed herewith electronically).                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 31.1   |   | Certification  of Chief Executive Officer Pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley  Act of 2002 (filed herewith electronically).                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 31.2   |   | Certification  of Chief Financial Officer Pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley  Act of 2002 (filed herewith electronically).                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 32.1   |   | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed  herewith electronically).                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 32.2   |   | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed  herewith electronically).                                                                                                                                                            |

 

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*                 Portions of suchexhibit are treated as confidential pursuant to a request for confidentialtreatment filed with the Commission by the Registrant.

 

**          Indicates a managementcontract or compensatory plan or arrangement.

 

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