**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K**

 
| **ý**                                                                                                                                                         | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**    |
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| **For the  fiscal year ended December 31, 2004**                                                                                                              |
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| **o**                                                                                                                                                              | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                               |
| **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.) |
|                                                                            |       |                                  |
| **5850  Opus Parkway, Suite 300  Minnetonka, MN 55343-4414**               | ** ** | **55343-4414**                        |
| (Address of  principal  executive offices)                                      |       | (Zip Code)                            |
|                                                                            |       |                                  |
| **(952) 487-9500**                                                              |
| (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 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes ý  No o

 

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 theForm 10-K.  o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act).  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 30,2004, the last business day of the registrant’s most recently completed secondfiscal quarter, was $144,724,926.  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 28,2005: Common stock, $.01 Par Value – 12,051,530.

 

DOCUMENTSINCORPORATED BY REFERENCE

 

Portions of registrant’sdefinitive Proxy Statement in connection with the Annual Meeting of Stockholdersto be held May 11, 2005 (“2005 Proxy Statement”) are incorporated by referenceinto Part III of this Form 10-K, as indicated in Items 10through 14 of Part III.

 

 

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Vital Images, Inc.

Form 10-K

 

Table of Contents

 
| Part I   |                                                                                                                |
|---------------|---------------------------------------------------------------------------------------------------------------------|
|          |                                                                                                                |   |
| Item 1.       | Business                                                                                                            |   |
| Item 2.       | Properties                                                                                                          |   |
| Item 3.       | Legal Proceedings                                                                                                   |   |
| Item 4.       | Submission  of Matters to a Vote of Security Holders                                                                |   |
|          |                                                                                                                |   |
| Part II  |                                                                                                                |
|          |                                                                                                                |   |
| Item 5.       | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |   |
| Item 6.       | Selected  Financial Data                                                                                            |   |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |
| Item  7A.     | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   |
| Item 8.       | Financial  Statements and Supplementary Data                                                                        |   |
| Item 9.       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                               |   |
| Item  9A.     | Controls  and Procedures                                                                                            |   |
| Item  9B.     | Other  Information                                                                                                  |   |
|          |                                                                                                                |   |
| Part III |                                                                                                                |
|          |                                                                                                                |   |
| Item  10.     | Directors  and Executive Officers of the Registrant                                                                 |   |
| Item  11.     | Executive  Compensation                                                                                             |   |
| Item  12.     | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |   |
| Item  13.     | Certain  Relationships and Related Transactions                                                                     |   |
| Item  14.     | Principal  Accountant Fees and Services                                                                             |   |
|          |                                                                                                                |   |
| Part IV  |                                                                                                                |
|          |                                                                                                                |   |
| Item  15.     | Exhibits  and Financial Statement Schedules                                                                         |   |
|          |                                                                                                                |   |
| Signatures    |                                                                                                                |   |

 

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**Part I**

 

**Cautionary Statement Regarding Forward-LookingInformation**

 

*Vital Images desires to takeadvantage of the “safe harbor” provisions of the Private Securities LitigationReform Act of 1995 and is filing this cautionary statement in connection withthe Reform Act. This Annual Report on Form 10-K and any otherwritten or oral statements made by or on our behalf may include forward-lookingstatements that reflect our current views with respect to future events andfuture financial performance. Certain statements in this Annual Report on Form 10-K are “forward-lookingstatements” withinthe meaning of Section 27(a) of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. You can identify these forward-looking statements by our use of thewords “believes,” “anticipates,” “forecasts,” “projects,” “could,” “plans,” “expects,”“may,” “will,” “would,” “intends,” “estimates” and similar expressions, whetherin the negative or affirmative. We wish to caution you that anyforward-looking statements made by us or on our behalf are subject touncertainties and other factors that could cause such statements to be wrong.**We cannot guarantee that we actually willachieve these plans, intentions or expectations.  Actual results or events could differmaterially from the plans, intentions and expectations disclosed in theforward-looking statements that we make.*  * **These statements are only predictions and speak onlyof our views as of the date the statements were made. Although we believe thatthe expectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, and/or performance ofachievements.   We do not assume anyobligation to update or revise any forward-looking statements that we make,whether as a result of new information, future events or otherwise.*

 

*Factors that may impact forward-looking statements include,among others,**ourabilities to maintain the technological competitiveness of our currentproducts, develop new products, successfully market our products, respond tocompetitive developments, develop and maintain partnerships with providers ofcomplementary technologies, manage our costs and the challenges that may comewith growth of our business, and attract and retain qualified sales, technicaland management employees.  We are alsoaffected by the growth and regulation of the enterprise-wide advancedvisualization industry, including the acceptance of enterprise-wide advancedvisualization by hospitals, clinics, and universities, and reimbursement andregulatory practices by Medicare, Medicaid, and private third-party payerorganizations.  We are also affected byother factors identified in our filings with the Securities and ExchangeCommission, some of which are set forth in the section entitled “RiskFactors” in this Annual Report on Form 10-K (and many of which wehave discussed in prior filings).**Although wehave attempted to list comprehensively these important factors, we also wish tocaution investors that other factors may prove to be important in the future inaffecting our operating results.  Newfactors emerge from time to time, and it is not possible for us to predict allof these factors, nor can we assess the impact each factor or combination offactors may have on our business.*

 

**Item 1.****                                   Business**

 

**Our Business**

 

Vital Images, Inc. (“VitalImages,” “we,” “us,” or “our”) is a provider of enterprise-wide advancedvisualization and analysis solutions for use in clinical diagnosis, diseasescreening applications, and therapy planning. Our technology utilizes high-speed volume visualization and analysis, aswell as network communications based on DICOM and Internet protocols. *Vitrea*® 2, our flagship software, rapidlycreates accurate, interactive 2D, 3D, and 4D images from 2D informationgenerated by standard computed tomography (“CT”), magnetic resonance (“MR”),and positron emission tomography (“PET”) scanners.  *ViTALConnect*TM,our Web enabled medical diagnostic tool, allows physicians anywhere, anytimeaccess to interactive 2D, 3D, and 4D advanced visualization.

 

Our strategy is toaddress the growing interest among radiologists, cardiologists, oncologists andother specialists to improve their workflow and productivity.  Our products provide clinical benefits andallow physicians to collaborate with their peers via Web- and picture archivingand communications systems (“PACS”)-based solutions.  PACS enable hospitals and clinics to acquire,distribute and archive medical images and diagnostic reports, eliminating theneed for film and enhancing productivity.

 

We offer two primarysoftware products, *Vitrea* and *ViTALConnect*.  *Vitrea* is our flagshipadvanced visualization product for radiological and surgical applications.  *Vitrea*providesimage clarity, processing speed, and simplicity, and allows clinicians toscreen for disease, diagnose less invasively, and plan treatments moreaccurately.  We offer several optionalmodules so clinicians can customize their *Vitrea*workstations for their specialties. These modules include the following: 3D Angio, Automated VesselMeasurements, CT Brain Perfusion, CT Cardiac, CT Colon, Fusion7DTM,ImageCheckerTM CT, Lung,

 

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SoftRead, Vessel Probe,and VScore.  *Vitrea 2*is offered both as a stand-alone software package and as part of an integratedsoftware and hardware system, consisting of *Vitrea 2*software installed on a computer workstation. We have licensed approximately 1,900 copies of *Vitrea*and*Vitrea 2*to hospitals, clinics, imaging centers and other sites.

 

As specialists outsidethe radiology department increasingly rely on *Vitrea*as a diagnostic and communications tool, demand for access toadvanced visualization is growing across the healthcare enterprise.  To address this market opportunity, we areforming strategic distribution partnerships with PACS providers and promotingthe capabilities of ViTALConnect, our thin-client Web-based solution.

 

*ViTALConnect*allows physicians and other users to access 2D, 3D and 4D enterprise-wideadvanced visualization capabilities, including the ability to measure, rotate,analyze and segment images, all with a personal computer using a Web-enabledbrowser, thus allowing access to advanced visualization from anywhere and atanytime, including critical patient situations. With ViTALConnect, users canemploy a PC or notebook computer to process, analyze, review and distributemulti-dimensional medical images securely over the Web.  In addition, a collaboration mode letsseveral physicians in different locations confer while interacting with thesame images in real time.

 

Our enterprise-wideadvanced visualization and analysis software solutions are used with medicaldiagnostic equipment, primarily in clinical diagnosis, disease screening andtherapy planning.  Our software appliesproprietary computer graphics and image processing technologies to a widevariety of data supplied by CT, MR and PET scanners to allow medical 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.  We market *Vitrea 2* and *ViTALConnect*both as standalone software packages and as part of integrated software andhardware systems to radiologists, surgeons, primary care physicians and medicalresearchers.  We markets our productsdirectly to end-user customers, such as hospitals and clinics, and todiagnostic imaging companies, digital imaging equipment manufacturers andpicture archive and communication systems (“PACS”) companies, who sell ourproducts in conjunction with products they either manufacture or acquire fromthird parties.

 

Our products work withequipment from all major manufacturers of diagnostic imaging systems, includingToshiba Medical Systems Corporation, GE Medical Systems, Siemens MedicalSystems, Inc. and Philips Medical Systems, and can be integrated intoPACS, such as those marketed by McKesson Information Systems, Sectra and Stentor.

 

We were founded andincorporated in Iowa in September 1988, and we re-incorporated inMinnesota in March 1997.  Ourprincipal executive offices are located at 5850 Opus Parkway, Suite 300,Minnetonka, MN 55343 (telephone (952) 487-9500, facsimile (952) 487-9510,e-mail – info@vitalimages.com ).  From May 24,1994 through May 11, 1997, we were a wholly-owned subsidiary ofBio-Vascular, Inc., which is now known as Synovis Life Technologies, Inc.

 

Our corporate websiteaddress is www.vitalimages.com. In the “SEC Filings” category of the “Investors”section of our website, we make our Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-Kand amendments to these reports available free of charge as soon as reasonablypracticable after such reports are filed with or furnished to the United StatesSecurities and Exchange Commission (the “SEC”). The “Corporate Governance”category of the Investors section of our website also contains free copiesof the Charters for the Audit Committee, Compensation Committee, and Governanceand Nominating Committee of our Board of Directors, as well as our Code ofBusiness Conduct and Ethics.  Each of theabove referenced documents can also be obtained free of charge (other than areasonable charge for copying exhibits to our reports on Forms 10-K, 10-Qor 8-K) in print by any shareowner who requests them from our investorrelations department.  The investorrelations department’s email address is investment@vitalimages.com and its mailaddress is: Investor Relations, Vital Images, Inc., 5850 Opus Parkway, Suite 300,Minnetonka, MN 55343. Information available on our websiteis not incorporated by reference into this Annual Report on Form 10-K.

 

You may also obtaincopies of our SEC filings on the SEC’s website at www.sec.gov or at the SEC’sPublic Reference Room at 450 Fifth Street N.W., Washington, D.C.20549.  You may obtain information on theoperation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 

**Market Opportunity**

 

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, MR and PET scanners andthe incorporation of new physician-care practices based on the imaginginformation provided by these devices.

 

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CT, MR and PET imagingtechnologies capture data that provide a physician with a graphicalrepresentation of the inside of the human body. These images have traditionally been viewed as a series oftwo-dimensional, cross-sectional slices on x-ray-type film.  As computer processing speed increased,software performance improved and networking technologies developed,manufacturers of scanning equipment began offering integrated systems thatallowed clinicians to view, analyze and manipulate these medical images in adigital environment.

 

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 enterprise-wide advanced visualization industry involves the creation,visualization, manipulation, analysis and communication of medical images intwo, three and four dimensions (collectively, “enterprise-wide advancedvisualization software”).

 

Initially, theenterprise-wide advanced visualization industry and the markets forenterprise-wide advanced visualization products lagged the market for imagingdevices due to the lack of industry standards for the generation, transmissionand storage of medical imaging data and due to computer costs and performanceconsiderations.  After a time, many ofthe technical and cost barriers to growth in the enterprise-wide advancedvisualization industry and the PACS industry began to erode.  In particular, the medical industry embracedan image transmission and archiving standard called Digital Imaging andCommunications in Medicine (“DICOM”), which is promulgated by the AmericanCollege 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 forenterprise-wide advanced visualization capabilities and PACS within the graspof most healthcare providers.  We believethat the acceptance of industry standards such as DICOM and the improvements inthe cost-to-performance ratio for clinical workstations will support continuedmarket growth in the enterprise-wide advanced visualization and PACSindustries.

 

We believe that growingacceptance of 3D medical imaging offers us numerous market expansionopportunities.  Research and developmentefforts are currently focused on using our base of visualization technology toexpand to other imaging modalities, such as x-ray angiography, as well asexpanding the features and functions in the current modalities.  We are also enhancing our enterprise-wideadvanced visualization software tools for less-invasive screening applications,such as CT colonography for colon cancer screening, CT Lung to diagnose lungcancer and CT cardiac for diagnosis of heart disease.

 

The diagnostic medicalimaging market continues to expand both its geographic boundaries and itsdefinitive boundaries.  Long defined asthe market for CT, MR, PET, ultrasound and other imaging modalities, thediagnostic imaging market has grown to include both PACS and enterprise-wideadvanced visualization systems, which have become integral technologies formany radiology practices around the world.

 

The use ofenterprise-wide advanced visualization software and systems to assist insurgical planning and navigation has only begun to emerge in clinical practicein the last few years.  Whileenterprise-wide advanced visualization solutions have been used in theseapplications and to support cancer treatment planning in the past, we believethat perspective, three-dimensional volume rendering represents anunderutilized resource to practitioners for diagnostic screening and radiology,surgical planning and navigation and cancer treatment planning.

 

Today, a minority ofhospitals, clinics and imaging centers use enterprise-wide advancedvisualization products in diagnostic imaging. Technological advances over the last several years in both computerhardware and software development have dramatically improved thecost-to-performance ratio, bringing the prices for enterprise-wide advanced visualizationproducts within the reach of most healthcare providers.  In addition, increasing clinical awareness,improving utility of applications and an exponential increase in CT slicevolumes are driving demand for enterprise-wide advanced visualization products.

 

Hospitals recognize thatPACS solutions, or picture archiving and communications systems, enhanceworkflow and boost productivity by eliminating the need to store and transferbulky film.  In fact, hospitals areinvesting in this area, and the PACS market is growing 30 percent annually.  Adopting a PACS solution is a significantinvestment for a hospital.  Sales tend toencompass more decision makers and follow a longer sales cycle.  Ultimately, PACS opportunities involve moreVitrea licenses and make our software accessible to more physicians in anorganization.

 

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We also expect marketgrowth due to a number of other advantages of enterprise-wide advancedvisualization, including the following:

 

•                        Recenttechnology improvements in CT and MR scanners enable them to generate anincreasing number of slices per exam, sometimes resulting in over 5,000 images,which is more than 30 times as many images as were possible to obtain in examsfive years ago.  To obtain this manyprinted images on traditional x-ray film is quite expensive and may belogistically impractical.

 

•                        Medicare,Medicaid, private insurance companies and managed care organizations areincreasingly approving reimbursement for procedures utilizing PET scanners,which has greatly increased the number of procedures performed.  In addition, recent advances in integratingCT and PET technologies into a single scanner have also contributed to anincrease in the number of procedures performed utilizing such technology.  Through our partnership with Mirada SolutionsLimited (“Mirada”), we offer an optional module to *Vitrea 2*that uses Mirada’s fusion technology to provide clinicians with an integrated viewof images generated by PET and PET/CT scanners.

 

•                        Theuse of imaging procedures as medical planning tool procedures is growing, andphysicians are increasingly recognizing the clinical value of enterprise-wideadvanced visualization imaging.  Inaddition, the Baby Boom generation has a strong interest in screeningprocedures for the early detection of cancer and heart disease.  Accordingly, these factors are driving ademand for an increased number of 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 fast and efficient integrated 2D, 3D and4D visualization and analysis tools, which can be used to generate andinterpret images at a much greater speed than traditional X-ray technology.

 

•                        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 visualization is a valuable tool for acceleratingdiagnoses, potentially eliminating unnecessary tests and treatment, optimizingthe use of minimally invasive surgery and therapies, and gaining additionalinsight for clinical decisions.

 

•                        Spatialrelationships are of paramount importance in surgery, and 3D views displayinganatomy and pathology can greatly aid in surgical planning.  Enterprise-wide advanced visualization hasthe potential to promote improved surgical outcomes by giving surgeons a better“road map” with which to plan their operative procedures.  Interactive navigation of volume data fromscanners may also have the capability to spare patients from invasiveprocedures like endoscopy or conventional angiography.

 

•                        Increaseduse of enterprise-wide advanced visualization technology has the potential toenhance radiologists’ ability to communicate their findings to fellowclinicians, referring physicians and patients. In addition, the integration of these clinical disciplines throughelectronic visualization, networking and the Internet could allow for greatercross-discipline coordination due to increased speed, access to information andthe resulting ability to perform consultative, interactive planning andexamination on computer workstations.

 

**Strategy**

 

Our goal is to be aleading provider of enterprise-wide advanced visualization and analysis solutionsthat improve clinical outcomes and reduce costs.  To achieve this goal, we intend to implementthe following key strategies:

 

•                        Developand maintain leading-edge technology*.*  We intend to continue our overall strategy ofdeveloping and marketing leading-edge enterprise-wide advanced visualization solutionsfor a variety of medical applications. As part of this strategy, we will continue to improve the speed andperformance of *Vitrea 2* and *ViTALConnect*software.  In particular, wewill be focused on developing additional protocols that enhance the ease-of-useof *Vitrea 2*and *ViTALConnect*,as well as increasing the number of platforms on which the software operates.

 

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•                        Furtherdevelop applications for our enterprise-wide advanced visualization solutions.  We intend to leverage our core competenciesin volume rendering, computer graphics and clinical applications.  We plan to develop and offer a full range ofenterprise-wide advanced visualization solutions for diagnostic imaging,disease screening and therapy planning. We believe that significant new opportunities exist for the applicationof our innovative technologies for the diagnosis and treatment ofcardiovascular disease, cancer and orthopedics.

 

•                        Furtherpenetrate the enterprise-wide advanced visualization market.  We intend to expand our sales and marketingstaff and increase our marketing efforts in order to continue building momentumfor the acceptance and purchase of *Vitrea 2* and *ViTALConnect*.  We havea multiple-point strategy to increase our market penetration.  This strategy includes contacting andeducating physicians and clinicians as to the benefits of our high-performanceadvanced visualization software; expanding our partnership with Toshiba; developingand growing our technology and marketing relationships with PACS vendors, sothat we can expand physician access within the healthcare enterprise throughPACS- and Web-based solutions; offering high-performance advanced visualizationsoftware options, as well as maintenance and service, to our growing installedbase; and working with other manufacturers of diagnostic imaging equipment andother hardware that works with enterprise-wide advanced visualizationsolutions.  By convincing users of the benefitsof our system, we believe that we can successfully influence purchasingdecisions for medical institutions that are making initial purchases of orupgrades to their imaging technology.  Inaddition, we will continue to work to expand our appeal by implementingadditional 2D capability as well as ensuring that our technology will easilyintegrate into PACS networks.

 

•                        Continueto seek collaborative partnerships with leading medical institutions.  We have historically sought out and developedcollaborative relationships with many prestigious medical institutions todevelop and test our enterprise-wide advanced visualization solutions.  We will continue to pursue collaborations tofocus on developing products that will improve clinical outcomes and reducecosts for the practices of medical imaging and surgery.

 

•                        Continueto seek collaborative partnerships with leading medical technology companies.  In addition to collaborations with medicalinstitutions, we intend to selectively pursue relationships with leadingmedical technology companies to expand our clinical, distribution, financialand/or technical capabilities for our enterprise-wide advanced visualizationsolutions.  Such relationships includeour development, marketing and/or distribution agreements with Toshiba AmericaMedical Systems; the Surgical Navigation Technologies division of Medtronic, Inc.;E-Z-EM, Inc.; R2 Technology, Inc. (“R2”); McKesson InformationSolutions (“McKesson”); Sectra; Mirada; and Stentor, Inc.  Referring physicians, surgeons and otherclinicians, who understand 3D and 4D images better than 2D images, are placinggreater demands on radiologists.  Infact, 3D images are becoming a common language between radiology and thesurgical and interventional worlds. Delivering Vitrea through a hospital’s PACS solution, coupled with ourfloating license capabilities, which give multiple end users the opportunity toshare access to enterprise-wide advanced visualization, is an efficient way toput advanced visualization in the hands of more physicians throughout a healthcareenterprise.  See “Business-Marketing andDistribution,” “–Intellectual Property” and “–Manufacturing and Service.”

 

**Our Solution and Technology**

 

Two core technologiesunderlying our products are “customized protocols” and a visualizationtechnique known as “volume rendering.” We believe that our customized protocols make our products simple to use. This feature is critical to *Vitrea 2’s*speed and ease-of-use, as it provides automated 2D, 3D and 4D renderings ofscanner data, automated presentation of appropriate software tools, andautomated image analysis algorithms optimized for individual clinicalapplications.  Our 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 immediately providesuseful views of the patient data.  Theuse of customized protocols automates the complex and time-consuming approachesinherent in many competing enterprise-wide advanced visualization products andeliminates the need for the user to be proficient in operating complex graphicsprograms.  We have been issued Patent No. 5,986,662from the U.S. Patent and Trademark

 

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Office for its mechanismfor automated protocol selection, Patent No. 6,130,671 for the mechanismto calculate simulated lighting in 3D images, and Patent No. 6,219,059 forthe user interface and mechanism used to control the relative transparency of3D data in volume renderings of medical images.

 

Volume rendering is anadvanced technique for displaying three-dimensional views on a computer monitorthat we believe has significant advantages over the alternative technique,known as “surface rendering.”  Volumerendering permits the direct display of all of the imaging data withoutmathematical 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, webelieve visualization processes that use volume rendering provide clinicianswith better images to define and display pathology and anatomy in a more usefulmanner.

 

Enterprise-wide advancedvisualization companies largely overlooked volume rendering because thecomputer power necessary to perform volume rendering was significantly moreexpensive and intensive than the requirements for surface rendering.  Our experience with volume rendering has itsbasis in the efforts of Vincent J. Argiro, Ph.D., who founded Vital Images and developedenterprise-wide advanced visualization software using volume rendering as anaid in his research in developmental neuroscience.  Dr. Argiro focused on accelerating theperformance of volume rendering on standard computer platforms.  As a result of his work, he developedexpertise in accelerated volume rendering, which forms the core of our volumerendering technology.  Because theperformance of standard computer platforms has increased while the relative costof such performance has decreased, we believe that volume rendering has becomea more accessible imaging solution for routine clinical applications.

 

We believe thecombination of customized protocols and accelerated volume rendering offered byour products, together with improved computer performance, allow us to deliversimple, fast and affordable enterprise-wide advanced visualization products.

 

**Products and Product Development**

 

License fees accountedfor 67% of total revenue in each of the fiscal years ended December 31,2004, 2003, and 2002, respectively. Maintenance and services comprised 26%, 25%, and 19% of total revenuefor the years ended December 31, 2004, 2003, and 2002, respectively, whilehardware sales accounted for 7%, 8%, and 14% of total revenue for the yearsended December 31, 2004, 2003, and 2002, respectively.

 

*Vitrea**.*  *Vitrea* 2 is our advanced medical imagingsoftware for diagnostic evaluation of computed tomography (CT), magneticresonance (MR) and position emission tomography (PET) image data. *Vitrea*2 features real-time navigation of3D volume data, permitting the user to create two- and three-dimensional viewsof human anatomy and to interactively navigate within these images to bettervisualize and understand internal structures and disease conditions. Inaddition, *Vitrea*2 utilizes anintuitive clinical workflow and automatic settings to improve speed andsimplicity over other visualization techniques.

 

We conceived of Vitrea inDecember 1995, when we assessed our business strategy and determined thatto optimize our dedicated participation in the medical field, we needed tocreate a new product for direct clinical application.  The objective for this new product effort wasto produce an easy-to-use clinical software tool to allow radiologists andother clinicians to use two- and three-dimensional visualization in theirroutine clinical processes. Specifications for this new product, called *Vitrea,*were developed in early 1996, with software development beginning in latespring of that year.  We submitted 510(k)documentation in September 1996 for *Vitrea*, which was granted marketingclearance by the U.S. Food and Drug Administration (the “FDA”) in November 1996for use as a clinical diagnostic and surgical planning device when used with CTand MR medical imaging data.  *Vitrea* was first released for sale to customers in October 1997.  Due to its speed and ease-of-use, we believe *Vitrea*wasthe first advanced visualization product with the ability to appeal primarilyto the clinical market.  Historically, 3Dmedical imaging software was slow, difficult to use, and operated only onexpensive workstations.  Consequently,the functionality of such software was appealing only for researchapplications.  *Vitrea*combinedspeed with ease-of-use to enable a physician to access, manipulate and analyze2D, 3D and 4D images, typically in less than five to ten minutes.

 

In December 1999, wereleased *Vitrea 2*, a Microsoft® Windows andIntel®-architecture-based version of its *Vitrea* softwarefor 2D/3D visualization and analysis of medical image data.  *Vitrea* 2 wasVital Images’ first advanced visualization software product available for theMicrosoft Windows operating system and provides the speed and ease-of-use themedical community demands for diagnosis and treatment planning in a clinicalenvironment.  In June 2004, wereleased *Vitrea 2 Version 3.5*, which has improvedusability and networking features to meet the diagnostic, screening and therapyplanning needs of busy radiology departments and operates on the MicrosoftWindows XP operating system.

 

*Vitrea 2*capitalizes on our experience in enterprise-wide advanced visualization andprovides clinicians with an easy-to-use tool for disease screening,radiological diagnosis and therapy planning. It represents our most important step to date as a

 

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provider of a range ofclinical tools for broad distribution to the enterprise-wide advancedvisualization market.  *Vitrea**2’s* primaryfeatures are its high-speed rendering capability and its ability to provide 2D,3D and 4D viewing for routine diagnosis and therapy planning without requiringthe user to be trained in computer graphics techniques.  We believe that both of these features -speed and ease-of-use - now make it possible to use enterprise-wide advancedvisualization solutions in daily clinical routines.  A *Vitrea* 2 user,following a built-in clinical workflow, can view the image data in two, threeor four dimensions using visualization settings based on specific clinicalapplications stored within the system as dedicated visualizationprotocols.  The user may theninteractively navigate around, or “fly through,” the image to view clinicallyrelevant anatomies 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 industry standards,such as *OpenGL*TM computer graphics applicationprogramming interface and DICOM.

 

We offer *Vitrea 2* both as an integrated software and hardware system,consisting of *Vitrea 2*software integrated on apersonal computer (“PC”) and as a stand-alone software package.  Pursuant to purchasing arrangements we havewith computer resellers, we purchase personal computers at a nominal discount,install *Vitrea 2*, and market the package as anintegrated enterprise-wide advanced visualization solution.  Some customers prefer to purchase their ownhardware.  For such customers, as well aswhen selling to our diagnostic imaging OEM and PACS partners, we sell softwarelicenses only for use on hardware qualified for use with *Vitrea 2.*  The list price for a base model integratedworkstation and software package is approximately $87,000, and the list pricefor the *Vitrea 2* software without a workstationis approximately $72,000.

 

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.  We believe 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 productofferings, thereby providing us the opportunity to leverage the *Vitrea 2* software development investment into new commercialareas.

 

**Software options. **We have developed a number of value-added softwareoptions that work with the base *Vitrea 2*software platform.  These options providea variety of clinical information for specialized uses.  Our optionsinclude the following:

 

*VScoreTM*.  Our *VScore* softwareoption allows clinicians to non-invasively quantify calcium in the four majorcoronary arteries using CT image data. We introduced *VScore*in August 1999,and it was the first add-on option to our *Vitrea 2*enterprise-wide advanced visualization software product.

 

CT Brain Perfusion.  Our CT Brain Perfusion software option helpsradiologists analyze blood flow of stroke victims where the speed of diagnosisand treatment is often the primary factor in determining the extent of recovery.  We introduced CT Brain Perfusion in October 2001.

 

Innerview GITM.  Our Innerview GI software option generates 2Dand 3D images of the entire colon, increasing the speed and ease of locatingand analyzing polyps.  This optionprovides a less invasive, more comfortable diagnostic procedure than previouslypossible, improving patient compliance for screening.

 

Automated VesselMeasurements.  OurAutomated Vessel Measurements software option helps physicians characterize thecourse and dimensions of diseased blood vessels.  Automated Vessel Measurements is designed tosupport activities such as pre-surgical diagnosis, evaluation and stentplanning in the abdominal aorta, carotid arteries, coronary arteries and renalarteries.  We introduced Automated VesselMeasurements in October 2001.

 

CT Cardiac.  Our CT Cardiac software option defines thecoronary anatomy and the degree of luminal obstruction of the coronaryarteries.  It is commonly used todetermine the extent of obstructive coronary artery disease and to assess thefeasibility and appropriateness of various forms of therapy or surgicalinterventions.  We introduced CT Cardiacin February 2003.  In the firstquarter of 2005, the CT Cardiac option was enhanced with the addition of thecardiac functional analysis (CFA) capability that enables measurement of bloodvolume changes in the left ventricle of the heart.

 

Vessel Probe.  Our Vessel Probe software option is acomplementary product to the CT Cardiac software option.  It

 

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is used to definevascular anatomy and the degree of luminary obstruction in vessels other thanthe coronary arteries.  With this option,physicians can determine the extent of obstructive vascular disease and assessthe feasibility of various forms of therapy or surgical interventions.  We introduced Vessel Probe in December 2003.

 

Concurrent License.  In December 2003, we introduced ourConcurrent License option, which gives multiple end users the ability to sharea single *Vitrea 2* license within a facility.  While limiting the number of simultaneoususers 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.

 

SoftRead.Our SoftRead option, when used in conjunction with concurrent licensing, allowsphysicians to view studies in 2D when the Vitrea workstation is already inuse.  It supports data from multiplesources of diagnostic equipment, and can provide comparisons between multiplestudies.

 

CT Lung. Our CT Lung software option providesfast and simple-to-use visualization of nodules in the lung. CT Lung can play akey role in diagnosis, treatment, follow up comparisons and inter-departmentalcommunication.  Our CT Lung softwareoption is currently being reviewed for approval by the FDA.

 

3D-Angio. Our 3D-Angio software optionconverts and displays Toshiba digital angiograms, allowing views of patientangiographic data in 2D and 3D from an unlimited number of viewing angles. Mostof Vitrea’s standard visualization capabilities for CT and MR images areavailable for use with 3D-Angio datasets.

 

ImageChecker® CT.  Through our partnership with R2 Technology, Inc.,we offer the ImageChecker CT software option, which is a clinically-focusedoption that seamlessly integrates the ImageChecker® CT (ICCT) software into theVitrea software. R2 Technology Inc.’s ICCT software is an advanced imageanalysis and visualization system designed to assist radiologists in thedetection of pulmonary nodules during review of multidetector CT (MDCT) examsof the chest. This separately-licensed Vitrea option allows users to detectlung nodules and visualize studies of the chest from data acquired by amulti-slice CT scanner. There are two ImageChecker CT models: LN-500 – afull-featured chest CT review system, and LN-1000 – a full-featured, lungnodule detection system that uses computer-aided detection (CAD) technology.

 

Fusion7DTM. Through our partnership with MiradaSolutions, we offer the Fusion7D software option. Fusion7D is the onlycommercially available package with the deformable fusion component, making itthe most comprehensive solution on the market. Fusion7D enables physicians tovisualize images, fuse studies, calculate and display Standard Uptake Valuesand effectively communicate their findings to referring physicians.  In addition, Fusion7D allows physicians toeliminate unnecessarily repeating an exam due to patient motion; accuratelyfuse images to combine anatomical and metabolic information about lesions; distinguishbetween scar tissue and tumor; and perform temporal comparisons, enablingphysicians to monitor disease progression and therapy effectiveness.

 

*ViTALConnect. **ViTALConnect* is a thin-client Web-enabled medicaldiagnostic tool that allows physicians to use PCs or notebook computers to accessinteractive 2D, 3D and 4D advanced visualization. Building on our knowledge andunderstanding of advanced diagnostic workflow, *ViTALConnect*offers users the access that is critical in today’s hospital enterprise. *ViTALConnect*enables users to make quick diagnosticdecisions, review studies and perform advanced analysis from anywhere atanytime. Also a communication tool, *ViTALConnect*includes collaboration capabilities that enable multiple physicians indifferent locations to confer while interacting with the same data inreal-time.

 

We acquired thepredecessor product to *ViTALConnect*when we acquired HInnovation, Inc. in February 2004.  HInnovation’s core product, iConnectionTM, wasrefined and re-introduced to the market in the fall of 2004 as *ViTALConnect.*

 

As specialists outside the radiology department increasingly rely on *Vitrea*as a diagnostic and communicationstool, demand for access to advanced visualization is growing across thehealthcare enterprise.  *ViTALConnect* allows these specialists to use enterprise-wideadvanced visualization.  With *ViTALConnect*, users can employ a PC or notebook computer toprocess, analyze, review and distribute multi-dimensional medical imagessecurely over the Web.

 

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**Maintenance and Support**

 

In addition to system andsoftware products, we also market maintenance and support services, as well ascertain other services, such as installation and training.  In connection with licensing *Vitrea 2*andViTALConnect software, we offer annual maintenance and support servicesfor both *Vitrea 2* and ViTALConnect software, as well as for the integrated *Vitrea 2* system, pursuant to which we provide softwareupdates, minor feature enhancements, error correction, telephone support andother general support services.  Ourmaintenance and support services do not include installation, training andother services, whether on- or off-site, which can be purchasedseparately.  Additionally, because ourproducts are classified by the FDA as medical devices, we are required by FDAregulations to provide certain levels of support to end users, whether or notthose end users have purchased any maintenance or support services.

 

**Marketing and Distribution**

 

We market *Vitrea 2* and *ViTALConnect*both as standalone software packages and as part of integrated software andhardware systems to radiologists, surgeons, primary care physicians and medicalresearchers.  We market our productsdirectly to end-user customers, such as hospitals and clinics, and todiagnostic imaging companies, digital imaging equipment manufacturers and PACScompanies, who sell our products in conjunction with products they eithermanufacture or acquire from third parties.

 

We have signed severalagreements with manufacturers of complementary products in which we collaboratein marketing our products.  In September 2000,we signed a marketing and distribution agreement with Toshiba America MedicalSystems (“TAMS”), a primary manufacturer of diagnostic equipment, which named *Vitrea 2* as TAMS’ primary 3D software foruse with its CT scanners in the United States. In February 2002, we announced that we had entered into a marketingand distribution agreement 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. We arecurrently in the process of renegotiating our agreement with Toshiba.  See “Business – Dependence on MajorCustomers.”

 

We work collaborativelyon products and services in image-guided surgery and surgical planning with theSurgical Navigation Technologies (“SNT”) division of Medtronic, Inc. Underour agreement with SNT, our advanced visualization technology will beintegrated into Medtronic SNT’s image-guided surgery products, and the twocompanies will collaborate on new surgical planning software and serviceofferings.  We also have an agreementwith E-Z-EM, Inc. to market and develop our CT colonography product.  We have a joint distribution agreement withMcKesson Information Systems, a primary provider of PACS, under which eachcompany has been granted the right to distribute the other party’sproducts.  We also have a distributionagreement with Stentor, Inc. to integrate Vitrea with Stentor’s iSite PACSsolution – a unique technology for distributing and managing images over theWeb.  Current and future Stentorcustomers will have the ability to access Vitrea at their Stentorworkstations.  We have also recentlyentered into an agreement with London-based Medicsight to integrate Medicsight’sColon CAR, or computer-assisted reader – an image analysis software tool todetect colon polyps – into InnerviewGI, our CT colon option.

 

We market our productsdirectly to select OEMs on either a standard basis or, in the case of MedtronicSNT, on a customized basis.  Inconnection with OEM opportunities, we will either provide complete systems forresale by such OEMs or will provide discrete elements of our technology forincorporation into the products and systems of such OEMs.

 

We market our productsboth domestically and internationally. In the United States, we market our products through a direct salesforce as well as through OEMs and resellers. Internationally, we market our products through OEMs and resellers.  See Note 9 to the Financial Statements - “MajorCustomers and Geographic Data” for information regarding our export sales.  As of December 31, 2004, we had 29salespeople in the U.S., one salesperson supporting our internationalresellers, one OEM reseller in the United States and 11 international resellers.  Many of our international resellers are alsoToshiba resellers.

 

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**Relationshipwith Toshiba Medical Systems Corporation**

 

Our marketing anddistribution agreement with Toshiba Medical Systems Corporation (“Toshiba”)names *Vitrea 2* as Toshiba’sprimary enterprise-wide advanced visualization software for use with their CTscanners in the United States and in more than 50 countries in North and SouthAmerica, Europe, the Middle East, Africa, Australia and Asia, except Japan.Sales to Toshiba accounted for approximately 50%, 42%, and 34% of our totalrevenue for the years ended December 31, 2004, 2003, and 2002,respectively.  We are currently in theprocess of renegotiating our agreement with Toshiba.  See “Business – Marketing and Distribution”and “– Dependence on Major Customers.”

 

**CollaborativeRelationships**

 

We have formedcollaborative relationships with some of the leading universities andphysicians in medicine and medical imaging to develop what we believe to be themost innovative and clinically relevant medical imaging solutions.  We have entered into clinical collaborationagreements with universities and physicians to:

 

•                        Identifynew clinical applications where enterprise-wide advanced visualization canimprove clinical outcomes and reduce costs;

 

•                        Assistin the development of clinical routines that incorporate our enterprise-wideadvanced visualization solutions in normal diagnostic, screening and therapyplanning practices;

 

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

 

•                        Assessthe clinical value of our enterprise-wide advanced visualization solutions forgiven applications; and

 

•                        Developautomated rendering protocols for CT or MR data.

 

Our collaborativepartners do not receive any ownership of technology we develop in connectionwith the collaboration, nor do they receive any fees or royalties under thecollaboration agreements.

 

**Competition**

 

The enterprise-wideadvanced visualization market is developing and growing rapidly.  It is intensely competitive, subject to rapidchange and significantly affected by new product introductions and other marketactivities of industry participants.  Ourprimary competitors are diagnostic imaging system suppliers, which aretypically large, multinational companies with far greater financial andtechnical resources. 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, develop andmarket medical imaging systems, such as CT and MR equipment, which may bepurchased with integrated medical imaging capabilities.  Our software works on the products offered byeach of these companies.  In order to winbusiness against equipment manufacturers, we must convince customers to buy ourenterprise-wide advanced visualization software separately from their purchase ofimaging equipment, instead of buying integrated systems from our competitors.

 

We also face competitionfrom PACS vendors and other suppliers of medical imaging systems andsoftware.  PACS companies sometimesprovide medical imaging capability in addition to their image archiving andnetworking products.  Vendors ofhospital, clinical and radiology information systems have also diversified intothe PACS and medical imaging product lines, either through internal developmentor business development.  Thesecompanies, which may be large or small, attempt to offer an integrated systemcovering a full range of administrative, clinical and radiology informationmanagement capabilities to healthcare providers.  Other suppliers of medical imaging systemsand software compete on the basis of volume rendering or other visualizationtechnologies, specific applications or market niches.  Most of these suppliers, including VoxarLtd., Viatronix, Inc. and TeraRecon, Inc., are smaller than orsimilar in size to us.

 

Our competitive strengthis based on several factors, including our ability to do the following:

 

•                  Providedifferentiated enterprise-wide advanced visualization and analysis solutionsthat operate in multi-vendor network and image source environments;

•                  Provideclinical quality, integrated 2D, 3D and 4D images, volume rendered at highspeed with interactive navigation on a relatively low-cost standard computer;

•                 Integrateclinical knowledge from our collaborative clinical partners into our products;

•                  Leverageour visualization technology across multiple clinical disciplines, includingclinical diagnosis, disease

 

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screeningand therapy planning;

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

•                  Serveoriginal equipment manufacturers (“OEMs”), PACS vendors and end-user customersthrough the development of a modular end-user product that can easily besegmented for OEM customers or integrated into a PACS environment.

 

We believe that productquality, performance, functionality and features, quality of support andservice, reputation, and price are also important competitive factors.  We believe that customers will prefer oursolutions because they are the best-in-class productivity tools fordoctors.  While price has been lesssignificant than other factors, increasing competition in the enterprise-wideadvanced visualization market may result in price reductions and reduced grossmargins.  In particular, should one ormore of the diagnostic imaging system suppliers choose to provide or distributemore competitive medical imaging products than ours, our business, financialcondition and results of operations could be materially adversely affected.

 

**Customersand Customer Support**

 

Through December 31,2004, we have sold approximately 1,900 separate software licenses for *Vitrea*,*Vitrea 2,*InnerviewGITM and *ViTALConnect*,**for use inover 1,500 different sites, including hospitals and teaching hospitals,clinics, imaging centers, and other sites, both in major cities as well as insmaller population areas.

 

We are committed to rapidresponse to customer service requests. Customer support representatives are available during business hours toanswer questions about the operation, maintenance and repair of our products.

 

**IntellectualProperty**

 

Although we have filedpatent applications and have received patents with respect to certain aspectsof our technology, we generally do not rely only on patent protection withrespect to our products and technologies. We also rely on a combination of trade secret and copyright law,employee and third-party nondisclosure agreements and other protective measuresto protect intellectual property rights pertaining to our products andtechnologies.  Because of the rapid paceof technological change in the enterprise-wide advanced visualization industry,we believe that the knowledge, ability and experience of our personnel; newproduct developments and enhancements; and ongoing, reliable product maintenanceand support are also significant factors in our competitive position.

 

We do not own all of thesoftware and other technologies used in our products, but we believe we havethe necessary licenses from third parties for using that technology in ourcurrent products. It may be necessary to renegotiate with such third partiesfor any new versions of current products or any new products. Such third partylicenses may not be available on reasonable terms, or at all.

 

**Manufacturingand Service**

 

Our manufacturing effortsare limited to the production, quality assurance and distribution of oursoftware, which is distributed on CD-ROM. After we send software to our customers, it will be loaded into aworkstation, either by our personnel, personnel from one of our authorizedresellers, or our customers’ personnel. If our personnel load the software, it is as part of our installationservices, which we price and bill incrementally to the price for oursoftware.  In addition to loadingsoftware into the workstation, our installation services generally includeintegrating *Vitrea 2* workstations and *ViTALConnect* software into customers’ computer networks,configuring the network requirements and verifying software operability onsite.

 

We rely primarily on our ownsoftware development as our core competence. We obtain certain application and utility software from third parties(see “—Intellectual Property” above) and use a third party operating system forintegrated computer workstations.  Inaddition, we obtain systems components, computers and computer peripherals fromthird party suppliers.

 

We have also signedreseller distribution agreements that allow us to distribute products fromcertain third parties.  We currently haveagreements with R2 for R2’s ImageChecker® CT software applications for thedetection of lung nodules and with Mirada for Mirada’s Fusion 7D softwareapplication for the anatomical alignment of two different image data sets fromtwo different types of diagnostic equipment, such as combining images from CTand PET scanners.

 

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**GovernmentalRegulation**

 

As medical devices, ourenterprise-wide advanced visualization software solutions are subject toextensive and rigorous regulation by numerous governmental authorities,principally the FDA and corresponding foreign agencies.  In the United States, the FDA administers theFederal Food, Drug and Cosmetic Act and its amendments.  These regulations classify medical devices aseither Class I, II or III devices, which are subject to generalcontrols, 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* and *ViTALConnect* are classified as Class II medical devicesand have received marketing clearances from the FDA as the result of 510(k)pre-market notifications.  Specifically, *Vitrea , ViTALConnect* and the Company’s add-on options have beencleared to be marketed for use with CT, MR, and PET scanners.  Future products, add-on options to existingsoftware, and expanded claims of efficacy will likely 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. If our current or future products become classified as Class IIIdevices, they could be subject to a more expensive, uncertain and lengthyapproval process, and approval, if granted, could include significantlimitations on the indicated uses for which a product may be marketed.

 

We are also increasinglybecoming subject to regulation in foreign countries in which we sell ourproducts.  Many of the regulationsapplicable to our products in such countries are similar to those of theFDA.  Our ability to successfully marketand sell our products in foreign markets depends in large part on our abilityto comply with such foreign regulatory requirements. *Vitrea 2*software has been Conformitee Europeene (“CE”) marked, indicating conformancewith applicable sections of the Medical Device Directive 93/42/EEC, whichallows the products to be marketed in the member countries of the EuropeanCommunities.

 

We are also subject toperiodic inspections by the FDA and similar foreign regulatory agencies, whoseprimary purpose is to audit our compliance with quality system regulationsestablished by the FDA and other applicable government standards.  Regulatory action may be initiated in responseto audit deficiencies or to product performance problems.  We believe that our manufacturing and qualitycontrol procedures are in compliance with all applicable requirements of theFDA and foreign regulatory agencies in countries in which we sell our products.We have received ISO 13485 Certification.

 

Medicare and Medicaidlaws and regulations may impact the financial arrangements through which wemarket, sell and distribute our products and services to patients who areMedicare or Medicaid beneficiaries. Violations of these laws and regulations may result in civil andcriminal penalties, including substantial fines and imprisonment.  In a number of states, the scope of theselaws and regulations has been extended to include the provision of services orproducts to all patients, regardless of the source of payment, although thereis variation from state to state as to the exact provisions of such laws orregulations.  In other states and, on anational level, several health care reform initiatives have been proposed whichwould have a similar impact.  We believethat our operations and our marketing, sales and distribution practicescurrently comply with all current fraud and abuse and physician anti-referrallaws and regulations, to the extent they are applicable.

 

**ThirdParty Reimbursement and Cost Containment**

 

Our products arepurchased primarily by hospitals, clinics, imaging centers and other users thatbill various third party payers for the services provided to the patients.  These payers, which include Medicare,Medicaid, private insurance companies and managed care organizations, reimbursepart or all of the costs and fees associated with the diagnostic proceduresutilizing our products.  The medical imagingservices performed using our software, except for disease screening procedures,are covered by current CPT codes (Current Procedural Terminology, as defined bythe Centers for Medicare & Medicaid Services).  As such, hospitals providing services usingour enterprise-wide advanced visualization solutions can seek reimbursement forsuch services 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 fixedreimbursement method, hospitals have incentives to use less costly methods intreating Medicare and Medicaid patients, and they will frequently make capital

 

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expenditures to takeadvantage of less costly treatment technologies.  Often, reimbursement is reduced to reflectthe availability of a new procedureor technique and, as a result, hospitals are generally willing to implement newcost-saving technologies before these downward adjustments take effect.  Likewise, because the rate of reimbursementfor certain physicians who perform certain procedures has been, and may in thefuture, be reduced in the event of changes in the resource-based relative valuescale method of payment calculation, physicians may seek greater costefficiency in treatment to minimize any negative impact of reducedreimbursement.  Any amendments toexisting reimbursement rules and regulations that restrict or terminatethe reimbursement eligibility (or the extent or amount of coverage) of medicalprocedures using our products or the eligibility (or the extent or amount ofcoverage) of our 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,proposals by 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 affiliate themselves with as many managed care plans aspossible.  Higher managed carepenetration typically drives down the prices of healthcare procedures, which inturn places pressure on medical supply prices. This causes hospitals to implement tighter vendor selection andcertification processes by reducing the number of vendors used, purchasing moreproducts from fewer vendors and trading discounts on price for guaranteedhigher volumes to vendors.  Hospitalshave also sought to control and reduce costs over the last decade by joininggroup purchasing organizations or purchasing alliances.  We cannot predict what continuing or futureimpact these practices, the existing or proposed legislation, or such thirdparty payer measures may have on our future business.

 

**HealthInsurance Portability and Accountability Act of 1996 (“HIPAA”)**

 

The HIPAA regulations arecausing our customers to request that we sign “business associate” agreementswith them.  A “business associate” is aperson or entity that performs certain functions or activities that involve theuse or disclosure of protected health information on behalf of, or providesservices to, a covered entity.  By law,the HIPAA Privacy Rule applies only to covered entities – health plans,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 todisclose protected health information to these “business associates” if theproviders or plans obtain satisfactory assurances that the business associatewill use the information only for the purposes for which it was engaged by thecovered entity, will safeguard the information from misuse, and will help thecovered entity comply with some of the covered entity’s duties under thePrivacy Rule.  Covered entities maydisclose protected health information to an entity in its role as a businessassociate *only* to help thecovered entity carry out its health care functions – not for the businessassociate’s independent use or purposes, except as needed for the propermanagement and administration of the business associate.

 

**Employees**

 

As of February 28,2005, we had 151 full-time employees, with 50 involved in research anddevelopment, 53 in sales and marketing, 25 in technical support functions and 23in administrative functions.  We are nota party to any collective bargaining agreement involving our employees.   We believe our relationship with ouremployees is good.

 

**Acquisitionof HInnovation, Inc.**

 

On February 18,2004, we completed our 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., awholly-owned subsidiary of Vital Images (“HInnovation Acquisition”),HInnovation and Mr. Hui Hu and JMS Co., Ltd., the principal stockholdersof HInnovation.  Pursuant to theAcquistion Agreement, HInnovation was merged with and into HInnovationAcquisition, and HInnovation became a wholly-owned subsidiary of Vital Images.  We acquired the predecessor product to *ViTALConnect* when we acquired HInnovation.  HInnovation’s core product, iConnectionTM, wasrefined and re-introduced to the market in the fall of 2004 as *ViTALConnect.*

 

The merger considerationincluded 376,262 newly-issued shares of common stock of Vital Images valued at$6 million and $5.8 million in cash at the time of the merger.  The merger consideration for HInnovationincludes contingent milestone payments of up to a maximum of $6.0 million ofcontingent milestone payments comprised of $3.0 million in common stock and$3.0 million in cash.  The contingent milestone payments are based on 1)the achievement of certain revenue targets resulting from the sale of productscontaining HInnovation technology during the 12 month period following theclosing date; 2) the porting of our product to HInnovation’s product platformand the commercial launch thereof; and 3) licensing the

 

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HInnovation patentedtechnology within 24 months after the closing date.  The number of sharesissued under the contingent milestone payments will be determined based on theaverage closing price of our common stock during the 10 trading days beforecompletion of the milestone objective.  However, the Acquisition Agreementprovides that the number of shares of our common stock comprising thecontingent consideration cannot exceed 300,000 shares.  If, at the time ofits issuance, the value of such stock is less than $3.0 million due to thislimitation on the number of shares, we will pay the shortfall in cash. Any contingent payments made by us will result in an increase in goodwill.  As of December 31, 2004, no contingentpayments had been earned.  The firstmilestone was not met before the February 2005 deadline.  As a result, the potential maximum contingentconsideration was reduced to $4.5 million, which consists of $3.0 million incommon stock and $1.5 million in cash.

 

HInnovation was aprivately-held company founded in June 2000 and is a provider ofinnovative and cost-effective solutions to deliver medical imaging softwareapplications and services online. HInnovation’s enabling technologies have been developed to helphospitals, clinics and industry reach a new dimension in optimizing workflow,improving productivity, enhancing service and increasing revenue.  It obtained 510(k) marketing clearance foriConnectionTM from the FDA in November 2001.  HInnovation was awarded U.S. Patent No. 6,621,918,which covers a server-based MPR/3D/4D software system and design.

 

**RiskFactors**

 

*Historical Operating Losses*

 

For the years ended December 31,2004, 2003 and 2002, we had operating income of $514,000, $1.9 million and$677,000, respectively.  However, we hadan operating loss of $1.1 million for the year ended December 31, 2001 andincurred operating losses for each year prior to that since 1990, with theexception of the fiscal year ended October 31, 1995.  As of December 31, 2004, our accumulateddeficit was $11.3 million.  Our abilityto maintain profitability will depend on, among other things, our abilities tomaintain the technological competitiveness of our current products, develop newproducts, successfully market our products, respond to competitivedevelopments, and attract and retain qualified sales, technical and managementemployees.  We may not be able tocontinue to achieve profitable operations on an annual basis.

 

*Market Acceptance*

 

Our success depends onour ability to successfully market *Vitrea 2* and *ViTALConnect* software for clinical use, and on the abilityand willingness of physicians to use enterprise-wide advanced visualizationsoftware medical imaging software in disease screening, clinical diagnosis andtherapy planning.  The enterprise-wideadvanced visualization software offered by *Vitrea 2* and *ViTALConnect* represent new alternatives to the conventionalmethods traditionally used for viewing medical images in the clinicalsetting.  The acceptance of *Vitrea 2* and *ViTALConnect* byphysicians and other clinicians will depend on our ability to educate thoseusers as to the speed, ease-of-use and other benefits offered by the *Vitrea 2* and *ViTALConnect*systems, as well as our timely introduction of new features and functions.  There can be no assurance that users willprefer enterprise-wide advanced visualization software over less expensivetwo-dimensional medical imaging software or that we will succeed in our effortsto further develop, commercialize, and achieve market acceptance for *Vitrea 2* and *ViTALConnect* orfor any other product in the clinical setting.

 

*Substantial Reliance on a SingleProduct*

 

Revenue from sales andservicing of the *Vitrea 2* system constituted 95%,96%, and 98% of our total revenues for the years ended December 31, 2004,2003, and 2002.** **Weanticipate that revenue from the sale of *Vitrea 2* willcontinue to account for a substantial portion of our revenue for theforeseeable future.  As such, the failureof physicians to accept *Vitrea 2* wouldhave a material adverse impact on our business, financial condition, andresults of operations.

 

*Dependence on Market Growth*

 

The enterprise-wideadvanced visualization industry in which we market our products is stilldeveloping due to the fairly recent availability of high performance computersat reduced prices, the recent adoption of industry standards for thegeneration, transmission and storage of medical imaging data, and changingmedical practices. Historically, there has been a perception thatenterprise-wide advanced visualization was too slow or difficult for clinicaluse.  This perception was due largely tothe relatively slower processing speed of workstations available in thepast.  We believe that the recentadvances in the affordability of high performance computers and in thedevelopment of industry standards for the generation, transmission, and storageof imaging data will provide opportunities for growth in the enterprise-wideadvanced visualization industry. However, given the uncertainties associated with the developing stage ofthis industry, there can be no assurance

 

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that it will continue todevelop in the manner we anticipate. Accordingly, there can be no assurance that the enterprise-wide advancedvisualization industry will provide growth opportunities for us and oursoftware products or that our business strategies will be successful as theenterprise-wide advanced visualization industry continues to evolve.  Ultimately, if the enterprise-wide advancedvisualization industry fails to develop as we expect, our business, results ofoperations and financial condition will be materially and adversely affected.

 

*Highly Competitive Industry*

 

We face intensecompetition in the enterprise-wide advanced visualization industry.  We expect technology to continue to developrapidly, and our success will depend to a large extent on our ability tomaintain a competitive position with our products.  Our competitors in the enterprise-wideadvanced visualization industry include large, established manufacturers of CTand MR imaging equipment.  Companies suchas GE Healthcare, Siemens Medical Systems, Inc. and Philips MedicalSystems typically offer their own enterprise-wide advanced visualizationsoftware and workstations as part of their integrated imaging and scannersystems.  Our software works on theproducts offered by each of these companies. In order to win business against equipment manufacturers, we mustconvince customers to buy our enterprise-wide advanced visualization softwareseparately from their purchase of imaging equipment, instead of buyingintegrated systems from our competitors.

 

In addition to having acompetitive advantage in marketing enterprise-wide advanced visualization toolsas an integrated part of their imaging products, our competitors havesignificantly greater capital and staffing resources for research anddevelopment that are critical to success in the rapidly changingenterprise-wide advanced visualization industry, more recognizable brand names,and more well-established marketing and distribution networks.  While price has been less significant thanother factors, increasing competition may result in price reductions andreduced gross margins.  Additionally, weface competition from other entities, such as software suppliers and PACSvendors.  We may not be able to competeeffectively with such manufacturers or competing entities.

 

*Risk of TechnologicalObsolescence*

 

The enterprise-wideadvanced visualization market is characterized by rapid innovation andtechnological change.  We may be unableto compete effectively in the marketplace, and products developed by ourcompetitors may render our products obsolete or non-competitive.  Similarly, our competitors may succeed indeveloping or marketing products that are viewed as providing superior clinicalperformance or are less expensive than our current or future products.

 

*Dependence on Major Customers*

 

One of our principaldistribution channels is to sell our *Vitrea 2*medical imaging software in connection with medical imaging equipment sold byToshiba.  Sales to Toshiba accounted for50%, 42% and 34% of our total revenue for the years ended December 31,2004, 2003, and 2002, respectively. Toshiba’s account receivable represented 23% of the Company’s accountsreceivable at December 31, 2004 and 7% at December 31, 2003. Management believes a limited number of large customers may continue toaccount for a significant portion of our revenue during any given period forthe foreseeable future.  Except for ourmarketing and distribution agreements with Toshiba, Medtronic SNT, E-Z-EM, Inc.and McKesson, we currently have no long-term purchase or other agreements withany of our customers, and we generally make sales pursuant to purchaseorders.  A reduction, delay, orcancellation of orders from one or more of our significant customers, or ourinability to collect accounts receivable from these customers, likely wouldhave a material adverse effect on our operating results.

 

*Impact of Purchase Commitments*

 

We have an agreement withR2 to distribute R2’s lung nodule CAD software product in conjunction with our product.  We began purchasing the lung CAD product inthe first half of 2004 and will continue for a three-year period.  Our total purchase commitment is a maximum of$5.6 million of product over the three-year commitment period.  Our purchase commitment price will be reducedif the selling price of the lung CAD product when sold directly to end-users byR2 falls below a specified price.  Thepurchase commitment units we are required to purchase will be reduced if R2 andits other distributors of the lung CAD product are unable to sell as many unitsas we are required to purchase.  However,we must purchase the minimum amount under the agreement with R2 regardless ofhow much of the lung CAD product we sell. If our cost to purchase the lung CAD product is greater than the priceat which we can sell the lung CAD product, or if we are unable to sell some orall of the lung CAD product we buy, our business could be adversely affected.

 

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*Fluctuations in Operating Results*

 

We may experiencesignificant fluctuations in future annual and quarterly operating results.  If these fluctuations occur, they may resultin volatility in the price of our common stock. Quarterly revenue and operating results may fluctuate as a result of avariety of factors that are outside of our control including, but not limitedto, the timing of significant orders, the timing of product enhancements andnew product introductions by us or our competitors, the pricing of ourproducts, changes in customers’ budgets, and competitive conditions.

 

*Government Regulation*

 

Our products are subjectto regulation by the FDA and by comparable agencies in foreign countries.  In the United States, the FDA regulates thedevelopment, introduction, manufacturing, labeling and record keepingprocedures for medical devices, including 3D medical imaging software andsystems.  The process of obtainingmarketing clearance from the FDA for new products and new applications forexisting products can be time-consuming and expensive.  All of our current products have receivedmarketing clearance from the FDA pursuant to 510(k) pre-marketnotifications.  *Vitrea 2*and *ViTALConnect* and our add-on options havebeen cleared to be marketed for use with CT, MR and PET scanners.** **The FDA may not grantclearance with respect to our future products or enhancements, or future FDAreview may involve delays that could adversely affect our ability to marketsuch future products or enhancements.  Inaddition, our future products or enhancements may be subject to a more lengthyand expensive pre-market approval process with the FDA.

 

Even if we obtainregulatory clearances and approvals to market a product from the FDA, theseapprovals may entail limitations on the indicated uses of the product.  Product clearances and approvals by the FDAcan also be withdrawn due to failure to comply with regulatory standards or theoccurrence of unforeseen problems following initial approval.  The FDA could also limit or prevent thedistribution of our products and has the power to require the recall of suchproducts.  FDA regulations depend heavilyon administrative interpretation, and future interpretations made by the FDA orother regulatory bodies may adversely affect us.  The FDA may inspect our facilities andoperations to determine whether we are in compliance with various regulationsrelating to specification, development, documentation, validation, testing,quality control and product labeling.  Ifthe FDA determines that we are in violation of such regulations, it couldimpose civil penalties, including fines, recall or seize products and, inextreme cases, impose criminal sanctions.

 

We market our productsboth domestically and internationally. International regulatory bodies have established varying regulationsgoverning product standards, packaging requirements, labeling requirements,import restrictions, tariff regulations, duties and tax requirements.  Our inability or failure to comply with thevarying regulations, or the imposition of new regulations, could restrict ourability to sell our products internationally and could adversely affect ourbusiness.

 

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

 

The HIPAA regulations arecausing our customers to request that we sign “business associate” agreementswith them.  A “business associate” is aperson or entity that performs certain functions or activities that involve theuse or disclosure of protected health information on behalf of, or thatprovides services to, a covered entity. By law, the HIPAA Privacy Rule applies only to covered entities –health plans, health care clearinghouses, and certain health careproviders.  However, most health careproviders do not carry out all of their health care activities and functions bythemselves.  Instead, they often use theservices of a variety of other persons or businesses.  The Privacy Rule allows coveredproviders and health 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.  These agreements are necessary for us in thenormal course of servicing and supporting our products.  If we are not willing to or are unable toenter into a business associate agreement with current and potential customers,such customers may not purchase our products or services, which would have amaterial adverse effect on our business, financial condition, or results of operations.

 

*Uncertain Protection forIntellectual Property; Possible Claims of Others*

 

Although we have receivedpatents and have filed patent applications with respect to certain aspects ofour technology, we generally do not rely only on patent protection with respectto our products and technologies.  We alsorely on a combination of trade secret and copyright law, employee andthird-party nondisclosure agreements and other protective measures to protectintellectual property rights pertaining to our products and technologies.  Such measures may not provide meaningfulprotection of our trade secrets, know-how or other intellectual property in theevent of any unauthorized use, misappropriation or disclosure.  Others may independently develop similartechnologies or duplicate our technologies. In

 

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addition, to the extentthat we apply for any patents, such applications may not result in issuedpatents or, if issued, such patents may not be valid or of value.  We do not believe that our products andtechnologies infringe any existing patents or intellectual property rights ofthird parties.  However, our products andtechnologies may infringe existing patents or intellectual property rights ofthird parties.  The costs of prosecutingor defending an intellectual property claim could be substantial and couldadversely affect our business, even if we are ultimately successful inprosecuting or defending any such claims. If our products or technologies are found to infringe the rights of athird party, we could be required to pay significant damages or license fees orcease production, any of which could have a material adverse effect on ourbusiness.

 

*Product Liability Risk; LimitedInsurance Coverage*

 

The manufacture and saleof products used in the practice of medicine entail significant risk of productliability claims.  We currently maintainproduct liability insurance and coverage limits that we consider to bereasonable.  However, our coverage limitsmay not be adequate to protect us from any liabilities we might incur inconnection with claims in connection with our products.  Further, we may not be able to maintain thesame level of coverage in the future.  Wemay also need increased product liability coverage as we release additionalproducts and updates.  Such insurance isexpensive and may not be available on acceptable terms, if at all.  A successful product liability claim orseries of such claims against us in excess of our insurance coverage could havea material adverse effect on our business, financial condition, or results ofoperations.

 

*Need to Hire Additional Personnel*

 

Our ability to enhanceand develop markets for our current products and to introduce new products tothe marketplace also depends on our ability to attract and retain qualifiedscientific and management personnel.  Wecompete for such personnel with other companies, academic institutions, and governmententities and organizations, many of which have substantially greater capital resources,name recognition, and research and development capabilities.  There can be no assurance that we will besuccessful in recruiting or retaining such personnel.  We may not be able to recruit and retain suchpersonnel, which would have a material adverse effect on our business.

 

*Management of Growth*

 

Ourability to grow successfully requires an effective planning and managementprocess.  The expansion and growth of ourbusiness could place a significant strain on our management systems,infrastructure and other resources.  Tomanage growth successfully, we must continue to improve and expand our systemsand infrastructure in a timely and efficient manner.  In addition, the success of any acquisition,such as our acquisition of HInnovation, will depend on our ability tosuccessfully integrate the acquired business with our business.  Our controls, systems, procedures andresources may not be adequate to support a changing and growing company.  If management fails to respond effectively tochanges and growth in business, including acquisitions, such failure could havea material adverse effect on our business, financial condition, orresults of operations.

 

*Dependence on Third-PartyReimbursement*

 

Our products arepurchased by hospitals, clinics, imaging centers and other users, which billvarious third party payers, such as government health programs, private healthinsurance plans, managed care organizations and other similar programs, for thehealth care goods and services provided to their patients.  There are currently Current ProceduralTerminology (CPT) reimbursement codes for most of the diagnostic proceduresthat use our products.  However, theamount of such reimbursement varies by location and is subject to change.  Payers may deny reimbursement if theydetermine that a product used in a procedure was not used in accordance withestablished payer protocol regarding cost-effective treatment methods or wasused for an unapproved indication.  Thirdparty payers are increasingly challenging the prices charged for medicalservices and, in some instances, have put pressure on service providers tolower their prices or reduce their services. We are unable to predict what changes will be made in the reimbursementmethods used by third party healthcare payers. Third party payers may not consider as cost effective the procedures inwhich our products are used. Reimbursement for such procedures may not be available or, if available,payers’ low reimbursement levels may adversely affect our ability to sell our productson a profitable basis.  In addition,there have been and may continue to be proposals by legislators, regulators andthird party payers to curb further these costs in the future.  A failure by hospitals and other users of ourproducts to obtain reimbursement from third party payers, changes in thirdparty payers’ policies toward reimbursement for procedures using our productsor legislative action could have a material adverse effect on our business, financial condition, or results ofoperations.

 

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*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 we expect that there will continue to be, a numberof federal, state, and private proposals to control health care costs.  These proposals may contain measures intendedto control public and private spending on health care as well as to provideuniversal 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 we conductbusiness and could have a material adverse effect on our business, financialcondition and results of operations.

 

*Possible Issuances of PreferredStock*

 

Our Articles ofIncorporation authorize our Board of Directors, without any action by ourcommon stock stockholders, to establish the rights and preferences of up to5,000,000 shares of currently undesignated preferred stock.  These shares of preferred stock could possessvoting and conversion rights that could adversely affect the voting power ofthe holders of the common stock and may have the effect of delaying, deferringor preventing a change in control of Vital Images.  No shares of preferred stock or other seniorequity securities are currently designated, and currently we have no plan todesignate or issue any such securities.

 

*Anti-Takeover Considerations*

 

We are subject to “anti-takeover”provisions of the Minnesota Business Corporation Act.  In addition, we have adopted a ShareholderRights Plan (the “Rights Agreement”) designed to protect against unsolicitedattempts to acquire Vital Images.  Thesemeasures may deter or discourage takeover attempts and other changes in controlthat are not approved by our Board of Directors, and they may have a depressiveeffect on any market for our common stock. As a result, our stockholders may lose opportunities to dispose of theirshares at the higher prices typically available in takeover attempts or that maybe available under a merger proposal.  Inaddition, these measures may have the effect of permitting our currentdirectors to retain their positions and place them in a better position toresist changes that stockholders may wish to make if they are dissatisfied withthe conduct of our business.

 

*No Dividends*

 

We have not paid cashdividends on our common stock in the past, and we do not intend to do so in theforeseeable future.

 

*Limitations on Director Liability*

 

As permitted by Minnesotalaw, our Articles of Incorporation provide that members of our board ofdirectors shall not be personally liable to us or our stockholders for monetarydamages for breach of fiduciary duty as a director, with certainexceptions.  These provisions maydiscourage stockholders from bringing suit against a director for breach offiduciary duty and may reduce the likelihood of derivative litigation broughtby stockholders on our behalf against a director.  In addition, our Bylaws provide for mandatoryindemnification of directors and officers to the fullest extent permitted byMinnesota law.

 

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**Item 2.****   Properties**

 

The Company’s principaloffice is located in Minnetonka, Minnesota, where the Company currentlyoccupies approximately 41,000 square feet under a lease that expires January 31,2012. Under certain conditions contained in the lease, the Company will expandits facilities to approximately 61,000 square feet by July 31, 2007.

 

The Company considers itscurrent facilities adequate for its current needs and believes that suitableadditional space will be available as and if needed.

 

**Item 3.****                                   LegalProceedings**

 

The Company is notengaged in any legal proceedings at this time.

 

**Item 4.****                                   Submissionof Matters to a Vote of Security Holders**

 

There was no mattersubmitted to the vote of security holders during the fourth quarter of thefiscal year ended December 31, 2004.

 

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**Part II**

 

**Item 5.****                                   Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities**

 

The Company’s common stock is listed on The NASDAQ National Marketunder the symbol “VTAL.”  The table belowreflects the high and low per share closing sale prices of the Company’s commonstock as reported by The NASDAQ Stock Market for each of the periodsindicated.  Such prices reflectinter-dealer prices, do not include adjustments for retail mark-ups, markdownsor commissions, and may not necessarily represent actual transactions.

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| 2004           |       |     |       |    |       |
| Fourth Quarter |       | $        | 16.95      |    | $          | 12.18 |   |
| Third Quarter  |       | $        | 12.60      |    | $          | 9.84 |   |
| Second Quarter |       | $        | 12.39      |    | $          | 9.26 |   |
| First Quarter  |       | $        | 20.01      |    | $          | 9.34 |   |
|           |       |     |       |    |       |
| 2003           |       |     |       |    |       |
| Fourth Quarter |       | $        | 21.05      |    | $          | 15.75 |   |
| Third Quarter  |       | $        | 24.55      |    | $          | 17.42 |   |
| Second Quarter |       | $        | 19.09      |    | $          | 11.12 |   |
| First Quarter  |       | $        | 12.90      |    | $          | 9.05 |   |

 

The Company has never paid or declared any cash dividends on its commonstock and does not intend to pay dividends on its common stock in the nearfuture.  To date, the Company hasincurred cumulative operating losses and presently expects to retain its futureanticipated earnings to finance development and expansion of its business.  As of February 28, 2005, there were approximately8,200 beneficial owners and approximately 800 registered holders of record ofthe Company’s common stock.

 

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**Item 6.****                                   SelectedFinancial Data**

 
| ** **                                                 | ** ** | **2004**                                      | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                                 | ** ** | **(in thousands, except for per share data)** | ** ** |
| **Years  ended December 31:**                         |       |                                          |       |     |       |     |       |     |       |     |       |
| Revenue                                                    |       | $                                             | 36,122     |     | $          | 27,300   |       | $        | 21,116     |     | $          | 15,196 |   | $ | 10,628 |   |
| Gross profit                                               |       | 25,675                                        |       | 20,229   |       | 14,808   |       | 10,723   |       | 7,168    |       |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Operating  expenses                                        |       | 25,161                                        | (2)        | 18,294   |       | 14,131   |       | 11,778   |       | 9,955    |       |
| Operating income  (loss)                                   |       | 514                                           |       | 1,935    |       | 677      |       | (1,055   | )          | (2,787   | )          |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Net income  (loss)                                         |       | $                                             | 296        |     | $          | 8,462    | (1)        | $        | 790        |     | $          | (1,012 | ) | $ | (2,637 | ) |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Net income  (loss) per share-basic                         |       | $                                             | 0.03       |     | $          | 0.83     |       | $        | 0.09       |     | $          | (0.14 | ) | $ | (0.39 | ) |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Weighted average  common shares outstanding – basic   |       | 11,632                                        |       | 10,189   |       | 8,861    |       | 7,075    |       | 6,760    |       |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Net income  (loss) per share-diluted                       |       | $                                             | 0.02       |     | $          | 0.71     |       | $        | 0.08       |     | $          | (0.14 | ) | $ | (0.39 | ) |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Weighted average  common shares outstanding – diluted |       | 12,536                                        |       | 11,848   |       | 9,822    |       | 7,075    |       | 6,760    |       |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| **At December 31:**                                   |       |                                          |       |     |       |     |       |     |       |     |       |
| Working capital                                            |       | 30,996                                        |       | 31,915   |       | 9,219    |       | 6,094    |       | 2,344    |       |
| Total assets                                               |       | 69,284                                        |       | 53,063   |       | 18,827   |       | 13,269   |       | 7,287    |       |
| Long-term debt                                             |       | —                                        |       | —   |       | —   |       | —   |       | —   |       |
| Total  stockholders’ equity                           |       | 54,554                                        |       | 44,594   |       | 11,721   |       | 8,051    |       | 3,765    |       |

 

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(1)          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.

(2)          Includes $1,000 ofacquired in-process research and development charge relating to the acquisitionof HInnovation, Inc. in February 2004.

 

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**Item 7.****                                   Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Executive summary**

 

Vital Images, Inc. (the “Company”) achieved significant growth in 2004.  Total revenue increased 32% to $36.1 millionin 2004 compared to $27.3 million in 2003. Operating income was$514,000 in 2004, which included amortization of identified intangibles of $1.1million and an acquired in-process research and development charge of $1.0million related to the acquisition of HInnovation, compared to $1.9 million in2003.

 

The Company recorded net income of $296,000,or $0.02 per diluted share, in 2004 compared to $8.5 million of net income, or$0.71 per diluted share, in 2003. Full-year earnings for 2003 include a net tax benefit of $6.3 million,or $0.53 per diluted share.

 

The Company’s balance sheet remainsstrong:  total cash, cash equivalents andmarketable securities were $35.7 million as of December 31, 2004 comparedto $34.2 million as of December 31, 2003; working capital was $31.0 millionas of December 31, 2004 compared to $31.9 million as of December 31,2003; and working capital included deferred revenue of $8.1 million and $4.5million as of December 31, 2004 and 2003, respectively.

 

Throughout the Company’s history, asignificant portion of the Company’s revenue has been generated from the U.S.CT market.  Going forward, the Companyanticipates a growing contribution from other sources, including an expanding picturearchive and communication systems (“PACS”) market, sales of Web-based products and the Company’s installedcustomer base.  In February 2004, theCompany acquired 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, which represents another step towardsexpanding the Company’s presence in the PACS and Web-based markets.

 

**Overview**

 

The Company develops, markets and supports enterprise-wide advancedvisualization software for use primarily in clinical diagnosis, diseasescreening and therapy planning.  TheCompany’s software applies proprietary computer graphics and image processingtechnologies to a wide variety of data supplied by computed tomography (“CT”),magnetic resonance (“MR”) and positron emission tomography (“PET”)scanners.  The Company’s 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 and PACSthrough a direct sales force in the United States and independent distributorsin international markets.

 

On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.(“Bio-Vascular”), now known as Synovis Life Technologies, Inc., the formerparent company of Vital Images, approved a plan to spin off and establish VitalImages as an independent, publicly-owned company.  On May 12, 1997, Bio-Vasculardistributed all of the shares of Vital Images to the stockholders ofBio-Vascular, and on that date Vital Images began operating as an independentpublic company.  All Bio-Vascular stockholdersof record as of May 5, 1997 received one share of Vital Images commonstock for each two shares of Bio-Vascular stock held on that date, and cash inlieu of fractional shares.  Vital Images’common stock is currently listed on The NASDAQ National Market under the symbolVTAL.

 

**Critical accounting policies and estimates**

 

Management’s discussion and analysis of financial condition and resultsof operations are based upon the Company’s audited consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America.  The preparation of these financial statementsrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.  The notes to the consolidatedfinancial statements contained in this Annual Report describe the Company’ssignificant accounting polices used in the preparation of the consolidatedfinancial statements.

 

The Company continually evaluates its critical accounting policies andestimates.  The Company believes thecritical accounting polices listed below reflect significant judgments,estimates and assumptions used in the preparation of its

 

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consolidated financial statements.

 

*Allowancefor doubtful accounts*

 

The Company maintains an allowance for doubtful accounts at an amountestimated to be sufficient to provide adequate protection against lossesresulting from extending credit to the Company’s customers. In judging theadequacy of the allowance for doubtful accounts, the Company considers multiplefactors, including historical bad debt experience, the general economicenvironment, the need for specific client reserves and the aging of the Company’sreceivables.  This provision is includedin operating expenses as a general and administrative expense in theconsolidated statements of operations.  Aconsiderable amount of judgment is required in assessing these factors. If thefactors utilized in determining the allowance do not reflect futureperformance, then a change in the allowance for doubtful accounts would benecessary in the period such determination has been made which would impactfuture results of operations.  As of December 31,2004, the allowance for doubtful accounts was $767,000 for gross accountsreceivable of $8.9 million.

 

*Deferredtaxes*

 

Significant judgment is required in determining the realizability ofthe Company’s deferred tax assets.  TheCompany must assess the likelihood that its net deferred tax assets will berecovered from future taxable income, and to the extent the Company believesthat recovery is not likely, it must establish a valuation allowance.  To the extent the Company establishes avaluation allowance; it must include an expense within the tax provision in thestatement of operations.  As of December 31,2004, the consolidated balance sheet included net deferred tax assets of $9.1million.

 

The Company’s methodology for determining therealizability of its deferred tax assets involves estimates of future taxableincome from its core business, the estimated impact of future tax deductionsfrom the exercise of stock options outstanding as of December 31, 2004,and the expiration dates and amounts of net operating loss carryforwards andother tax credits.  These estimates areprojected through the life of the related deferred tax assets based onassumptions which management believes to be reasonable and consistent withcurrent operating results.

 

Although the Company had cumulative pre-taxincome for financial reporting purposes for the three years ended December 31,2004, the Company did not pay any significant income taxes over that period dueto tax deductions from the exercise of stock options as well as its utilizationof net operating losses.  In assessingthe realizability of its deferred tax assets as of December 31, 2004, theCompany considered evidence regarding its ability to generate sufficient futuretaxable income to realize its deferred tax assets. The primary evidenceconsidered included the cumulative pre-tax income for financial reportingpurposes for the past three years; the cumulative tax operating loss for thepast three years; the estimated impact of future tax deductions from theexercise of stock options outstanding as of December 31, 2004; and theestimated future taxable income based on historical operating results.

 

After giving consideration to these factors,the Company concluded that it was more likely than not that tax losscarryforwards that expire in 2005 and other tax credits that expire within thenext four years will not be utilized due to the estimated future tax deductionsfrom the exercise of stock options outstanding as of December 31,2004.  As a result, the Company recordeda valuation allowance of $183,000 for the year ended December 31,2004.  The Company also recorded a full valuationallowance of $43,000 relating to 2004 foreign net operating losses that aresubject to uncertainty regarding utilization.

 

The Company also concluded that it was morelikely than not that the net deferred tax assets of $9.1 million as of December 31,2004 and the estimated future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2004 would be utilized prior toexpiring.  Based on this conclusion, theCompany would require approximately $42 million in cumulative future taxableincome to be generated at various times over the next twenty years to realizethe related net deferred tax assets of $9.1 million as of December 31,2004 as well as the estimated future tax deductions from the exercise of stockoptions outstanding and in-the-money as of December 31, 2004.

 

In the event that the Company adjusts itsestimates of future taxable income or tax deductions from the exercise of stockoptions; or the Company’s stock price increases significantly without acorresponding increase in taxable income, the Company may need to establishadditional valuation allowances, which could materially impact its financialposition and results of operations.

 

*Long-lived assets*

 

The Company reviews long-lived assets for impairment whenever events orchanges in circumstances indicate the carrying

 

26

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amount may not be recoverable, in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” Events or changes in circumstances that indicate the carrying amount maynot be recoverable include, but are not limited to, a significant decrease inthe market value of the business or asset acquired, a significant adverse changein the extent or manner in which the business or asset acquired is used, or asignificant adverse change in the business climate.  If such events or changes in circumstancesare present, the undiscounted cash flows method is used to determine whetherthe asset is impaired.  Cash flows wouldinclude the estimated terminal value of the asset and exclude any interestcharges.  To the extent the carryingvalue of the asset exceeds the undiscounted cash flows over the estimatedremaining life of the asset; the impairment is measured using the discountedcash flows.  The discount rate utilizedwould be based on management’s best estimate of the related risks and return atthe time the impairment assessment is made.

 

The Company’s long-lived assets consist of property and equipment of$3.2 million, licensed technology of $330,000 and other intangible assetssubject to amortization of $5.8 million as of December 31, 2004.

 

*Goodwill and other intangible assets withindefinite lives*

 

The Company accounts for goodwill and other intangible assets inaccordance with the provisions of SFAS No. 142, “Goodwill and OtherIntangible Assets”.  Under SFAS No. 142,goodwill and intangible assets with indefinite lives are not amortized toexpense and must be reviewed for impairment annually or more frequently ifevents or changes in circumstances indicate that the asset might beimpaired.  The first step of the goodwillimpairment test, used to identify potential impairment, compares the fair valueof a reporting unit with its carrying amount, including goodwill.  The Company operates as one reporting unitand therefore compares the book value to the market value (marketcapitalization plus a control premium). If the market value exceeds the book value, goodwill is considered notimpaired, thus the second step of the impairment test is not necessary.  If the Company’s book value exceeds themarket value, the second step of the goodwill impairment test is performed tomeasure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure theamount of impairment loss, compares the implied fair value of the goodwill withthe book value of the goodwill.  If thecarrying value of the goodwill exceeds the implied fair value of the goodwill,an impairment loss would be recognized in an amount equal to the excess.  Any loss recognized cannot exceed thecarrying amount of goodwill.  After agoodwill impairment loss is recognized, the adjusted carrying amount ofgoodwill is its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment lossis prohibited once the measurement of that loss is completed.  The Company completed the annual goodwillimpairment assessment as of December 31, 2004, upon which no impairmentwas recorded.

 

The Company’s goodwill was $6.1 million as of December 31, 2004.

 

*Commitments and contingencies*

 

As of December 31, 2004, the Company had a commitment with R2Technology, Inc. (“R2”) to purchase an estimated $5.4 million of product forresale over the next 11 quarters.  Basedon current sales estimates, the Company will be able to sell all productanticipated to be purchased under the obligation.  Any changes to these estimates could have anadverse impact on the Company’s financial position and results of operations.

 

The Company is subject to the possibility of various loss contingenciesin the normal course of business.  TheCompany accrues for loss contingencies when a loss is estimable and probable.  The Company did not have any material losscontingencies recorded as of December 31, 2004.

 

*Revenue recognition*

 

Revenue recognition rules for software companies are complex. TheCompany follows specific and detailed guidelines in determining the properamount of revenue to be recorded; however, certain judgments affect theapplication of the Company’s revenue recognition policy.  Revenue results are difficult to predict, andany shortfall in revenue or delay in recognizing revenue could cause theCompany’s operating results to vary significantly from period to period.

 

The significant judgments for revenue recognition typically involvewhether collectibility can be considered probable and whether fees are fixed ordeterminable.  In addition, the Company’stransactions often consist of multiple element arrangements, which must beanalyzed to determine the relative fair value of each element, the amount ofrevenue to be recognized upon shipment, if any, and the period and conditionsunder which deferred revenue should be recognized.

 

The Company licenses its software and sells products and services toend-users and also indirectly through original equipment manufacturers (“OEMs”)and independent distributors (collectively “Resellers”).  Terms offered by the Company do not generallydiffer based on whether the customer is an end-user, or a Reseller.  The Company offers terms that require paymentwithin 30 to 90 days after product delivery. The Company does not offer rights of return, acceptance clauses or priceprotection to its customers.

 

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License fees revenue is derived from the licensing of computersoftware.  Hardware revenue is derivedfrom the sale of system hardware, including peripheral equipment.  Maintenance and service revenue is derivedfrom software maintenance and from telephone support, installation, trainingand 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 software modification or developmentservices that are sold separately to OEMs.  The Company generally sellshardware as part of a system sale, but it occasionally sells hardware as partof a system upgrade or additional product sale.

 

The Company recognizes revenue in accordance with American Institute ofCertified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2,Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, as well asTechnical Practice Aids issued from time to time by the AICPA and SEC StaffAccounting Bulletin No. 104. The Company recognizes revenue when it isrealized or realizable and earned.  TheCompany considers revenue realized or realizable and earned when it haspersuasive evidence of an arrangement, the product has been shipped or theservices have been provided to the customer, the sales price is fixed ordeterminable, and collectability is probable. Provided all other revenue recognition criteria are met, license revenuefrom Resellers is recognized on a sell-in or sell-through basis depending onthe arrangement with the Reseller.  TheCompany recognizes revenue from Resellers on a sell-in basis provided theReseller i) assumes all risk of the purchase, ii) has the ability andobligation to pay regardless of receiving payment from the end user, and iii)has a history of timely payments.

 

The Company 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 that collection is probable, revenue is deferred until the arrangementfees are collected and all other revenue recognition criteria in thearrangement have been met.

 

In addition to the aforementioned general policy, the following are thespecific revenue recognition policies for services and multiple-elementarrangements.

 

Software and Hardware – Revenue from license fees and hardware isrecognized when shipment of the product has occurred, no significant Companyobligations with regard to implementation remain and the Company’s services arenot considered essential to the functionality of other elements of thearrangement.  See also “—Multiple ElementArrangements” below for further information.

 

Services – Revenue from maintenance and support arrangements isdeferred and recognized ratably over the term of the maintenance and supportarrangements.  Revenue from training andinstallation services is recognized as the services are provided to customers.  Revenue from engineering services, where theCompany is performing significant customization or modification of software, isrecognized using contract accounting on a percentage-of-completion basis.  The Company records revenue by reference toactual hours incurred to date and the estimated hours remaining to complete theservices.

 

Multiple-Element Arrangements – The Company enters into arrangementswith customers that include a combination of software products, systemhardware, specified upgrades, maintenance and support, or installation andtraining services.  For sucharrangements, the Company recognizes revenue using the residual valuemethod.  The Company allocates the totalarrangement fee among the various elements of the arrangement based on therelative fair value of each of the undelivered elements determined byvendor-specific objective evidence. The fair value of maintenance and supportservices is based upon the renewal rate for continued service arrangements.  The fair value of installation and trainingservices is established based upon separate pricing for the services. Insoftware arrangements for which the Company does not have vendor-specificobjective evidence of fair value for all elements, revenue is deferred untilthe earlier of when vendor-specific objective evidence is determined for theundelivered elements (residual method) or when all elements for which theCompany does not have vendor-specific objective evidence of fair value, havebeen delivered.

 

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The following table sets forth information from the Company’sStatements of Operations, expressed as a percentage of total revenue.

 
| ** **                                    | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                          |       |                                      |       |   |   |   |   |
| Revenue:                                      |       |                                      |       |   |   |   |   |
| License fees                                  |       | 66.6                                      | %          | 67.4 | % | 67.3 | % |
| Maintenance and  services                     |       | 26.4                                      |       | 25.1 |   | 19.0 |   |
| Hardware                                      |       | 7.0                                       |       | 7.5 |   | 13.7 |   |
| Total revenue                                 |       | 100.0                                     |       | 100.0 |   | 100.0 |   |
|                                          |       |                                      |       |   |   |   |   |
| Cost of revenue:                              |       |                                      |       |   |   |   |   |
| License fees                                  |       | 11.1                                      |       | 6.7 |   | 5.9 |   |
| Maintenance and  services                     |       | 12.8                                      |       | 13.8 |   | 13.6 |   |
| Hardware                                      |       | 5.0                                       |       | 5.4 |   | 10.4 |   |
| Total cost of  revenue                        |       | 28.9                                      |       | 25.9 |   | 29.9 |   |
|                                          |       |                                      |       |   |   |   |   |
| Gross profit                                  |       | 71.1                                      |       | 74.1 |   | 70.1 |   |
|                                          |       |                                      |       |   |   |   |   |
| Operating  expenses:                          |       |                                      |       |   |   |   |   |
| Sales and  marketing                          |       | 33.8                                      |       | 34.1 |   | 32.2 |   |
| Research and  development                     |       | 17.5                                      |       | 18.9 |   | 19.6 |   |
| General and  administrative                   |       | 15.6                                      |       | 14.0 |   | 15.1 |   |
| Acquired  in-process research and development |       | 2.8                                       |       |   |   |   |   |
| Total operating  expenses                     |       | 69.7                                      |       | 67.0 |   | 66.9 |   |
|                                          |       |                                      |       |   |   |   |   |
| Operating income                              |       | 1.4                                       |       | 7.1 |   | 3.2 |   |
|                                          |       |                                      |       |   |   |   |   |
| Interest income                               |       | 1.0                                       |       | 0.8 |   | 0.6 |   |
| Income before  income taxes                   |       | 2.4                                       |       | 7.9 |   | 3.8 |   |
|                                          |       |                                      |       |   |   |   |   |
| Provision  (benefit) for income taxes, net    |       | 1.6                                       |       | (23.1 | ) | 0.1 |   |
| Net income                                    |       | 0.8                                       | %          | 31.0 | % | 3.7 | %  |

 

**Revenue**

 

Total revenue increased 32% to $36.1 million in 2004 from $27.3 millionin 2003.  Total revenue increased 29% to$27.3 million in 2003 from $21.1 million in 2002.  The revenue growth was driven by the increasein the Company’s core revenue components of software license fees andmaintenance and service revenue.  Licensefee revenue increased 31% to $24.1 million from $18.4 million in 2003 andincreased 29% to $18.4 million in 2003 from $14.2 million in 2002.  The increase in software license fee revenuewas driven by an increase in the number of *Vitrea* 2licenses sold, principally to Toshiba Medical Systems Corporation (“Toshiba”),and an increase in the number of Vitrea add-on options sold.  In addition, the sale of third-party softwareproducts increased to $1.8 million in 2004 from $194,000 in 2003.  The installed base of Vitrea customersincreased from approximately 850 at December 31, 2002, to approximately1,300 at December 31, 2003, and to approximately 1,900 at December 31,2004.  The number of Vitrea add-onmodules sold by the Company increased from approximately 660 in 2002, to 1,200in 2003, and to 2,400 in 2004.

 

Maintenance and services revenue increased 39%to $9.5 million for 2004 compared to $6.8 million for 2003 and increased 70% to$6.8 million in 2003 from $4.0 million in 2002. Of the $2.7 million increase for 2004 compared to 2003, $2.0 million consistedof an increase in maintenance revenue and $1.1 million was an increase intraining revenue.  The increases for 2004were partially offset by a $380,000 decrease in engineering services renderedunder product development agreements with Medtronic Surgical NavigationTechnologies (“SNT”), E-Z-EM, Inc. and Toshiba and a $44,000 decrease ininstallation

 

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revenue due to Toshiba performing its owninstallations of *Vitrea 2*. The increase intraining revenue in 2004 was due in part to the introduction of the offsiteregional training program.  Maintenancerevenue increased $2.8 million from 2002 to 2003.  Maintenance revenue increased in all periodsprimarily due to an increased customer base and improved pricing.

 

For 2004, the Company generated 57% revenuegrowth from the sale of *Vitrea 2*options,including *VScoreTM*, CTColonography, Automated Vessel Measurements and CT Cardiac.  The sale of *Vitrea2* options totaled $14.1 million for 2004 compared with $9.0 millionfor 2003 and $6.0 million for 2002.  For2004, software license fee revenue from sales to Toshiba totaled $12.9 millioncompared with $8.3 million for 2003 and $6.0 million for 2002.  Toshiba represented 50%, 42% and 34% of totalrevenue in 2004, 2003 and 2002, respectively.

 

Hardware revenue increased 23% to $2.5million in 2004 from $2.1 million in 2003. The increase from 2003 to 2004 was due to price increases in hardwareand overall increases in sales of *Vitrea* licenses.  Hardware revenue decreased 28% to $2.1million in 2003 from $2.9 million in 2002. The decrease from 2002 to 2003 was due to a decrease in the number ofcomplete system sales and lower unit pricing for hardware platforms shipped in2003.

 

**Gross margin**

 

The Company’s gross margin was 71% in 2004, down from 74% in 2003, inpart due to the increase in the cost of third-party software, which is up $1.1million over 2003.  In addition, $976,000of expense was incurred due to amortization of intangibles throughout the yearrelated to the HInnovation acquisition that was charged to cost of revenue.  These factors led to reduced software marginsof 83% in 2004, compared to 90% in 2003. Maintenance and services margins were 51% in 2004, up from 45% in 2003,in part due to changes in pricing structure for maintenance and trainingservices.  Hardware margins were 30% in2004 compared to 28% in 2003.  Grossmargin in 2003 increased to 74% from 70% in 2002, as total revenue includedhigher margin license revenue and less hardware revenue, which carries a lowermargin.

 

**Sales and marketing**

 

Sales and marketing expenses were $12.2 million, $9.3 million and $6.8million for 2004, 2003 and 2002, respectively. The increases weremostly due to increases in compensation costs as a result of additionalpersonnel required to drive and support recent growth and increased salescommissions as a result of increased revenue. Compensation costs, including commissions, increased $1.8 million from2003 to 2004 and $1.5 million from 2002 to 2003, due to more sales andmarketing personnel and higher commissions related to the increase in revenue.  There were 53, 42, and 33 sales and marketingpersonnel as of December 31, 2004, 2003 and 2002, respectively.  Due to the increase in the number ofpersonnel from 2003 to 2004, travel and entertainment expenses increased $440,000.  Tradeshow, advertising and marketingbrochure costs increased $425,000 and $65,000 from 2003 to 2004 and 2002 to2003, respectively, due to the Company attending more tradeshows and increasingits presence at tradeshows by purchasing more booth space.

 

From 2002 to 2003, there was a $356,000increase in expenses related to utilizing outside consultants to help sell andpromote *Vitrea 2* and related options for 2003 ascompared to 2002.  The Company expectssales and marketing costs to increase in future periods as a result of the costof additional sales and marketing personnel and increased sales of its product.

 

**Researchand development**

 

Research and development expenses were $6.3million, $5.2 million and $4.1 million in 2004, 2003 and 2002, respectively.  Of the $1.2 million expense increase from2003 to 2004, $677,000 was due to increased compensation costs resulting fromadditional personnel supporting software and product development and additionalemployees related to the Company’s acquisition of HInnovation, Inc.  Total research and development personnelincreased from 38 at December 31, 2003 to 50 at December 31, 2004.

 

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Due to more training and increased personnel,training and hiring costs increased $64,000 from 2002 to 2003, respectively.  There was a $189,000 expense increase due toa decrease in expenses classified in cost of revenue in connection with engineeringservices provided to certain third parties under various product developmentagreements in 2003 as compared to 2002.  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 andadministrative**

 

General and administrative expenses were $5.6 million, $3.8 million, and$3.2 million in 2004, 2003 and 2002, respectively.  Of the $1.8 million increase from 2003 to2004, $404,000 was due to an increase in compensation costs related toadditional personnel.  Fees related toaccounting, legal, consulting, regulatory filings and temporary worker servicesincreased $518,000 in 2004.  These fees wereprimarily due to costs related to implementation of Section 404 of theSarbanes-Oxley Act of 2002, as well as additional costs incurred as a result ofa restatement at the end of the third quarter of 2004.  In addition, bad debt expense increased$580,000 during 2004 as a result of reserves established for specific accountsin the first quarter of 2004.  Totalgeneral and administrative personnel increased from 21 at December 31,2003 to 23 at December 31, 2004.

 

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. Registration and filing fees increased $104,000 in 2003 as compared to 2002,which includes a $100,000 NASDAQ National Market registration fee.  Thisregistration fee was paid for the first time in June 2003 when the Companyqualified for listing on the NASDAQ National Market.  These increases werepartially offset by a $230,000 decrease due to severance costs paid in 2002 tothe Company’s former chief executive officer.  The Company believes thatgeneral and administrative expenses will increase in future periods due toincreased infrastructure costs as the business grows and as the legal and regulatoryenvironment continues to place increased emphasis on administrative functions.

 

**Operating income**

 

The increased revenue from *Vitrea 2* and add-onsoftware options and related service revenues, net of the increased expensesattributable to the development of the Company’s infrastructure and thedevelopment and promotion of the *Vitrea 2*product,resulted in operating income of $514,000 for 2004 compared with $1.9 million for2003 and $677,000 for 2002.

 

Operating income was $514,000 in 2004, whichincluded amortization of identified intangibles of $1.1 million and an acquiredin-process research and development charge of $1.0 million related to theacquisition of HInnovation, compared to $1.9 million in 2003.

 

**Interest income**

 

There was $368,000 of interest income for 2004, compared with $214,000in 2003 and $135,000 in 2002.  Theseincreases were primarily due to increases in cash, cash equivalents andmarketable securities.  The increases incash, cash equivalents and marketable securities were due to the increased cashflows from operations from 2002 to 2003 and from 2003 to 2004 and the $19.0million of cash generated from the private placement in June 2003.

 

**Income taxes**

 

The Company’s methodology for determining therealizability of its deferred tax assets involves estimates of future taxableincome from its core business, the estimated impact of future tax deductionsfrom the exercise of stock options outstanding as of December 31, 2004,and the expiration dates and amounts of net operating loss carryforwards andother tax credits. These estimates are projected through the life of therelated deferred tax assets based on assumptions which management believes tobe reasonable and consistent with current operating results.

 

Although the Company had cumulative pre-taxincome for financial reporting purposes for the three years ended December 31,2004, the Company did not pay any significant income taxes over that period dueto tax deductions from the exercise of stock options as well as utilization ofnet operating losses.  In assessing therealizability of its deferred tax assets as of December 31, 2004, theCompany considered evidence regarding its ability to generate sufficient futuretaxable income to realize its deferred tax assets. The primary evidenceconsidered included the cumulative pre-tax income for financial reportingpurposes for the past three years; the cumulative tax operating loss for thepast three years; the estimated impact of future tax deductions from theexercise of stock options outstanding as of December 31, 2004; and theestimated future

 

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taxable income based on historical operatingresults.

 

After giving consideration to these factors,the Company concluded that it was more likely than not that tax losscarryforwards that expire in 2005 and other tax credits that expire within thenext four years will not be utilized due to the estimated future tax deductionsfrom the exercise of stock options outstanding as of December 31,2004.  As a result, the Company recordeda valuation allowance of $183,000 for the year ended December 31,2004.  The Company also recorded avaluation allowance of $43,000 relating to 2004 foreign net operating lossesthat are subject to uncertainty regarding utilization and, therefore, a fullvaluation allowance was recorded.

 

The Company also concluded that it was morelikely than not that the net deferred tax assets of $9.1 million as of December 31,2004 and the estimated future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2004 would be utilized prior toexpiring.  Based on this conclusion, theCompany would require approximately $42 million in cumulative future taxableincome to be generated at various times over the next twenty years to realizethe related net deferred tax assets of $9.1 million as of December 31,2004 as well as the estimated future tax deductions from the exercise of stockoptions outstanding and in-the-money as of December 31, 2004.

 

In the event that the Company adjusts itsestimates of future taxable income or tax deductions from the exercise of stockoptions; or the Company’s stock price increases significantly without acorresponding increase in taxable income, the Company may need to establishadditional valuation allowances, which could materially impact its financialposition and results of operations.

 

During 2003, the Company concluded that it ismore likely than not that substantially all of its net deferred tax assetswould be 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 reversal of thevaluation allowance resulted in a tax benefit of $7.2 million.  This reversal net of other current year stateand federal income taxes resulted in a net tax benefit of $6.5 million in 2003.

 

The Company’s effective income tax rate is volatile based on the levelof operating income achieved, the level of research and development creditsavailable to the Company, the mix between our U.S. operating results, for whichwe record income taxes, and our foreign operating results, for which we do notrecord an income tax benefit due to the uncertainty of realizing these taxbenefits in future years in our foreign jurisdictions.  Based on currentestimates, the Company anticipates an effective tax rate of 36% to 39% forfiscal 2005.  Any future valuation allowance recorded on the Company’s netdeferred tax assets of $9.1 million as of December 31, 2004, would have anadverse effect on the Company’s tax provision and operating results.

 

The income tax provision for 2002 consistssolely of certain state minimum fees.  Asa result of the Company’s history of generating net operating losses, theCompany had established a valuation allowance to completely reserve for thedeferred tax asset of the Company at December 31, 2002.

 

**Liquidity and capital resources**

 

As of December 31, 2004, the Company had $24.1 million in cash andcash equivalents, $11.5 million in marketable securities, working capital of$30.1 million and no borrowings, as compared to $30.1 in cash and cashequivalents, $4.1 million in marketable securities, working capital of $31.9million and no borrowings as of December 31, 2003.

 

*Operating activities*

 

During 2004, cash provided by operations was $7.6 million, whichconsisted of an increase of $1.8 million in working capital accounts and $5.8million in cash flow from other operating activities.  The increase in accounts receivable was dueto the Company’s significant overall revenue increase in the fourth quarter of2004 versus the same period in 2003.  Theincrease in deferred revenue was due to the increase in maintenance andservices on a year-over year basis and an overall increase in customer base towhich these services are sold.  Theincrease in accrued expenses and other current liabilities was primarily due toan overall increase in operations and the general timing of cash disbursementsin the fourth quarter of 2004.  Cashflows from other operating activities in 2004 consisted primarily of non-cashexpenses related to the amortization from identified intangibles and IPR&Drelated to the HInnovation acquisition, an increased provision for doubtfulaccounts related to the establishment of reserves for specific customeraccounts, depreciation and amortization of property and equipment, and a tax benefitrelated to the exercise of stock options. Days’ sales outstanding as of December 31, 2004 increased to 82days, compared to 65 days as of December 31, 2003.  Days’ sales outstanding is calculated basedon net accounts receivable and total revenue.

 

Cash provided by operations was $4.4 million and $2.4 million in 2003and 2002, respectively, which consisted of an increase in working capitalaccounts of $760,000 in 2003 and $550,000 in 2002, and cash flow from other operatingactivities

 

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of $3.6 million in 2003 and $1.9 million in 2002.  Days’ sales outstanding as of December 31,2003 decreased to 65 days from 90 days as of December 31, 2002.

 

*Investing activities*

 

The Company used $15.7 million, $3.4 million and $4.0 million of cashin investing activities in 2004, 2003 and 2002, respectively.

 

The Company used $1.6 million, $1.9 million and $1.5 million for purchases ofproperty and equipment in 2004, 2003 and 2002, respectively.  The purchases for all periods wereprincipally to upgrade computer equipment and to purchase computer equipmentfor new personnel.  In addition, theCompany purchased furniture and fixtures and leasehold improvements related toexpansions of the Company’s offices in 2003 and 2002.  Management anticipates that the Company willcontinue to purchase property and equipment necessary in the normal course ofthe Company’s business.  The amount andtiming of these purchases and the related cash outflows in future periods isdifficult to predict and depends on a number of factors, including the hiringof employees and the rate of change of computer hardware.  The Company anticipates increased property andequipment purchases in 2005 as the Company moves to its new corporate office inthe first quarter of 2005.

 

The Company used $30.4 million, $6.8 millionand $8.0 million to purchase investments in marketable securities during 2004,2003 and 2002, respectively.  The Companyrealized $22.5 million, $5.2 million and $5.5 million of proceeds from sales ofmarketable securities during 2004, 2003 and 2002, respectively.  The marketable securities are invested inU.S. government obligations, U.S. government agency obligations, corporatecommercial obligations and certificates of deposits.

 

During the first quarter of 2004, the Company completed the acquisitionof HInnovation, Inc. in accordance with the terms and conditions of anAcquisition Agreement and Plan of Reorganization dated as of January 8,2004, using $6.1 million of cash.  SeeNote 3 to the Consolidated Financial Statements for additional information onthe acquisition.

 

*Financing activities*

 

Cash provided by financing activities totaled$2.2 million, $21.1 million, and $2.9 million for 2004, 2003 and 2002,respectively.  The cash provided byfinancing activities in 2004 and 2002 resulted primarily from the exercise ofstock options granted under the Company’s stock plans and upon the exercise ofwarrants.  Of the cash provided byfinancing activities during 2003, $19.0 million consisted of net proceeds,after deducting offering costs of $1.3 million, from the Company’s privateplacement in June 2003 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.

 

The Company has never paid or declared any cash dividends and does notintend to pay dividends in the near future.

 

The following summarizes our contractual obligations, including purchasecommitments, at December 31, 2004, and the effect such obligations areexpected to have on our liquidity and cash flow in future periods.

 
| ** **                  | ** ** | **2005**  | ** ** | **2006** | ** ** | **2007**  | ** ** | **2008** | ** ** | **2009 through  2012** | ** ** |
|-----------------------------|------------|-----------|------------|----------|------------|-----------|------------|----------|------------|------------------------|------------|
|                        |       |      |       |     |       |      |       |     |       |                   |       |
| Operating  leases(1)        |       | $         | 673,000    |     | $          | 471,000   |       | $        | 618,000    |                   | $          | 711,000 |   | $ | 2,289,000 |   |
|                        |       |      |       |     |       |      |       |     |       |                   |       |
| Purchase  commitment(2)     |       |      | 1,915,000  |     |       | 1,890,000 |       |     | 1,575,000  |                   |       | — |   |   | — |   |
|                        |       |      |       |     |       |      |       |     |       |                   |       |
| HInnovation  acquisition(3) |       | 4,500,000 |       | —   |       | —    |       | —   |       | —                 |       |
| Total                       |       | $         | 7,088,000  |     | $          | 2,361,000 |       | $        | 2,193,000  |                   | $          | 711,000 |   | $ | 2,289,000 |   |
|                             |            |           |            |          |            |           |            |          |            |                        |            |  |  |  |  |  |  |  |  |  |  |

 

----

(1)  The Company currently leases its office facilities in Minnetonka,Minnesota under a lease that expires in January 2012.  In March 2004, the Company signed anon-cancelable operating lease for new office space. The new lease term startedin February 2005 and expires in January 2012. Under the terms of thenew lease, the lessor for the Minnetonka office began making the minimum leasepayments for the Company’s former facilities located in Plymouth, Minnesota in February 2005.As part of the new lease, the Company is also required to pay a portion of thelessor’s operating costs for the new facilities. The minimum lease paymentslisted include both the Plymouth and Minnetonka office locations.  See Note 5 to the Consolidated FinancialStatements for additional information on the new lease.

 

33

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(2)  In November 2002, the Company entered into anagreement with R2 Technology, Inc. (“R2”) to distribute R2’s lung noduleCAD software product in conjunction with the Company’s products.  The Company completed its development work tomeet the clinical requirements for selling the lung nodule CAD software withVitrea 2 on August 26, 2004.  Underthe agreement, the first purchase was required in the fourth quarter of2004.  The total purchase commitment willbe a maximum of $5.6 million worth of product over a three-year commitmentperiod.  The purchase commitment price theCompany must pay will be reduced if the selling price of the lung CAD productwhen sold directly to end-users by R2 falls 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 units as the Company is required topurchase.

 

As of December 31, 2004, the Company had a commitment to purchasean estimated $200,000 worth of additional R2 lung nodule CAD software under theagreement that was not fulfilled.  TheCompany and R2 are currently renegotiating the terms of the contract.

 

(3) The merger consideration for HInnovation includes contingentmilestone payments of up to a maximum of $6.0 million of contingent milestonepayments comprised of $3.0 million in common stock and $3.0 million incash.  The contingent milestone payments are based on 1) the achievementof certain revenue targets resulting from the sale of products containingHInnovation technology during the 12 month period following the closing date;2) the porting of Vital Images’ product to HInnovation’s product platform andthe commercial launch thereof; and 3) licensing the HInnovation patentedtechnology within 24 months after the closing date.  The number of sharesissued under the contingent milestone payments will be determined based on theaverage closing price of the Company’s common stock during the 10 trading daysbefore completion of the milestone objective.  However, the AcquisitionAgreement provides that the number of shares of Vital Images common stockcomprising the contingent consideration cannot exceed 300,000 shares.  If,at the time of its issuance, the value of such stock is less than $3.0 milliondue to this limitation on the number of shares, Vital Images will pay theshortfall in cash.  Any contingent payments made by the Company willresult in an increase in goodwill.  As ofDecember 31, 2004, no contingent payments had been earned.  The first milestone was not met before theFebruary 2005 deadline. As a result, the potential maximum contingentconsideration was reduced to $4.5 million, which consists of $3.0 million incommon stock and $1.5 million in cash.

 

The Company had no significant outstanding purchase orders as ofDecember, 31 2004.  The Company hasentered into a number of technology licensing agreements that provide for thepayment of royalties when the Company sells *Vitrea2*. Except for the R2-purchase commitment discussed above, theCompany is not obligated for any minimum payments under such agreements.

 

Management believes that its cash and cash equivalents should besufficient to satisfy the Company’s cash requirements for at least the next 12months.  The future availability offinancing is influenced by many factors, including profitability, operatingcash flows and market conditions.  TheCompany believes that its strategies and actions toward maintaining financialflexibility mitigate much of this risk.

 

**Foreign currency transactions**

 

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

 

**Inflation**

 

Management believes inflation has not had a material effect on theCompany’s operations or on its financial condition.

 

**Recent accounting pronouncement**

 

In December 2004, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 123 (revised 2004), “Share-Based Payment”. SFAS No. 123Rsupersedes APB Opinion No. 25, which requires recognition of an expensewhen goods or services are provided. SFAS No. 123R requires thedetermination of the fair value of the share-based compensation at the grantdate and the recognition of the related expense over the period in which theshare-based compensation vests. SFAS No. 123R permits a prospective or twomodified versions of retrospective application under which financial statementsfor prior periods are adjusted on a basis consistent with the pro formadisclosures required for those periods by the original SFAS No. 123. TheCompany is required to adopt the provisions of SFAS No. 123R effective July 1,2005, at which time the Company will begin recognizing an expense for unvestedshare-based compensation that has been issued or will be issued after thatdate. Under the retroactive options, prior periods may be restated either as ofthe beginning of the year of adoption, January 1, 2005 for the Company, orfor all periods presented. The Company has not yet finalized its decisionconcerning the transition option it will utilize to adopt SFAS No. 123R.  The Company is currently assessing itsstock-based compensation strategy and related tax implications.  Future stock-based compensation may differfrom pro forma amounts disclosed in Note 2 to the consolidated financialstatements. The Company expects the impact of the adoption of SFAS No. 123Rto be material to its

 

34

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consolidated financial statements.

 

**Forward-looking statements**

 

This Annual Report on Form 10-K contains certain forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995 and information that is based on management’s beliefs as well as onassumptions made by, and upon information currently available to,management.  When used in this AnnualReport on Form 10-K, the words “expect,” “anticipate,” “intend,” “plan,” “believe,”“seek,” and “estimate” or similar expressions are intended to identify suchforward-looking statements.  However,this Annual Report on Form 10-K also contains other forward-lookingstatements.  Forward-looking statementsare not guarantees of future performance and are subject to certain risks,uncertainties and assumptions including, but not limited to, the followingfactors, which could cause the Company’s future results and shareholder valuesto differ materially from those expressed in any forward-looking statementsmade by or on behalf of the Company: the dependence on market growth of theindustry in which the Company operates; the extent to which the Company’sproducts gain market acceptance; the potential for litigation regarding patentand other intellectual property rights; the introduction of competitiveproducts by others; dependence on major customers; fluctuations in quarterlyresults; the progress of product development; the availability of third partyreimbursement; and the receipt and timing of regulatory approvals and otherfactors detailed from time to time in the Company’s filings with the Securitiesand Exchange Commission, including those set forth under the heading “RiskFactors” included in Item 1 of this Annual Report on Form 10-K.

 

**Item 7A.****  Quantitative and QualitativeDisclosures About Market Risk**

 

Market risk refers to the risk that a change in the level of one ormore market prices, interest rates, indices, volatilities, correlations orother market factors such as liquidity will result in losses for a certainfinancial instrument or group of financial instruments.  The Company does not hold or issue financialinstruments for trading purposes, and it does not enter into forward financialinstruments to manage and reduce the impact of changes in foreign currencyrates because, as disclosed above, substantially all of the Company’s foreigntransactions are negotiated, invoiced and paid in U.S. dollars.  Based on the controls in place and therelative size of the financial instruments entered into, the Company believesthe risks associated with not using these instruments would not have a materialadverse effect on the Company’s consolidated financial position or results ofoperations.

 

In addition, the Company does not engage in speculative transactionsand does not use derivative instruments or engage in hedging activities.  See the Notes to the Consolidated FinancialStatements for a description of the Company’s accounting policies and otherinformation related to these financial instruments.

 

In the normal course of business, the Company is exposed to marketrisks, including changes in interest rates and price changes that could affectthe Company’s operating results.  As of December 31,2004, fluctuations in interest rates, exchange rates and price changes wouldnot have had a material effect on the Company’s financial position or operatingresults.

 

**Interest rate risk**

 

The Company places its cash and cash equivalents, which generally havea term of less than 90 days, with a high-quality financial institution and hasinvestment guidelines relative to diversification and maturities designed tomaintain safety and liquidity.  As of December 31,2004, the Company had cash and cash equivalents totaling $24.1 million.  Due to the short-term nature of theseinstruments, the carrying value approximates market value.  If, during 2005, average short-term interestrates decreased by 1.0% from 2004 average rates, the Company’s projectedinterest income from short-term investments would decrease by approximately $241,000,assuming a similar level of investments in 2005.

 

**Price risk**

 

As of December 31, 2004, the Company held marketable securitieswith an aggregate fair market value of $11.5 million.  All of the Company’s marketable securitiesare classified as available-for-sale and all mature in one year or less.  Available-for-sale investments are recordedat market value, which is based on quoted market prices, with unrealizedholding gains and losses included as a separate component of stockholders’ equity.  The Company uses a specific identificationcost method to determine the gross realized gains and losses on the sale of itssecurities.  Had market prices of suchsecurities declined 10% as of December 31, 2004, the values of theseinstruments would have decreased by approximately $1.2 million.

 

35

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**Foreign currency risk**

 

Substantially all of the Company’s foreign transactions are negotiated,invoiced and paid in U.S. dollars. Therefore, fluctuations in the value of the dollar as compared to otherforeign currencies have not had an effect on the Company.

 

**Item 8.****                                   FinancialStatements and Supplementary Data**

 

The Company’s financial statements, supplemental schedule andReport of Independent Registered Public Accounting Firm thereon, all of whichare included in this Annual Report on Form 10-K, are listed in Item 15(a)(1) ofthis Form 10-K.

 

**Item 9.****                                   Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

 

Not applicable.

 

**Item 9A.****                          Controlsand Procedures**

 

**Disclosure controls and procedures**

** **

The Company maintains disclosure controls and procedures that aredesigned to ensure that information required to be disclosed in the Company’speriodic Securities Exchange Act reports is recorded, processed, summarized,and reported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to the Company’smanagement, including its Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required financialdisclosure.

 

As of the end of the period covered by this report, the Company carriedout an evaluation, under the supervision and with the participation of Companymanagement, including the Chief Executive Officer and the Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures pursuant to the Securities Exchange Act of 1934 (“ExchangeAct”) Rules 13a-15(e) and 15d-15(e). Based upon, and as of the date of this evaluation, the Chief ExecutiveOfficer and the Chief Financial Officer concluded that our disclosure controlsand procedures were not effective, because of the material weaknesses discussedbelow.  To address the material weaknessesdescribed below, the Company performed additional analysis and otherpost-closing procedures to ensure that the consolidated financial statements wereprepared in accordance with generally accepted accounting principles.  Accordingly, management believes that thefinancial statements included in this report fairly present in all materialrespects our financial condition, results of operations and cash flows for theperiods presented.

 

**Internal control over financial reporting**

 

Management of the Company is responsible for establishing andmaintaining adequate internal control over financial reporting. The Company’sinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. Because of its inherent limitations,internal control over financial reporting may not prevent or detectmisstatements. Also, projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may become inadequate because ofchanges in conditions or that the degree of compliance with establishedpolicies or procedures may deteriorate.

 

The Company is in theprocess of conducting an evaluation of its internal control over financialreporting as of December 31, 2004.  Inmaking its assessment of internal control over financial reporting, managementis using the criteria described in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission.

 

A material weakness is acontrol deficiency, or combination of control deficiencies, that results inmore than a remote likelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected.  As of December 31, 2004, the Company did notmaintain effective controls over (a) the accuracy and completeness of deferredrevenue for maintenance and services, (b) the accuracy and completeness ofproperty and equipment and, (c) the execution of certain financial reportingcontrols.  Specifically, (a) effectivecontrols were not in place to recognize deferred maintenance revenue in theappropriate period and there were errors in the detailed deferred revenueschedules, (b) effective controls were not in place to verify the existence ofcertain property and equipment and, (c) effective controls were not in place toensure sufficient documentationover the quarterly closing process to demonstrate that managementreviewed the quarterly financial results and related disclosures.  

 

The material weakness related to theaccuracy and completeness of deferred revenue for maintenance andservices resulted in therestatement of the Company’s consolidated financial statements for the yearended December 31, 2003 and for the first and second quarters of 2004.   Additionally, these control deficienciescould result in a material misstatement to annual or interim financialstatements that would not be prevented or detected.  Accordingly, management has determined thateach of these control deficiencies constitutes a material weakness.  Because of these material weaknesses,management will be unable to

 

36

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conclude that the Company maintained effective internal control overfinancial reporting as of December 31, 2004 based on the criteria in the *Internal Control*—*Integrated Framework*.** **

** **

The Company’s evaluation of its internal control over financialreporting as of December 31, 2004 is not complete.  Further, there can be no assurance that as aresult of the ongoing evaluation of internal control over financial reporting,additional deficiencies will not be identified or that any deficienciesidentified, either alone or in combination with others, will not be considereda material weakness.

 

Securities and ExchangeCommission Release No. 34-50754, subject to certain conditions, provides up to45 additional days beyond the due date of this Annual Report on Form 10-K forthe filing of management’s annual report on internal control over financialreporting required by Item 308(a) of Regulation S-K and the related attestationreport of the independent registered public accounting firm required by Item308(b) of Regulation S-K.  Pursuant tothe Release, management’s report on internal control over financial reportingand the associated report on the audit of management’s assessment of theeffectiveness of the Company’s internal control over financial reporting as ofDecember 31, 2004 are not filed herein and are expected to be filed no laterthan May 2, 2005 with an amendment to this Annual Report on Form 10-K.

 

The Companyexpects that the material weaknesses identified will result in an adverseopinion by the Company's independent registered public accounting firm on theeffectiveness of the Company's internal control over financial reporting.

 

**Changes in internal control overfinancial reporting**

 

Except as otherwise discussed herein, there have been no changes in ourinternal control over financial reporting during our fourth fiscal quarterended December 31, 2004 that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

 

**Item 9B.****                          OtherInformation**

 

None.

 

37

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**Part III**

 

Certain information required by Part IIIis omitted from this Annual Report on Form 10-K because the Registrantwill file a definitive Proxy Statement relating to our 2005 Annual Meeting of Stockholderspursuant to Schedule 14A (the “Proxy Statement”) not later than120 days after the end of the fiscal year covered by this Annual Report onForm 10-K, and certain information included therein is incorporated hereinby reference as indicated below.

 

**Item 10.****                            Directorsand Executive Officers of Registrant**

 

The information required by this Item 10 will be included underthe captions “Election of Directors” and “Information Concerning Directors,Nominees and Executive Officers” in the Company’s 2005 Proxy Statement.  Information concerning the compliance of theCompany’s officers, directors and 10% stockholders with Section 16(a) ofthe Securities Exchange Act of 1934 is incorporated by reference to theinformation to be contained in the 2005 Proxy Statement under the caption “Compliancewith Section 16(a)”.  Theinformation regarding Audit Committee members and “audit committee financialexperts” is incorporated by reference to the information to be contained in the2005 Proxy Statement under the caption “Board Committees.”  The information regarding the Company’s Codeof Business Ethics is incorporated by reference to the information to becontained in the Company’s 2005 Proxy Statement under the heading “Code ofBusiness Conduct and Ethics.”

 

**Item 11.****                            ExecutiveCompensation**

 

The information under the captions “Executive Compensation” and “DirectorCompensation” to be contained in the Company’s 2005 Proxy Statement isincorporated herein by reference.

 

**Item 12.****                            SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters**

 

The information under the captions “Beneficial Ownership of CommonStock” and “Equity Compensation Plan Information” to be contained in theCompany’s 2005 Proxy Statement is incorporated herein by reference.

 

**Item 13.****                            CertainRelationships and Related Transactions**

 

Not applicable.

 

**Item 14.****                            PrincipalAccountant Fees and Services**

 

The information under the caption “Independent Registered PublicAccounting Firm” to be contained in the Company’s 2005 Proxy Statement isincorporated herein by reference.

 

38

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**Part IV**

 

**Item 15.****                            Exhibitsand Financial Statement Schedules**

 

(a)          The followingconsolidated financial statements of Vital Images, Inc. and Report ofIndependent Registered Public Accounting Firm thereon are included herein:

 

(1)          Financial Statements

 
| Report  of Independent Registered Public Accounting Firm                                                                                        |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets  as of December 31, 2004 and 2003                                                                              |   |
| Consolidated  Income Statement for the years ended December 31, 2004, 2003 and 2002                                                        |   |
| Consolidated  Statements of Stockholders’ Equity and Other Comprehensive Income for the  years ended December 31, 2004, 2003 and 2002 |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                                               |   |
| Notes to  Consolidated Financial Statements                                                                                                     |   |

 

(2)          All other schedules tothe consolidated financial statements required by Article 12 of RegulationS-X are not required under the related instructions or are inapplicable andtherefore have been omitted.

 

(3)          Listing of Exhibits

 

The Exhibits required tobe a part of this Report are listed in the Index to Exhibits.

 

(b)         Exhibits

 

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

 

39

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**Signatures**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the Registrant has duly caused this Report tobe signed on its behalf by the undersigned, thereunto duly authorized, inMinneapolis, Minnesota, on the 16th day of March, 2005.

 
|   |   |   | Vital Images, Inc.                                                                                                   |
|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                      |   |
|   |   | By:    | /s/Michael H. Carrel                                                                                                      |   |
|   |   |   | Michael H. Carrel                                                                                                         |
|   |   |   | Chief Financial Officer  and  Vice President-Finance  (Principal Financial Officer and Principal Accounting Officer) |

 

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

 
| **Signature**                | ** ** | **Title**                                                            | ** **                                      | **Date** |
|------------------------------|------------|----------------------------------------------------------------------|-------------------------------------------------|----------|
|                         |       |                                                                 |                                            |     |
| /s/Jay D. Miller             |       |                                                                 | President, Chief Executive Officer and Director |     | March 16, 2005 |
| Jay D. Miller                |       | (Principal  Executive Officer)                                       |                                            |     |
|                         |       |                                                                 |                                            |     |
| /s/Michael H. Carrel         |       |                                                                 | Chief Financial Officer,                        |     | March 16, 2005 |
| Michael H. Carrel            |       | Vice President-Finance,  Treasurer and Secretary                     |                                            |     |
|                         |       | (Principal  Financial Officer and Principal Accounting Officer) |                                            |     |
|                         |       |                                                                 |                                            |     |
| /s/Douglas M. Pihl           |       |                                                                 | Chairman of the Board and Director              |     | March 16, 2005 |
| Douglas M. Pihl              |       |                                                                 |                                            |     |
|                         |       |                                                                 |                                            |     |
| /s/Vincent J. Argiro         |       |                                                                 | Chief Technology Officer, Founder and Director  |     | March 16, 2005 |
| Vincent J. Argiro            |       |                                                                 |                                            |     |
|                         |       |                                                                 |                                            |     |
| /s/James B. Hickey, Jr. |       |                                                                 | Director                                        |     | March 16, 2005 |
| James B. Hickey, Jr.    |       |                                                                 |                                            |     |
|                         |       |                                                                 |                                            |     |
| /s/Richard W. Perkins        |       |                                                                 | Director                                        |     | March 16, 2005 |
| Richard W. Perkins           |       |                                                                 |                                            |     |
|                         |       |                                                                 |                                            |     |
| /s/Michael W. Vannier        |       |                                                                 | Director                                        |     | March 16, 2005 |
| Michael W. Vannier           |       |                                                                 |                                            |     |
|                         |       |                                                                 |                                            |     |
| /s/Sven A. Wehrwein          |       |                                                                 | Director                                        |     | March 16, 2005 |
| Sven A. Wehrwein             |       |                                                                 |                                            |     |

 

40

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**Reportof Independent Registered Public Accounting Firm**

 

To the Board of Directors and Stockholders ofVital Images, Inc.:

 

In our opinion, the consolidated financialstatements listed in the index appearing under Item 15(a)(1) present fairly, inall material respects, the financial position of Vital Images, Inc. andits subsidiary (the Company) at December 31, 2004 and 2003, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2004 in conformity with accountingprinciples generally accepted in the United States of America.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits. We conducted ouraudits of these statements in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

 

PricewaterhouseCoopers LLP

Minneapolis, Minnesota

March 2, 2005

 

41

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**Vital Images, Inc.**

**Consolidated Balance Sheets**

 
| ** **                                                                                                                           | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                                                                                                                           | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Assets**                                                                                                                           | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                      | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                           |       | $                     | 24,119,157 |   | $ | 30,111,613 |   |
| Marketable  securities                                                                                                               |       | 11,546,140            |       | 4,078,587 |   |
| Accounts  receivable, net                                                                                                            |       | 8,090,359             |       | 4,877,876 |   |
| Deferred income  taxes                                                                                                               |       | 600,000               |       | 275,000 |   |
| Prepaid expenses  and other current assets                                                                                           |       | 1,092,495             |       | 776,558 |   |
| Total current  assets                                                                                                                |       | 45,448,151            |       | 40,119,634 |   |
| Property and  equipment, net                                                                                                         |       | 3,222,367             |       | 3,043,239 |   |
| Deferred income  taxes                                                                                                               |       | 8,454,000             |       | 9,306,000 |   |
| Licensed  technology, net                                                                                                            |       | 330,000               |       | 450,000 |   |
| Other intangible  assets, net                                                                                                        |       | 5,777,000             |       | — |   |
| Goodwill                                                                                                                             |       | 6,052,744             |       | — |   |
| Other assets                                                                                                                         |       | —                |       | 144,346 |   |
| Total assets                                                                                                                         |       | $                     | 69,284,262 |   | $ | 53,063,219 |   |
|                                                                                                                                 |       |                  |       |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                       |       |                  |       |   |   |
| Current  liabilities:                                                                                                                |       |                  |       |   |   |
| Accounts payable                                                                                                                     |       | $                     | 1,892,657  |   | $ | 1,485,451 |   |
| Accrued  compensation                                                                                                                |       | 3,175,354             |       | 1,347,464 |   |
| Accrued  royalties                                                                                                                   |       | 573,985               |       | 556,494 |   |
| Other current  liabilities                                                                                                           |       | 673,131               |       | 285,121 |   |
| Deferred revenue                                                                                                                     |       | 8,136,844             |       | 4,530,333 |   |
| Total current  liabilities                                                                                                           |       | 14,451,971            |       | 8,204,863 |   |
| Deferred revenue                                                                                                                     |       | 277,568               |       | 264,691 |   |
| Total  liabilities                                                                                                                   |       | 14,729,539            |       | 8,469,554 |   |
|                                                                                                                                 |       |                  |       |   |   |
| Commitments and  contingencies (Note 3 and 5)                                                                                        |       |                  |       |   |   |
|                                                                                                                                 |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                          |       |                  |       |   |   |
| Preferred stock:  $0.01 par value; 5,000,000 shares authorized; none issued or outstanding                                           |       | —                |       | — |   |
| Common stock:  $0.01 par value; 20,000,000 shares authorized; 12,007,160 and 11,140,380  shares issued and outstanding, respectively |       | 120,072               |       | 111,404 |   |
| Additional  paid-in capital                                                                                                          |       | 65,813,282            |       | 56,108,590 |   |
| Accumulated  other comprehensive loss                                                                                                |       | (47,865               | )          | — |   |
| Accumulated  deficit                                                                                                                 |       | (11,330,766           | )          | (11,626,329 | ) |
| Total stockholders’  equity                                                                                                     |       | 54,554,723            |       | 44,593,665 |   |
| Total  liabilities and stockholders’ equity                                                                                     |       | $                     | 69,284,262 |   | $ | 53,063,219 |   |

 

The accompanying notesare an integral part of the consolidated financial statements.

 

42

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**VitalImages, Inc.Consolidated Statements ofOperations**

 
| ** **                                                 | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                       |       |                                     |       |   |   |   |   |
| Revenue:                                                   | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees                                               |       | $                                        | 24,054,251 |   | $ | 18,388,794 |   | $ | 14,211,640 |   |
| Maintenance and  services                                  |       | 9,524,791                                |       | 6,844,470 |   | 4,019,639 |   |
| Hardware                                                   |       | 2,543,005                                |       | 2,066,454 |   | 2,884,795 |   |
| Total revenue                                              |       | 36,122,047                               |       | 27,299,718 |   | 21,116,074 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Cost of revenue:                                           |       |                                     |       |   |   |   |   |
| License fees                                               |       | 3,993,982                                |       | 1,818,353 |   | 1,250,426 |   |
| Maintenance and  services                                  |       | 4,660,433                                |       | 3,773,794 |   | 2,862,459 |   |
| Hardware                                                   |       | 1,792,666                                |       | 1,478,914 |   | 2,195,182 |   |
| Total cost of  revenue                                     |       | 10,447,081                               |       | 7,071,061 |   | 6,308,067 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Gross profit                                               |       | 25,674,966                               |       | 20,228,657 |   | 14,808,007 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Operating  expenses:                                       |       |                                     |       |   |   |   |   |
| Sales and  marketing                                       |       | 12,204,574                               |       | 9,317,766 |   | 6,795,377 |   |
| Research and  development                                  |       | 6,329,190                                |       | 5,168,695 |   | 4,143,257 |   |
| General and  administrative                                |       | 5,626,719                                |       | 3,806,914 |   | 3,192,735 |   |
| Acquired  in-process research and development              |       | 1,000,000                                |       | — |   | — |   |
| Total operating  expenses                                  |       | 25,160,483                               |       | 18,293,375 |   | 14,131,369 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Operating income                                           |       | 514,483                                  |       | 1,935,282 |   | 676,638 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Interest income                                            |       | 368,080                                  |       | 213,859 |   | 134,870 |   |
| Income before  income taxes                                |       | 882,563                                  |       | 2,149,141 |   | 811,508 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Provision  (benefit) for income taxes, net                 |       | 587,000                                  |       | (6,313,000 | ) | 22,000 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Net income                                                 |       | $                                        | 295,563    |   | $ | 8,462,141 |   | $ | 789,508 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Net income per  share – basic                         |       | $                                        | 0.03       |   | $ | 0.83 |   | $ | 0.09 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Weighted average  common shares outstanding – basic   |       | 11,632,351                               |       | 10,189,114 |   | 8,861,132 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Net income per  share – diluted                       |       | $                                        | 0.02       |   | $ | 0.71 |   | $ | 0.08 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Weighted average  common shares outstanding – diluted |       | 12,535,670                               |       | 11,848,268 |   | 9,821,798 |   |

 

The accompanying notesare an integral part of the consolidated financial statements.

 

43

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**Vital Images, Inc.Consolidated Statements ofStockholders’ Equity and Comprehensive Income**

 
| ** **                                                                            | ** ** | ** **        | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**        | ** **  | ** **        | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|------------------------|-------------|-------------------|------------|------------|------------|
| ** **                                                                            | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **        | ** ** | **Other**              | ** **  | **Total**         | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | **Common  Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** **  | **Comprehensive** | ** ** |
| ** **                                                                            | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**       | ** ** | **Loss**               | ** **  | **Equity**        | ** ** | **Income** | ** ** |
|                                                                                  |       |              |       |        |       |            |       |              | ** ** | ** **             |        |              |       |       |       |
| 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 income                                                                            |       |              |       |        |       |            |       | 789,508           |       |                   |        | 789,508           |       | $          | 789,508    |   |
| Balances as of December 31,  2002                                                |       | 8,987,009         |       | 89,870      |       | 31,719,371      |       | (20,088,470       | )          | —                 |        | 11,720,771        |       | $          | 789,508    |   |
|                                                                                  |       |              |       |        |       |            |       |              |       | ** **             |        |              |       |       |       |
| 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 |       | 1,500,000         |       | 15,000      |       | 18,975,515      |       |              |       | ** **             |        | 18,990,515        |       |       |       |
| Net income                                                                            |       |              |       |        |       |            |       | 8,462,141         |       |                   |        | 8,462,141         |       | $          | 8,462,141  |   |
| Balances as of December 31,  2003                                                |       | 11,140,380        |       | 111,404     |       | 56,108,590      |       | (11,626,329       | )          | —                 |        | 44,593,665        |       | $          | 8,462,141  |   |
|                                                                                  |       |              |       |        |       |            |       |              |       | ** **             |        |              |       |       |       |
| Stock-based  compensation                                                             |       |              |       |        |       | 11,507          |       |              |       | ** **             |        | 11,507            |       |       |       |
| Issuance of  common stock upon exercise of stock options                              |       | 456,380           |       | 4,564       |       | 1,967,064       |       |              |       | ** **             |        | 1,971,628         |       |       |       |
| Tax benefit  related to exercise of stock options                                     |       |              |       |        |       | 1,430,000       |       |              |       | ** **             |        | 1,430,000         |       |       |       |
| Issuance of  common stock under employee stock purchase plan                          |       | 18,344            |       | 183         |       | 171,648         |       |              |       | ** **             |        | 171,831           |       |       |       |
| Issuance of  common stock upon exercise of stock warrants                             |       | 15,794            |       | 158         |       | 18,682          |       |              |       | ** **             |        | 18,840            |       |       |       |
| Acquistion of  HInnovation                                                            |       | 376,262           |       | 3,763       |       | 6,105,791       |       |              |       | ** **             |        | 6,109,554         |       |       |       |
| Unrealized loss  on investments                                                       |       |              |       |        |       |            |       |              |       | (47,865                | )           | (47,865           | )          | $          | (47,865    | ) |
| Net income                                                                            |       |              |       |        |       |            |       | 295,563           |       |                   |        | 295,563           |       | 295,563    |       |
| Balances as of December 31,  2004                                                |       | 12,007,160        |       | $           | 120,072    |            | $          | 65,813,282        |       | $                      | (11,330,766 | )                 | $          | (47,865    | )          | $ | 54,554,723 |   | $ | 247,698 |   |

 

The accompanying notesare an integral part of the consolidated financial statements.

 

44

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**Vital Images, Inc.**

**Consolidated Statements of CashFlows**

 
| ** **                                                                         | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  operating activities:                                             |       |                                     |       |   |   |   |   |
| Net income                                                                         |       | $                                        | 295,563    |   | $ | 8,462,141 |   | $ | 789,508 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                     |       |   |   |   |   |
| Depreciation and  amortization                                                     |       | 1,569,390                                |       | 1,220,468 |   | 894,814 |   |
| Amortization of  identified intangibles                                            |       | 1,243,000                                |       | 120,000 |   | 120,000 |   |
| Acquired  in-process research and development                                      |       | 1,000,000                                |       | — |   | — |   |
| Provision for  doubtful accounts                                                   |       | 626,800                                  |       | 46,000 |   | 64,000 |   |
| Deferred income  taxes                                                             |       | (878,000                                 | )          | (9,581,000 | ) | — |   |
| Tax benefit from  stock option transactions                                        |       | 1,430,000                                |       | 3,189,000 |   | — |   |
| Amortization of  discount and accretion of premium on marketable securities        |       | 463,192                                  |       | — |   | — |   |
| Non-employee  stock-based compensation                                             |       | 11,507                                   |       | 137,485 |   | 18,279 |   |
| Changes in  operating assets and liabilities, net of effect from acquisition:      |       |                                     |       |   |   |   |   |
| Accounts  receivable                                                               |       | (3,839,283                               | )          | 47,203 |   | (1,397,125 | ) |
| Prepaid expenses  and other assets                                                 |       | (168,864                                 | )          | (422,212 | ) | 59,141 |   |
| Accounts payable                                                                   |       | 301,200                                  |       | 499,981 |   | (106,670 | ) |
| Accrued and  other liabilities                                                     |       | 1,892,334                                |       | (63,204 | ) | 383,822 |   |
| Deferred revenue                                                                   |       | 3,611,889                                |       | 698,527 |   | 1,611,323 |   |
| Net cash  provided by operating activities                                         |       | 7,558,728                                |       | 4,354,389 |   | 2,437,092 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  investing activities:                                             |       |                                     |       |   |   |   |   |
| Purchases of  property and equipment                                               |       | (1,626,777                               | )          | (1,879,117 | ) | (1,499,533 | ) |
| Purchases of  marketable securities                                                |       | (30,433,525                              | )          | (6,775,592 | ) | (8,047,536 | ) |
| Sales of  marketable securities                                                    |       | 22,454,915                               |       | 5,205,118 |   | 5,539,423 |   |
| Acquisition of  HInnovation, Inc., net of cash acquired                       |       | (6,108,096                               | )          | — |   | — |   |
| Net cash used in  investing activities                                             |       | (15,713,483                              | )          | (3,449,591 | ) | (4,007,646 | ) |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  financing activities:                                             |       |                                     |       |   |   |   |   |
| Proceeds from  sale of common stock under stock plans                              |       | 2,143,459                                |       | 1,846,162 |   | 1,136,809 |   |
| Proceeds from  sale of common stock under stock warrants                           |       | 18,840                                   |       | 247,591 |   | 1,725,386 |   |
| Proceeds from  sale of common stock, net of offering costs                         |       | —                                   |       | 18,990,515 |   | — |   |
| Net cash  provided by financing activities                                         |       | 2,162,299                                |       | 21,084,268 |   | 2,862,195 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | (5,992,456                               | )          | 21,989,066 |   | 1,291,641 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash and cash equivalents,  beginning of year                                      |       | 30,111,613                               |       | 8,122,547 |   | 6,830,906 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash and cash  equivalents, end of year                                            |       | $                                        | 24,119,157 |   | $ | 30,111,613 |   | $ | 8,122,547 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Supplemental  cash flow information:                                               |       |                                     |       |   |   |   |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Purchases of  property and equipment with accounts payable                         |       | $                                        | 301,200    |   | $ | 227,755 |   | $ | — |   |

 

The accompanying notesare an integral part of the consolidated financial statements.

 

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**VitalImages, Inc.**

**Notes toConsolidated Financial Statements**

 

**1.****              Business description**

 

Vital Images, Inc. (the “Company”) develops, markets and supportsenterprise-wide advanced visualization 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”), magnetic resonance (“MR”) and positronemission tomography (“PET”) scanners. The Company’s products allow clinicians to create 2D, 3D and 4D views ofhuman anatomy and to non-invasively navigate within these images to bettervisualize and understand internal structures and pathologies.  The Company believes that its high-speedvisualization technology and customized protocols cost-effectively bring 3Dvisualization and analysis into the routine, day-to-day practice ofmedicine.  The Company, which operates ina single business segment, markets its products to healthcare providers and tomanufacturers of diagnostic imaging systems and picture archive andcommunication systems (“PACS”) through a direct sales force in the UnitedStates and independent distributors in international markets.

 

The Company is subject to risks and uncertainties, including dependenceon information technology spending by customers, well-established competitors,concentration of clients in a limited number of industries, fluctuations ofquarterly results, a lengthy and variable sales cycle, dependence on principalproducts and third-party technology, rapid technological change, development ofproducts that gain market acceptance and international expansion.

 

**2.****              Summary ofsignificant accounting policies**

 

**Basis of presentation**

 

The consolidated financial statements include the accounts of the Companyand its wholly-owned subsidiary, HInnovation, Inc.  All significant intercompany accounts andtransactions have been eliminated.

 

**Use of estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ from those estimates.

 

**Fair value of financial instruments**

 

The Company’s financial instruments consist primarily of cash, cash andcash equivalents, marketable securities, trade accounts receivable and accountspayable for which the current carrying amounts approximate fair market value.

 

**Cash and cash equivalents**

 

Cash and cash equivalents consist of cash and temporary investmentswith maturities of ninety days or less when purchased.  The carrying amount of cash equivalentsapproximates fair value due to the short maturity of these instruments.

 

**Marketable securities**

 

Management determines the appropriate classification of marketablesecurities at the time of purchase and reevaluates such designation as of eachbalance sheet date.  Currently, allmarketable securities held by the Company are classified asavailable-for-sale.  Available-for-sale securitiesare carried at fair value as determined by quoted market prices, withunrealized gains and losses, net of tax, reported as a separate component ofstockholders’ equity. If an unrealized loss for any investment is considered tobe other-than-temporary, the loss will be recognized in the consolidatedstatements of operations in the period the determination is made.  The cost basis of securities sold isdetermined using the specific identification method.  The cost of marketable securities is adjustedfor amortization of premiums and accretion of discounts to maturity.  Such amortization and accretion is includedin interest income.  Interest anddividends on securities classified as available-for-sale are included ininterest income.  As of December 31,2004, all investments mature within one year.

 

46

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As of December 31, 2004 and 2003, the Company’s marketablesecurities were as follows:

 
| ** **               | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|--------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **               | ** ** | **Cost  Basis**            | ** ** | **Aggregate  Fair Value**  | ** ** | **Net Unrealized  Gains (Losses)** | ** ** | **Cost  Basis** | ** ** | **Aggregate  Fair Value** | ** ** | **Net Unrealized  Gains (Losses)** | ** ** |
|                     |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Corporate debt           |       | $                          | 10,596,591 |                       | $          | 10,553,290 |   | $ | (43,301 | ) | $ | — |   | $ | — |   | $ | — |   |
| Certificates of  deposit |       | 997,414                    |       | 992,850                    |       | (4,564 | ) | 2,060,000 |   | 2,060,000 |   | — |   |
| Mutual funds             |       | —                     |       | —                     |       | — |   | 2,018,587 |   | 2,018,587 |   | — |   |
|                     |       | $                          | 11,594,005 |                       | $          | 11,546,140 |   | $ | (47,865 | ) | $ | 4,078,587 |   | $ | 4,078,587 |   | $ | — |   |

 

**Accounts receivable and allowance for doubtfulaccounts**

 

Accounts receivable are initially recorded at a selling price, whichapproximates fair value upon the sale of goods or services to customers.  The Company maintains an allowance fordoubtful accounts at an amount estimated to be sufficient to provide adequateprotection against losses resulting from extending credit to the Company’scustomers. In judging the adequacy of the allowance for doubtful accounts, theCompany considers multiple factors, including historical bad debt experience,the general economic environment, the need for specific client reserves and theaging of the Company’s receivables.  Thisprovision is included in operating expenses as a general and administrativeexpense in the consolidated statements of operations.  A considerable amount of judgment is requiredin assessing these factors. If the factors utilized in determining theallowance do not reflect future performance, then a change in the allowance fordoubtful accounts would be necessary in the period such determination has beenmade which would impact future results of operations.

 

**Concentration of credit risk**

 

Financial instruments that potentially subject the Company toconcentrations of credit risk consist primarily of cash and cash equivalentsand trade accounts receivable.  Depositswith the Company’s bank may exceed the amount of insurance provided on suchdeposits.  Generally, these deposits maybe redeemed upon demand and, therefore, bear minimal risk.  Financial instruments that potentiallysubject the Company to concentrations of credit risk consist principally ofmarketable securities.  Marketablesecurities consist of corporate debt and certificates of deposit.  The Company’s investment policy, approved bythe Board of Directors, limits the amount the Company may invest in any onetype of investment, thereby reducing credit risk concentrations.  The Company’s customer base is generallyconcentrated with a small number of customers. The Company reviews the creditworthiness of its customers prior toproduct shipment and generally does not require collateral.

 

**Property and equipment**

 

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

 

**Long-lived assets**

 

The Company reviews long-lived assets for impairment whenever events orchanges in circumstances indicate the carrying amount may not be recoverable,in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144“Accounting for the Impairment or Disposal of Long-Lived Assets.”  Events or changes in circumstances thatindicate the carrying amount may not be recoverable include, but are notlimited to, a significant decrease in the market value of the business or assetacquired, a significant adverse change in the extent or manner in which thebusiness or asset acquired is used, or a significant adverse change in thebusiness climate.  If such events orchanges in circumstances are present, the undiscounted cash flows method isused to determine whether the asset is impaired.  Cash flows would include the estimatedterminal value of the asset and exclude any interest charges.  To the extent the carrying value of the assetexceeds the undiscounted cash flows over the estimated remaining life of theasset; the impairment is measured using the discounted cash flows.  The discount rate utilized would be based onmanagement’s best estimate of the related risks and return at the time theimpairment assessment is made.

 

**Goodwill and other intangible assets withindefinite lives**

 

The Company accounts for goodwill and other intangible assets inaccordance with the provisions of SFAS No. 142, “Goodwill and OtherIntangible Assets”.  Under SFAS No. 142,goodwill and intangible assets with indefinite lives are not

 

47

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amortized to expense and must be reviewed for impairment annually ormore frequently if events or changes in circumstances indicate that the assetmight be impaired.  The first step of thegoodwill impairment test, used to identify potential impairment, compares thefair value of a reporting unit with its carrying amount, includinggoodwill.  The Company operates as onereporting unit and therefore compares the book value to the market value(market capitalization plus a control premium). If the market value exceeds the book value, goodwill is considered notimpaired, thus the second step of the impairment test is not necessary.  If the Company’s book value exceeds themarket value, the second step of the goodwill impairment test is performed tomeasure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure theamount of impairment loss, compares the implied fair value of the goodwill withthe book value of the goodwill.  If thecarrying value of the goodwill exceeds the implied fair value of the goodwill,an impairment loss would be recognized in an amount equal to the excess.  Any loss recognized cannot exceed thecarrying amount of goodwill.  After agoodwill impairment loss is recognized, the adjusted carrying amount ofgoodwill is its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment lossis prohibited once the measurement of that loss is completed.  The Company completed the annual goodwillimpairment assessment as of December 31, 2004, upon which no impairmentwas recorded.

 

**Revenue recognition**

 

The Company licenses its software and sells products and services toend-users and also indirectly through original equipment manufacturers (“OEMs”)and independent distributors (collectively “Resellers”).  Terms offered by the Company do not generallydiffer based on whether the customer is an end-user, or a Reseller.  The Company offers terms that require paymentwithin 30 to 90 days after product delivery. The Company does not offer rights of return, acceptance clauses or priceprotection to its customers.

 

License fees revenue is derived from the licensing of computersoftware.  Hardware revenue is derivedfrom the sale of system hardware, including peripheral equipment.  Maintenance and service revenue is derivedfrom software maintenance and from telephone support, installation, trainingand 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 software modification or developmentservices that are sold separately to OEMs.  The Company generally sellshardware as part of a system sale, but it occasionally sells hardware as partof a system upgrade or additional product sale.

 

The Company recognizes revenue in accordance with American Institute ofCertified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2,Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, as well asTechnical Practice Aids issued from time to time by the AICPA and StaffAccounting Bulletin No. 104. The Company recognizes revenue when it isrealized or realizable and earned.  TheCompany considers revenue realized or realizable and earned when it haspersuasive evidence of an arrangement, the product has been shipped or theservices have been provided to the customer, the sales price is fixed ordeterminable, and collectability is probable. Provided all other revenuerecognition criteria are met, license revenue from Resellers is recognized on asell-in or sell-through basis depending on the arrangement with theReseller.  The Company recognizes revenuefrom Resellers on a sell-in basis provided the Reseller i) assumes all risk ofthe purchase, ii) has the ability and obligation to pay regardless of receivingpayment from the end user, and iii) has a history of timely payments.

 

The Company 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 that collection is probable, revenue is deferred until the arrangementfees are collected and all other revenue recognition criteria in thearrangement have been met.

 

In addition to the aforementioned general policy, the following are thespecific revenue recognition policies for services and multiple-elementarrangements.

 

Software and Hardware – Revenue from license fees and hardware isrecognized when shipment of the product has occurred, provided no significantCompany obligations remain and the Company’s services are not consideredessential to the functionality of other elements of the arrangement.  See also “—Multiple Element Arrangements”below for further information.

 

Services – Revenue from maintenance and support arrangements isdeferred and recognized ratably over the term of the maintenance and supportarrangements.  Revenue from training andinstallation services is recognized as the services are provided tocustomers.  Revenue from engineeringservices, where the Company is performing significant customization ormodification of software, is recognized using contract accounting on apercentage-of-completion basis.  TheCompany records revenue by reference to actual hours incurred to date and theestimated hours remaining to complete the services.

 

Multiple-Element Arrangements – The Company enters into arrangementswith customers that include a combination of software products, systemhardware, specified upgrades, maintenance and support, or installation andtraining services.  For

 

48

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such arrangements, the Company recognizes revenue using the residualvalue method.  The Company allocates thetotal arrangement fee among the various elements of the arrangement based onthe relative fair value of each of the undelivered elements determined byvendor-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 elementsfor which the Company does not have vendor-specific objective evidence of fairvalue, have been delivered.

 

**Stock-based compensation**

 

The Company has stock-based employee and director compensation plans,which are described more fully in Note 6. The Company accounts for stock-based employee compensation arrangementsin accordance with the provisions of Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees”, and complies with the disclosureprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” andSFAS No. 148, “Accounting for Stock-Based Compensation-Transition andDisclosure-an amendment of Financial Accounting Standards Board (“FASB”)Statement No. 123.”

 

The Company has adopted the disclosure-only provisions of SFAS No. 123.For purposes of the pro forma disclosures below, the estimated fair value ofthe options is amortized to expense over the options’ vesting period. Hadcompensation cost for the Company’s stock options been recognized based on thefair value at the grant date consistent with the provisions of SFAS No. 123,the Company’s net income would have been adjusted to the pro forma amountsindicated below:

 
| ** **                                                                                                                              | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income, as  reported                                                                                                                |       | $                                        | 295,563    |   | $ | 8,462,141 |   | $ | 789,508 |   |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value method  for all awards, net of related tax effects |       | (2,155,282                               | )          | (1,387,174 | ) | (1,560,508 | ) |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Pro forma net  income (loss)                                                                                                            |       | $                                        | (1,859,719 | ) | $ | 7,074,967 |   | $ | (771,000 | ) |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Net income  (loss) per share - basic                                                                                                    |       |                                     |       |   |   |   |   |
| As reported                                                                                                                             |       | $                                        | 0.03       |   | $ | 0.83 |   | $ | 0.09 |   |
| Pro forma                                                                                                                               |       | $                                        | (0.16      | ) | $ | 0.69 |   | $ | (0.09 | ) |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Net income  (loss) per share - diluted                                                                                                  |       |                                     |       |   |   |   |   |
| As reported                                                                                                                             |       | $                                        | 0.02       |   | $ | 0.71 |   | $ | 0.08 |   |
| Pro forma                                                                                                                               |       | $                                        | (0.16      | ) | $ | 0.62 |   | $ | (0.09 | ) |

 

The pro forma effects on the net income (loss) for 2004, 2003 and 2002are not necessarily representative of the pro forma effect that may occur onthe net income (loss) in future periods.

 

**Research and development costs**

 

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

 

49

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**Income taxes**

 

The Company provides for income taxes using the liability method underSFAS No. 109, “Accounting for Income Taxes,” which requires recognition ofdeferred tax assets and liabilities for the expected future tax consequences ofevents that have been included in the financial statements. Under this statement,deferred tax assets and liabilities are determined based on the differencebetween the financial statement and tax basis of assets and liabilities, usingenacted tax rates in effect for the year in which the differences are expectedto reverse. Deferred tax assets are reduced by a valuation allowance when it ismore likely than not that some component or all of the deferred tax assets willnot be realized. Tax rate changes are reflected in income during the periodsuch changes are enacted.

 

**Computation of net income per share**

 

Basic earnings per share is computed using net income and the weightedaverage number of common shares outstanding. Diluted earnings per share reflectthe weighted average number of common shares outstanding plus any potentiallydilutive shares outstanding during the period. Potentially dilutive shares consist of shares issuable upon the exerciseof stock options and warrants.

 

The computations for basic and diluted net income per share are asfollows:

 
| ** **                                                                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                  | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                  | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                                  |       |                                     |       |   |   |   |   |
| Net income                                                                  |       | $                                        | 295,563    |   | $ | 8,462,141 |   | $ | 789,508 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Denominator:                                                                |       |                                     |       |   |   |   |   |
| Denominator for  weighted average common shares outstanding – basic    |       | 11,632,351                               |       | 10,189,114 |   | 8,861,132 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Dilution  associated with common stock warrants                             |       | 5,402                                    |       | 59,389 |   | 59,984 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Dilution  associated with the company’s stock based compensation plans |       | 897,917                                  |       | 1,599,765 |   | 900,682 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Denominator:                                                                |       |                                     |       |   |   |   |   |
| Denominator for weighted  average common shares outstanding – diluted  |       | 12,535,670                               |       | 11,848,268 |   | 9,821,798 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Net income per  share – basic                                          |       | $                                        | 0.03       |   | $ | 0.83 |   | $ | 0.09 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Net income per  share – diluted                                        |       | $                                        | 0.02       |   | $ | 0.71 |   | $ | 0.08 |   |

 

Potential dilutive shares of common stock excluded from the diluted netincome per share computations were 545,000, 172,000 and 94,000 for the yearsended December 31, 2004, 2003 and 2002, respectively.  Certain potential dilutive shares of commonstock were excluded from the diluted earnings per share computation becausetheir exercise prices were greater than the average market price of the commonshares during the period and were therefore not dilutive.

 

**Comprehensive income (loss)**

 

Comprehensive income (loss) as defined by SFAS No. 130, “ReportingComprehensive Income”, includes net income and items defined as othercomprehensive income (loss).  SFAS No. 130requires that items defined as other comprehensive income (loss), such asforeign currency translation adjustments and unrealized gains and losses oncertain marketable securities, be separately classified in the financialstatements.  Such items are reported inthe consolidated statements of stockholders’ equity as comprehensive income(loss).

 

50

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**New accounting pronouncement**

 

In December 2004, the FASB issued SFAS No. 123 (revised2004), “Share-Based Payment”. SFAS No. 123R supersedes APB Opinion No. 25,which requires recognition of an expense when goods or services are provided.SFAS No. 123R requires the determination of the fair value of theshare-based compensation at the grant date and the recognition of the relatedexpense over the period in which the share-based compensation vests. SFAS No. 123Rpermits a prospective or two modified versions of retrospective applicationunder which financial statements for prior periods are adjusted on a basisconsistent with the pro forma disclosures required for those periods by theoriginal SFAS No. 123. The Company is required to adopt the provisions ofSFAS No. 123R effective July 1, 2005, at which time the Company willbegin recognizing an expense for unvested share-based compensation that hasbeen issued or will be issued after that date. Under the retroactive options,prior periods may be restated either as of the beginning of the year ofadoption, January 1, 2005 for the Company, or for all periods presented.The Company has not yet finalized its decision concerning the transition optionit will utilize to adopt SFAS No. 123R. The Company is currently assessing its stock-based compensation strategyand related tax implications.  Futurestock-based compensation may differ from pro forma amounts. The Company expectsthe impact of the adoption of SFAS No. 123R to be material to its consolidatedfinancial statements.

 

**3.****              Acquisition**

 

The following acquisition was accounted for under the purchase methodof accounting under SFAS No. 141, “Business Combinations,” andaccordingly, the assets and liabilities acquired were recorded at theirestimated fair values at the effective date of the acquisition, and the resultsof operations have been included in the consolidated statements of operationssince the acquisition date. In accordance with SFAS No. 142, “Goodwill andOther Intangible Assets,” goodwill recorded as a result of the acquisition issubject to an annual impairment test and will not be amortized.

 

**HInnovation, Inc.**

 

On February 18, 2004, the Company completed the acquisition ofHInnovation, Inc. (“HInnovation”) in accordance with the terms andconditions of an Acquisition Agreement and Plan of Reorganization (the “AcquisitionAgreement”) dated as of January 8, 2004.  HInnovation is a providerof software solutions that allow physicians to use PCs or notebook computers toaccess 2D, 3D and 4D medical imaging applications securely over theInternet.  The acquisition of HInnovation was made to acquire products andtechnology that will enable the Company to more effectively compete in thedistributed computing market for 2D/3D/4D visualization and analysis software.

 

The total purchase price of the HInnovation acquisition wasapproximately $12.6 million.  The Companyacquired all of the outstanding common stock of HInnovation in exchange for$5.8 million in cash paid and 376,262 newly issued shares of common stockissued to the stockholders of HInnovation. The common stock was valued at $6.1million for accounting purposes.  Vital Images’ stock was valued at$16.2375 per share, which was equal to the average of the closing sale pricesof one share of Vital Images’ stock as reported on the NASDAQ National Marketfor the two consecutive trading days occurring before the first publicannouncement of the signing of the Acquisition Agreement and the twoconsecutive trading days occurring immediately after such public announcementdate. The Company incurred approximately $400,000 in direct costs of theacquisition and assumed $400,000 of liabilities.  During the fourth quarter of 2004, theCompany finalized the valuation of certain contingent liabilities and settledcertain tax matters with the former stockholders of HInnovation, which resultedin a reduction in goodwill previously reported in interim periods.  The Company did not assume any stock optionsor warrants.

 

In addition, the transaction includes a maximum of $6.0 million ofcontingent milestone payments comprised of $3.0 million in common stock and$3.0 million in cash.  The contingent milestone payments are based on 1)the achievement of certain revenue targets resulting from the sale of productscontaining HInnovation technology during the 12 month period following theclosing date; 2) the porting of Vital Images’ product to HInnovation’s productplatform and the commercial launch thereof; and 3) licensing the HInnovationpatented technology within 24 months after the closing date.  The numberof shares issued under the contingent milestone payments will be determinedbased on the average closing price of the Company’s common stock during the 10trading days before completion of the milestone objective.  However, theAcquisition Agreement provides that the number of shares of Vital Images commonstock comprising the contingent consideration cannot exceed 300,000shares.  If, at the time of its issuance, the value of such stock is lessthan $3.0 million due to this limitation on the number of shares, Vital Imageswill pay the shortfall in cash.  Any contingent payments made by theCompany will result in an increase in goodwill. As of December 31, 2004,no contingent payments had been earned.  Thefirst milestone was not met before the February 2005 deadline.  As a result, the potential maximum contingentconsideration was reduced to $4.5 million, which consists of $3.0 million incommon stock and $1.5 million in cash.

 

The purchase price was allocated to the identified assets ofHInnovation.  A third-party appraisal firm assisted the Company with thevaluation of the identified intangible assets.  The valuation resulted inthe allocation of $6.9 million to identifiable intangibles, which will beamortized over periods ranging from three to seven years.  The valuationalso resulted in the identification of $1.0 million of acquired in-processresearch and development costs (“IPR&D”), which was immediately expensed onthe closing date and represents a non-deductible charge for income taxpurposes.

 

51

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At the time of acquisition, HInnovation had development projects inprocess, including the collaboration module of its Web-based product (the “CollaborationModule Project”). The Collaboration Module Project involves the design anddevelopment of innovative features for Web-based consultation meetings withinteractive and synchronized viewing of full-quality images, annotation andmouse movement.  The Collaboration Module Project includes significant andinnovative advancements to the HInnovation software platform in the areas ofnetwork synchronization of high quality images and user privilege managementfor online collaboration. The design, verification and other processes involvedin the Collaboration Module Project require tools and skills that are new toHInnovation.  The appraisal referenced above estimated that $1.0 millionof the purchase price represents the fair value of purchased IPR&D relatedto the Collaboration Module Project, that it has not yet reached technologicalfeasibility and that it has no alternative future uses. This amount wasexpensed as a non-recurring, non-tax-deductible charge upon consummation of theacquisition.

 

The appraisal firm applied the income valuation approach to assist theCompany in determining the estimated fair value of the purchasedIPR&D.  These estimates were based on the following assumptions:

 

•                     The estimatedrevenue was based upon HInnovation’s estimate of revenue growth over the nextseven years from the revenue growth of primarily the Collaboration Module.

 

•                     The estimatedgross margin of 65% to 78% was based upon gross margin for comparable products.

 

•                     The estimatedselling, general and administrative expenses were based on consideration ofhistorical operating expenses as a percentage of revenue and HInnovation’sprojected operating expenses.

 

•                     The cost tocomplete each project was based on estimated remaining labor hours and afully-burdened labor cost and other direct expenses.

 

•                     The discountrate used in the alternative income valuation approach was based on theweighted average cost of capital (“WACC”). The WACC calculation produces theaverage required rate of return of an investment in an operating enterprisebased on various required rates of return from investments in various areas ofthat enterprise. The discount rate used in the alternative valuation approachwas 35%.  Premiums were added to the WACC to account for the inherentrisks in the development of the products, the risks of the products beingcompleted on schedule, and the risk of the eventual sales of the productmeeting the expectations of HInnovation.

 

The first phase of the Collaboration Module was released in the thirdquarter of 2004.  The first phase provides basic collaboration betweenusers allowing one user to present to another user.  The second, and moresophisticated, phase of the Collaboration Module will provide two-waycollaboration between users allowing both users to interact with the data andis expected to be available for general market release in mid-2005. Through December 31, 2004, the Company has incurred approximately $267,000in costs to develop the Collaboration Module.  The Company estimates thatit will incur another $33,000 to complete the development of the second phaseof the Collaboration Module.  Given the uncertainties of the developmentprocess, these estimates are subject to change, and deviations from theseestimates may occur.

 

The total purchase price is as follows:

 
| Fair value of  common stock issued (376,262 shares) |   | $         | 6,109,554  |   |
|-----------------------------------------------------|--------|-----------|------------|--------|
| Cash paid to  HInnovation shareholders              |   | 5,752,626 |       |
| Direct  acquisition costs                           |   | 360,259   |       |
| Liabilities  assumed                                |   | 381,562   |       |
|                                                |   | $         | 12,604,001 |   |

 

52

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The allocation of the total purchase price is as follows:

 
| Existing  software technology, subject to amortization - 5 year life       |   | $          | 3,400,000  |   |
|----------------------------------------------------------------------------|--------|------------|------------|--------|
| Patent and  patent applications, subject to amortization - 7 year life     |   | 3,000,000  |       |
| Non-compete/employement  agreements, subject to amortization - 3 year life |   | 500,000    |       |
| Goodwill, not  subject to amortization                                     |   | 6,052,744  |       |
| In-process  research and development costs                                 |   | 1,000,000  |       |
| Deferred tax  liabilities, net                                             |   | (1,405,000 | )          |
| Fair value of  assets acquired                                             |   | 51,468     |       |
| Fair value of  cash acquired                                               |   | 4,789      |       |
|                                                                       |   | $          | 12,604,001 |   |

 

The following factors contributed to a purchase price that resulted inthe recognition of goodwill:

 

•                                          HInnovationhad the first Web-based product in the Company’s market.

 

•                                          HInnovationhad a patent and patent applications that cover certain important aspects ofthe underlying technology.

 

•                                          HInnovationalso had unique technology under development that was included as part of theacquired IPR&D.

 

The following unaudited pro forma condensed consolidated results ofoperations have been prepared as if the acquisition of HInnovation had occurredas of the beginning of the periods presented.  Pro forma adjustmentsrelate to amortization of identified intangible assets, acquired IPR&D and incometaxes.  The unaudited pro forma condensed consolidated results ofoperations are for comparative purposes only and are not necessarily indicativeof results that would have occurred had the acquisition occurred as of thebeginning of the periods presented, nor are they necessarily indicative offuture results.

 
| ** **                             | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------|------------|------------------------------------------|------------|
| ** **                             | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                             | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                |       | $                                        | 36,150,047 |   | $ | 27,322,218 |   | $ | 21,116,074 |   |
|                                   |       |                                     |       |   |   |   |   |
| Net income  (loss)                     |       | $                                        | 1,172,570  |   | $ | 6,517,277 |   | $ | (1,770,648 | ) |
|                                   |       |                                     |       |   |   |   |   |
| Net income  (loss) per share - diluted |       | $                                        | 0.09       |   | $ | 0.53 |   | $ | (0.19 | ) |

 

**4.****              Financial statementcomponents**

 

**Allowance for doubtful accounts**

 
| ** **         | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------|------------|-------------------------------------------|------------|
| ** **         | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Beginning  balance |       | $                                         | 235,000    |   | $ | 240,000 |   | $ | 185,000 |   |
| Provision          |       | 626,800                                   |       | 46,000 |   | 64,000 |   |
| Write-offs         |       | (94,800                                   | )          | (51,000 | ) | (9,000 | ) |
| Recoveries         |       | —                                    |       | — |   | — |   |
| Ending balance     |       | $                                         | 767,000    |   | $ | 235,000 |   | $ | 240,000 |   |

 

53

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**Property and equipment, net**

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                            |       |                  |       |   |   |
| Equipment                                       |       | $                     | 5,247,471  |   | $ | 3,725,849 |   |
| Furniture and  fixtures                         |       | 1,516,497             |       | 1,474,485 |   |
| Computer  software                              |       | 765,870               |       | 580,986 |   |
| Leasehold  improvements                         |       | 273,924               |       | 273,924 |   |
| Total property  and equipment                   |       | 7,803,762             |       | 6,055,244 |   |
|                                            |       |                  |       |   |   |
| Less accumulated  depreciation and amortization |       | (4,581,395            | )          | (3,012,005 | ) |
| Property and  equipment, net                    |       | $                     | 3,222,367  |   | $ | 3,043,239 |   |

 

Depreciation expense was $1,569,390 and $1,220,468 and $894,814 for theyears ended December 31, 2004 and 2003, respectively.

 

**Licensed technology, net**

 

In July 2001, the Company entered into an agreement to licensetechnology from a third party.  TheCompany paid an aggregate of $750,000 to the licensor in 2001.  The Company recorded this $750,000 purchaseas licensed technology and is amortizing it over the estimated useful life ofthe technology of 75 months.  Thisamortization expense is reported as cost of revenue for license fees.  As part of this agreement, the Company isalso obligated to pay the licensor royalties on the sales of certain productsas defined in the agreement.  During2004, 2003 and 2002, $1.0 million, $772,000 and $608,000, respectively, of suchroyalties were incurred and were reported as cost of revenue for license fees.

 
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                           |       |                  |       |   |   |
| Licensed  technology           |       | $                     | 750,000    |   | $ | 750,000 |   |
| Less accumulated  amortization |       | (420,000              | )          | (300,000 | ) |
| Licensed  technology, net      |       | $                     | 330,000    |   | $ | 450,000 |   |

 

Amortization expense was $120,000 for each of the years endedDecember 31, 2004, 2003 and 2002, respectively.

 

**Other intangible assets, net**

 

Acquired intangible assets subject to amortization were as follows:

 
| ** **                                       | ** ** | **December 31, 2004** | ** ** | **December 31, 2003**    | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                                       | ** ** | **Gross Carrying  Value**  | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amorization** | ** ** | **Net  Carrying  Value** | ** ** |
|                                             |       |                       |       |                          |       |   |   |   |   |   |   |   |   |
| Existing  software technology                    |       | $                          | 3,400,000  |                          | $          | (598,000 | ) | $ | 2,802,000 |   | $ | — |   | $ | — |   | $ | — |   |
| Patents and  patent applications                 |       | 3,000,000                  |       | (378,000                      | )          | 2,622,000 |   | — |   | — |   | — |   |
| Non-compete/employment  agreements               |       | 500,000                    |       | (147,000                      | )          | 353,000 |   | — |   | — |   | — |   |
| Total intangible  assets subject to amortization |       | $                          | 6,900,000  |                          | $          | (1,123,000 | ) | $ | 5,777,000 |   | $ | — |   | $ | — |   | $ | — |   |

 

Intangible assets subject to amortization are amortized on astraight-line basis over the estimated period of benefit.  Amortization expense was $1.1 million for theyear ended December 31, 2004.   The estimated future annualamortization expense for identified intangible assets is as follows:

 

54

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| 2005               |   | $         | 1,284,000 |   |
|--------------------|--------|-----------|-----------|--------|
| 2006               |   | 1,284,000 |      |
| 2007               |   | 1,133,000 |      |
| 2008               |   | 1,116,000 |      |
| 2009 through  2011 |   | 960,000   |      |
|               |   | $         | 5,777,000 |   |

 

**Goodwill**

 

The changes in the carrying amount of goodwill for the year ended December 31,2004 are as follows:

 
| Beginning  balance                 |   | $         | —    |   |
|------------------------------------|--------|-----------|-----------|--------|
| Goodwill  acquired during the year |   | 6,052,744 |      |
| Ending balance                     |   | $         | 6,052,744 |   |

 

**Deferred revenue**

 
| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                   |       |                  |       |   |   |
| Maintenance and  support               |       | $                     | 4,734,764  |   | $ | 3,003,543 |   |
| Training                               |       | 2,697,892             |       | 1,591,854 |   |
| Installation                           |       | 309,200               |       | 104,301 |   |
| Software                               |       | 454,108               |       | — |   |
| Hardware and  other                    |       | 218,448               |       | 95,326 |   |
| Total deferred  revenue                |       | 8,414,412             |       | 4,795,024 |   |
| Less current  portion                  |       | (8,136,844            | )          | (4,530,333 | ) |
| Long-term  portion of deferred revenue |       | $                     | 277,568    |   | $ | 264,691 |   |

 

**5.****              Commitments andcontingencies**

 

**Operating lease commitments**

 

The Company rents office space and certain office equipment underoperating leases.  In addition to minimumlease payments, the office leases require payment of a proportionate share ofreal estate taxes and building operating expenses.  Total rent expense, including an allocationof the lessor’s operating costs, was $715,000, $678,000 and $596,000 for theyears ended December 31, 2004, 2003 and 2002, respectively.

 

In March 2004, the Company signed a non-cancelable operating leasefor a new office facility in Minnetonka, Minnesota.  The new lease term starts in February 2005and expires in January 2012.  TheCompany moved into the Minnetonka location and moved out of its Plymouth,Minnesota location in February 2005. The Company’s office facility in Plymouth expires on July 31, 2005with the exception of a small portion of the space that is under lease until May 31,2006.  Under the terms of the new lease,the Minnetonka lessor will pay the monthly base rent payments and taxes andoperating cost rent obligation payments for the Company’s former officefacility in Plymouth beginning February 2005.

 

In the first quarter of 2005, the Company estimates that it will recorddeferred rent of $1.7 million relating to estimated payments by the Minnetonkalessor for the benefit of the Company. Such payments are considered lease incentives under FASB TechnicalBulletin (“FTB”) 88-1, “Issues Relating to Accounting for Leases,” and will beamortized as a reduction of rent expense over the term of the Minnetonkalease.  Payments by the Minnetonka lessorfor the benefit of the Company consist of the following:

 

•                  $440,000relating to lease payments to be made by the Minnetonka lessor to the Plymouthlessor; under FTB 88-1, such payments must be recorded as a lease loss by theCompany in the first quarter of 2005.

•                  $206,000relating to moving costs reimbursed to the Company by the Minnetonka lessor;moving costs were

 

55

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expensed as incurredduring the first quarter of 2005.

•                  $1.0 millionrelating to leasehold improvements paid for by the Minnetonka lessor; under FTB88-1, such leasehold improvements must be recorded as an asset by the Companyand amortized over the shorter of their estimated useful lives or the remainingterms of the related leases.

 

The minimum lease payments, excluding estimated taxes and operatingcost rent obligations, are approximately:

 
| 2005       |   | $         | 673,000   |   |
|------------|--------|-----------|-----------|--------|
| 2006       |   | 471,000   |      |
| 2007       |   | 618,000   |      |
| 2008       |   | 711,000   |      |
| 2009       |   | 727,000   |      |
| Thereafter |   | 1,562,000 |      |
| Total      |   | $         | 4,762,000 |   |

 

**Purchase commitments**

 

In November 2002, the Company entered into an agreement with R2Technology, Inc. (“R2”) to distribute R2’s lung nodule CAD software productin conjunction with the Company’s products. The Company completed its development work to meet the clinicalrequirements for selling the lung nodule CAD software with Vitrea 2 on August 26,2004.  Under the agreement, the firstpurchase was required in the fourth quarter of 2004.  The total purchase commitment will be amaximum of $5.6 million of product over a three-year commitment period.  The purchase commitment price the Companymust pay will be reduced if the selling price of the lung CAD product when solddirectly to end-users by R2 falls 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 units as the Company is required topurchase.  As of December 31, 2004, theCompany had a commitment with R2 to purchase an estimated $5.4 million ofproduct for resale over the next 11 quarters. Based on current sales estimates, the Company will be able to sell allproduct anticipated to be purchased under the obligation.  Any changes to these estimates could have anadverse impact on the Company’s financial position and results of operations.

 

As of December 31, 2004, the Company had a commitment to purchasean estimated $200,000 worth of additional R2 lung nodule CAD software under theagreement that was not fulfilled.  TheCompany and R2 are currently renegotiating the terms of the contract.

 

**Other items**

 

Under general contract terms, the Company includes an indemnificationclause in its software licensing agreement that indemnifies the licenseeagainst liability and damages arising from any claims of patent, copyright,trademark or trade secret infringement by the Company’s software.  TheCompany has incurred insignificant costs as a result of this type ofindemnification clause, and the Company does not maintain a product warrantyliability related to such indemnification clauses.

 

The Company has entered into various employment agreements with certainexecutives of the Company, which provide for severance payments subject tocertain conditions and events.

 

**6.****              Stockholders’ equity**

 

**Background**

 

On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.(“Bio-Vascular”), now known as Synovis Life Technologies, Inc., the formerparent of the Company, approved a plan to spin off and establish the Company asan independent, publicly-owned company. On May 12, 1997 (the “Distribution Date”), Bio-Vascular distributedall of the shares of the Company to the stockholders of Bio-Vascular (the “Distribution”),and on that date the Company began operating as an independent publiccompany.  All Bio-Vascular stockholdersof record as of May 5, 1997 received one share of the Company’s commonstock for each two shares of Bio-Vascular stock held on that date and cash inlieu of fractional shares.

 

**Private placement**

 

In June 2003, the Company completed aprivate placement of 1.5 million shares of common stock at $13.50 per share fortotal gross proceeds of $20.3 million. After deducting offering costs of $1.3 million, the Company received netproceeds of

 

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$19.0 million.  A registration statement covering the resaleof these shares was declared effective on September 29, 2003 by the Securitiesand Exchange Commission.

 

**Stock option plans**

 

In May 1997, Bio-Vascular, as the sole shareholder of the Company,approved and adopted the Vital Images, Inc. 1997 Stock Option andIncentive Plan (the “Stock Option Plan”), which became effective on theDistribution Date.  Under the terms ofthe plan, the Board of Directors may grant options and other stock-based awardsto key employees to purchase shares of the Company’s common stock at an optionexercise price equal to or greater than 85% of the fair market value on thedate of grant.  The options areexercisable at such times, in installments or otherwise, as the Board ofDirectors may determine.  Generally,these options are incentive stock options with a term of eight years and areexercisable as to 28% of the total grant one year after the date of grant and2% per month thereafter.  The totalnumber of shares of common stock that may be issued or awarded under the StockOption Plan is 3.5 million.  As of December 31,2004, there were 594,841 shares available for the grant of awards under theStock Option Plan.

 

Also in May 1997, Bio-Vascular, as the sole shareholder of theCompany, approved and adopted the Vital Images, Inc. 1997 Director StockOption Plan (the “Director Plan”) (together with the Stock Option Plan, the “1997Plans”), which became effective on the Distribution Date.  The Director Plan provides non-employeedirectors with automatic grants of stock options and allows the Board ofDirectors to make additional discretionary option grants to any or alldirectors.  Options that are grantedunder the Director Plan are granted with an option price equal to the fairmarket 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.  The total number of shares of common stockthat may be issued or awarded under the Director Plan is 300,000.  As of December 31, 2004, there were25,000 shares available for the grant of awards under the Director Plan.

 

Certain non-plan options were granted to certain officers of theCompany in 1998, 1999 and 2002.  In February 1998,the Company reserved and granted non-qualified, non-plan options to purchase300,000 shares to an officer of the Company. These non-plan options had a term of eight years, vested over a two-yearperiod and were granted at exercise prices at least equal to fair market valueof the Company’s common stock on the date of grant.  Of these non-plan options, the Companycancelled options to purchase 100,000 shares in December 1999, and theofficer exercised the remaining options to purchase 200,000 shares in August 2003.  In December 1999, the Company grantednon-qualified, non-plan options to purchase 175,000 shares to another officerof the Company.  These non-plan optionshad a term of eight years, were exercisable as to 28% of the total grant oneyear after the date of grant and 2% per month thereafter and were granted atexercise prices at least equal to fair market value of the Company’s commonstock on the date of grant.  Of thesenon-plan options, the Company cancelled options to purchase 80,500 shares in February 2002,and the officer exercised the remaining options to purchase 94,500 shares in2002.  In March 2002, the Companygranted non-qualified, non-plan options to purchase 165,000 shares to anotherofficer of the Company.  These non-planoptions have a term of eight years, are exercisable as to 28% of the totalgrant one year after the date of grant and 2% per month thereafter and weregranted at exercise prices at least equal to fair market value of the Company’scommon stock on the date of grant.  As ofDecember 31, 2004, these options were still outstanding.

 

**Non-employee options**

 

In December 2000, the Company granted options to purchase 10,000shares to a non-employee consultant. Options to purchase 5,000 shares vest over a four-year period, and theremaining options vested immediately when a specified milestone was achieved,which occurred in May 2003.  Theoptions to purchase 5,000 shares that vested in May 2003 were exercised inJune 2003.  In December 2001,the Company granted options to purchase a total of 4,000 shares to twonon-employee consultants and, in December 2002, the Company grantedoptions to purchase an additional 4,000 shares to two non-employeeconsultants.  These options vest over afour-year period.  All of the non-planoptions have a term of eight years and were granted at exercise prices at leastequal to fair market value of the Company’s common stock on the date of grant.The Company records compensation expense related to these arrangements basedupon the fair values of the options during the periods the consultants provideservices. Such fair values are measured using the Black-Scholes option-pricingmodel.  The Company recorded $12,000,$137,000 and $18,000 of compensation expense related to these options for eachof the years ended December 31, 2004, 2003 and 2002, respectively.

 

57

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The following table summarizes stock option activity for 2004, 2003 and2002:

 
| ** **                                      | ** ** | **Shares Underlying  Options** | ** ** | **Weighted-Average  Exercise Price Per  Share** | ** ** |
|-------------------------------------------------|------------|--------------------------------|------------|-------------------------------------------------|------------|
|                                            |       |                           |       |                                            |       |
| 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 granted                                 |       | 514,100                        |       | $                                               | 12.29      |   |
| Options  exercised                              |       | (456,380                       | )          | $                                               | 4.32       |   |
| Options canceled                                |       | (172,017                       | )          | $                                               | 9.80       |   |
|                                            |       |                           |       |                                            |       |
| Total  outstanding as of December 31, 2004 |       | 2,326,675                      |       | $                                               | 8.54       |   |
|                                            |       |                           |       |                                            |       |
| Options  exercisable as of:                     |       |                           |       |                                            |       |
|                                            |       |                           |       |                                            |       |
| December 31,  2002                         |       | 1,505,069                      |       | $                                               | 3.83       |   |
| December 31,  2003                         |       | 1,407,347                      |       | $                                               | 5.09       |   |
| December 31,  2004                         |       | 1,409,650                      |       | $                                               | 6.74       |   |

 

Various price ranges and weighted average information for optionsoutstanding and exercisable as of December 31, 2004 are as follows:

 
| ** **                    | ** ** | **Options Outstanding**                     | ** ** | **Options Exercisable**                           | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|---------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding as of  Dec 31, 2004** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Number  Exercisable as of  Dec 31, 2004** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                          |       |                                        |       |                                              |       |   |   |   |   |   |   |
| $1.13 - $2.75                 |       | 208,151                                     |       | 1.15 years                                        |       | $ | 2.17 |   | 208,151 |   | $ | 2.17 |   |
| $3.51 - $5.70                 |       | 408,996                                     |       | 3.21 years                                        |       | $ | 4.90 |   | 401,486 |   | $ | 4.90 |   |
| $5.75 - $7.25                 |       | 485,410                                     |       | 5.19 years                                        |       | $ | 7.15 |   | 324,535 |   | $ | 7.16 |   |
| $7.34 - $9.24                 |       | 259,250                                     |       | 3.77 years                                        |       | $ | 7.60 |   | 239,100 |   | $ | 7.54 |   |
| $9.60 - $19.13                |       | 964,868                                     |       | 6.73 years                                        |       | $ | 12.40 |   | 236,378 |   | $ | 12.53 |   |
|                          |       | 2,326,675                                   |       | 4.96 years                                        |       | $ | 8.54 |   | 1,409,650 |   | $ | 6.74 |   |

 

**Employee stock purchase plan**

 

The 1997 Employee Stock Purchase Plan (the “ESPP”) was approved andadopted by Bio-Vascular, as the sole shareholder of the Company, in May 1997.  The ESPP, which became effective on July 1,1997, enables eligible employees to purchase the Company’s common stock at 85%of the fair market value of the stock on the date an offering period commencesor on the date an offering period terminates, whichever is lower.  The ESPP covers an aggregate of up to 250,000shares of common stock that can be issued and sold to participating employeesof the Company through a series of three-month offering periods, beginning July 1,1997.  The ESPP covers substantially allemployees, 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 offeringperiod.  Purchases under the ESPP for2004 were 18,344 shares, generating proceeds to the Company of $172,000 at an

 

58

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average purchase price of $9.37; for 2003 were 12,995 shares,generating proceeds to the Company of $151,000 at an average purchase price of$11.59; and purchases for 2002 were 24,539 shares, generating proceeds to theCompany of $131,000 at an average purchase price of $5.32.  As of December 31, 2004, there are 83,109shares of common stock reserved for purchases under the ESPP.

 

**Stock-based compensation**

 

For purposes of calculating the fair value of options under FASBStatement No. 123, the weighted average fair values of options grantedwere:

 
| ** **                    | ** ** | **For the  Years Ended December 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Options under  the 1997 Plans |       | $                                          | 8.30       |   | $ | 8.20 |   | $ | 5.03 |   |
| Non-plan options              |       | $                                          | —     |   | $ | — |   | $ | 5.13 |   |
| Options under  ESPP           |       | $                                          | 1.65       |   | $ | 2.04 |   | $ | 0.94 |   |

 

 

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

 
| ** **                  | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2002** | ** ** |
| Expected option  life       |       | 5.0 years                                 |       | 5.0 years |   | 5.0 years |   |
| Expected  volatility factor |       | 83.0                                      | %          | 84.7 | % | 85.9 | % |
| Expected  dividend yield    |       | 0                                         | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 3.41                                      | %          | 3.07 | % | 4.69 | % |

 

The fair values for the non-employee options were calculated using theBlack-Scholes option-pricing model with the following weighted-average assumptions:

 
| ** **                  | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2002** | ** ** |
| Expected option  life       |       | 5.38 years                                |       | 5.9 years |   | 8.0 years |   |
| Expected  volatility factor |       | 78.6                                      | %          | 84.5 | % | 85.9 | % |
| Expected  dividend yield    |       | 0                                         | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 3.50                                      | %          | 2.66 | % | 2.81 | % |

 

The weighted-average fair values of shares under the ESPP were based onthe 15% purchase discount.

 

**Warrants**

 

In December 1999, the Company completed a private placement of 1.65million units at $3.25 per unit.  Eachunit consisted of one share of the Company’s common stock and a redeemable,five-year warrant to purchase an additional share of common stock at $3.75 pershare.  The warrants were immediatelyexercisable with an expiration date in December 2004.  The warrants could be redeemed by the Companyat any time before December 2004 at a redemption price of $.01 perwarrant, upon notice of such redemption, provided that (i) the closing bidprice of the Company’s common stock exceeded $5.75 per share for any thirtyconsecutive trading days prior to such notice and (ii) a registrationstatement covering the resale of the warrant shares had been filed by theCompany with the Securities and Exchange Commission and was effective as of thedate of such notice. The Company satisfied the conditions for redemption of thewarrants on December 7, 2000. In December 2001, the Company calledfor redemption of all outstanding warrants. As of December 31, 2003, all 1.65 million warrants had beenexercised, generating proceeds of $1.7 million and $4.5 million during 2002 and2001, respectively.

 

The Company also issued warrants to the selling agent for the December 1999private placement to purchase 163,651 shares of the Company’s common stock at$3.25 per share.  The warrants wereimmediately exercisable and expired in December 2004.  During 2004, 2003 and 2002, warrants topurchase 19,156, 83,063 and 42,492 shares, respectively, were exercised.  These warrant exercises generated proceeds of$18,800, $248,000, and $6,000 for the years ended December 31, 2004, 2003and 2002, respectively.  In conjunctionwith these exercises, during 2004, 2003 and 2002, 3,362, 1,693 and 12,559shares, respectively, were forfeited as part of cashless exercises.  As of December 31, 2004, none of thesewarrants remained outstanding.

 

59

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**Rights plan**

 

In April 1997, the Company declared a dividend distribution of onePreferred Stock Purchase Right for each outstanding share of the Company’scommon stock (the “Rights”).  Withcertain exceptions, the Rights become exercisable only if one of the followingevents occurs: (i) an acquiring party accumulates 15% or more of theCompany’s common stock, (ii) a party announces an offer to acquire 15% ormore of the Company’s common stock, or (iii) the acquisition of asubstantial amount of the Company’s common stock by a person whom the Board ofDirectors has determined is an “Adverse Person” as defined in the underlyingRights Agreement.  Each Right entitlesthe holder to purchase one-thousandth of a share of the Company’s Series AJunior Preferred Stock at a price of $20.00 (the “Exercise Price”).  If a person or group becomes the beneficialowner of 15% or more of the Company’s common stock or the Board of 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.****              Income taxes**

 

The income tax provision (benefit) for the years ended December 31,2004, 2003 and 2002 include the following components:

 

 
| ** **                            | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------|------------|------------------------------------------|------------|
| ** **                            | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current income  taxes:                |       |                                     |       |   |   |   |   |
| Federal                               |       | $                                        | 25,000     |   | $ | — |   | $ | — |   |
| State                                 |       | 5,000                                    |       | 79,000 |   | 22,000 |   |
|                                  |       | 30,000                                   |       | 79,000 |   | 22,000 |   |
| Deferred income  taxes:               |       |                                     |       |   |   |   |   |
| Federal                               |       | 513,000                                  |       | (7,657,000 | ) | — |   |
| State                                 |       | 44,000                                   |       | 1,265,000 |   | — |   |
|                                  |       | 557,000                                  |       | (6,392,000 | ) | — |   |
| Provision  (benefit) for income taxes |       | $                                        | 587,000    |   | $ | (6,313,000 | ) | $ | 22,000 |   |

 

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

 
| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                            | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| Tax provision  computed at the federal statutory rate |       | $                                        | 300,000    |   | $ | 726,000 |   | $ | 276,000 |   |
| State taxes, net  of federal benefit                  |       | 94,000                                   |       | 116,000 |   | 24,000 |   |
| Increase  (decrease) in tax from:                     |       |                                     |       |   |   |   |   |
| Research and  development tax credits                 |       | (319,000                                 | )          | (85,000 | ) | (186,000 | ) |
| Business meals  and entertainment                     |       | 46,000                                   |       | 34,000 |   | 26,000 |   |
| Acquired  in-process research and development         |       | 340,000                                  |       | — |   | — |   |
| Change in state  tax rate                             |       | (54,000                                  | )          | — |   | — |   |
| Change in  valuation allowance                        |       | 226,000                                  |       | (7,171,000 | ) | (111,000 | ) |
| Other, net                                            |       | (46,000                                  | )          | 67,000 |   | (7,000 | ) |
| Provision  (benefit) for income taxes                 |       | $                                        | 587,000    |   | $ | (6,313,000 | ) | $ | 22,000 |   |

 

The significant components of the Company’s tax-effected net deferredtax assets, based on an assumed effective tax rate of 37.96% and 37.30% as of December 31,2004 and 2003, respectively, are as follows:

 

60

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| ** **                                          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Current:                                            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accrued expenses  and allowances                    |       | $                     | 600,000    |   | $ | 275,000 |   |
| Total current                                       |       | $                     | 600,000    |   | $ | 275,000 |   |
|                                                |       |                  |       |   |   |
| Noncurrent:                                         |       |                  |       |   |   |
| Net operating  loss carryforwards                   |       | $                     | 8,880,000  |   | $ | 8,101,000 |   |
| Research and  development tax credit carryforwards  |       | 1,570,000             |       | 1,063,000 |   |
| Depreciation and  amortization                      |       | 434,000               |       | 287,000 |   |
| Deferred revenue                                    |       | 105,000               |       | — |   |
| Identified  intangible assets                       |       | (2,193,000            | )          | — |   |
| Other, net                                          |       | 31,000                |       | 2,000 |   |
| Net deferred tax  assets before valuation allowance |       | 8,827,000             |       | 9,453,000 |   |
| Less valuation  allowance                           |       | (373,000              | )          | (147,000 | ) |
| Total noncurrent                                    |       | $                     | 8,454,000  |   | $ | 9,306,000 |   |

 

**Net operating loss carryforwards and other taxcredit carryforwards as of December 31, 2004**

 

The Company had federal tax losscarryforwards of approximately $24.5 million, representing an $8.3 milliondeferred tax asset as of December 31, 2004.  Of the total federal tax loss carryforward,$8.5 million was generated through the exercise of stock options.  The federal tax loss carryforwards willexpire in 2005 through 2023 if not utilized. The Company recorded a $79,000valuation allowance related to this deferred tax asset as of December 31,2004 due to the uncertainty in realization prior to expiration.

 

The Company had state tax loss carryforwardsof approximately $9.7 million, representing a $506,000 deferred tax asset as ofDecember 31, 2004.  The state taxloss carryforwards will expire in 2005 through 2024 if not utilized. TheCompany recorded a $9,000 valuation allowance related to this deferred taxasset as of December 31, 2004 due to the uncertainty in realization priorto expiration.

 

The Company had foreign tax losscarryforwards of approximately $144,000, representing a $43,000 deferred taxasset as of December 31, 2004.  TheCompany provided a full valuation allowance related these deferred tax assets asof December 31, 2004 due to the uncertainty in realization.

 

The Company had other federal and state taxcredits and carryforwards of approximately $1.6 million, representing a $1.6million deferred tax asset as of December 31, 2004.  The federal and state credits andcarryforwards will expire in 2005 through 2024 if not utilized.  The Company had a $242,000 valuationallowance related to this deferred tax asset as of December 31, 2004 dueto the uncertainty in realization prior to expiration of which $95,000 wererecorded in 2004.

 

**Activity during the year ended December 31,2004**

 

The Company’s methodology for determining therealizability of its deferred tax assets involves estimates of future taxableincome from its core business, the estimated impact of future tax deductionsfrom the exercise of stock options outstanding as of December 31, 2004,and the expiration dates and amounts of net operating loss carryforwards andother tax credits. These estimates are projected through the life of therelated deferred tax assets based on assumptions which management believes tobe reasonable and consistent with current operating results.

 

Although the Company had cumulative pre-taxincome for financial reporting purposes for the three years ended December 31,2004, the Company did not pay any significant income taxes over that period dueto tax deductions from the exercise of stock options as well as its utilizationof net operating losses.  In assessingthe realizability of its deferred tax assets as of December 31, 2004, theCompany considered evidence regarding its ability to generate sufficient futuretaxable income to realize its deferred tax assets. The primary evidenceconsidered included the cumulative pre-tax income for financial reportingpurposes for the past three years; the cumulative tax operating loss for thepast three years; the estimated impact of future tax deductions from theexercise of stock options outstanding as of December 31, 2004; and theestimated future taxable income based on historical operating results.

 

61

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After giving consideration to these factors,the Company concluded that it was more likely than not that tax losscarryforwards that expire in 2005 and other tax credits that expire within thenext four years will not be utilized due to the estimated future tax deductionsfrom the exercise of stock options outstanding as of December 31,2004.  As a result, the Company recordeda valuation allowance of $183,000 for the year ended December 31,2004.  The Company also recorded avaluation allowance of $43,000 relating to 2004 foreign net operating lossesthat are subject to uncertainty regarding utilization and, therefore, a fullvaluation allowance was recorded.

 

The Company also concluded that it was morelikely than not that the net deferred tax assets of $9.1 million as of December 31,2004 and the estimated future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2004 would be utilized prior toexpiring.  Based on this conclusion, theCompany would require approximately $42 million in cumulative future taxableincome to be generated at various times over the next twenty years to realizethe related net deferred tax assets of $9.1 million as of December 31,2004 as well as the estimated future tax deductions from the exercise of stockoptions outstanding and in-the-money as of December 31, 2004.

 

In the event that the Company adjusts itsestimates of future taxable income or tax deductions from the exercise of stockoptions; or the Company’s stock price increases significantly without acorresponding increase in taxable income, the Company may need to establishadditional valuation allowances, which could materially impact its financialposition and results of operations.

 

**Activity during the year ended December 31,2003**

 

During 2003, the Company concluded that it ismore likely than not that substantially all of its net deferred tax assetswould be 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 was 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 reversal of thevaluation allowance resulted in a tax benefit of $7,171,000.  This reversal, net of other current yearstate and federal income taxes, resulted in a net tax benefit of $6,507,000 in2003.

 

**Net operating loss carryforwardlimitations**

 

Under Section 382 of the InternalRevenue Code (“Code”) of 1986, certain stock transactions which significantlychange ownership, including the sale of stock and the granting of options topurchase stock, could limit the amount of net operating loss carryforwards thatmay be utilized on an annual basis to offset taxable income in futureperiods.  Future changes in ownership, asdefined by Section 382, could result in additional limitations in theamount of net operating loss carryforwards that may be utilized on an annualbasis.

 

As a result of Bio-Vascular’s acquisition ofthe Company in May 1994, the Company experienced an ownership change asdefined by Section 382 of the Code. Under the Code, the amount of pre-acquisition net operating losscarryforwards and research and development credits that can be used to offsetfuture taxable income and income taxes will be limited.  As of the date of the Company’s acquisitionby Bio-Vascular, the Company had approximately $1,800,000 of net operating losscarryforwards and $137,000 of research and experimentation credits, both ofwhich will be subject to limitation under the Code.

 

**8.****              Employee benefitplan**

 

The Company maintains the Vital Images, Inc. Salary Savings Plan(the “Plan”), which is intended to qualify under Section 401(k) of theInternal Revenue Code, as amended.  ThePlan covers substantially all employees. Each employee may elect to contribute to the Plan through payrolldeductions of up to 25% of his or her salary, subject to certainlimitations.  At the discretion of theBoard of Directors, the Company may make matching contributions equal to apercentage of the salary reduction contributions or other discretionary amounts.  The Company paid $43,600 in matching contributionsin 2004.  There were no contributions tothe Plan by the Company in 2003 or 2002.

 

62

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**9.****              Major customers andgeographic data**

 

Customers accounting for more than 10 percentof the Company’s total revenue are as follows:

 
| ** **                           | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                 |       |                                     |       |   |   |   |   |
| Toshiba Medical  Systems Corporation |       | $                                        | 18,130,000 |   | $ | 11,554,000 |   | $ | 7,246,000 |   |
| Percentage of  total revenue         |       | 50                                       | %          | 42 | % | 34 | % |
|                                      |            |                                          |            |  |  |  |  |  |  |  |

 

The Company’s accounts receivable are generally concentrated with asmall base of customers.  As of December 31,2004, Toshiba accounted for 23% of the accounts receivable balance.  As of December 31, 2003, no singlecustomer accounted for more than 10% of the accounts receivable balance.

 

All significant long-lived assets of the Company are located in theUnited States.

 

Export revenue accounted for 17%, 13% and 10% of total revenue for theyears ended December 31, 2004, 2003 and 2002, respectively.  Substantially all of the Company’s exportsales are negotiated, invoiced and paid in U.S. dollars.

 

Export sales by geographic area are summarized as follows:

 

 
| ** **   | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------|------------|------------------------------------------|------------|
| ** **   | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
|         |       |                                     |       |   |   |   |   |
| Europe       |       | $                                        | 3,692,000  |   | $ | 2,421,000 |   | $ | 1,094,000 |   |
| Asia-Pacific |       | 1,320,000                                |       | 846,000 |   | 709,000 |   |
| Canada       |       | 912,000                                  |       | 75,000 |   | 161,000 |   |
| Other        |       | 166,000                                  |       | 312,000 |   | 49,000 |   |
|         |       | $                                        | 6,090,000  |   | $ | 3,654,000 |   | $ | 2,013,000 |   |

 

**10.****       Quarterly financial data(unaudited)**

 

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

 
| ** **                                | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|-------------------------------------------|------------|-------------------|------------|--------------------|------------|-------------------|------------|--------------------|------------|
|                                      |       |              |       |               |       |              |       |               |       |
| **2004**                                  |       |              |       |               |       |              |       |               |       |
| Total revenue                             |       | $                 | 7,816,000  |               | $          | 7,960,000         |       | $                  | 9,248,000  |   | $ | 11,098,000 |   |
| Gross profit                              |       | $                 | 5,479,000  |               | $          | 5,399,000         |       | $                  | 6,643,000  |   | $ | 8,154,000 |   |
| Net income  (loss)                        |       | $                 | (1,352,000 | )                  | $          | 78,000            |       | $                  | 670,000    |   | $ | 900,000 |   |
| Earnings per  share – basic          |       | $                 | (0.12      | )                  | $          | 0.01              |       | $                  | 0.06       |   | $ | 0.08 |   |
| Earnings per  share – diluted        |       | $                 | (0.12      | )                  | $          | 0.01              |       | $                  | 0.05       |   | $ | 0.07 |   |
|                                      |       |              |       |               |       |              |       |               |       |
| **2003**                                  |       |              |       |               |       |              |       |               |       |
| Total revenue                             |       | $                 | 6,945,000  |               | $          | 7,660,000         |       | $                  | 7,404,000  |   | $ | 5,291,000 |   |
| Gross profit                              |       | $                 | 5,330,000  |               | $          | 5,627,000         |       | $                  | 5,627,000  |   | $ | 3,645,000 |   |
| Net income  (loss)                        |       | $                 | 801,000    |               | $          | 790,000           |       | $                  | 6,814,000  |   | $ | 57,000 |   |
| Earnings (loss)  per share – basic   |       | $                 | 0.09       |               | $          | 0.08              |       | $                  | 0.62       |   | $ | 0.01 |   |
| Earnings (loss)  per share – diluted |       | $                 | 0.08       |               | $          | 0.07              |       | $                  | 0.53       |   | $ | 0.00 |   |

 

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**Vital Images, Inc.Form 10-K**

 

**Index to Exhibits**

 
| **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         |       | Amended and Restated Development, Supply, Marketing  and Distribution Agreement dated as of June 1, 2003 by and between Vital  Images, Inc. and E-Z-EM, Inc. (incorporated by reference to Exhibit 10.1  to the Company’s Current Report on Form 8-K filed on August 3, 2004  (File No. 0-22229)).*                                              |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.2         |       | Schedule of Executive Officer Compensation                                                                                                                                                                                                                                                                                                                                          |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                     |
| 21.1         |       | Subsidiaries of Registrant                                                                                                                                                                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                     |
| 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.

 

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