**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the fiscal year endedDecember 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition period from             to         **

**Commission file number: ****0-22229**

**Vital Images, Inc.**

(Exact name of registrant as specified in itscharter)

| **Minnesota**                             | ** ** | **42-1321776**                        |
|-------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)           |       |                                  |
|                                      |       |                                  |
| **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:

| **Title of Each Class**                                        |   | **Name of  Each Exchange on Which Registered** |
|----------------------------------------------------------------|--------|------------------------------------------------|
| Common Stock,  $.01 par value; Preferred Stock Purchase Rights |   | Nasdaq Global  Market                          |

 

Securities registered pursuant to Section 12(g) of the Act: **None**

**Notapplicable.**

(Former name, former address and former fiscalyear, if changed since last report)

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act.

Yes o         No x

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Exchange Act.

Yes o         No x

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.       Yes x          No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.   o

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

Large accelerated filer o   Acceleratedfiler x   Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).  Yes o      No x

As ofJune 30, 2006, the last day of the registrant’s most recently completedsecond fiscal quarter, the aggregate market value of the registrant’s commonstock held by non-affiliates of the registrant was $326,325,162. The commonstock is the registrant’s only class of voting stock.

The number of shares outstanding of the issuer’s class of commonstock as of February 28, 2007 was 16,975,038 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of registrant’sdefinitive Proxy Statement in connection with the Annual Meeting ofStockholders to be held May 3, 2007 (“2007 Proxy Statement”) areincorporated by reference into Part III of this Form 10-K, asindicated in Items 10 through 14 of Part III.

 

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Vital Images, Inc.Form 10-K

Table of Contents
|            |   | Part I                                                                                                         |
|------------|--------|---------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                |
| Item 1.    |   | Business                                                                                                            |
| Item  1A.  |   | Risk Factors                                                                                                        |
| Item 1B.   |   | Unresolved Staff Comments                                                                                           |
| 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, Executive Officers and Corporate Governance                                                              |
| 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, and  Director Independence                                          |
| 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 RegardingForward-Looking Information**

*VitalImages desires to take advantage of the “safe harbor” provisions of the PrivateSecurities Litigation Reform Act of 1995 (the “Reform Act”) and is filingthis cautionary statement in connection with the Reform Act. This AnnualReport on Form 10-K and any other written or oral statements made by or onour behalf may include forward-looking statements that reflect our currentviews with respect to future events and future financial performance. Certain statements in this Annual Report onForm 10-K are “forward-looking statements” within the meaning ofSection 27(a) of the Securities Act of 1933 and Section 21E ofthe Securities Exchange Act of 1934. You can identify these forward-looking statementsby our use of the words “believes,” “anticipates,” “forecasts,” “projects,” “could,”“plans,” “expects,” “may,” “will,” “would,” “intends,” “estimates” and similarexpressions, whether in the negative or affirmative. We wish to cautionyou that any forward-looking statements made by us or on our behalf are subjectto uncertainties and other factors that could cause such statements to bewrong.**We cannot guarantee thatwe actually will achieve these plans, intentions or expectations. Actualresults or events could differ materially from the plans, intentions andexpectations disclosed in the forward-looking statements that we make.  These statements are onlypredictions and speak only of our views as of the date the statements weremade. Although we believe that the expectations reflected in theforward-looking statements are reasonable, we cannot guarantee future results,levels of activity, and/or performance of achievements.  We do not assume any obligation to update orrevise any forward-looking statements that we make, whether as a result of newinformation, future events or otherwise.*

*Factors thatmay impact forward-looking statements include, among others,**our abilities to maintain the technologicalcompetitiveness of our current products, develop new products, successfullymarket our products, respond to competitive developments, develop and maintainpartnerships with providers of complementary technologies, manage our costs andthe challenges that may come with growth of our business, and attract andretain qualified sales, technical and management employees. We are alsoaffected by the growth and regulation of the medical technology industry,including the acceptance of enterprise-wide advanced visualization byhospitals, clinics, and universities, product clearances and approvals by theUnited States Food and Drug Administration and similar regulatory bodiesoutside the United States, and reimbursement and regulatory practices byMedicare, Medicaid, and private third-party payer organizations. We are alsoaffected by other factors identified in our filings with the Securities andExchange Commission, some of which are set forth in the section entitled “Item1A.Risk Factors” 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 thefuture in affecting our operating results. New factors emerge from time totime, and it is not possible for us to predict all of these factors, nor can weassess the impact each factor or combination of factors may have on ourbusiness.*

**Item 1.Business**

**Our Business**

VitalImages, Inc. (“Vital Images,” “we,” “us,” or “our”) is a leading providerof enterprise-wide advanced visualization and image analysis solutions for useby medical professionals in clinical analysis and therapy planning for medicalconditions. We provide software, training, software maintenance, professional servicesand, on occasion, third-party hardware to our customers. Our technology rapidlytransforms complex data generated by diagnostic imaging equipment intofunctional digital images that can be manipulated and analyzed using ourspecialized applications to better understand internal anatomy and pathology.Our solutions are designed to improve physician workflow and productivity,enhance the ability to make clinical decisions, facilitate less invasivepatient care, and complement often significant capital investments indiagnostic imaging equipment made by our customers. Our software is compatiblewith equipment from all major manufacturers of diagnostic imaging equipment,such as computed tomography, or CT, magnetic resonance, or MR, and positronemission tomography, or PET, scanners, and can be integrated into picturearchiving and communication systems, or PACS. Many hospitals use PACS toacquire, distribute and archive medical images and diagnostic reports, reducingthe need for film and increasing reliance on advanced visualization solutionssuch as ours. We also offer a Web-based solution that provides physicians withanywhere, anytime access to medical images and visualization tools through anyInternet-enabled computer.

We were foundedand incorporated in Iowa in September 1988, and we re-incorporated inMinnesota in March 1997. Our principal executive offices are located at5850 Opus Parkway, Suite 300, Minnetonka, MN 55343

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(telephone (952)487-9500, facsimile (952) 487-9510, e-mail — info@vitalimages.com ). FromMay 24, 1994 through May 11, 1997, we were a wholly-owned subsidiaryof Bio-Vascular, Inc., which is now known as Synovis LifeTechnologies, 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-K, otherreports and documents filed with or furnished to the United States Securitiesand Exchange Commission (the “SEC”) and amendments to these reports availablefree of charge as soon as reasonably practicable after such reports are filedwith or furnished to the SEC. The “Corporate Governance” category of theInvestors section of our website also contains free copies of the Chartersfor the Audit Committee, Compensation Committee, and Governance Committee ofour Board of Directors, as well as our Code of Business Conduct and Ethics,which is our written code of ethics under Section 406 of theSarbanes-Oxley Act of 2002. Each of the above referenced documents can also beobtained free of charge (other than a reasonable charge for copying exhibits toour reports on Forms 10-K, 10-Q or 8-K) in print by any shareowner who requeststhem from our investor relations department. The investor relations department’semail address is investorrelations@vitalimages.com and its mail address is:Investor Relations, Vital Images, Inc., 5850 Opus Parkway,Suite 300, Minnetonka, MN 55343. Information available onour website is not incorporated by reference into this Annual Report onForm 10-K.

You may also obtain copies of our SEC filings on the SEC’s website at www.sec.gov or at the SEC’s Public Reference Room at 100 F Street N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

Vitrea®, ourflagship software product, is an easy-to-use, intuitive, high-speed volumerendering technology that creates interactive two-dimensional, or 2D,three-dimensional, or 3D, and four-dimensional, or 4D, images from informationgenerated by standard CT, MR or PET scanners. Vitrea is commonly deployed onstandalone workstations, using standard computer hardware, and providesadvanced visualization for radiological, cardiac, oncological and surgicalapplications. Vitrea renders vibrant, clear, color images at high speeds andenables users to interactively navigate within these images to visualize,measure and understand internal structures and disease conditions. We believeour user interfaces are intuitive, and they are specifically configured toassist physicians in optimizing their clinical workflow.

We recentlyintroduced VitreaACCESSTM, which provides physicians remote access to the fullsuite of advanced visualization and analysis tools provided by Vitrea software.It offers a cost effective solution designed to enable users to leverageworkstations by allowing secure access to Vitrea applications from any personalcomputer in a facility or from external locations through a virtual privatenetwork, or VPN.

ViTALConnect®, ourWeb-based solution, allows multiple physicians to collaboratively useenterprise-wide advanced visualization in their medical practices. It providesradiologists and referring physicians anywhere, anytime access to interactive2D, 3D and 4D medical images and the ability to measure, rotate, analyze andsegment those images. Our latest release includes features previously availableonly on multimodality workstations, such as a variety of multi-planar reformat,or MPR, modes, thick slab rendering in MPR, 3D volumetric visualization withsimple point of interest navigation, 4D dataset visualization, CT/PET fusionand advanced analysis tools.

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We also offerenterprise-wide advanced visualization options that can expand the relevance ofour products beyond the radiology department to referring physicians andsurgical specialists, particularly in the areas of cardiology, cardiovascular,oncology, neurology and gastroenterology. Our advanced visualization optionsallow physicians to customize their *Vitrea*software according to their unique requirements. Most options are proprietary;however, *Vitrea* also serves as anintegration platform for the applications offered by our visualizationtechnology partners. *Vitrea’s*add-on options include:
| **Vitrea Option**                         | ** ** | **Clinical Use**                                                                                         |
|-------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ·VScore                              |       | —Quantify calcium in the four major coronary  arteries                                              |
| ·CT  Brain Perfusion                 |       | —Analyze the blood flow of stroke victims                                                           |
| ·Innerview  GI (virtual colonoscopy) |       | —Locate and analyze polyps in the colon                                                             |
| ·Automated  Vessel Measurements      |       | —Characterize the course and dimensions of diseased  blood vessels                                  |
| ·CT  Cardiac                         |       | —Determine the extent of obstructive coronary artery  disease                                       |
| ·Vessel  Probe                       |       | —Define vascular anatomy and the extent of  obstruction in vessels other than the coronary arteries |
| ·CT  Lung and Lung Tools             |       | —Visualize and measure nodules in the lungs                                                         |
| ·ImageChecker®  CT              |       | —Detect pulmonary nodules in the chest                                                              |
| ·Fusion7DTM                      |       | —Visualize images and fuse studies from multiple  modalities, such as MR and PET                    |
| ·CADstreamTM                     |       | —Analyze MR breast exams                                                                            |
| ·QMassTM  MR                     |       | —Analyze MR cardiac images                                                                          |
| ·SUREPlaqueTM                    |       | —Aid in evaluating, characterizing and quantifying  plaque inside the coronary arteries             |

 

Our softwaresolutions are used with medical diagnostic equipment, primarily in clinicalanalysis and therapy planning. Our software applies proprietary technologies toa variety of data supplied by CT, MR and PET scanners to allow medicalclinicians 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. We market *Vitrea*and *ViTALConnect* both as standalone software packages and aspart of integrated software and hardware systems to radiologists,surgeons, primary care physicians and medical researchers. Our main customersare hospitals and clinics, university medical schools, and diagnostic imagingcompanies. We market our products and services to these customers both directlythrough our own sales force and indirectly through digital imaging equipmentmanufacturers and PACS companies, who sell our products with products theyeither manufacture or acquire from third parties.

Our products workwith equipment from all major manufacturers of diagnostic imaging systems,including Toshiba Medical Systems Corporation, GE Medical Systems, SiemensMedical Systems, Inc. and Philips Medical Systems. Our productsmay also be integrated into PACS, such as those marketed by McKessonCorporation, Sectra AB and DR Systems, Inc. and run on off-the-shelf thirdparty computer hardware manufactured by companies such as Dell, Inc. andHewlett-Packard Company.

**Maintenanceand Support**

In addition tosystem and software products, we market maintenance and support services, aswell as certain other services, such as installation and training. Inconnection with licensing *Vitrea*and *ViTALConnect* software, we offer annual maintenance and support services for both *Vitrea* and *ViTALConnect* pursuant to which weprovide software updates, minor feature enhancements, error correction,telephone support and other general support services. Our maintenance andsupport services do not include installation, training and other services,whether on- or off-site, which can be purchased separately.

**MarketOpportunity**

We believe theexpansion in the number and complexity of medical imaging examinationsassociated with CT scanners creates a substantial opportunity for us in theradiology market. Historically, imaging equipment generated comparatively lowamounts of image data that was typically viewed using film. However, currentgeneration CT and MR scanners are capable of quickly generating as many as10,000 discrete images, or slices, in a single imaging exam, which is more than20 times as many images as were generally attained in exams as few as fiveyears ago. This substantial data output cannot be analyzed in a timely orcost-effective manner using film or manual workflow

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and necessitatesdigital solutions capable of handling these large data sets efficiently andaccurately. Radiologists, who are in short supply, require advancedvisualization solutions that can quickly render 2D, 3D and 4D images to improvetheir productivity.

The cardiologymarket represents a significant and relatively new market opportunity for us.Although radiologists have historically used our cardiology and cardiovascularapplications, cardiologists are beginning to own and operate their own CTscanners. Advancements in technology now allow cardiologists to performnon-invasive diagnostic imaging procedures that were previously done invasivelyin a cardiac catheterization clinic. This growing interest among cardiologistsin cardiac CT imaging procedures expands our potential end-user market. Inaddition to cardiology, we believe other clinical specialties are increasinglyusing advanced visualization and analysis tools to improve productivity andfacilitate less invasive patient care, including neurology, women’s health,respiratory and pulmonary, and gastrointestinal.

We also expect tobenefit as medical images are increasingly used throughout the healthcareenterprise and in new, innovative ways. Once considered the domain of radiologists,images are now being used by referring physicians to educate patients, plantreatment and monitor patient progress. Physicians also use imaging technologyon an increasing basis in connection with their review of possible patientmedical conditions such as lung or colon cancer. This shift has created demandfor advanced visualization solutions that can be accessed by physiciansthroughout the enterprise. We facilitate enterprise-wide advanced visualizationby distributing images and certain analysis tools directly using ViTALConnectand VitreaACCESSTM, which allow remote access to Vitrea’s toolset, as well asthrough our ability to integrate with PACS.

We believe thefollowing factors together have increased the demand for our products and willcontinue to drive market growth in the future:

·                  increasingnumber of imaging exams performed due to the expanded use of CT imagingprocedures by physicians and an aging U.S. population;

·                  technologicaladvancements enabling CT and MR scanners to generate thousands of images perexam;

·                  demandfrom radiologists and referring physicians for enterprise-wide advancedvisualization solutions that can improve productivity, optimize clinicalworkflow and enhance treatment planning;

·                  increasinguse of imaging technology in departments outside of radiology, in part due tothe integration of advanced visualization with PACS; and

·                  growingimportance of integrating advanced visualization and analysis tools into theclinical enterprise to facilitate collaboration among physicians, increaseaccess to information and improve workflow productivity.

**Strengths**

One of our keycompetitive differentiators from other advanced visualization providers is ourfocus on, and investment in, developing intuitive, user-friendly software. Eachof our software products is designed to automate common elements of physicianvisualization workflow, which makes our software simple to use and facilitatesuser adoption. We believe our optimized workflow automation is an importantfactor that customers consider when choosing our advanced visualizationsolutions. We believe that the following additional competitive strengths alsocontribute to our success:

·                  ourcompatibility with all major diagnostic imaging scanners and with most PACS andclinical enterprise software;

·                  ourability to render integrated 2D, 3D and 4D images at high speeds and withinteractive navigation capabilities using a relatively low-cost standardcomputer;

·                  ourmodular products for digital equipment manufacturers, PACS vendors and end-usercustomers that can easily be segmented or integrated depending on theenvironment; and

·                  ourability to distribute our applications throughout a healthcare enterprise usingfloating licenses, PACS integration and a Web-based solution.

The advancedvisualization market is highly competitive and subject to rapid change. Ourproducts compete based on quality, performance, functionality and features,quality of support and service, reputation, brand and price. Our primarycompetitors include diagnostic imaging equipment manufacturers, which aretypically large, multinational companies with greater financial and technicalresources. These companies, including GE Healthcare, Siemens MedicalSystems, Inc. and Philips Medical Systems, develop and market imaging equipmentthat may be purchased

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with integratedvisualization capabilities. We also face competition from PACS vendors, whichmay provide visualization capabilities in addition to their image archiving andnetworking products. Other advanced visualization suppliers, such as TeraRecon,Inc., compete on the basis of visualization technologies, specific applicationsor market niches.

**Strategy**

Our goal is to bea leading provider of enterprise-wide advanced visualization and image analysissolutions that we believe can improve clinical outcomes and reduce costs. Toachieve this goal, we intend to implement the following key strategies:

·                  developand maintain leading-edge, enterprise-wide advanced visualization technology;

·                  increasepenetration of our existing customer base;

·                  furtherexpand our presence in the enterprise-wide advanced visualization market eitherselling directly or through PACS integration;

·                  continueto build our international direct sales and marketing efforts;

·                  continueto seek collaborative partnerships with leading medical technology companies;and

·                  selectivelypursue strategic acquisitions.

**Marketingand Distribution**

We market *Vitrea* and *ViTALConnect* both as standalone software packages and aspart of integrated software and hardware systems to radiologists,surgeons, primary care physicians and medical researchers. We market ourproducts directly to end-user customers and through several business partners,including diagnostic imaging equipment manufacturers, PACS companies, and softwaredevelopers, all of whom sell our products with products they either manufactureor acquire from third parties.

Our marketing partnersinclude Toshiba Medical Systems Corporation (“Toshiba”), which markets *Vitrea* to**its customers through its subsidiaries and distributors inmore than 50 countries throughout the world. Our agreement with Toshibacommenced in 2001, and it has been extended by amendment three times, mostrecently through December 31, 2006. Sales through Toshiba are a materialportion of our revenues, comprising approximately 41% of our 2006 revenues, 47%of our 2005 revenues, and 50% of our 2004 revenues. We also have a jointdistribution agreement with McKesson Corporation (“McKesson”), a primaryprovider of PACS, under which each company has been granted the right todistribute the other party’s products. Sales through McKesson representedapproximately 10% of our 2006 revenues, 7% or our 2005 revenues, and 2% of our2004 revenues. See “Item 1A. Risk Factors - Dependence on Major Customers.”

We also have marketingand reseller agreements with several other companies, such as Emageon, Inc.,Cerner Corp., DR Systems, Inc. and Eclipsys, Inc., under which thesecompanies will resell our products to their customers as add-on components totheir products.

We license software andsell products and services to end-users and also indirectly through originalequipment manufacturers, value-added resellers and independent distributors.Payment terms for the resellers do not generally differ from those we provideto end users. See Note 9 to the Financial Statements, “Major Customers andGeographic Data,” for information regarding our export sales. As ofDecember 31, 2006, we had 48 salespeople in the U.S., two salespeople inEurope, one salesperson supporting national accounts, and one salespersonsupporting our international resellers outside of Europe.

**Collaborative Relationships**

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 haveentered into clinical collaboration agreements with universities and physiciansto:

·                  identifynew clinical applications where noninvasive imaging software can improveclinical outcomes and reduce costs;

·                  assistin the development of clinical routines that incorporate our clinical solutionsin normal diagnostic and therapy planning practices;

·                  consultin the development of new features that facilitate and improve analysis andtherapy planning for our

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future products;

·                  assessthe clinical value of our clinical solutions for given applications; and

·                  developautomated clinical protocols for CT or MR data.

**Competition**

Theenterprise-wide advanced visualization and analysis market is developing andgrowing rapidly. It is intensely competitive, subject to rapid change andsignificantly affected by new product introductions and other market activitiesof industry participants. Our primary competitors are diagnostic imaging systemsuppliers, which are typically large, multinational companies with far greaterfinancial and technical resources. They also have well-established sales anddistribution networks for their products. These companies, including GE MedicalSystems, Siemens Medical Systems, Inc., and Philips Medical Systems,develop and market medical imaging systems, such as CT and MR equipment, whichmay be purchased with integrated medical imaging capabilities. Oursoftware works on the products offered by each of these companies. To winbusiness against equipment manufacturers, we must convince customers to buy oursolution separately from their purchase of imaging equipment instead of buyingintegrated systems from our competitors.

We also facecompetition from PACS vendors and other suppliers of medical imaging systemsand software. PACS companies sometimes provide medical imaging capability inaddition to their image archiving and networking products. Vendors of hospital,clinical and radiology information systems have also diversified into the PACSand medical imaging product lines, either through internal development orbusiness development and partnership channels. These companies, whichmay be large or small, attempt to offer an integrated system covering afull range of administrative, clinical and radiology information managementcapabilities to healthcare providers. Other suppliers of medical imagingsystems and software, such as TeraRecon, Inc., compete on the basis ofvolume rendering or other visualization technologies, specific applications ormarket niches.

Our competitivestrength is based on several factors, including our ability to do thefollowing:

·                  provide differentiated solutions thatoperate in multi-vendor network and image source environments;

·                  provide clinical quality, integrated2D, 3D and 4D images, volume rendered at high speed with interactive navigationon a relatively low-cost standard computer;

·                  build user interfaces that are easyfor physicians and clinicians to use so that they do not need to be advancedtechnology experts to derive value from enterprise-wide advanced visualizationanalysis and solutions;

·                  integrate clinical knowledge from ourcollaborative clinical partners into our products;

·                  leverage our visualization andanalysis technology across multiple clinical disciplines;

·                  offer a “DICOM client” product, whichcan operate on any network conforming to the Digital Imaging and Communicationsin Medicine (DICOM) standard, independent of the imaging system and networkprovider;

·                  serve original equipmentmanufacturers (OEMs), PACS vendors and end-user customers through thedevelopment of a modular end-user product that can easily be segmented for OEMcustomers or integrated into a PACS environment; and

·                  offer our market-leading clinicalapplications into the broadening clinical enterprise through Web-baseddeployable solutions.

We believe thatproduct quality, performance, functionality and features, quality of supportand service, reputation, brand and price are also important competitivefactors. We believe that customers will prefer our solutions because they arethe best-in-class productivity tools for doctors. Although price has beenless significant than other factors, increasing competition in the marketmay result in price reductions and reduced gross margins. In particular,if one or more of the diagnostic imaging system suppliers, with their greatersize and scale, provides or distributes more competitive medical imagingproducts than ours, our business, financial condition and results of operationscould be materially adversely affected.

**Customers and Customer Support**

ThroughDecember 31, 2006, we had sold approximately 3,800 separate softwarelicenses for *Vitrea* and *ViTALConnect*foruse in hospitals and teaching hospitals, clinics, and imaging centers, both inmajor cities as well as in smaller population areas.

We are committedto rapid response to customer service requests. Customer supportrepresentatives are available

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during businesshours and on an on-call basis to answer questions about the operation,maintenance and repair of our products.

**Intellectual Property**

We rely primarilyon a combination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to our products and technologies. We also have agrowing portfolio of patents for our technology. Because of the rapid pace oftechnological change in the medical software industry, we believe that theknowledge, ability and experience of our personnel; new product developmentsand enhancements; and ongoing, reliable product maintenance and support willenhance our competitive position.

We do not own allof the software and other technologies used in our products, but we believe wehave the necessary licenses from third parties for using that technology in ourcurrent products. It may be necessary to renegotiate with such thirdparties for any new versions of current products or any new products. Suchthird party licenses may not be available on reasonable terms, or at all.

**Manufacturing and Service**

Our manufacturingefforts are limited to the production, quality assurance and distribution ofour software, which is distributed on CD-ROM. After we send software to ourcustomers, it is loaded into a workstation, either by our personnel, personnelfrom one of our authorized resellers, or our customers’ personnel. If ourpersonnel load the software, it is as part of our installation services.In addition to loading software into the workstation, our installation servicesgenerally include implementation of *Vitrea* and *ViTALConnect* software into customers’ computer networks,configuring the network requirements and verifying software operability onsite.

We providetraining services for our customers, both in connection with their acquisitionof our software and as independent purchases. A license of one copy of our *Vitrea* softwareentitles the customer to place two people at no additional charge in athree-day intensive training program held at our headquarters in Minnetonka,Minnesota.  We also conduct trainingprograms for our software at customers’ locations and at various designatedlocations through the United States. Some customers defer attending training for several months after thepurchase of our software or decline to attend the training. Additionally, weoffer standalone training programs, which are separately purchased bycustomers, for advanced education in the uses of our software and for specificclinical applications, such as cardiology.

We rely primarilyon our own software development as our core competence. We obtain certainapplication and utility software from third parties (see “—IntellectualProperty” above) and use a third party operating system for integrated computerworkstations. In addition, we obtain systems components, computers and computerperipherals from third party suppliers.

We have alsosigned reseller distribution agreements that allow us to distribute products fromcertain third parties. These third party products include R2 Technology, Inc.’sImageChecker® CT software applications for the detection of lung nodules;Siemens Molecular Imaging Fusion 7DTM software application for the anatomicalalignment of two different image data sets from two different types ofdiagnostic equipment, such as combining images from CT and PET scanners;Confirma Inc.’s CADstreamTM breast MRI software; and Medis Inc.’s QMass® MRsoftware.

**Governmental Regulation**

As medicaldevices, our software solutions are subject to extensive and rigorousregulation by numerous governmental authorities, principally the US Food andDrug Administration (“FDA”) and corresponding foreign agencies. In the UnitedStates, the FDA administers the Federal Food, Drug, and Cosmetic Act, itsamendments (the “FD&C Act”) and its related regulations. The FD&C Actand these regulations classify medical devices as Class I, II or IIIdevices, which are subject to general controls, special controls or pre-marketapproval requirements, respectively. Most Class I and II devices, as wellas some Class III devices, can be cleared for marketing pursuant to a510(k) pre-market notification. The process of obtaining a 510(k) clearancetypically can take several months to a year or longer.

Class IIIdevices generally require more stringent clinical investigation and pre-marketclearance requirements. In such cases, the FDA will require that themanufacturer submit a pre-market approval (“PMA”) application that must bereviewed and approved by the FDA prior to the sale and marketing of the devicein the United States. The process of obtaining a PMA can be expensive,uncertain and lengthy, frequently requiring anywhere from one to

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several years fromthe date of FDA submission, if approval is obtained at all. Moreover, a PMA, ifgranted, may include significant limitations on the indicated uses forwhich a product may be marketed.

*Vitrea*and *ViTALConnect* are classified asClass II medical devices and have received marketing clearances from theFDA as the result of 510(k) pre-market notifications. Specifically, *Vitrea, ViTALConnect*and the Company’s add-on options havebeen cleared to be marketed for use with CT, MR, and PET scanners. Futureproducts, add-on options to existing software, and expanded claims of efficacywill likely require additional 510(k) pre-market notifications.

There can be noassurance that future FDA review processes will not involve delays or thatclearances will be granted on a timely basis. If our current or future productsbecome classified as Class III devices, they could be subject to a moreexpensive, uncertain and lengthy approval process, and approval, if granted,could include significant limitations on the indicated uses for which a productmay be marketed.

We are alsosubject to regulation in foreign countries in which we sell our products. Manyof the regulations applicable to our products in such countries are similar tothose of the FDA. Our ability to successfully market and sell our products inforeign markets depends in large part on our ability to comply with suchforeign regulatory requirements. *Vitrea*softwarehas been Conformitee Europeene (“CE”) marked, indicating conformance withapplicable sections of the Medical Device Directive 93/42/EEC, which allows theproducts to be marketed in the member countries of the European Communities.

We are alsosubject to periodic inspections by the FDA and similar foreign regulatoryagencies, whose primary purpose is to audit our compliance with quality systemregulations established by the FDA and other applicable government standards.Regulatory action may be initiated in response to audit deficiencies orproduct performance problems. We believe that our manufacturing and qualitycontrol procedures comply with all applicable requirements of the FDA andforeign regulatory agencies in countries in which we sell our products. We havereceived and maintain ISO 13485: 2003 Certification.

Medicare andMedicaid laws and regulations may impact the financial arrangementsthrough which we market, sell and distribute our products and services topatients who are Medicare or Medicaid beneficiaries. Violations of these lawsand regulations may result in civil and criminal penalties, includingsubstantial 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 a national level, several health carereform initiatives have been proposed which would have a similar impact.We believe that our operations and our marketing, sales and distribution practicescurrently comply with all current applicable fraud and abuse and physiciananti-referral laws and regulations.

**Third Party 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 andmanaged care organizations, reimburse part or all of the costs and feesassociated with the diagnostic procedures utilizing our products. The medicalimaging services performed using our software, except for disease screeningprocedures, are covered by current CPT codes (Current Procedural Terminology,as defined by the Centers for Medicare & Medicaid Services). As such,hospitals providing services using our enterprise-wide advanced visualizationsolutions can seek reimbursement for such services by using existing approvedCPT codes. Medicare and Medicaid reimbursement for hospitals is based on afixed amount for admitting a patient with a specific diagnosis. Because of thisfixed reimbursement method, hospitals have incentives to use less costlymethods in treating Medicare and Medicaid patients, and they will frequentlymake capital expenditures to take advantage of less costly treatmenttechnologies. Often, reimbursement is reduced to reflect the availability of a new procedure or technique and, as aresult, hospitals are generally willing to implement new cost-savingtechnologies before these downward adjustments take effect. Likewise, becausethe rate of reimbursement for certain physicians who perform certainprocedures has been and may in the future be, reduced in the event ofchanges in the resource-based relative value scale method of payment calculation,physicians may seek greater cost efficiency in treatment to minimize anynegative impact of reduced reimbursement. Any amendments to existingreimbursement rules and regulations that restrict or terminate thereimbursement 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 our business.

In response to thefocus of national attention on rising health care costs, a number of changes toreduce costs have

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been proposed orhave begun to emerge. There have been, and may continue to be, proposalsby legislators and regulators and third party payers to reduce these costs.There has also been a significant increase in the number of Americans enrollingin some form of managed care plan and, in addition, many hospitalsparticipate in or have agreements with HMOs (health maintenance organizations).It has become a typical practice for hospitals to affiliate themselves with asmany managed care plans as possible. Higher managed care penetration typicallydrives down the prices of healthcare procedures, which in turn places pressureon medical supply prices. This causes hospitals to implement tighter vendorselection and certification processes by reducing the number of vendors used,purchasing more products from fewer vendors and trading discounts on price forguaranteed higher volumes to vendors. Hospitals have also sought to control andreduce costs over the last decade by joining group purchasing organizations orpurchasing alliances. We cannot predict what continuing or future impact thesepractices, the existing or proposed legislation, or such third party payermeasures may have on our future business.

**Health Insurance Portability and AccountabilityAct of 1996 (“HIPAA”)**

The HIPAAregulations cause our customers to request that we sign “business associate”agreements with them. A “business associate” is a person or entity thatperforms certain functions or activities that involve the use or disclosure ofprotected health information on behalf of, or provides services to, a coveredentity. 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 not carry out all of their health careactivities and functions by themselves. Instead, they often use the services ofa 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. Covered entities may disclose protectedhealth information to an entity in its role as a business associate *only* to help the covered entity carry outits health care functions — not for the business associate’s independent use orpurposes, except as needed for the proper management and administration of thebusiness associate.

**Employees**

As of December 31,2006, we had 283 full-time employees, with 100 involved in research anddevelopment, 75 in sales and marketing, 58 in technical support functions and50 in administrative functions. We believe our relationship with our employeesis good.

**Item 1A.********Risk Factors**

Discussion of ourbusiness and operations included in this annual report on Form 10-K should beread together with the risk factors set forth below. They describe variousrisks and uncertainties to which we are or may become subject. These risks anduncertainties, together with other factors described elsewhere in this report,have the potential to affect our business, financial condition, results ofoperations, cash flows, strategies or prospects in a material and adversemanner.  New risks may emerge at anytime, and we cannot predict those risks or estimate the extent to which theymay affect financial performance. Each of the risks described below couldadversely impact the value of our securities. These statements, like all statements in this report, speak only as ofthe date of this report (unless another date is indicated), and we undertake noobligation to update or revise the statements in light of future developments.

*If ourVitrea and ViTALConnect software do not continue to gain market acceptance, ourfinancial results would be adversely affected.*

Our successdepends on our ability to successfully market *Vitrea*and *ViTALConnect* software for clinical use,and on the ability and willingness of physicians to use enterprise-wide advancedvisualization medical imaging software in clinical analysis and therapyplanning. The enterprise-wide advanced visualization software offered by *Vitrea* and *ViTALConnect*are alternatives to the conventional methods traditionally used for viewingmedical images in the clinical setting. The acceptance of *Vitrea*and *ViTALConnect* by physicians and otherclinicians will depend on our ability to educate those users as to the speed,ease-of-use and other benefits offered by the *Vitrea*and *ViTALConnect* systems, as well as ourtimely introduction of new features and functions. There can be no assurancethat users will prefer advanced visualization and analysis software solutionsover less expensive 2D medical imaging software or that we will succeed in ourefforts to further develop, commercialize and achieve market acceptance for *Vitrea* and *ViTALConnect* orfor any other product in the clinical setting. Further, most of our business inmarkets outside the United States is provided through third parties with whomwe have marketing agreements. There can be no assurance that these thirdparties will wish to continue our relationships on an indefinite basis or underthe same

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terms as thebusiness is currently conducted. Further, we have undertaken efforts to developdirect relationships with customers in markets outside the United States, wemay not be successful in doing so at a sufficient level. The loss of or adversechanges in our relationships with our third-party business partners, and ourfailure to establish sufficient direct relationships with customers outside theUnited States, would have a material adverse impact on our business, financialcondition, and results of operations.

*Asubstantial portion of our revenue is derived from sales of our Vitreasoftware, and any decline in the sales of our Vitrea software would have amaterial adverse effect on our results of operations and financial condition.*

Revenue related tosales of our *Vitrea* software (which includessoftware, hardware and maintenance and services) constituted 97% of our totalrevenues for the year ended December 31, 2006, 95% of our total revenues forthe year ended December 31, 2005, and 94% of our total revenues for the yearended December 31, 2004. We anticipate that revenue from the sale of *Vitrea* will continue to account for a substantial portion ofour revenue for the foreseeable future. As such, any decline in sales of *Vitrea* would have a material adverse impact on our business,financial condition, and results of operations. Sales of *Vitrea*could decline for a number of reasons, including the availability ofalternative products that may be, or may be perceived to be, more effective,safer, easier to use or less costly than *Vitrea*; anyreduction or discontinuance of reimbursement from healthcare payors forprocedures using *Vitrea*; the failure of physiciansto adopt *Vitrea*; or other reasons discussed inthese risk factors.

*Wepresently depend on Toshiba Medical Systems Corporation, or Toshiba, andMcKesson Corporation, or McKesson,  for asignificant portion of our total revenues. A reduction in the business fromToshiba could adversely affect our revenues and could seriously harm ourbusiness.*

A limited numberof large customers may continue to account for a significant portion ofour revenue during any given period for the foreseeable future.  One of our principal distribution channels isto sell our *Vitrea*medical imaging software inconnection with medical imaging equipment sold by Toshiba. Sales to Toshibaaccounted for 41% of our total revenue for the year ended December 31, 2006,47% of our total revenue for the year ended December 31, 2005, and 50% ofour total revenue for the year ended December 31, 2004. Toshiba’s accountreceivable represented 41% of the Company’s accounts receivable at December 31,2006 and 36% at December 31, 2005.Except for our agreement with Toshiba, we have no long-term purchasecommitments from any of our customers or business partners, and we generallymake sales pursuant to individual transactions. Although our agreement withToshiba has been extended by amendment three times, most recently throughDecember 31, 2006, and although we are in discussions with Toshibaregarding a further extension, we can provide no assurance that our agreementwith Toshiba will be extended beyond December 31, 2006. We also have ajoint distribution agreement with McKesson Corporation (“McKesson”), a primaryprovider of PACS, under which each company has been granted the right todistribute the other party’s products. Sales through McKesson representedapproximately 10% of our 2006 revenues, 7% or our 2005 revenues, and 2% of our2004 revenues. McKesson’s account receivable represented 14% of the Company’saccounts receivable at December 31, 2006. A reduction, delay, or cancellationof orders from one or more of our significant customers, or our inability tocollect accounts receivable from these customers, likely would have a materialadverse effect on our financial condition and operating results.

*We areobligated to purchase a minimum volume of product from R2 Technology, Inc., orR2, and the revenue we generate from the sale of the product has been and couldbe less than our minimum commitment for the product.*

As part of ourbusiness, we may offer third party products as components within ourproducts or as optional modules to our products. As a condition of enteringinto these agreements, or for other business reasons, the third partiesmay require us to commit to purchase a certain volume of their products,irrespective of the amount of their products that we sell to our customers. Ifwe enter into such a volume commitment with a third party but do not sell asufficient volume of its products, then we may be required to pay thethird party directly for the deficit in sales. We incurred such an event in thefourth quarter of 2005 and the second quarter of 2006, during which we did notsell a sufficient volume of our partner R2’s lung nodulecomputer-aided-diagnosis software product to meet our quarterly purchasecommitment under our contract with R2, resulting in a loss of approximately$410,000 in the fourth quarter of 2005, of which $236,000 was reversed in thefirst quarter of 2006, and a loss of approximately $167,000 in the secondquarter of 2006. There can be no assurance that we will not have similardeficits in future quarters under commitments we may have made to R2 or otherproviders of third party products.

Regarding R2, ourcommitment was for approximately $414,000 per quarter through the quarter endedMarch 31, 2006. After March 31, 2006, the contractual commitmentscontinue through the quarter ended June 30, 2008, but if we do not meetthe applicable minimum in any particular quarter, they may be reduced tothe lower of: (i) the quarterly commitment of the preceding quarter multipliedby the percent by which the revenue we generated in the preceding quarter fellbelow that quarter’s quarterly commitment, up to a maximum decline of 23%; or(ii) two times the R2 Lung CAD product revenue generated by R2 during thepreceding quarter through all other sales,

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marketing anddistribution channels; provided, that**ifat any time during the remainder of the agreement the quarterly commitment isless than $414,000 and R2 Lung CAD product revenue for a quarter exceeds$414,000, our quarterly commitment for the next quarter will again be $414,000,and the quarterly commitment for the following quarters may again besubject to the above adjustment. Additionally, at the end of every fourthquarter under the R2 agreement, if the aggregate revenue generated under theagreement in the previous four quarters exceeded the aggregate applicableminimums, the remaining quarterly commitments shall be reduced by the amount ofexcess divided by the number of quarters remaining under the agreement. Based oninformation available to us, R2 had not generated any significant R2 Lung CADProduct sales through any other sales, marketing and distribution channels,other than sales generated from customers under this agreement.  As a result, the Applicable Minimum for thequarter ended December 31, 2006 was $0 and the Applicable Minimum for thequarter ending March 31, 2007 is $0. As of December 31, 2006, the remainingpotential aggregate contractual commitment ranges from a minimum of $0 to amaximum of approximately $2.1 million. The timing of sales of the R2 LungCAD product and the revenue resulting from such sales is difficult toaccurately forecast. We may not generate sufficient revenue to meet the minimumcontractual commitment for any particular quarter, and thus may have to paycash to R2 for the deficit. If we foresee that we will not be able to attainthe minimum contractual commitment on a continued basis, we may have to take alarger charge to our earnings, which could be up to the amount of our maximumremaining total commitment.

*We dependupon growth in the enterprise-wide advanced visualization market. If thatmarket does not grow as we expect, our business, results of operations andfinancial condition will be adversely affected.*

The enterprise-wideadvanced visualization industry in which we market our products is stilldeveloping due to:

·                  thefairly recent availability of high-resolution CT, MR and combined CT-PETscanners and high-performance computers at reduced prices;

·                  therecent adoption of industry standards for the generation, transmission andstorage of medical imaging data; and

·                  changingmedical practices.

Historically,there has been a perception that enterprise-wide advanced visualization was tooslow, unresolved or difficult for clinical use. This perception was due largelyto the relatively slower processing speed of available workstations and thereality that true volumetric acquisition was not previously available. Webelieve that recent advances in scanner acquisition resolution, increasingaffordability of high-performance computers and the development of industrystandards for the generation, transmission, and storage of imaging data willprovide opportunities for substantial growth in the medical software industry.However, given the uncertainties associated with the developing stage of thismarket, there can be no assurance that it will continue to develop in themanner we anticipate. Accordingly, there can be no assurance that theenterprise-wide advanced visualization industry will provide growthopportunities for us and our software products or that our business strategieswill be successful as the industry continues to evolve. Ultimately, if theenterprise-wide advanced visualization industry fails to develop as we expect, ourbusiness, results of operations and financial condition will be materially andadversely affected.

*Weparticipate in a highly competitive industry. If we fail to competeeffectively, our results of operations and financial condition would beadversely affected.*

We face intensecompetition in the enterprise-wide advanced visualization industry. We expecttechnology to continue to develop rapidly, and our success will depend to alarge extent on our ability to maintain a competitive position with our products.Our competitors in the enterprise-wide advanced visualization industry includelarge, established manufacturers of CT and MR imaging equipment. Companies suchas GE Healthcare, Siemens Medical Systems, Inc. and Philips Medical Systemstypically offer their own enterprise-wide advanced visualization software andworkstations as part of their integrated imaging and scanner systems. Oursoftware works on the products offered by each of these companies. To winbusiness against equipment manufacturers, we must convince customers to buy oursoftware solutions separately from their purchase of imaging equipment insteadof buying integrated systems from our competitors.

In addition tohaving a competitive advantage in marketing enterprise-wide advanced visualizationtools as 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 dynamic enterprise-wideadvanced visualization industry, more recognizable brand names, and morewell-established marketing and distribution networks. Although price has beenless significant than other factors, increasing competition may result in pricereductions and reduced gross margins. Additionally, we face competition fromother entities, such as PACS vendors and developers of

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competitive orancillary software packages. We may not be able to compete effectively withsuch manufacturers or competing entities on each or any particular factor,including price, features and service.

*Ourproducts may become obsolete or non-competitive, which would result in reducedrevenue and profit margins.*

Theenterprise-wide advanced visualization market is characterized by rapidinnovation and technological change. For example, as scanners become faster andgenerate more and more slices, our software must maintain its capability tohandle the increased data volumes generated by the more powerful scanners. Wemay be unable to compete effectively in the marketplace, and products developedby our competitors may render our products obsolete or non-competitive.Similarly, our competitors may succeed in developing or marketing products thatare viewed as providing superior clinical performance or are less expensivethan our current or future products.

*We maymake future acquisitions, which may be difficult to integrate, divertmanagement resources, result in unanticipated costs or dilute our shareholders.*

Part of ourcontinuing business strategy is to make acquisitions of, or investments in,companies, products or technologies that complement our current products,enhance our market coverage or technical capabilities, or offer growthopportunities. Future acquisitions could pose numerous risks to our operations,including:

·                  wemay have difficulty integrating the purchased operations, technologies orproducts;

·                  wemay incur substantial unanticipated integration costs;

·                  assimilatingthe acquired businesses may divert significant management attention andfinancial resources from our other operations and could disrupt our ongoingbusiness;

·                  acquisitionscould result in the loss of key employees, particularly those of the acquiredoperations;

·                  wemay have difficulty retaining or developing the acquired businesses’ customers;

·                  acquisitionscould adversely affect our existing business relationships with suppliers andcustomers;

·                  wemay fail to realize the potential cost savings or other financial benefitsand/or the strategic benefits of the acquisitions; and

·                  wemay incur liabilities from the acquired businesses for infringement ofintellectual property rights or other claims, and we may not be successful inseeking indemnification for such liabilities or claims.

In connection withthese acquisitions or investments, we could incur debt, amortization expensesrelated to intangible assets, large and immediate write-offs, assumeliabilities, or issue stock that would dilute our current shareholders’percentage of ownership. We may not be able to complete acquisitions orintegrate the operations, products or personnel gained through any suchacquisition without a material adverse effect on our business, financialcondition and results of operations.

*We sellour products internationally and are subject to various risks relating to suchinternational activities, which could harm our international sales andprofitability.*

During the yearsended December 31, 2006, December 31, 2005 and December 31, 2004, 15%, 16% and17% of our total revenues were attributable to international sales. Toshiba hasbeen the primary source of our international sales. We are also developingdirect international sales and marketing efforts. By doing business ininternational markets, we are exposed to risks separate and distinct from thosewe face in our domestic operations. Our international business may be adverselyaffected by changing economic conditions in foreign countries. Because most ofour sales are currently denominated in U.S. dollars, if the value of the U.S.dollar increases relative to foreign currencies, our products could become morecostly to the international consumer and therefore less competitive ininternational markets, which could adversely affect our profitability.Furthermore, although currently only a small percentage of our sales aredenominated in non-U.S. currency, this percentage may increase in the future,in which case fluctuations in exchange rates could affect demand for ourproducts. Engaging in international business inherently involves a number ofother difficulties and risks, including:

·                  exportrestrictions and controls relating to technology;

·                  theavailability and level of reimbursement within prevailing foreign healthcarepayment systems;

·                  pricingpressure that we may experience internationally;

·                  requiredcompliance with existing and new foreign regulatory requirements and laws;

·                  lawsand business practices favoring local companies;

·                  longerpayment cycles;

·                  difficultiesin enforcing agreements and collecting receivables through foreign legalsystems;

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·                  politicaland economic instability;

·                  potentiallyadverse tax consequences, tariffs and other trade barriers;

·                  internationalterrorism and anti-American sentiment;

·                  difficultiesand costs of staffing and managing foreign operations;

·                  changesin currency exchange rates; and

·                  difficultiesin enforcing intellectual property rights.

Our exposure toeach of these risks may increase our costs, lengthen our sales cycle andrequire significant management attention. We cannot assure you that one or moreof these factors will not harm our business.

*If ourinternal control over financial reporting is found to be inadequate, ourfinancial results may not be accurate, raising concerns for investors andpotentially adversely affecting our stock price.*

Under Section 404of the Sarbanes-Oxley Act of 2002, we are required to evaluate and determinethe effectiveness of our internal controls over financial reporting. We havededicated a significant amount of time and resources to ensure compliance withthis legislation for the year ended December 31, 2006 and will continue todo so for future fiscal periods. We may encounter problems or delays incompleting the review and evaluation, the implementation of improvements, andthe receipt of a positive attestation, or any attestation at all, from ourindependent registered public accounting firm. In addition, our assessment ofour internal controls may identify deficiencies that need to be addressedin our internal controls over financial reporting or other matters thatmay raise concerns for investors and therefore adversely affect our stockprice.

*We mayexperience fluctuations in operating results, which may result in volatility inthe price of our common stock.*

We have in thepast experienced, and may in the future experience, significant fluctuations inannual and quarterly operating results. If these fluctuations occur, they mayresult in volatility in the price of our common stock. Quarterly revenue andoperating results may fluctuate as a result of a variety of factors that areoutside of our control including, but not limited to, the timing of significantorders, the timing of product enhancements and new product introductions by usor our competitors, the pricing of our products, changes in customers’ budgetsand competitive conditions. Our quarterly license and services revenue mayfluctuate and may be difficult to forecast for a variety of reasons, includingthe following:

·                  asignificant number of our existing and prospective clients’ decisions regardingwhether to enter into license agreements with us are made within the last fewweeks or days of each quarter;

·                  thesize and number of license transactions can vary significantly;

·                  ourdependence on Toshiba for a significant portion of our revenues;

·                  adecrease in license fee revenue may likely result in a decrease in servicesrevenue in the same or subsequent quarters;

·                  clientsmay unexpectedly postpone or cancel projects due to changes in their strategicpriorities, project objectives, budget or personnel;

·                  theuncertainty caused by potential business combinations in the software industrymay cause clients and prospective clients to cancel, postpone or reduce capitalspending projects on software;

·                  clientevaluations and purchasing processes vary significantly from company tocompany, and a client’s internal approval and expenditure authorization processcan be difficult and time consuming to complete, even after selection of avendor;

·                  thenumber, timing and significance of software product enhancements and new softwareproduct announcements;

·                  existingclients may decline to renew support for our products, and market pressures maylimit our ability to increase support fees or require clients to upgrade fromolder versions of our products;

·                  prospectiveclients may decline or defer the purchase of new products or releases if we donot have sufficient client references for those products; or

·                  wemay have to defer revenues under our revenue recognition policies.

*We aresubject to government regulation, which can result in additional costs orrestrict our ability to market our products. *

Our products aresubject to regulation by the United States Food and Drug Administration, or theFDA, and by comparable agencies in foreign countries. In the United States, theFDA regulates the development, introduction, manufacturing, labeling and recordkeeping procedures for medical devices, including 3D medical imaging software 

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and systems. Ourmedical devices require clearance or approval by the FDA before they can becommercially distributed in the United States. Modifications and enhancementsto a medical device also require a new FDA clearance or approval if they couldsignificantly affect its safety or effectiveness or would constitute a majorchange in its intended use, design or manufacture. The FDA requires everymanufacturer to make this determination in the first instance, but the FDA mayreview any manufacturer’s decision and may require a new clearance or approvalfor the modification if it disagrees with the decision. If the FDA requires usto seek clearance or approval for the modification of a previously clearedproduct for which we have concluded that new clearances or approvals areunnecessary, we may be required to cease marketing or to recall the modifiedproduct until we obtain clearance or approval, and we may be subject tosignificant regulatory fines or penalties, which could have a material adverseeffect on our financial results and competitive position. The process ofobtaining marketing clearance from the FDA for new products and newapplications for existing products can be time-consuming and expensive. All ofour current products are marketed pursuant to 510(k) pre-market clearance fromthe FDA. *Vitrea* and *ViTALConnect*and our add-on options have been cleared to be marketed for use with CT, MR andPET scanners. The FDA may not grant clearance with respect to our futureproducts or enhancements, or future FDA review may involve delays that couldadversely affect our ability to market such 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. Productclearances and approvals by the FDA can also be withdrawn due to failure tocomply with regulatory standards or the occurrence of unforeseen problemsfollowing 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 heavily on administrative interpretation, andfuture interpretations made by the FDA or other regulatory bodies may adverselyaffect us. The FDA may inspect our facilities and operations to determinewhether we are in compliance with various regulations relating tospecification, development, documentation, validation, testing, quality controland product labeling. If the FDA determines that we are in violation of suchregulations, it could impose civil penalties, including fines, recall or seizeproducts and, in extreme cases, impose criminal sanctions.

We market ourproducts both domestically and internationally. International regulatory bodieshave established varying regulations governing product standards, packagingrequirements, 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.

*Theimposition of requirements under the Health Insurance Portability andAccountability Act of 1996, or HIPAA, could adversely affect our business.*

The HIPAAregulations cause our customers to request that we sign “business associate”agreements with them. A “business associate” is a person or entity thatperforms certain functions or activities that involve the use or disclosure ofprotected health information on behalf of, or that provides services to, acovered entity. By law, the HIPAA Privacy Rule applies only to coveredentities—health plans, healthcare clearinghouses, and certain healthcareproviders. However, most healthcare providers do not carry out all of theirhealthcare activities and functions by themselves. Instead, they often use theservices of a variety of other persons or businesses. The Privacy Rule allowscovered providers and health plans to disclose protected health information tothese “business associates” if the providers or plans obtain satisfactoryassurances that the business associate will use the information only for thepurposes for which it was engaged by the covered entity, will safeguard theinformation from misuse, and will help the covered entity comply with some ofthe covered entity’s duties under the Privacy Rule. Covered entities maydisclose protected health information to an entity in its role as a businessassociate only to help the covered entity carry out its healthcarefunctions—not for the business associate’s independent use or purposes, exceptas needed for the proper management and administration of the businessassociate. These agreements are necessary for us in the normal course ofservicing and supporting our products and may require us to incur liabilitiesif we disclose protected health information in a manner not allowed under anyrespective agreement. Our potential liabilities may include indemnifying ourcustomer against any damages resulting from the disclosure. If we are notwilling to or are unable to enter into a business associate agreement withcurrent and potential customers, such customers may not purchase our productsor services, which would have a material adverse effect on our business,financial condition, or results of operations.

 

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*We aresubject to various federal and state “fraud and abuse” laws, and if we areunable to fully comply with such laws, we could face substantial penalties,which may adversely affect our business.*

We are subject tovarious federal and state laws pertaining to health care fraud and abuse,including the following:

·                  thefederal Anti-Kickback Statute, which prohibits persons from knowingly andwillfully soliciting, offering, receiving or providing remuneration, directlyor indirectly, in cash or in kind, to induce either the referral of anindividual, or furnishing or arranging for a good or service, for which paymentmay be made under federal health care programs (such as Medicare and Medicaid);

·                  thefederal False Claims Act, which prohibits anyone from knowingly presenting orcausing to be presented a false or fraudulent claim for payment to the federalgovernment;

·                  thefederal Health Insurance Portability and Accountability Act of 1996, or HIPAA,which prohibits executing a scheme to defraud any health care benefit program;

·                  thefederal False Statements Statute, which prohibits knowingly and willfullyfalsifying, concealing or covering up a material fact or making any materiallyfalse statement in connection with the delivery of or payment for health carebenefits, items or services; and

·                  statelaw equivalents to these federal laws, which may not be limited to governmentreimbursed items, and may not contain identical exceptions.

If our past orpresent operations are found to be in violation of any of the laws describedabove or the other similar governmental regulations to which we are subject, wemay be subject to the applicable penalty associated with the violation,including civil and criminal penalties, damages, fines, exclusion from federalhealth care programs and/or the curtailment or restructuring of our operations.Similarly, if the physicians or other providers or entities with whom we dobusiness are found to be non-compliant with applicable laws, they may besubject to sanctions, which could also have a negative impact on us. Anypenalties, damages, fines, curtailment or restructuring of our operations couldadversely affect our ability to operate our business and our financial results.The risk of our being found in violation of these laws is increased by the factthat their provisions are open to a variety of interpretations and are subjectto further legal or regulatory change. Any action against us for violation ofthese laws, even if we successfully defend against it, could cause us to incursignificant legal expenses, fines and other penalties, divert our management’sattention from the operation of our business and damage our reputation.

*Theprotection of our intellectual property may be uncertain, and we may facepossible claims of others.*

Although we havereceived patents and have filed patent applications with respect to certainaspects of our technology, we generally do not rely on patent protection withrespect to our products and technologies. Instead, we rely primarily on acombination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to our products and technologies. Such measures maynot provide meaningful protection of our trade secrets, know-how or otherintellectual property in the event of any unauthorized use, misappropriation ordisclosure. Others may independently develop similar technologies or duplicateour technologies. In addition, to the extent that we apply for any patents,such applications may not result in issued patents or, if issued, such patentsmay not be valid or of value. Third parties could, in the future, assertinfringement or misappropriation claims against us with respect to our currentor future products and technologies, or we may need to assert claims ofinfringement against third parties. Any infringement or misappropriation claimby us or against us could place significant strain on our financial resources,divert management’s attention from our business and harm our reputation. Thecosts of prosecuting or defending an intellectual property claim could besubstantial and could adversely affect our business, even if we are ultimatelysuccessful in prosecuting or defending any such claims. If our products ortechnologies are found to infringe the rights of a third party, we could berequired to pay significant damages or license fees or cease production, any ofwhich could have a material adverse effect on our business.

*We facethe risk of product liability claims, and our product liability and errors andomissions insurance coverage may not be adequate to pay products liabilityclaims, which could have a material adverse effect on our financial condition.*

Our businessexposes us to the risk of product liability claims that is inherent in themanufacturing and marketing of medical devices, including those which may arisefrom the misuse or malfunction of, or design flaws in, our products. We may besubject to product liability claims if our products cause, or merely appear tohave caused, an injury. Claims may be made by patients, healthcare providers orothers selling our products. Although we have product liability and errors andomissions insurance that we believe is appropriate, this insurance is subjectto deductibles and coverage limitations. Our current product liabilityinsurance may not continue to be available to us on acceptable terms, if atall, and, if available, the coverages may not be adequate to protect us againstany future product liability claims. Further, if additional products areapproved for marketing, we may seek additional insurance coverage. If we areunable to obtain insurance at an acceptable cost or on acceptable terms withadequate 

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coverage orotherwise protect against potential product liability claims, we will beexposed to significant liabilities, which may harm our business. A productliability claim, recall or other claim with respect to uninsured liabilities orfor amounts in excess of insured liabilities could result in significant costsand significant harm to our business.

*If wefail to attract and retain qualified personnel, our business would be harmed.*

We expect torapidly expand our operations and grow our sales, research and development andadministrative operations. This expansion is expected to place a significantstrain on our management and will require hiring a significant number ofqualified personnel. Accordingly, recruiting and retaining such personnel inthe future will be critical to our success. There is intense competition fromother companies, research and academic institutions, government entities andother organizations for qualified personnel in the areas of our activities. Ifwe fail to identify, attract, retain and motivate these highly skilledpersonnel, we may be unable to continue our marketing and developmentactivities.

*If we donot effectively manage changes in our business, these changes could place asignificant strain on our management and operations and, as a result, ourbusiness might not succeed.*

Our ability to grow successfully requires an effective planning andmanagement process. The expansion and growth of our business could place asignificant strain on our management systems, infrastructure and otherresources. To manage our growth successfully, we must continue to improve andexpand our systems and infrastructure in a timely and efficient manner. Ourcontrols, systems, procedures and resources may not be adequate to support achanging and growing company. If our management fails to respond effectively tochanges and growth in our business, including acquisitions, such failure couldhave a material adverse effect on our business.

*We dependon third-party reimbursement. A reduction or other change in reimbursement fromthird parties could negatively affect our business.*

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 thehealthcare goods and services provided to their patients. There are currentlyCurrent Procedural Terminology, or CPT, reimbursement codes that describe most ofthe diagnostic procedures that use our products. However, the amount ofreimbursement from third-party payers varies by site of service and geographiclocation 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. Third-party payers are increasinglychallenging the prices charged for medical services and, in some instances,have put pressure on service providers to lower their prices or reduce theirservices. We are unable to predict what changes will be made in thereimbursement methods used by third-party healthcare payers. Third-party payersmay not consider as cost effective the procedures in which our products areused. Reimbursement for such procedures may not be available or, if available,payers’ low reimbursement levels may adversely affect our ability to sell ourproducts on a profitable basis. In addition, there have been and may continueto be changes and proposals by legislators, regulators and third-party payersto curb further these costs in the future. For example, the Deficit ReductionAct of 2005, or the DRA, which was signed into law on February 8, 2006, imposescaps on Medicare payment rates for certain imaging services, including MR andPET, furnished in physicians’ offices and other non-hospital based settings.Under the caps, payments for specified imaging services cannot exceed thehospital outpatient payment rates for these services. This change applies toservices furnished on or after January 1, 2007. The DRA also codifies areduction in Medicare payments for certain multiple images performed oncontiguous body parts, which was previously established in the 2006 PhysicianFee Schedule final rule. A failure by hospitals and other users of our productsto obtain reimbursement from third-party payers, changes in third-party payers’policies toward reimbursement for procedures using our products, or legislativeaction could have a material adverse effect on our business, financialcondition and results of operations.

*Healthcarereform may negatively impact our business.*

The levels ofrevenue and profitability of medical technology companies may be affected bythe efforts of government and third-party payers to contain or reduce the costsof healthcare through various means. In the United States, there have been, andwe expect that there will continue to be, a number of federal, state and privateproposals to control healthcare costs. These proposals include legislative,regulatory and other initiatives and may contain measures intended to controlpublic and private spending on healthcare as well as to provide universalpublic access to the healthcare system. If enacted, these proposals may resultin a substantial restructuring of the healthcare 

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delivery system.Significant changes in the nation’s healthcare system could have a substantialimpact on the manner in which we conduct business and could have a materialadverse effect on our business, financial condition and results of operations.

*Changesin or interpretations of accounting rules and regulations, such as expensing ofstock options, could result in unfavorable accounting charges or require us tochange our compensation policies.*

Accounting methodsand policies for business and market practices, including policies regardingexpensing stock options, are subject to further review, interpretation andguidance from relevant accounting authorities, including the Securities andExchange Commission, or SEC, and the Financial Accounting Standards Board, orFASB. For example, we were previously not required to record equity-basedcompensation charges if the employee’s stock option exercise price equaled orexceeded the fair value of our common stock at the date of grant. In December2004 and as amended in April 2005, the FASB issued Statement of FinancialAccounting Standard No. 123 (revised 2004), “Share-Based Payment,” or SFAS No.123(R), which requires all equity-based payments to employees, including grantsof employee stock options, to be recognized in the financial statements basedon their fair values beginning for the year ended December 31, 2006. We adoptedSFAS No. 123(R) using the modified prospective application method under whichwe apply SFAS No. 123(R) to new awards granted on or after the January 1, 2006date of our adoption of SFAS No. 123(R) and to any portion of existing awardsthat were granted after December 15, 1994 and had not vested by January 1,2006. We expect the impact of the adoption of SFAS No. 123(R) to be material toour consolidated financial statements. We rely heavily on stock options tocompensate existing employees and attract new employees. Our adoption of SFAS No.123(R) may cause us to reduce our reliance on stock options as a compensationtool. If we reduce our use of stock options, it may be more difficult for us toattract and retain qualified employees. We estimate that equity-basedcompensation charges in 2007 will be approximately $5.7 million to $6.2 millionbefore tax, depending on the stock price when new options are granted and thevolume and timing of disqualifying dispositions of incentive stock options, allof which are difficult to predict. These factors could also affect oureffective tax rate.

*We mayissue shares of preferred stock without the consent of our holders of commonstock, which could adversely affect the rights of the holders of our commonstock.*

Our Articles ofIncorporation authorize our Board of Directors, without any action by theholders of our common stock, to establish the rights and preferences of up to5,000,000 shares of currently undesignated preferred stock. These shares ofpreferred stock could possess voting and conversion rights that could adverselyaffect the voting power of the holders of the common stock or dilute theirownership rights, and it may have the effect of delaying, deferring orpreventing a change in control of Vital Images. No shares of preferred stock orother senior equity securities are currently designated, and currently we haveno plan to designate or issue any such securities.

*We aresubject to certain laws and plans which may discourage takeover attempts thatcould be beneficial for shareholders.*

We are subject toanti-takeover provisions of the Minnesota Business Corporation Act. Inaddition, we have adopted a shareholder rights plan designed to protect againstunsolicited attempts to acquire our company, which expires on April 30, 2007.Our Board of Directors has determined at this time to not renew our shareholderrights plan or adopt another plan. These measures may deter or discouragetakeover attempts and other changes in control that are not approved by ourBoard of Directors, and they may have a depressive effect on any market for ourstock. As a result, our shareholders may lose opportunities to dispose of theirshares at the higher prices typically available in takeover attempts or thatmay be available under a merger proposal. In addition, these measures may havethe effect of permitting our current directors to retain their positions andplace them in a better position to resist changes that our shareholders maywish to make if they are dissatisfied with the conduct of our business.

*We havenever paid any cash dividends and, therefore, our shareholders’ onlyopportunity to achieve a return on their investment in our common stock is ifthe price of our common stock appreciates.*

We have not paidcash dividends on our common stock in the past, and we do not intend to do soin the foreseeable future. Consequently, our shareholders’ only opportunity toachieve a return on their investment in our common stock will be if the marketprice of our common stock appreciates and they sell their shares at a profit.

*Ourdirectors may not be held personally liable for certain actions, which coulddiscourage shareholder suits against them.*

As permitted byMinnesota law, our Articles of Incorporation provide that members of our Boardof Directors shall 

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not be personallyliable to our company or our shareholders for monetary damages for breach offiduciary duty as a director, with certain exceptions. These provisions maydiscourage shareholders from bringing suit against a director for breach offiduciary duty and may reduce the likelihood of derivative litigation broughtby shareholders on behalf of our company against a director. In addition, ourBylaws provide for mandatory indemnification of directors and officers to thefullest extent permitted by Minnesota law.

**Item 1B.Unresolved Staff Comments**

None.

**Item2.  Properties**

Our principaloffice is located in an office building in Minnetonka, Minnesota, where wecurrently occupy approximately 72,000 square feet under a lease that expiresJanuary 31, 2012. We have the right under our lease to expand into anadditional approximately 15,000 square feet in 2009. We also lease smalloffices in Den Haag, Netherlands, and Beijing, China, for our operations inthose countries.

We consider ourcurrent facilities adequate for our current needs, but continued growth inheadcount and our expansion internationally could require us to obtainadditional space. We believe that suitable additional space will be availableas and if needed.

**Item3.  Legal Proceedings**

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

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

There was nomatter submitted to the vote of security holders during the fourth quarter ofthe fiscal year ended December 31, 2006.

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**Part II**

**Item 5.**** Market for Registrant’s Common Equity, Related StockholderMatters and Issuer Purchases of Equity Securities**

The Company’scommon stock is quoted on The Nasdaq Global Market under the symbol “VTAL.”  The table below reflects the high and low pershare closing sale prices of our common stock as reported by The Nasdaq GlobalMarket for each of the periods indicated. Such prices reflect inter-dealerprices, do not include adjustments for retail mark-ups, markdowns orcommissions, and may not necessarily represent actual transactions.

|                | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| 2006           |       |     |       |    |       |
| Fourth Quarter |       | $        | 35.98      |    | $          | 28.86 |   |
| Third Quarter  |       | $        | 31.80      |    | $          | 19.80 |   |
| Second Quarter |       | $        | 35.06      |    | $          | 21.25 |   |
| First Quarter  |       | $        | 34.87      |    | $          | 25.85 |   |
|           |       |     |       |    |       |
| 2005           |       |     |       |    |       |
| Fourth Quarter |       | $        | 28.17      |    | $          | 20.58 |   |
| Third Quarter  |       | $        | 22.26      |    | $          | 17.42 |   |
| Second Quarter |       | $        | 18.95      |    | $          | 14.37 |   |
| First Quarter  |       | $        | 16.14      |    | $          | 13.60 |   |

 

We have never paidor declared any cash dividends on our common stock and do not intend to paydividends on our common stock in the foreseeable future. We expect to retainour future anticipated earnings to finance development and expansion of ourbusiness. As of February 28, 2007, there were approximately 7,390beneficial owners and approximately 794 registered holders of record of our commonstock.

**PerformanceGraph**

Since June 9, 2003,the Company’s common stock has been quoted on The Nasdaq Global Market(formerly known as The Nasdaq National Market). From September 29, 2000through June 6, 2003, the Company’s common stock was quoted on The NasdaqSmallCap Market (now known as The Nasdaq Capital Market). The following graphshows changes during the period from December 31, 2001 toDecember 31, 2006 in the value of $100 invested in: (1) the Company’scommon stock; (2) the CRSP Total Return Index for The Nasdaq Composite;and (3) Nasdaq Non-Financial Stocks. The values of each investment as ofthe dates indicated are based on share prices plus any dividends paid in cash,with the dividends reinvested on the date they were paid. The calculationsexclude trading commissions and taxes.

Notwithstanding anythingto the contrary set forth in any of our previous or future filings under theSecurities Act of 1933 or the Securities Exchange Act of 1934 that mightincorporate future filings by reference, including this Annual Report on Form10-K, in whole or in part, the following performance graph shall not be deemedto be incorporated by reference into any such filings and shall not otherwisebe deemed filed under such acts.

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|                      | ** ** | **12/31/01** | ** ** | **12/31/02** | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
|----------------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| Vital Images,  Inc.  |       | $            | 100.00     |         | $          | 95.94        |       | $            | 191.02     |         | $          | 179.14       |       | $ | 279.68 |   | $ | 372.19 |   |
| Nasdaq Composite     |       | $            | 100.00     |         | $          | 69.66        |       | $            | 99.71      |         | $          | 113.79       |       | $ | 114.47 |   | $ | 124.20 |   |
| Nasdaq Non-Financial |       | $            | 100.00     |         | $          | 67.93        |       | $            | 101.41     |         | $          | 110.11       |       | $ | 111.20 |   | $  | 120.84 |   |

 

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**Item 6.**** Selected Financial Data (in thousands, except per share data)**
| ** **                         | ** ** | **2006**(1) | ** ** | **2005**(1) | ** ** | **2004**(1) | ** ** | **2003**(1) | ** ** | **2002**(1) | ** ** |
|------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|
| **Years  ended December 31:** | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| Revenue                            |       | $           | 70,512     |        | $          | 51,717      |       | $           | 36,122     |        | $          | 27,300 |   | $ | 21,116 |   |
| Gross profit                       |       | 56,302      |       | 40,157      |       | 25,675      |       | 20,229      |       | 14,808      |       |
|                               |       |        |       |        |       |        |       |        |       |        |       |
| Operating  expenses                |       | 49,371      |       | 32,592      | (2)        | 25,161      | (3)        | 18,294      |       | 14,131      |       |
| Operating income                   |       | 6,931       |       | 7,565       |       | 514         |       | 1,935       |       | 677         |       |
|                               |       |        |       |        |       |        |       |        |       |        |       |
| Net income                         |       | $           | 6,583      |        | $          | 5,801       |       | $           | 296        |        | $          | 8,462 | (4) | $ | 790 |   |
|                               |       |        |       |        |       |        |       |        |       |        |       |
| Net income per  share-basic        |       | $           | 0.49       |        | $          | 0.47        |       | $           | 0.03       |        | $          | 0.83 |   | $ | 0.09 |   |
|                               |       |        |       |        |       |        |       |        |       |        |       |
| Weighted average  common shares    |       | 13,463      |       | 12,379      |       | 11,632      |       | 10,189      |       | 8,861       |       |
|                               |       |        |       |        |       |        |       |        |       |        |       |
| Net income per  share-diluted      |       | $           | 0.46       |        | $          | 0.44        |       | $           | 0.02       |        | $          | 0.71 |   | $ | 0.08 |   |
|                               |       |        |       |        |       |        |       |        |       |        |       |
| Weighted average  common shares    |       | 14,259      |       | 13,283      |       | 12,536      |       | 11,848      |       | 9,822       |       |
|                               |       |        |       |        |       |        |       |        |       |        |       |
| **At  December 31:**          |       |        |       |        |       |        |       |        |       |        |       |
| Working capital                    |       | $           | 162,202    |        | $          | 45,604      |       | $           | 30,996     |        | $          | 31,915 |   | $ | 9,219 |   |
| Total assets                       |       | $           | 219,730    |        | $          | 91,151      |       | $           | 69,284     |        | $          | 53,063 |   | $ | 18,827 |   |
| Long-term debt                     |       | $           | —     |        | $          | —      |       | $           | —     |        | $          | — |   | $ | — |   |
| Total stockholders’  equity   |       | $           | 190,902    |        | $          | 68,789      |       | $           | 54,554     |        | $          | 44,594 |   | $ | 11,721 |   |

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(1)             Includesequity-based compensation of $5,063, $335, $12, $137 and $18 for the fiscal years2006, 2005, 2004, 2003 and 2002, respectively.

(2)             Includes a loss onoperating lease of $493 related to the Company’s facility move in the firstquarter of 2005.

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

(4)             Includesa net tax benefit of $6,313 resulting from the reversal of the Company’svaluation allowance for its net deferred tax assets, net of other current yearstate and federal income taxes.

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

**Executive summary**

Vital Images, Inc.(also referred to as “we”, “us” and “our”) continued to achieve significantgrowth during 2006. Specifically:

·                  Totalrevenue increased 36% to $70.5 million, compared to $51.7 million in 2005.

·                  Pretaxincome increased to $10.3 million, which included $5.1 million of equity-basedcompensation costs, compared to pretax income of $8.6 million in 2005, whichincluded $335,000 of equity-based compensation costs.

·                  Netincome was $6.6 million, or $0.46 per diluted share, which includedequity-based compensation costs of $3.6 million (after tax), compared to netincome of $5.8 million, or $0.44 per diluted share in 2005, which includedequity-based compensation costs of $213,000 (after tax).

Our balance sheetcontinued to strengthen during 2006. Total cash, cash equivalents andmarketable securities were $166.0 million as of December 31, 2006, compared to$49.8 million as of December 31, 2005. Working capital (defined as currentassets less current liabilities) was $162.2 million as of December 31, 2006,compared to $45.6 million as of December 31, 2005.  The increase in cash, cash equivalents and marketablesecurities and working capital was due in large part to our recently completedpublic offering of 3.4 million shares of common stock, resulting in netproceeds of $97.7 million.

Throughout ourhistory, a significant portion of our revenue has been generated from the U.S.radiology computed tomography, or CT, market. Going forward, we anticipate agrowing contribution from other sources, including international sales, salesfrom an expanding picture archive and communication systems, or PACS, market,sales to medical specialists in areas other than radiology, sales of Web-basedproducts and sales to our growing installed customer base.

**Overview**

We are a leadingprovider of enterprise-wide advanced visualization and image analysis solutionsfor use by medical professionals in clinical analysis and therapy planning formedical conditions. We provide software, training, software maintenance,professional services and, on occasion, third-party hardware to our customers.Our technology rapidly transforms complex data generated by diagnostic imagingequipment into functional digital images that can be manipulated and analyzedusing our specialized applications to better understand internal anatomy andpathology. Our solutions are designed to improve physician workflow andproductivity, enhance the ability to make clinical decisions, facilitate lessinvasive patient care, and complement often significant capital investments indiagnostic imaging equipment made by our customers. Our software is compatiblewith equipment from all major manufacturers of diagnostic imaging equipment,such as computed tomography, or CT, magnetic resonance, or MR, and positronemission tomography, or PET, scanners, and can be integrated into PACS. Manyhospitals use PACS to acquire, distribute and archive medical images anddiagnostic reports, reducing the need for film and increasing reliance onadvanced visualization solutions such as ours. We also offer a Web-basedsolution that provides physicians with anywhere, anytime access to medicalimages and visualization tools through any Internet-enabled computer.

We operate andmanage our business as a single business segment — the development andmarketing of software and related services for enterprise-wide advancedvisualization and analysis solutions for use by medical professionals inclinical analysis and therapy planning. We market our products and servicesthrough a direct sales force, resellers and independent distributors in theUnited States and in international markets. Our common stock is currentlytraded on The NASDAQ Global Market under the symbol “VTAL.”

**Criticalaccounting policies and estimates**

Our discussion andanalysis of financial condition and results of operations are based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Thenotes to the consolidated financial statements contained in this Annual Reportdescribe our significant accounting policies used in the preparation of theconsolidated financial statements. The preparation of these financialstatements requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. Actual resultscould

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differ from thoseestimates. We continually evaluate our critical accounting policies andestimates.

We believe thecritical accounting policies listed below reflect significant judgments,estimates and assumptions used in the preparation of our consolidated financialstatements.

*Allowancefor doubtful accounts*

We maintain an allowance for doubtful accounts at anamount estimated to be sufficient to provide adequate protection against lossesresulting from extending credit to our customers. In judging the adequacy ofthe allowance for doubtful accounts, we consider multiple factors, includinghistorical bad debt experience, the general economic environment, the need forspecific client reserves and the aging of our outstanding receivables. Aportion of this provision is included in operating expenses as a general andadministrative expense and a portion of this provision is included as areduction of license revenue. A considerable amount of judgment is required inassessing these factors. If the factors utilized in determining the allowancedo not reflect future performance, then a change in the allowance for doubtfulaccounts would be necessary in the period such determination has been made,which would impact future results of operations.  As of December 31, 2006, the allowancefor doubtful accounts was $266,000 for gross accounts receivable of $19.9million.

*Deferred taxes*

Significantjudgment is required in determining the realizability of our deferred taxassets. We must assess the likelihood that our net deferred tax assets will berecovered from future taxable income, and to the extent we believe thatrecovery is not likely, we must establish a valuation allowance. To the extentthat we establish a valuation allowance, it must include an expense within thetax provision in the statement of operations. As of December 31, 2006, theconsolidated balance sheet included net deferred tax assets of $10.6 million.

Our methodology for determining the realizability of our deferred taxassets involves estimates of future taxable income from our core business, theestimated impact of future tax deductions from the exercise of stock optionsoutstanding as of each balance sheet date, and the expiration dates and amountsof net operating loss carryforwards and other tax credits. These estimates areprojected through the life of the related deferred tax assets based onassumptions which we believe to be reasonable and consistent with currentoperating results.

Although we had cumulative pre-tax income for financial reportingpurposes for the three years ended December 31, 2006, we did not pay anysignificant income taxes for that period due to tax deductions from the exerciseof stock options as well as our utilization of net operating losses. Inassessing the realizability of our deferred tax assets as of each balance sheetdate, we considered evidence regarding our ability to generate sufficientfuture taxable income to realize our deferred tax assets. The primary evidenceconsidered included the cumulative pre-tax income for financial reportingpurposes for the past three years; the estimated impact of future taxdeductions from the exercise of stock options outstanding as ofDecember 31, 2006; and the estimated future taxable income based onhistorical operating results.

After giving consideration to these factors, we concluded that it wasmore likely than not that the tax loss carryforwards will be realized prior toexpiration and that other tax credits that expire prior to 2010 will not beutilized due to the estimated future tax deductions from the exercise of stockoptions outstanding as of December 31, 2006 as well as utilization of taxloss carryforwards. As a result, we have a valuation allowance of $185,000 asof December 31, 2006 relating to net operating losses and tax credits thatexpire prior to 2010.

We also concluded that it was more likely than not that the net deferredtax assets of $10.6 million as of December 31, 2006 and the estimatedfuture tax deductions from the exercise of stock options outstanding as ofDecember 31, 2006 would be utilized prior to expiring. Based on thisconclusion, we will require approximately $53.6 million in cumulative futuretaxable income to be generated at various times over the next 20 years torealize the related net deferred tax assets of $10.6 million as ofDecember 31, 2006 as well as the estimated future tax deductions from theexercise of stock options outstanding and in-the-money as of December 31,2006.

If we adjusteither our estimates of future taxable income or tax deductions from theexercise of stock options down, or our stock price increases significantlywithout an increase in taxable income, causing us to believe that our deferredtax assets will not be utilized, we may need to establish additionalvaluation allowances on our deferred tax assets, which could materially impactour financial position and results of operations.

*Long-livedassets*

We review long-livedassets for impairment whenever events or changes in circumstances indicate thecarrying amount may not be recoverable, in accordance with Statement ofFinancial Accounting Standards (“SFAS”)

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No. 144, “Accountingfor 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 or changes in circumstances are present, theundiscounted cash flows method is used to determine whether the asset is impaired.Cash flows would include the estimated terminal value of the asset and excludeany interest charges. To the extent the carrying value of the asset exceeds theundiscounted cash flows over the estimated remaining life of the asset, theimpairment is measured using the discounted cash flows. The discount rateutilized would be based on our best estimate of the related risks and return atthe time the impairment assessment is made.

Our long-livedassets consist of property and equipment of $9.2 million, other intangibleassets subject to amortization of $3.2 million and licensed technology of$90,000 as of December 31, 2006.

*Goodwill*

We account forgoodwill in accordance with the provisions of SFAS No. 142, “Goodwill andOther Intangible Assets.”  Under SFASNo. 142, goodwill and intangible assets with indefinite lives are reviewedfor impairment annually or more frequently if events or changes incircumstances indicate that the asset might 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, including goodwill. Weoperate as one reporting unit and therefore compare the book value to themarket value (market capitalization plus a control premium). If the marketvalue exceeds the book value, goodwill is considered not impaired, and thus thesecond step of the impairment test is not necessary. If our book value exceedsthe market value, the second step of the goodwill impairment test is performedto measure the amount of impairment loss, if any. The second step of thegoodwill impairment test, used to measure the amount of impairment loss,compares the implied fair value of the goodwill with the book value of thegoodwill. If the carrying value of the goodwill exceeds the implied fair valueof the goodwill, an impairment loss would be recognized in an amount equal tothe excess. Any loss recognized cannot exceed the carrying amount of goodwill.After a goodwill impairment loss is recognized, the adjusted carrying amount ofgoodwill is its new accounting basis. Subsequent reversal of a previouslyrecognized goodwill impairment loss is prohibited once the measurement of thatloss is completed. We completed the annual goodwill impairment assessment as ofDecember 31, 2006, in which no impairment was identified. Goodwill was$9.1 million as of December 31, 2006.

*Agreementwith R2 Technology, Inc.*

In April 2005, weentered into an agreement with R2 Technology, Inc. (“R2”) to market R2’slung nodule CAD software product to our customers. The April 2005agreement replaced our November 2002 agreement with R2. Under theApril 2005 agreement, we committed to provide R2 with certain minimumquarterly sales (“Applicable Minimums”) from certain R2 lung CAD relatedproducts and services (“R2 Lung CAD Products”) over a 12-quarter period endingJune 30, 2008. We will receive a commission based on sales of R2 Lung CADProducts to our customers. To the extent the quarterly Applicable Minimum isnot met, we will pay R2 the difference between the Applicable Minimum and theactual R2 Lung CAD Product sales achieved.

In the first quarter of2006, we reversed $236,000 of the $410,000 expense recorded in the fourthquarter of 2005 relating to our agreement with R2.  In the second quarterof 2006, we recorded a $167,000 expense relating to relating to our agreementwith R2.  No such charges or reversals occurred during the second half of2006.  As of December 31, 2006, the remaining potential aggregatecommitment under this agreement ranges from a minimum of $0 to a maximum ofapproximately $2.1 million. Based on information available to us, R2 had notgenerated any significant R2 Lung CAD Product sales through any other sales,marketing and distribution channels, other than sales generated from customersunder this agreement.  As a result, theApplicable Minimum for the quarter ended December 31, 2006 was $0, and theApplicable Minimum for the quarter ending March 31, 2007 is $0. See Note 9 tothe Condensed Consolidated Financial Statements for further discussion.

The estimated futureaggregate Applicable Minimums is a highly subjective determination, and actualresults and any changes to estimates could have an adverse impact on ourfinancial position and results of operations. We may not generate sufficient sales to meet the minimum contractualcommitment for any particular quarter, and thus we may have to pay cash to R2for the deficit.  As of December 31,2006, the remaining potential aggregate Applicable Minimums ranged from aminimum of $0 to a maximum of approximately $2.1 million.  If we foresee that we will not be able toattain the minimum contractual commitment on a continued basis, we may have totake a charge to earnings, which could be up to the amount of the maximumremaining total commitment.  Any futurelosses would be recorded under SFAS No. 5, “Accounting for Contingencies,”which requires the amount to be probable and estimable.

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*RevenueRecognition*

We follow specificand detailed guidelines in determining the proper amount of revenue to berecorded; however, certain judgments affect the application of our revenuerecognition policy. Revenue results are difficult to predict, and any shortfallin revenue or delay in recognizing revenue could cause our operating results tovary significantly from period to period.

The significantjudgments for revenue recognition typically involve whether collectability canbe considered probable and whether fees are fixed or determinable.  Significant judgment is also required whenevaluating and assessing revenue recognition relating to our distributionagreements with original equipment manufacturers, value-added resellers andindependent distributors (collectively, “Resellers”). In addition, ourtransactions often consist of multiple element arrangements, which must beanalyzed to determine the fair value of each element, the amount of revenue tobe recognized upon shipment, if any, and the period and conditions under whichdeferred revenue should be recognized. As a result, if facts and circumstances change that affect our currentjudgments, our revenue could be materially different in the future.

We recognizerevenue in accordance with American Institute of Certified Public Accountants (“AICPA”)Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended bySOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time totime by the AICPA, and SEC Staff Accounting Bulletin No. 104. We recognizerevenue when it is realized or realizable and earned. We consider revenuerealized or realizable and earned when we have persuasive evidence of anarrangement, the product has been shipped or the services have been provided tothe customer, the sales price is fixed or determinable, and collectability is probable.

*Equity-basedcompensation*

EffectiveJanuary 1, 2006, we adopted the fair value recognition provisions of SFASNo. 123(R), using the modified prospective transition method, and thereforehave not restated prior periods’ results. Under this method, we recognizecompensation expense for all equity-based payments granted on or afterJanuary 1, 2006 and prior to but not yet vested as of January 1, 2006in accordance with SFAS No. 123(R). Under the fair value recognition provisionsof SFAS No. 123(R), we recognize equity-based compensation net of an estimatedforfeiture rate and recognize compensation cost only for those shares expectedto vest over the requisite service period of the award. Prior to SFAS No.123(R)adoption, we accounted for equity-based payments under Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees”, andaccordingly did not recognize equity-based compensation related to theseoptions, as the exercise price equaled the fair market value of the common stockon the date of grant.

The fair value ofeach option award is estimated on the date of grant using the Black-Scholesoption valuation model. The Black-Scholes option valuation model requires thedevelopment of assumptions that are input into the model. These assumptions arethe expected stock volatility, the risk-free interest rate, the option’sexpected life and the dividend yield on the underlying stock. Expectedvolatility is calculated based on the historical volatility of our common stockover the expected option life and other appropriate factors. Risk-free interestrates are calculated based on continuously compounded U.S. Treasury risk-freerates for the appropriate term. Prior to March 9, 2006, the expected lifeof stock options was calculated by performing a detailed analysis of allhistorical stock option information available. On March 9, 2006, we beganto grant options with a five-year legal life instead of the eight-year legallife that had historically been used. As a result, we elected to use the “simplified”method, as described in SAB 107, to estimate the expected life of optionsgranted on and after March 9, 2006. We will utilize the simplified methoduntil sufficient historical information becomes available on the five-yearlegal life options. The dividend yield is assumed to be zero as we have neverpaid or declared any cash dividends on our common stock and do not intend topay dividends on our common stock in the foreseeable future. The expectedforfeiture rate is estimated based on historical experience.

Determining theappropriate fair value model and calculating the fair value of equity-basedpayment awards require the input of the subjective assumptions described above.The assumptions used in calculating the fair value of equity-based paymentawards represent management’s best estimates, which involve inherentuncertainties and the application of management judgment. As a result, iffactors change and we use different assumptions, our equity-based compensationexpense could be materially different in the future. In addition, we arerequired to estimate the expected forfeiture rate and recognize expense onlyfor those shares expected to vest. If our actual forfeiture rate is materiallydifferent from our estimate, the equity-based compensation expense could besignificantly different from what we have recorded in the current period. SeeNote 2 to the Condensed Consolidated Financial Statements for a furtherdiscussion of equity-based compensation.

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**Resultsof Operations**

The following tablesets forth information from our Statements of Operations, expressed as apercentage of total revenue.
| ** **                                   | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                         |       |                                                          |       |   |   |   |   |
| Revenue:                                     |       |                                                          |       |   |   |   |   |
| License fees                                 |       | 65.7                                                          | %          | 68.1 | % | 66.6 | % |
| Maintenance and services                     |       | 32.1                                                          |       | 27.7 |   | 26.4 |   |
| Hardware                                     |       | 2.2                                                           |       | 4.2 |   | 7.0 |   |
| Total revenue                                |       | 100.0                                                         |       | 100.0 |   | 100.0 |   |
|                                         |       |                                                          |       |   |   |   |   |
| Cost of revenue:                             |       |                                                          |       |   |   |   |   |
| License fees                                 |       | 7.1                                                           |       | 9.1 |   | 11.1 |   |
| Maintenance and services                     |       | 11.4                                                          |       | 10.7 |   | 12.8 |   |
| Hardware                                     |       | 1.7                                                           |       | 2.6 |   | 5.0 |   |
| Total cost of revenue                        |       | 20.2                                                          |       | 22.4 |   | 28.9 |   |
|                                         |       |                                                          |       |   |   |   |   |
| Gross profit                                 |       | 79.8                                                          |       | 77.6 |   | 71.1 |   |
|                                         |       |                                                          |       |   |   |   |   |
| Operating  expenses:                         |       |                                                          |       |   |   |   |   |
| Sales and marketing                          |       | 36.0                                                          |       | 32.7 |   | 33.8 |   |
| Research and development                     |       | 18.6                                                          |       | 15.8 |   | 17.5 |   |
| General and administrative                   |       | 15.4                                                          |       | 13.5 |   | 15.6 |   |
| Loss on operating lease                      |       | —                                                        |       | 1.0 |   | — |   |
| Acquired in-process research and development |       | —                                                        |       | — |   | 2.8 |   |
| Total operating expenses                     |       | 70.0                                                          |       | 63.0 |   | 69.7 |   |
|                                         |       |                                                          |       |   |   |   |   |
| Operating income                             |       | 9.8                                                           |       | 14.6 |   | 1.4 |   |
|                                         |       |                                                          |       |   |   |   |   |
| Interest income                              |       | 4.7                                                           |       | 2.1 |   | 1.0 |   |
| Income before  income taxes                  |       | 14.5                                                          |       | 16.7 |   | 2.4 |   |
|                                         |       |                                                          |       |   |   |   |   |
| Provision for  income taxes                  |       | 5.2                                                           |       | 5.5 |   | 1.6 |   |
|                                         |       |                                                          |       |   |   |   |   |
| Net income                                   |       | 9.3                                                           | %          | 11.2 | % | 0.8 | % |

 

**Revenue (in thousands)**
| ** **               | ** ** | **For the Years Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------|------------|---------------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                      | ** ** | **2005**                     | ** ** | **2004**                                  | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
| Revenues:                |       |                                                          |       |                         |       |                                      |       |   |   |   |   |   |   |   |   |
| License fees             |       | $                                                             | 46,332     |                         | $          | 35,228                                    |       | $ | 24,054 |   | $ | 11,104 |   | $ | 11,174 |   | 32 | % | 46 | % |
| Maintenance and services |       | 22,615                                                        |       | 14,324                       |       | 9,525                                     |       | 8,291 |   | 4,799 |   | 58 | % | 50 | % |
| Hardware                 |       | 1,565                                                         |       | 2,165                        |       | 2,543                                     |       | (600 | ) | (378 | ) | (28 | )% | (15 | )% |
| Total revenue            |       | $                                                             | 70,512     |                         | $          | 51,717                                    |       | $ | 36,122 |   | $ | 18,795 |   | $ | 15,595 |   | 36 | % | 43 | % |

 

Revenue growthduring 2006 and 2005 was driven by an increase in our core revenue componentsof software license fees, including revenue from software options andmaintenance and service revenue from a larger installed base of customers.

For 2007, weexpect revenue of $90.0 million to $95.0 million, or a 28% to 35% increase overfull-year 2006 revenue.

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**License fee revenue (in thousands)**
| ** **                               | ** ** | **For the Years Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                                      | ** ** | **2005**                     | ** ** | **2004**                                  | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
| License fee revenue:                     |       |                                                          |       |                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Vitrea licenses                          |       | $                                                             | 18,585     |                         | $          | 14,453                                    |       | $ | 7,920 |   | $ | 4,132 |   | $ | 6,533 |   | 29 | % | 82 | % |
| Vitrea options  and third party software |       | 26,486                                                        |       | 19,389                       |       | 15,721                                    |       | 7,097 |   | 3,668 |   | 37 | % | 23 | % |
| Other                                    |       | 1,261                                                         |       | 1,386                        |       | 413                                       |       | (125 | ) | 973 |   | (9 | )% | 236 | % |
| Total license fee  revenue               |       | $                                                             | 46,332     |                         | $          | 35,228                                    |       | $ | 24,054 |   | $ | 11,104 |   | $ | 11,174 |   | 32 | % | 46 | % |

 

License feerevenue increased 32% to $46.3 million in 2006 from $35.2 million in 2005.License fee revenue increased 46% to $35.2 million in 2005 from $24.0 millionin 2004. The increase in license fee revenue was driven by an increase in thenumber of Vitrea licenses sold and an increase in average revenue per Vitrealicense sold. During 2006, sales of Vitrea options and third party softwaregrew faster than Vitrea sales due to increased option sales both upfront and asadd-on purchases from our installed base of existing customers. Top-sellingoptions in 2006 and 2005 were General Vessel Probe, Automated VesselMeasurement and CT Cardiac — all cardiovascular solutions. As of December 31,2006, we have sold approximately 3,800 separate software licenses for oursolutions, compared to approximately 2,750 and 1,900 as of December 31, 2005and 2004, respectively. License fee revenue by source is as follows:
| ** **                       | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Percent of  license fee revenue: |       |                                                          |       |   |   |   |   |
| Direct                           |       | 44                                                            | %          | 42 | % | 44 | % |
| Toshiba                          |       | 44                                                            | %          | 49 | % | 53 | % |
| McKesson                         |       | 12                                                            | %          | 9 | % | 3 | % |
| Total license fee  revenue       |       | 100                                                           | %          | 100 | % | 100 | % |

 

The decrease in Toshiba license fee revenue as a percentage of totallicense fee revenue reflects our growth in PACS and direct enterprise deals.

**Maintenance and services revenue (in thousands)**
| ** **                         | ** ** | **For the Years Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|------------------------------------|------------|---------------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                                      | ** ** | **2005**                     | ** ** | **2004**                                  | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
| Maintenance and services  revenue: |       |                                                          |       |                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Maintenance and  support           |       | $                                                             | 16,379     |                         | $          | 9,808                                     |       | $ | 5,860 |   | $ | 6,571 |   | $ | 3,948 |   | 67 | % | 67 | % |
| Training                           |       | 5,178                                                         |       | 3,718                        |       | 3,091                                     |       | 1,460 |   | 627 |   | 39 | % | 20 | % |
| Installation                       |       | 1,058                                                         |       | 798                          |       | 574                                       |       | 260 |   | 224 |   | 33 | % | 39 | % |
| Total maintenance and  services    |       | $                                                             | 22,615     |                         | $          | 14,324                                    |       | $ | 9,525 |   | $ | 8,291 |   | $ | 4,799 |   | 58 | % | 50 | % |

 

Maintenance and services revenue increased 58% to $22.6 million in 2006compared to $14.3 million in 2005. Maintenance and services revenue increased 50% to $14.3 million in 2005compared to $9.5 million in 2004. The increases in maintenance revenues in eachyear were due to a significant increase in our installed base of customers,increased pricing on maintenance related services and an increased maintenancerenewal rate. The increase in training revenue and installation revenue was dueto an increase in the number of Vitrea licenses sold each year.  Also contributing to the increase in trainingrevenue is that in the fourth quarter of 2005, we put in place an expirationpolicy for unused training. The 2006 fourth quarter was the first period wewere able to expire unused training. Additionally, in the 2006 fourth quarter,we reached an agreement with one of our partners on an expiration period fortraining. As a result, maintenance and services revenue during the fourthquarter of 2006 included approximately $490,000 of non-recurring revenuerelating to unused training that expired.

**Hardware revenue**

Hardware revenuedecreased 28% to $1.6 million in 2006 compared to $2.2 million in 2005.  Hardware revenue decreased 15% to $2.2million in 2005 compared to $2.5 million in 2004. We sell hardware as a convenience to ourcustomers, and fluctuations are driven by individual customer purchasingpreferences. Sales of hardware systems are not core to our strategy and willfluctuate from period to period depending upon the needs of our customers.

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**Cost of revenue**

Gross profitincreased 40% to $56.3 million in 2006 compared to $40.2 million in 2005. Grossprofit increased 56% to $40.2 million in 2005 compared to $25.7 million in2004. Gross margin percentage increased to 80% in 2006 compared to 78% in 2005and 71% in 2004.

A comparison ofgross profit and gross margin by revenue category is as follows (in thousands):
| ** **               | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------|------------|---------------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Gross profit:            |       |                                                          |       |   |   |   |   |
| License fees             |       | $                                                             | 41,341     |   | $ | 30,546 |   | $ | 20,060 |   |
| Maintenance and services |       | 14,592                                                        |       | 8,765 |   | 4,865 |   |
| Hardware                 |       | 369                                                           |       | 846 |   | 750 |   |
| Total gross profit       |       | $                                                             | 56,302     |   | $ | 40,157 |   | $ | 25,675 |   |
|                     |       |                                                          |       |   |   |   |   |
| Gross margin:            |       |                                                          |       |   |   |   |   |
| License fees             |       | 89                                                            | %          | 87 | % | 83 | % |
| Maintenance and services |       | 65                                                            | %          | 61 | % | 51 | % |
| Hardware                 |       | 24                                                            | %          | 39 | % | 30 | % |
| Total gross  margin      |       | 80                                                            | %          | 78 | % | 71 | % |

 

The increase inlicense fee gross margin during 2006 and 2005 was due to an increase in averagerevenue per Vitrea license sold due to an increase in the sales price and anincrease in total Vitrea option revenue, which has lower associated costs.  Also contributing to the increase in 2005 wasan increase in the percentage of license revenue generated outside of our Toshibarelationship, as sales through Toshiba have lower average revenue pertransaction. Amortizationcharged to cost of revenue related to the HInnovation acquisition was $1.1million, $1.1 million and $976,000 in 2006, 2005 and 2004, respectively. Asrevenue continues to increase, amortization expense as a percentage of licenserevenue will decrease.

Maintenance andservices gross margin increased during 2006 and 2005 due to increased pricingon maintenance services and increased revenue from a growing installed base,without an increase in costs at a similar rate. We will continue to invest in our training,installation, professional services and customer support areas in the future toadequately support our growing installed base of customers, as well as toevaluate maintenance and services pricing as our cost structure increases,which could have an impact on maintenance and services gross margins in thefuture.

The decrease inhardware gross margin during 2006 was primarily due to a maintenance and supportpromotion which provided customers with a discount on hardware in connectionwith their purchasing contracts for maintenance and support.  During 2005, hardware gross margin increaseddue to increased pricing.

During 2007 weexpect total gross margin to be approximately 80%.

**Operatingexpenses**

The following is acomparison of operating expenses as a percent of revenue as well as the percentincrease or decrease in the total expense:
| ** **                  | ** ** | **Percent of Revenue for the  Years Ended December 31,** | ** ** | **Percent Increase (Decrease)** | ** ** |
|-----------------------------|------------|---------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
| Operating  expenses:        |       |                                                                                        |       |                                      |       |   |   |   |   |   |   |
| Sales and marketing         |       | 36.0                                                                                        | %          | 32.7                                      | %          | 33.8 | % | 49.9 | % | 38.7 | % |
| Research and development    |       | 18.6                                                                                        |       | 15.8                                      |       | 17.5 |   | 60.7 |   | 28.7 |   |
| General and administrative  |       | 15.4                                                                                        |       | 13.5                                      |       | 15.6 |   | 55.4 |   | 24.7 |   |
| Loss on operating lease     |       | —                                                                                      |       | 1.0                                       |       | — |   | N/A |   | N/A |   |
| Acquired in-process R&D |       | —                                                                                      |       | —                                    |       | 2.8 |   | — |   | N/A |   |
| Total operating  expenses   |       | 70.0                                                                                        | %          | 63.0                                      | %          | 69.7 | % | 51.5 | % | 29.5 | % |

 

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**Sales and marketing**

Sales andmarketing expenses increased $8.4 million to $25.4 million in 2006 compared to$16.9 million in 2005. Sales and marketing expenses increased $4.7 million to$16.9 million in 2005 compared to $12.2 million in 2004.  The change in sales and marketing expense isas follows (in thousands):
| ** **                       | ** ** | **Year-over-year  Change from Fiscal** | ** ** | **Year-over-year Percent  Change from Fiscal** | ** ** |
|----------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                       | ** ** | **2005 to 2006**                       | ** ** | **2004 to 2005**                                    | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
| Salaries,  benefits and bonus    |       | $                                                | 2,939      |                                                          | $          | 850 |   | 54 | % | 19 | % |
| Equity-based  compensation       |       | 1,869                                            |       | 126                                                           |       | 1483 | % | 100 | % |
| Commissions                      |       | 1,069                                            |       | 1,305                                                         |       | 25 | % | 45 | % |
| Trade shows                      |       | 836                                              |       | 777                                                           |       | 61 | % | 129 | % |
| Travel, meals  and entertainment |       | 818                                              |       | 168                                                           |       | 48 | % | 11 | % |
| Depreciation                     |       | 275                                              |       | 158                                                           |       | 52 | % | 42 | % |
| R2 Technology,  Inc contract     |       | (479                                             | )          | 410                                                           |       | (117 | )% | 100 | % |
| Overhead and  other expenses     |       | 1,115                                            |       | 934                                                           |       | 35 | % | 42 | % |
| Total                            |       | $                                                | 8,442      |                                                          | $          | 4,728 |   | 50 | % | 39 | % |

 

The increase inexpenses during both periods was due to an increase in compensation costs as aresult of additional personnel, higher sales commission expenses resulting fromsignificantly increased revenue, higher travel and entertainment costs andhigher costs for attending industry tradeshows. We had 75, 50 and 45 sales andmarketing personnel as of December 31, 2006, 2005 and 2004, respectively.The increase in equity-based compensation costs during 2006 was the result ofour adoption of SFAS No. 123(R) as of January 1, 2006. Also, in the firstquarter of 2006, we reversed $236,000 of the $410,000 expense recorded in thefourth quarter of 2005 relating to our agreement with R2.  In the second quarter of 2006, we recorded a$167,000 expense relating to relating to our agreement with R2. See Note 5 tothe Condensed Consolidated Financial Statements for further discussion.

We expect salesand marketing expenses to continue to increase in future periods primarily as aresult of the need to support additional growth through the hiring of sales andmarketing personnel. Including equity-based compensation, we expect sales andmarketing expenses to be between 36% and 37% of total revenue for the yearending December 31, 2007.

**Research and development**

Research anddevelopment expenses increased $4.9 million to $13.1 million in 2006 comparedto $8.1 million in 2005. Research and development expenses increased $1.8million to $8.1 million in 2005 compared to $6.3 million in 2004. The change inresearch and development expense is as follows (in thousands):
| ** **                    | ** ** | **Year-over-year  Change from Fiscal** | ** ** | **Year-over-year Percent  Change from Fiscal** | ** ** |
|-------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                    | ** ** | **2005 to 2006**                       | ** ** | **2004 to 2005**                                    | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
| Salaries,  benefits and bonus |       | $                                                | 2,961      |                                                          | $          | 949 |   | 56 | % | 22 | % |
| Equity-based  compensation    |       | 797                                              |       | 43                                                            |       | 1853 | % | 100 | % |
| Depreciation                  |       | 283                                              |       | 103                                                           |       | 63 | % | 30 | % |
| Consulting                    |       | 158                                              |       | 442                                                           |       | 24 | % | 217 | % |
| Overhead and  other expenses  |       | 745                                              |       | 282                                                           |       | 44 | % | 20 | % |
| Total                         |       | $                                                | 4,944      |                                                          | $          | 1,819 |   | 61 | % | 29 | % |

 

The increases inexpenses for both periods were due in part to increases in compensationcosts as a result of additional personnel focused on product innovation anddevelopment. We had 100, 62, and 50 research and development personnel as ofDecember 31, 2006, 2005 and 2004, respectively. Salaries, benefits andbonus for the year ended December 31, 2006 included a $284,000 one-time chargerelated to the retirement of Vincent Argiro, our Chief Technology Officer andfounder, which was recorded in the first quarter of 2006.  Of this charge, $138,000 is included insalaries, benefits and bonus above and $146,000 is included in equity-basedcompensation.  The increase inequity-based compensation costs during 2006 was the result of our adoption ofSFAS No. 123(R) as of January 1, 

30

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2006.

During 2006 and2005, we required a significant amount of temporary consulting services incompleting certain research and development activities, specifically in thearea of software testing and validation. However, during 2006 we added a significant number of research anddevelopment personnel, which allowed us to rely less on outside consulting as atotal percentage of research and development expense.

We expect researchand development expenses to continue to increase in future periods primarily asa result of additional personnel to support the expansion of our productdevelopment activities so that we can maintain our status as an industry leaderin advanced visualization. Including the equity-based compensation, we expectresearch and development expenses to be between 17% and 18% of total revenuefor the year ending December 31, 2007.

**General and administrative**

General andadministrative expenses increased 55% to $10.9 million in 2006 compared to $7.0million in 2005. General and administrative expenses increased 25% to $7.0million in 2005 compared to $5.6 million in 2004. The change in general andadministrative expense is as follows (in thousands):
| ** **                    | ** ** | **Year-over-year  Change from Fiscal** | ** ** | **Year-over-year Percent  Change from Fiscal** | ** ** |
|-------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                    | ** ** | **2005 to 2006**                       | ** ** | **2004 to 2005**                                    | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
| Salaries,  benefits and bonus |       | $                                                | 1,376      |                                                          | $          | 1,393 |   | 40 | % | 67 | % |
| Equity-based  compensation    |       | 1,712                                            |       | 144                                                           |       | 1189 | % | 100 | % |
| Overhead and  other expenses  |       | 798                                              |       | (145                                                          | )          | 23 | % | (4 | )% |
| Total                         |       | $                                                | 3,886      |                                                          | $          | 1,392 |   | 55 | % | 25 | % |

 

The increaseduring 2006 was primarily due to higher equity-based compensation costs as aresult of our adoption of SFAS No. 123(R) as of January 1, 2006.  The remaining increases in both periods weredue to increases in compensation costs as a result of additional personnel andincreases in overhead expenses due to the growth of the business. We had 50,30, and 23 general and administrative personnel as of December 31, 2006,2005 and 2004, respectively.

We expect generaland administrative expenses to continue to increase in future periods primarilyas a result of increased personnel and administrative costs associated withvarious company initiatives to build the infrastructure for a larger business,as well as international expansion. Including the equity-based compensation, weexpect general and administrative expenses to be approximately 15% to 16% oftotal revenue for the year ending December 31, 2007.

**Otheritems**

Loss on operatinglease — In March 2004, we signed a non-cancelable operating lease for anew office facility in Minnetonka, Minnesota. The new lease term started inFebruary 2005 and expires in January 2012. We moved into theMinnetonka location and moved out of the Plymouth, Minnesota location inFebruary 2005. Our lease for the office facility in Plymouth expired on July 31,2005, with the exception of a small portion of the space that was under leaseuntil May 31, 2006. Under the terms of the Minnetonka lease, sinceFebruary 2005, the lessor paid the monthly base rent payments and taxesand operating cost rent obligation payments for our former office facility inPlymouth.  In the first quarter of 2005,we recorded a lease loss of $493,000 related to the abandonment of the Plymouthoffice. The estimated lease payments to be made by the Minnetonka landlord tothe Plymouth landlord are considered a lease incentive and recorded as animmediate charge and deferred rent, which is amortized as a reduction of rentexpense through the term of the lease.

Acquiredin-process research and development — Results for the first quarter of 2004included a $1.0 million write-off of in-process research and development costsrelated to the HInnovation acquisition.

**Interestincome**

We generated $3.3million of interest income in 2006, compared with $1.1 million in 2005 and$368,000 in 2004. During the fourth quarter of 2006, we completed a publicoffering of 3.4 million shares of common stock, resulting in net proceeds of$97.7 million, which significantly increased interest income in the fourthquarter. In addition to the increased interest income resulting from theoffering, the increases were primarily due to increases in cash, cash

31

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equivalents andmarketable securities, which were generated from increased cash flows in allperiods, and an increase in interest rates.

**Incometaxes**

Our effectiveincome tax rate was 36%, 33% and 67% in 2006, 2005 and 2004, respectively. Theincrease in our effect tax rate in 2006 from 2005 was due to thenon-deductibility of incentive stock options, for which the tax benefit isrecorded only upon a disqualifying disposition which was a result of theadoption of SFAS No. 123(R) on January 1, 2006 which required that we recognizecompensation expense for all equity-based payments granted on or afterJanuary 1, 2006 and prior to but not yet vested as of January 1,2006.  Our effective tax rate of 67% in2004 was impacted by non-deductible in-process research and development and anincrease in our valuation allowance.

We estimate aneffective income tax rate of approximately 36% to 37% in 2007. Due to theutilization of deferred tax assets relating to net operating losses and taxdeductions from the exercise of stock options, we do not anticipate paying anysignificant cash for income taxes for the next two to four years.

Our methodology for determining the realizability of our deferred taxassets involves estimates of future taxable income from our core business, theestimated impact of future tax deductions from the exercise of stock optionsoutstanding as of each balance sheet date, and the expiration dates and amountsof net operating loss carryforwards and other tax credits. These estimates areprojected through the life of the related deferred tax assets based onassumptions which we believe to be reasonable and consistent with currentoperating results.  If we adjusteither our estimates of future taxable income or tax deductions from theexercise of stock options down, or our stock price increases significantlywithout an increase in taxable income, causing us to believe that our deferredtax assets will not be utilized, we may need to establish additionalvaluation allowances on our deferred tax assets, which could materially impactour financial position and results of operations.

**Liquidityand capital resources**

As ofDecember 31, 2006, we had $144.4 million in cash and cash equivalents,$21.6 million in marketable securities, working capital of $162.2 million andno borrowings, as compared to $20.8 million in cash and cash equivalents, $29.0million in marketable securities, working capital of $45.6 million and noborrowings as of December 31, 2005.

*Operatingactivities*

During 2006, cashprovided by operations was $14.8 million, which consisted of net income of $6.6million, a decrease of $526,000 from changes in working capital accounts, anincrease of $561,000 in deferred rent relating to payments and estimatedpayments to be made by our Minnetonka landlord for our benefit, and an increaseof $8.2 million from other non-cash operating activities. Changes in workingcapital accounts primarily related to an increase in accounts receivable of$5.3 million and an increase in deferred revenue of $4.4 million due toincreased sales and an increased customer base. Days’ sales outstanding(calculated by dividing ending net accounts receivable by revenue per day) was101 as of December 31, 2006 and 2005. Our aging remains relatively current, with less than 2% of receivablesgreater than 90 days past due as of December 31, 2006 and 2005. We use days’sales outstanding as an activity measure which places emphasis and focus onaccounts receivable, but this measure is not defined under U.S. generallyaccepted accounting principles, and similarly titled measures may not becomputed the same by other companies. Other changes in working capital accountsincluded an increase of $701,000 in prepaid and other current assets and anincrease of $836,000 in accounts payable due to increased operating costs andgeneral timing of payments to vendors.

During 2005, cashprovided by operations was $13.7 million, which consisted of a decrease of$101,000 from changes in working capital accounts, an increase of $1.2 millionin deferred rent relating to payments and estimated payments to be made by ourMinnetonka landlord for our benefit, and an increase of $12.6 million fromother operating activities. Changes in working capital accounts primarilyrelated to an increase in accounts receivable of $6.1 million and an increasein deferred revenue of $3.5 million due to increased sales and an increasedcustomer base. Days’ sales outstanding as of December 31, 2005 increasedto 101 days, compared to 82 days as of December 31, 2004, which increasedas a result of a significant portion of sales occurring in the third month ofthe fourth quarter of 2005. Other changes in working capital accounts includeda decrease of $135,000 in prepaid and other current assets; an increase of$740,000 in accounts payable due to increased operating costs and generaltiming of payments to vendors; and an increase of $1.9 million related toaccruals for bonuses and royalty payments.

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*Investingactivities*

Net cash providedby investing activities was $1.4 million in 2006.  We used $21.7 million and $15.7 million ofcash in investing activities in 2005 and 2004, respectively.

We used $6.4million, $4.3 million and $1.6 million for purchases of property and equipment in 2006, 2005and 2004, respectively. The purchasesfor all periods were principally to expand our facilities and upgrade computerequipment and to purchase computer equipment for new personnel. We anticipatethat we will continue to purchase property and equipment in the normal courseof business. The amount and timing of these purchases and the related cashoutflows in future periods are difficult to predict and depend on a number offactors, including the hiring of employees and the rate of change of computerhardware.

We used $29.5 million, $38.8 million and $30.4 million to purchaseinvestments in marketable securities during 2006, 2005 and 2004, respectively. We realized $37.4 million,$21.4 million and $22.5 million of proceeds from maturities and sales ofmarketable securities during 2006, 2005 and 2004, respectively. The marketable securities consist of U.S. governmentobligations, U.S. government agency obligations, corporate commercialobligations and certificates of deposits.

During the firstquarter of 2004, we completed the acquisition of HInnovation, Inc. inaccordance with the terms and conditions of an Acquisition Agreement and Planof Reorganization dated as of January 8, 2004, using $6.1 million of cash.See Note 3 to the Consolidated Financial Statements for additional informationon the acquisition.

*Financingactivities*

Cash provided by financing activities totaled $107.4 million, $4.7million and $2.2 million for 2006, 2005 and 2004, respectively. The cash provided byfinancing activities in 2006 related primarily to the $97.7 million in netproceeds from our public offering of 3.4 million shares of common stock.  The cash provided by financing activities in2005 and 2004 resulted primarily from the exercise of stock options grantedunder our stock plans and upon the exercise of warrants.

We have never paidor declared any cash dividends and do not intend to pay dividends in the nearfuture.

The followingsummarizes our contractual obligations at December 31, 2006 and the effectsuch obligations are expected to have on our liquidity and cash flow in futureperiods (in thousands).

|                  | ** ** | **Total** | ** ** | **1 Year or Less** | ** ** | **1 to 3 Years** | ** ** | **3 to 5 Years** | ** ** | **More than 5  Years** | ** ** |
|------------------|------------|-----------|------------|-----------------------------------|------------|---------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
|             |       |      |       |                              |       |                            |       |                            |       |                             |       |
| Operating leases |       | $         | 4,652      |                              | $          | 1,010                           |       | $                               | 1,771      |                             | $          | 1,795 |   | $ | 76 |   |
|                  |            |           |            |                                   |            |                                 |            |                                 |            |                                  |            |  |  |  |  |  |

 

Off-balance-sheetarrangements

We did not haveany off-balance sheet arrangements as of December 31, 2006 or 2005.

Agreement with R2Technology, Inc.

In the firstquarter of 2006, we reversed $236,000 of the $410,000 expense recorded in thefourth quarter of 2005 relating to our agreement with R2.  In the secondquarter of 2006, we recorded a $167,000 expense relating to relating to ouragreement with R2.  No such charges or reversals occurred during the secondhalf of 2006.  As of December 31, 2006, the remaining potential aggregatecommitment under this agreement ranges from a minimum of $0 to a maximum ofapproximately $2.1 million and we estimate that we will incur no additionallosses relating to this agreement. Based on information available to us, R2 hadnot generated any significant R2 Lung CAD Product sales through any othersales, marketing and distribution channels, other than sales generated fromcustomers under this agreement.  As aresult, the Applicable Minimum for the quarter ended December 31, 2006 was $0,and the Applicable Minimum for the quarter ending March 31, 2007 is $0. SeeNote 9 to the Condensed Consolidated Financial Statements for furtherdiscussion.

Other purchasecommitments

We had nosignificant outstanding purchase orders as of December, 31 2006. We haveentered into a number of technology licensing agreements that provide for thepayment of royalties when we sell *Vitrea*. Exceptfor the R2 purchase commitment described above, we are not obligated for anyminimum payments under such agreements.

**Foreigncurrency transactions**

Substantially allof our foreign transactions are negotiated, invoiced and paid in U.S. dollars.

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**Inflation**

We believeinflation has not had a material effect on our operations or financialcondition.

**Recentaccounting pronouncement**

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements and prescribes a recognition threshold andmeasurement attribute for financial statement recognition and measurement of atax position taken or expected to be taken in a tax return. FIN 48 alsoprovides related guidance on derecognition, classification, interest andpenalties, accounting in interim periods and disclosure. FIN 48 is effectivefor us beginning January 1, 2007. We are currently evaluating the impact of FIN48.

**Item 7A.****                          Quantitativeand Qualitative Disclosures about Market Risk**

Market risk refersto the risk that a change in the level of one or more market prices, interestrates, indices, volatilities, correlations or other market factors such asliquidity will result in losses for a certain financial instrument or group offinancial instruments. We do not hold or issue financial instruments fortrading purposes, and we do not enter into forward financial instruments tomanage and reduce the impact of changes in foreign currency rates because, asdisclosed above, substantially all of our foreign transactions are negotiated,invoiced and paid in U.S. dollars. Based on the controls in place and therelative size of the financial instruments entered into, we believe the risksassociated with not using these instruments would not have a material adverseeffect on our consolidated financial position or results of operations.

In addition, we donot engage in speculative transactions and do not use derivative instruments orengage in hedging activities. See the Notes to the Consolidated FinancialStatements for a description of our accounting policies and other informationrelated to these financial instruments.

In the normalcourse of business, we are exposed to market risks, including changes ininterest rates and price changes, which could affect our operating results. Asof December 31, 2006, fluctuations in interest rates, exchange rates andprice changes would not have had a material effect on our financial position oroperating results.

**Interestrate risk**

We place our cash,cash equivalents and marketable securities, which generally have a term of lessthan one year, with a high-quality financial institution and have investmentguidelines relative to diversification and maturities designed to maintainsafety and liquidity. As of December 31, 2006, we had cash, cashequivalents and marketable securities totaling $166.0 million. If, during 2006,average short-term interest rates decreased by 1.0% from 2006 average rates,based on our quarterly average balance of cash, cash equivalents and marketablesecurities, our projected interest income from short-term investments wouldhave decreased by approximately $860,000.

**Foreigncurrency risk**

Substantially allof our foreign transactions are negotiated, invoiced and paid in U.S. dollars.Therefore, fluctuations in the value of the dollar as compared to other foreigncurrencies have not had an effect on our results of operations or financialcondition.

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

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

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

Not applicable.

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

**Evaluation of disclosure controls and procedures**

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed

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in the reports that we file or submit under theSecurities Exchange Act of 1934, as amended (“Exchange Act”), are recorded,processed, summarized, and reported within the time periods specified in therules and forms of the Securities and Exchange Commission, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate, to allowtimely decisions regarding required disclosure. Our management, under the supervision of and with the participation ofour Chief Executive Officer and Chief Financial Officer, has evaluated theeffectiveness of our disclosure controls and procedures, as defined inRules 13a-15(e) and 15d-15(e) under the Exchange Act, as of theend of the period covered by this report. Based on such evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures were effective as of December 31, 2006.

Wemaintain a disclosure committee to assist our Chief Executive Officer and ChiefFinancial Officer in performing the evaluation discussed above. The members ofthis committee include certain of our executive officers, senior members of ourfinance and accounting staff, our general counsel and our outside legalcounsel.

**Management’s report on internal control overfinancial reporting**

Management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as defined in Exchange Act Rules 13a-15(f) and15d-15(f). Our internal control over financial reporting is a process designedto provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. Because of itsinherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controlsmay become inadequate because of changes in conditions or that the degreeof compliance with the policies or procedures may deteriorate.

Our management,under the supervision of and with the participation of our Chief ExecutiveOfficer and Chief Financial Officer, has evaluated the effectiveness of ourinternal control over financial reporting as of December 31, 2006 based onthe criteria established in *Internal Control —Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Based on the results of thisevaluation, we concluded that our internal control over financial reporting waseffective as of December 31, 2006.

Our assessment of the effectiveness of our internalcontrol over financial reporting as of December 31, 2006 has been auditedby PricewaterhouseCoopers LLP, an independent registered accounting firm, asstated in their report which is included in Item 15(a)(1) of this Annual Reporton Form 10-K.

**Changesin internal control over financial reporting**

Therewere no changes in internal control over financial reporting during 2006 thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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

None.

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**Part III**

Certain information required by Part III is omitted from thisAnnual Report on Form 10-K because we will file a definitive ProxyStatement relating to our 2007 Annual Meeting of Stockholders pursuant toSchedule 14A (the “Proxy Statement”) not later than 120 days afterthe end of the fiscal year covered by this Annual Report on Form 10-K, andcertain information included therein is incorporated herein by reference asindicated below.

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

The informationrequired by this Item 10 will be included under the captions “Election ofDirectors” and “Information Concerning Directors, Nominees and ExecutiveOfficers” in our 2007 Proxy Statement. Information concerning the compliance ofour officers, directors and 10% shareholders with Section 16(a) ofthe Securities Exchange Act of 1934 is incorporated by reference to theinformation to be contained in the 2006 Proxy Statement under the caption “InformationConcerning Directors Nominees and Executive Officers —Section 16(a) Beneficial Ownership Reporting Compliance.”  The information regarding Audit Committeemembers and “audit committee financial experts” is incorporated by reference tothe information to be contained in the 2007 Proxy Statement under the caption “InformationConcerning Directors Nominees and Executive Officers — Board Committees.”  The information regarding our Code ofBusiness Ethics is incorporated by reference to the information to be containedin the 2007 Proxy Statement under the heading “Information Concerning DirectorsNominees and Executive Officers — Code of Business Conduct and Ethics.”

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

The informationunder the captions “Information Concerning Directors Nominees and ExecutiveOfficers — Executive Compensation” and “Information Concerning DirectorsNominees and Executive Officers — Director Compensation” to be contained in the2007 Proxy Statement is incorporated herein by reference.

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

The informationunder the captions “Beneficial Ownership of Common Stock” and “InformationConcerning Directors, Nominees and Executive Officers — Securities Authorizedfor Issuers Under Equity Compensation Plans” to be contained in the 2007 ProxyStatement is incorporated herein by reference.

**Item 13.****                            CertainRelationships and Related Transactions, and Director Independence**

Not applicable.

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

The informationunder the caption “Ratification of Appointment of PricewaterhouseCoopers LLP asIndependent Registered Public Accounting Firm” to be contained in the 2007Proxy Statement is incorporated herein by reference.

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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, 2006 and 2005                                                                              |   |   |   |
| Consolidated Income  Statements for the years ended December 31, 2006, 2005 and 2004                                                       |   |   |   |
| Consolidated  Statements of Stockholders’ Equity and Other Comprehensive Income for the  years ended December 31, 2006, 2005 and 2004 |   |   |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and  2004                                               |   |   |   |
| 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 to be a part of this Reportare listed in the Index to Exhibits.

(b)         Exhibits

Includedin Item 15(a)(3) above.

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**Signatures**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized, in Minneapolis, Minnesota, on the12th day of March, 2007.

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

 

Pursuant to therequirement of the Securities Exchange Act of 1934, this Report has been signedby the following persons in the capacities and on the dates indicated.

 
| Signature                     | ** ** | **Title**                                                       | ** ** | **Date**             |
|-------------------------------|------------|-----------------------------------------------------------------|------------|----------------------|
|                          |       |                                                            |       |                 |
| /s/Jay D. Miller              |       | President, Chief  Executive Officer and Director                |       | March 15,  2007 |
| Jay D. Miller                 |       | (Principal  Executive Officer)                                  |       |                 |
|                          |       |                                                            |       |                 |
| /s/Michael H.  Carrel         |       | Chief Operating  Officer and Chief Financial Officer            |       | March 15,  2007 |
| Michael H.  Carrel            |       | Treasurer and  Secretary                                        |       |                 |
|                          |       | (Principal  Financial Officer and Principal Accounting Officer) |       |                 |
|                          |       |                                                            |       |                 |
| /s/Douglas M.  Pihl           |       | Chairman of the  Board and Director                             |       | March 15,  2007 |
| Douglas M. Pihl               |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/James B.  Hickey, Jr. |       | Director                                                        |       | March 15,  2007 |
| James B.  Hickey, Jr.    |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Richard W.  Perkins        |       | Director                                                        |       | March 15,  2007 |
| Richard W.  Perkins           |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Michael W.  Vannier        |       | Director                                                        |       | March 15,  2007 |
| Michael W.  Vannier           |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Sven A.  Wehrwein          |       | Director                                                        |       | March 15,  2007 |
| Sven A. Wehrwein              |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Gregory J.  Peet           |       | Director                                                        |       | March 15,  2007 |
| Gregory J. Peet               |       |                                                            |       |                 |

 

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**Report of IndependentRegistered Public Accounting Firm**

To****the Board of Directors and Stockholders of VitalImages, Inc.:

We have completed integrated audits of Vital ImagesInc.’s consolidated financial statements and of its internal control overfinancial reporting as of December 31, 2006, in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, arepresented below.

Consolidated financial statements

In our opinion, the consolidated financial statements listed inthe index appearing under Item 15(a)(1) present fairly, in allmaterial respects, the financial position of Vital Images, Inc. and itssubsidiaries (the “Company”) at December 31, 2006 and 2005, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2006****in conformitywith accounting principles generally accepted in the United States of America.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits. We conducted our audits of these statements in accordance withthe standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit of financial statements includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

As discussed inNote 2 to the consolidated financial statements, the Company changed themanner in which it accounts for share-based compensation in 2006.

Internal controlover financial reporting

Also, in ouropinion, management’s assessment, included in Management’s report on internalcontrol over financial reporting appearing under Item 9A, that the Companymaintained effective internal control over financial reporting as ofDecember 31, 2006 based on criteria established in *InternalControl - Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, the Companymaintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on criteria established in *Internal Control - Integrated Framework* issued by the COSO.The Company’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to expressopinions on management’s assessment and on the effectiveness of theCompany’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. An audit ofinternal control over financial reporting includes obtaining an understandingof internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we consider necessaryin the circumstances. We believe that our audit provides a reasonable basis forour opinions.

A 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. A company’s internal control overfinancial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements in accordancewith generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and(iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

Because of itsinherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controlsmay become inadequate because of changes in conditions, or that the degreeof compliance with the policies or procedures may deteriorate.

PricewaterhouseCoopersLLP

Minneapolis, Minnesota

March 14, 2007

 

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**Vital Images, Inc.Consolidated Balance Sheets**

**(Inthousands)**

 
| ** **                                                                                                                                                                          | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                          | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                                          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                     |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                          |       | $                     | 144,382    |   | $ | 20,845 |   |
| Marketable  securities                                                                                                                                                              |       | 20,821                |       | 28,965 |   |
| Accounts  receivable, net                                                                                                                                                           |       | 19,589                |       | 14,330 |   |
| Deferred income  taxes                                                                                                                                                              |       | 1,661                 |       | 717 |   |
| Prepaid expenses  and other current assets                                                                                                                                          |       | 1,928                 |       | 1,228 |   |
| Total current  assets                                                                                                                                                               |       | 188,381               |       | 66,085 |   |
| Marketable securities                                                                                                                                                               |       | 750                   |       | — |   |
| Property and equipment,  net                                                                                                                                                        |       | 9,242                 |       | 5,361 |   |
| Deferred income taxes                                                                                                                                                               |       | 8,969                 |       | 8,949 |   |
| Licensed technology,  net                                                                                                                                                           |       | 90                    |       | 210 |   |
| Other intangible  assets, net                                                                                                                                                       |       | 3,209                 |       | 4,493 |   |
| Goodwill                                                                                                                                                                            |       | 9,089                 |       | 6,053 |   |
| Total assets                                                                                                                                                                        |       | $                     | 219,730    |   | $ | 91,151 |   |
|                                                                                                                                                                                |       |                  |       |   |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                      | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                    |       | $                     | 3,830      |   | $ | 2,640 |   |
| Accrued  compensation                                                                                                                                                               |       | 3,977                 |       | 3,688 |   |
| Accrued  royalties                                                                                                                                                                  |       | 1,158                 |       | 1,348 |   |
| Other current  liabilities                                                                                                                                                          |       | 2,083                 |       | 1,575 |   |
| Deferred revenue                                                                                                                                                                    |       | 15,131                |       | 11,231 |   |
| Total current  liabilities                                                                                                                                                          |       | 26,179                |       | 20,482 |   |
| Deferred revenue                                                                                                                                                                    |       | 1,174                 |       | 645 |   |
| Deferred rent                                                                                                                                                                       |       | 1,475                 |       | 1,235 |   |
| Total  liabilities                                                                                                                                                                  |       | 28,828                |       | 22,362 |   |
|                                                                                                                                                                                |       |                  |       |   |   |
| Commitments and  contingencies (Note 5)                                                                                                                                             |       |                  |       |   |   |
|                                                                                                                                                                                |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                          |       |                  |       |   |   |
| Preferred stock:  $0.01 par value; 5,000 shares authorized; none issued or outstanding                                                                                              |       | —                |       | — |   |
| Common stock:  $0.01 par value; 20,000 shares authorized; 16,908 issued and outstanding as  of December 31, 2006; and 12,848 shares issued and outstanding as of December  31, 2005 |       | 169                   |       | 128 |   |
| Additional  paid-in capital                                                                                                                                                         |       | 189,669               |       | 75,918 |   |
| Deferred  stock-based compensation                                                                                                                                                  |       | —                |       | (1,707 | ) |
| Retained earnings  (accumulated deficit)                                                                                                                                            |       | 1,053                 |       | (5,530 | ) |
| Accumulated  other comprehensive income (loss)                                                                                                                                      |       | 11                    |       | (20 | ) |
| Total  stockholders’ equity                                                                                                                                                    |       | 190,902               |       | 68,789 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                    |       | $                     | 219,730    |   | $ | 91,151 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

40

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**Vital Images, Inc.Consolidated Income Statements**

**(Inthousands, except for per share amounts)**

 
| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                  |       |                                                         |       |   |   |   |   |
| Revenue:                                              |       |                                                         |       |   |   |   |   |
| License fees                                          |       | $                                                            | 46,332     |   | $ | 35,228 |   | $ | 24,054 |   |
| Maintenance and services                              |       | 22,615                                                       |       | 14,324 |   | 9,525 |   |
| Hardware                                              |       | 1,565                                                        |       | 2,165 |   | 2,543 |   |
| Total revenue                                         |       | 70,512                                                       |       | 51,717 |   | 36,122 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Cost of revenue:                                      |       |                                                         |       |   |   |   |   |
| License fees                                          |       | 4,991                                                        |       | 4,682 |   | 3,994 |   |
| Maintenance and services                              |       | 8,023                                                        |       | 5,559 |   | 4,660 |   |
| Hardware                                              |       | 1,196                                                        |       | 1,319 |   | 1,793 |   |
| Total cost of revenue                                 |       | 14,210                                                       |       | 11,560 |   | 10,447 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Gross profit                                          |       | 56,302                                                       |       | 40,157 |   | 25,675 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Operating  expenses:                                  |       |                                                         |       |   |   |   |   |
| Sales and marketing                                   |       | 25,374                                                       |       | 16,932 |   | 12,204 |   |
| Research and development                              |       | 13,092                                                       |       | 8,148 |   | 6,329 |   |
| General and administrative                            |       | 10,905                                                       |       | 7,019 |   | 5,627 |   |
| Loss on operating lease                               |       | —                                                       |       | 493 |   | — |   |
| Acquired in-process research and development          |       | —                                                       |       | — |   | 1,000 |   |
| Total operating expenses                              |       | 49,371                                                       |       | 32,592 |   | 25,160 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Operating income                                      |       | 6,931                                                        |       | 7,565 |   | 515 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Interest income                                       |       | 3,342                                                        |       | 1,067 |   | 368 |   |
| Income before  income taxes                           |       | 10,273                                                       |       | 8,632 |   | 883 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Provision for  income taxes                           |       | 3,690                                                        |       | 2,831 |   | 587 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Net income                                            |       | $                                                            | 6,583      |   | $ | 5,801 |   | $ | 296 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Net income per  share — basic                    |       | $                                                            | 0.49       |   | $ | 0.47 |   | $ | 0.03 |   |
| Net income per  share — diluted                  |       | $                                                            | 0.46       |   | $ | 0.44 |   | $ | 0.02 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Weighted average  common shares outstanding - basic   |       | 13,463                                                       |       | 12,379 |   | 11,632 |   |
| Weighted average  common shares outstanding - diluted |       | 14,259                                                       |       | 13,283 |   | 12,536 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

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

**(Inthousands)**

 

 
| ** **                                                                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **       | ** ** | **Retained**        | ** ** | **Accumulated**               | ** ** | ** **        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|------------------|------------|---------------------|------------|-------------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **       | ** ** | **Earnings /** | ** ** | **Other**                     | ** ** | **Total**         | ** ** | ** ** | ** ** |
| ** **                                                                                                     | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Deferred**   | ** ** | **(Accumulated** | ** ** | **Comprehensive**   | ** ** | **Stockholders’**        | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                     | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Deficit)**        | ** ** | **Income / (Loss)** | ** ** | **Equity**        | ** ** | **Income** | ** ** |
|                                                                                                           |       |                  |       |        |       |           |       |             |       |                |       |                          |       |              |       |       |       |
| Balances as of  December 31, 2003                                                                         |       | 11,140                |       | 111         |       | 56,109         |       |             |       | (11,627             | )          |                          |       | 44,593            |       |       |       |
|                                                                                                           |       |                  |       |        |       |           |       |             |       |                |       |                          |       |              |       |       |       |
| Issuance of  common stock upon exercise of stock options                                                       |       | 456                   |       | 5           |       | 1,967          |       |             |       |                |       |                          |       | 1,972             |       |       |       |
| Tax benefit  related to exercise of stock options                                                              |       |                  |       |        |       | 1,430          |       |             |       |                |       |                          |       | 1,430             |       |       |       |
| Issuance of  common stock under employee stock purchase plan                                                   |       | 19                    |       | —      |       | 171            |       |             |       |                |       |                          |       | 171               |       |       |       |
| Issuance of  common stock upon exercise of stock warrants                                                      |       | 16                    |       | —      |       | 19             |       |             |       |                |       |                          |       | 19                |       |       |       |
| Stock-based  compensation                                                                                      |       |                  |       |        |       | 11             |       |             |       |                |       |                          |       | 11                |       |       |       |
| Acquistion of  HInnovation                                                                                     |       | 376                   |       | 4           |       | 6,106          |       |             |       |                |       |                          |       | 6,110             |       |       |       |
| Unrealized loss  on investments                                                                                |       |                  |       |        |       |           |       |             |       |                |       | (48                           | )          | (48               | )          | (48        | )          |
| Net income                                                                                                     |       |                  |       |        |       |           |       |             |       | 296                 |       |                          |       | 296               |       | 296        |       |
| Balances as of  December 31, 2004                                                                         |       | 12,007                |       | 120         |       | 65,813         |       | —           |       | (11,331             | )          | (48                           | )          | 54,554            |       | $          | 248        |   |
|                                                                                                           |       |                  |       |        |       |           |       |             |       |                |       |                          |       |              |       |       |       |
| Issuance of  common stock upon exercise of stock options                                                       |       | 711                   |       | 7           |       | 4,496          |       |             |       |                |       |                          |       | 4,503             |       |       |       |
| Tax benefit  related to exercise of stock options                                                              |       |                  |       |        |       | 3,359          |       |             |       |                |       |                          |       | 3,359             |       |       |       |
| Issuance of  common stock under employee stock purchase plan                                                   |       | 15                    |       | —      |       | 210            |       |             |       |                |       |                          |       | 210               |       |       |       |
| Grant of  restricted stock to employees, net                                                                   |       | 115                   |       | 1           |       | 2,019          |       | (2,021           | )          |                |       |                          |       | (1                | )          |       |       |
| Stock-based  compensation                                                                                      |       |                  |       |        |       | 21             |       | 314              |       |                |       |                          |       | 335               |       |       |       |
| Change in  unrealized loss on investments, net of tax                                                          |       |                  |       |        |       |           |       |             |       |                |       | 28                            |       | 28                |       | $     | 28         |   |
| Net income                                                                                                     |       |                  |       |        |       |           |       |             |       | 5,801               |       |                          |       | 5,801             |       | 5,801      |       |
| Balances as of  December 31, 2005                                                                         |       | 12,848                |       | 128         |       | 75,918         |       | (1,707           | )          | (5,530              | )          | (20                           | )          | 68,789            |       | $          | 5,829      |   |
|                                                                                                           |       |                  |       |        |       |           |       |             |       |                |       |                          |       |              |       |       |       |
| Issuance of  common stock upon exercise of stock options                                                       |       | 564                   |       | 6           |       | 5,168          |       |             |       |                |       |                          |       | 5,174             |       |       |       |
| Tax benefit  related to exercise of stock options                                                              |       |                  |       |        |       | 4,403          |       |             |       |                |       |                          |       | 4,403             |       |       |       |
| Issuance of  common stock under employee stock purchase plan                                                   |       | 16                    |       | —      |       | 364            |       |             |       |                |       |                          |       | 364               |       |       |       |
| Grant of  restricted stock to employees, net                                                                   |       | 34                    |       | —      |       | —         |       |             |       |                |       |                          |       | —            |       |       |       |
| Common stock  surrendered for payment of payroll tax liability resulting from the vesting  of restricted stock |       | (14                   | )          | —      |       | (292           | )          |             |       |                |       |                          |       | (292              | )          |       |       |
| Issuance of  common stock as contingent consideration related to the acquisition of  Hinnovation (See note 3)  |       | 106                   |       | 1           |       | 3,083          |       |             |       |                |       |                          |       | 3,084             |       |       |       |
| Issuance of  common stock in connection with public offering, net of offering costs of  $6,271                 |       | 3,354                 |       | 34          |       | 97,669         |       |             |       |                |       |                          |       | 97,703            |       |       |       |
| Stock-based compensation                                                                                       |       |                  |       |        |       | 5,063          |       |             |       |                |       |                          |       | 5,063             |       |       |       |
| Reclassification  of deferred compensation pursuant to FAS123R                                                 |       |                  |       |        |       | (1,707         | )          | 1,707            |       |                |       |                          |       | —            |       |       |       |
| Change in  unrealized loss on investments, net of tax                                                          |       |                  |       |        |       |           |       |             |       |                |       | 27                            |       | 27                |       | $     | 27         |   |
| Cumulative translation  adjustment                                                                             |       |                  |       |        |       |           |       |             |       |                |       | 4                             |       | 4                 |       | 4          |       |
| Net income                                                                                                     |       |                  |       |        |       |           |       |             |       | 6,583               |       |                          |       | 6,583             |       | 6,583      |       |
| Balances as of  December 31, 2006                                                                         |       | 16,908                |       | $           | 169        |           | $          | 189,669          |       | $                   | —     |                          | $          | 1,053             |       | $          | 11         |   | $ | 190,902 |   | $ | 6,614 |   |
|                                                                                                                |            |                       |            |             |            |                |            |                  |            |                     |            |                               |            |                   |            |            |            |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

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**VitalImages, Inc.**

**Consolidated Statements of Cash Flows**

**(In thousands)**
| ** **                                                                         | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                               |       |                                                         |       |   |   |   |   |
| Cash flows from  operating activities:                                             |       |                                                         |       |   |   |   |   |
| Net income                                                                         |       | $                                                            | 6,583      |   | $ | 5,801 |   | $ | 296 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                                         |       |   |   |   |   |
| Depreciation and amortization of property and  equipment                           |       | 2,910                                                        |       | 2,143 |   | 1,569 |   |
| Amortization of identified intangible assets                                       |       | 1,404                                                        |       | 1,404 |   | 1,243 |   |
| Acquired in-process research and development                                       |       | —                                                       |       | — |   | 1,000 |   |
| Provision for doubtful accounts                                                    |       | 25                                                           |       | (159 | ) | 627 |   |
| Deferred income taxes                                                              |       | 3,472                                                        |       | (600 | ) | (878 | ) |
| Tax benefit from stock option transactions                                         |       | —                                                       |       | 3,359 |   | 1,430 |   |
| Excess tax benefit from stock transactions                                         |       | (4,143                                                       | )          | — |   | — |   |
| Amortization of discount and accretion of premium on  marketable securities        |       | (382                                                         | )          | 24 |   | 463 |   |
| Employee stock-based compensation                                                  |       | 5,045                                                        |       | 314 |   | — |   |
| Non-employee stock-based compensation                                              |       | 18                                                           |       | 21 |   | 12 |   |
| Loss on operating lease                                                            |       | —                                                       |       | 493 |   | — |   |
| Amortization of deferred rent                                                      |       | (195                                                         | )          | (163 | ) | — |   |
| Changes in operating assets and liabilities, net of  effect from acquisition:      |       |                                                         |       |   |   |   |   |
| Accounts receivable                                                                |       | (5,284                                                       | )          | (6,080 | ) | (3,839 | ) |
| Prepaid expenses and other assets                                                  |       | (701                                                         | )          | (135 | ) | (169 | ) |
| Accounts payable                                                                   |       | 836                                                          |       | 740 |   | 301 |   |
| Accrued and other liabilities                                                      |       | 194                                                          |       | 1,913 |   | 1,892 |   |
| Deferred revenue                                                                   |       | 4,429                                                        |       | 3,461 |   | 3,612 |   |
| Deferred rent                                                                      |       | 561                                                          |       | 1,180 |   | — |   |
| Net cash provided by operating activities                                          |       | 14,772                                                       |       | 13,716 |   | 7,559 |   |
|                                                                               |       |                                                         |       |   |   |   |   |
| Cash flows from  investing activities:                                             |       |                                                         |       |   |   |   |   |
| Purchases of property and equipment                                                |       | (6,436                                                       | )          | (4,275 | ) | (1,627 | ) |
| Purchases of marketable securities                                                 |       | (29,545                                                      | )          | (38,845 | ) | (30,434 | ) |
| Maturities of marketable securities                                                |       | 35,987                                                       |       | 21,417 |   | 22,455 |   |
| Sales of marketable securities                                                     |       | 1,376                                                        |       | — |   | — |   |
| Acquisition of HInnovation, Inc., net of cash  acquired                            |       | —                                                       |       | — |   | (6,108 | ) |
| Net cash provided by (used in) investing activities                                |       | 1,382                                                        |       | (21,703 | ) | (15,714 | ) |
|                                                                               |       |                                                         |       |   |   |   |   |
| Cash flows from  financing activities:                                             |       |                                                         |       |   |   |   |   |
| Proceeds from sale of common stock under stock plans                               |       | 5,538                                                        |       | 4,713 |   | 2,143 |   |
| Proceeds from sale of common stock under stock  warrants                           |       | —                                                       |       | — |   | 19 |   |
| Proceeds from sale of common stock, net of offering  costs                         |       | 97,703                                                       |       | — |   | — |   |
| Excess tax benefit from stock transactions                                         |       | 4,143                                                        |       | — |   | — |   |
| Net cash provided by financing activities                                          |       | 107,384                                                      |       | 4,713 |   | 2,162 |   |
|                                                                               |       |                                                         |       |   |   |   |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | 123,538                                                      |       | (3,274 | ) | (5,993 | ) |
|                                                                               |       |                                                         |       |   |   |   |   |
| Cash and cash  equivalents, beginning of year                                      |       | 20,845                                                       |       | 24,119 |   | 30,112 |   |
|                                                                               |       |                                                         |       |   |   |   |   |
| Cash and cash  equivalents, end of year                                            |       | $                                                            | 144,383    |   | $ | 20,845 |   | $ | 24,119 |   |
|                                                                               |       |                                                         |       |   |   |   |   |
| Supplemental  cash flow information:                                               |       |                                                         |       |   |   |   |   |
| Purchases of property and equipment with accounts  payable                         |       | $                                                            | 662        |   | $ | 308 |   | $ | 301 |   |
| Non-cash  investing and financing activities:                                      |       |                                                         |       |   |   |   |   |
| Common stock issued relating to acquisition of  HInnovation, Inc. (see Note 3)     |       | $                                                            | 3,084      |   | $ | — |   | $ | 6,110 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

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**VitalImages, Inc.**

**Notes to Consolidated FinancialStatements**

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

VitalImages, Inc. (the “Company”) is a leading provider of enterprise-wideadvanced visualization and image analysis solutions for use by medicalprofessionals in clinical analysis and therapy planning for medical conditions.The Company provides software, training, software maintenance, professionalservices and, on occasion, third-party hardware to its customers. The Company’stechnology rapidly transforms complex data generated by diagnostic imagingequipment into functional digital images that can be manipulated and analyzedusing our specialized applications to better understand internal anatomy andpathology. The Company’s solutions are designed to improve physician workflowand productivity, enhance the ability to make clinical decisions, facilitateless invasive patient care, and complement often significant capitalinvestments in diagnostic imaging equipment made by its customers. The Company’ssoftware is compatible with equipment from all major manufacturers ofdiagnostic imaging equipment, such as computed tomography, or CT, magneticresonance, or MR, and positron emission tomography, or PET, scanners, and canbe integrated into picture archiving and communication systems, or PACS. Manyhospitals use PACS to acquire, distribute and archive medical images anddiagnostic reports, reducing the need for film and increasing reliance onadvanced visualization solutions such as ours. The Company also offers aWeb-based solution that provides physicians with anywhere, anytime access tomedical images and visualization tools through any Internet-enabled computer.

The Company viewsits operations and manages its business as one reportable segment — thedevelopment and marketing of software and related services for enterprise-wideadvanced visualization and analysis solutions for use by medical professionalsin clinical analysis and therapy planning. Factors used to identify the Company’ssingle operating segment include the financial information available forevaluation by the chief operating decision maker in making decisions about howto allocate resources and assess performance. The Company markets its productsand services through a direct sales force and independent distributors in theUnited States and international markets.

The Company issubject to risks and uncertainties, including but not limited to, dependence oninformation 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, its ability todevelop products that gain market acceptance and international expansion.

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

**Basis ofpresentation**

The consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiaries. All intercompany accounts and transactions have been eliminated.

**Use ofestimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

**Fairvalue of financial instruments**

The Company’sfinancial instruments consist primarily of cash, cash equivalents, andmarketable securities, for which the current carrying amounts approximate fairmarket values.

**Cash andcash equivalents**

Cash and cashequivalents consist of cash and temporary investments with maturities of 90days or less when purchased. The carrying amount of cash equivalentsapproximates fair value due to the short maturity of these instruments.

**Marketablesecurities**

Managementdetermines the appropriate classification of marketable securities at the timeof purchase and

44

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reevaluates suchdesignation as of each balance sheet date. Currently, all marketable securitiesheld by the Company are classified as available-for-sale. Available-for-salesecurities are carried at fair value as determined by quoted market prices,with unrealized gains and losses, net of tax, reported as a separate componentof stockholders’ equity. If an unrealized loss for any investment is consideredto be other-than-temporary, the loss will be recognized in the consolidatedstatements of operations in the period the determination is made. The costbasis of securities sold is determined using the specific identificationmethod. The cost of marketable securities is adjusted for amortization ofpremiums and accretion of discounts to maturity. Such amortization andaccretion is included in interest income. Interest and dividends on securitiesclassified as available-for-sale are included in interest income. As ofDecember 31, 2006, all investments mature within two years.

As ofDecember 31, 2006 and 2005, the Company’s marketable securities were asfollows (in thousands):
| ** **                   | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **Adjusted**                    | ** ** | **Aggregate**                   | ** ** | **Net Unrealized** | ** ** | **Adjusted** | ** ** | **Aggregate** | ** ** | **Net Unrealized** | ** ** |
| ** **                   | ** ** | **Cost Basis**             | ** ** | **Fair Value**             | ** ** | **Gains / (Losses)** | ** ** | **Cost Basis** | ** ** | **Fair Value** | ** ** | **Gains / (Losses)** | ** ** |
| Corporate debt  (short term) |       | $                               | 20,810     |                            | $          | 20,821 |   | $ | 11 |   | $ | 27,998 |   | $ | 27,970 |   | $ | (28 | ) |
| Corporate debt  (long term)  |       | $                               | 750        |                            | $          | 750 |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Certificates of  deposit     |       | —                          |       | —                          |       | — |   | 999 |   | 995 |   | $ | (4 | ) |
|                         |       | $                               | 21,560     |                            | $          | 21,571 |   | $ | 11 |   | $ | 28,997 |   | $ | 28,965 |   | $ | (32 | ) |

 

**Accountsreceivable and allowance for doubtful accounts**

Accounts receivable are initially recorded at aselling price, which approximates fair value upon the sale of goods or servicesto customers. The Company maintains an allowance for doubtful accounts toreflect accounts receivable at net realizable value. In judging the adequacy ofthe allowance for doubtful accounts, the Company considers multiple factors,including historical bad debt experience, the general economic environment, theneed for specific client reserves and the aging of the Company’s receivables. Aportion of this provision is included in operating expenses as a general andadministrative expense and a portion is of this provision is included as areduction of license revenue A considerable amount of judgment is required inassessing these factors. If the factors utilized in determining the allowancedo not reflect future performance, then a change in the allowance for doubtfulaccounts would be necessary in the period such determination has been made,which would impact future results of operations.

**Concentrationof credit risk**

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist primarily of cash and cash equivalents and trade accountsreceivable. Deposits with the Company’s bank may exceed the amount ofinsurance provided on such deposits. Generally, these deposits may beredeemed upon demand and, therefore, bear minimal risk. Financial instrumentsthat potentially subject the Company to concentrations of credit risk consistprincipally of marketable securities. Marketable securities consist ofcorporate debt and certificates of deposit. The Company’s investment policy,approved by its Board of Directors, limits the amount the Companymay invest in any one type of investment, thereby reducing credit riskconcentrations. The Company’s customer base is generally concentrated with asmall number of customers. The Company reviews the creditworthiness of itscustomers prior to product shipment and generally does not require collateral.

**Propertyand equipment**

Property andequipment are recorded at cost. Depreciation is computed using thestraight-line method over the related asset’s estimated useful life, generallythree to seven years. Equipment is generally depreciated over three to sevenyears, furniture and fixtures are generally depreciated over seven years,computer software is generally depreciated over three years and leaseholdimprovements are amortized over the shorter of their estimated useful lives orthe remaining terms of the related leases. The asset cost and relatedaccumulated depreciation or amortization are adjusted for asset retirement ordisposal with the resulting gain or loss, if any, credited or charged toresults of operations.

**Long-livedassets**

The Companyreviews long-lived assets for impairment whenever events or changes incircumstances indicate the carrying amount may not be recoverable, inaccordance with Statement of Financial Accounting Standards

45

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(“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 or changes in circumstances are present, theundiscounted cash flows method is used to determine whether the asset isimpaired. Cash flows would include the estimated terminal value of the assetand 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 discountrate utilized would be based on management’s best estimate of the related risksand return at the time the impairment assessment is made.

**Goodwill**

The Companyaccounts for goodwill in accordance with the provisions of SFAS No. 142, “Goodwilland Other Intangible Assets”. Under SFAS No. 142, goodwill and intangibleassets with indefinite lives are reviewed for impairment annually or morefrequently if events or changes in circumstances indicate that the asset mightbe impaired. The first step of the goodwill impairment test, used to identifypotential impairment, compares the fair value of a reporting unit with itscarrying 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 bookvalue, goodwill is considered not impaired, and thus the second step of theimpairment 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 goodwillimpairment test, used to measure the amount of impairment loss, compares theimplied fair value of the goodwill with the 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. Anyloss recognized cannot exceed the carrying amount of goodwill. After a goodwillimpairment loss is recognized, the adjusted carrying amount of goodwill is itsnew accounting basis. Subsequent reversal of a previously recognized goodwillimpairment loss is prohibited once the measurement of that loss is completed.The Company completed the annual goodwill impairment assessment as of December 31,2006, in which no impairment was recorded.

**Revenuerecognition**

The Companyrecognizes revenue in accordance with American Institute of Certified PublicAccountants (“AICPA”) Statement of Position (“SOP”) 97-2, Software RevenueRecognition, as amended by SOP 98-4 and SOP 98-9, as well as Technical PracticeAids issued from time to time by the AICPA, and SEC Staff Accounting BulletinNo. 104. The Company recognizes revenue when it is realized or realizableand earned. The Company considers revenue realized or realizable and earnedwhen it has persuasive evidence of an arrangement, the product has been shippedor the services have been provided to the customer, the sales price is fixed ordeterminable, and collectability is probable.

License feerevenue is derived from the licensing of computer software. Hardware revenue isderived from the sale of system hardware, including peripheral equipment.Maintenance and service revenue is derived from software maintenance and fromtelephone support, installation, training and consulting services. The Company’ssoftware licenses are generally sold as part of an arrangement thatincludes maintenance and support and often installation and training services.

The Companylicenses software and sells products and services to end-users and alsoindirectly through original equipment manufacturers, value-added resellers andindependent distributors (collectively, “Resellers”). Terms offered by theCompany do not generally differ between end users and Resellers. The Companygenerally offers terms that require payment within 30 to 90 days after productdelivery. In rare situations where the Company offers terms that requirepayment beyond 90 days after product delivery, revenue is deferred until thepayment becomes due. The Company does not generally offer rights of return oracceptance clauses to its customers. In rare situations where the Companyprovides rights of return or acceptance clauses, revenue is deferred until theclause expires. The Company evaluates the credit worthiness of all customers.In circumstances in which the Company does not have experience selling to acustomer and lacks adequate credit information to conclude that collection isprobable, revenue is deferred until collection is reasonably assured and all otherrevenue recognition criteria in the arrangement have been met. Provided allother revenue recognition criteria are met, license revenue from Resellers isrecognized on a sell-in or sell-through basis depending on the arrangement withthe Reseller. The Company recognizes revenue from Resellers on a sell-in basisprovided the Reseller i) assumes all risk of the purchase, ii) has the abilityand obligation to pay regardless of receiving payment from the end user, andiii) all other revenue recognition criteria are met. The majority of revenuegenerated through Resellers has been on a sell-in basis.

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Additionally:

·                  Softwareand Hardware — Revenue from license fees and hardware is recognized whenshipment of the product has occurred, no significant Company obligations withregard to implementation remain and the Company’s services are not consideredessential to the functionality of other elements of the arrangement.

·                  Services— Revenue from maintenance and support arrangements is deferred and recognizedratably over the term of the maintenance and support arrangements. Revenue fromtraining, installation and consulting services is recognized as the servicesare provided to customers.

·                  Multiple-ElementArrangements — The Company enters into arrangements with customers that includea combination of software products, system hardware, specified upgrades,maintenance and support, or installation and training services. For sucharrangements, the Company recognizes revenue using the residual method. TheCompany allocates the total arrangement fee among the various elements of thearrangement based on the fair value of each of the undelivered elementsdetermined by vendor-specific objective evidence. The fair value ofinstallation and training services and maintenance and support services isestablished based upon sold separately pricing for the services or statedrenewal rate. 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.

**Equity-based compensation**

On January 1, 2006, the Company adopted Statement of FinancialAccounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment”(“SFAS No. 123(R)”), which requires the measurement and recognition ofcompensation expense for all equity-based payment awards made to employees anddirectors, including employee stock options and employee stock purchasesrelated to the Employee Stock Purchase Plan, based on estimated fair values.SFAS No. 123(R) supersedes the Company’s previous accounting under AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees”(“APB 25”), for periods beginning in 2006. In March 2005, the Securitiesand Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”)relating to SFAS No. 123(R). The Company has applied the provisions of SAB 107in its adoption of SFAS No. 123(R).

The Company adopted SFAS No. 123(R) using the modified prospectivetransition method, which requires the application of the accounting standard asof January 1, 2006. The Company’s Consolidated Financial Statements as ofand for the year ended December 31, 2006 reflect the impact of SFAS No. 123(R).In accordance with the modified prospective transition method, the Company’sCondensed Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS No. 123(R).Equity-based compensation expense recognized under SFAS No. 123(R) for the yearended December 31, 2006 was $5.1 million. Equity-based compensationexpense of $335,000 was recorded as expense for the year endedDecember 31, 2005 related to restricted stock awards. There was noequity-based compensation expenses related to employee stock options andemployee stock purchases prior to fiscal 2006. Applying SFAS No. 123, “Accountingfor Stock-Based Compensation” (“SFAS No. 123”), on a pro forma basis,equity-based compensation expense was $3.5 million and $2.9 million for theyears ended December 31, 2005 and 2004, respectively.

SFAS No. 123(R) requires companies to estimate the fair value ofequity-based payment awards on the date of grant using an option-pricing model.The Company uses the Black-Scholes option-pricing model, which requires theinput of assumptions, including an estimate of the average period of timeemployees will retain vested stock options before exercising them, theestimated volatility of the Company’s common stock price over the expected termand the number of options that will ultimately be forfeited before completingvesting requirements. Changes in the assumptions can materially affect theestimate of fair value of equity-based compensation and, consequently, therelated expense recognized. The value of the portion of the award that isultimately expected to vest is recognized as expense over the requisite vestingperiod. Prior to the adoption of SFAS No. 123(R), the Company accounted forequity-based awards to employees and directors using the intrinsic value methodin accordance with APB 25 as allowed under SFAS No. 123.

Under the intrinsic value method, no equity-based compensation expensehad been recognized related to employee stock options because the exerciseprice of the Company’s stock options granted to employees and directors equaledthe fair market value of the underlying stock at the date of grant.

Equity-based compensation expense recognized for the year endedDecember 31, 2006 included compensation

47

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expense for equity-based payment awards granted on or prior toDecember 31, 2005 but not yet vested as of that date. The compensationexpense for these awards is based on the grant date fair value estimated inaccordance with the pro forma provisions of SFAS No. 123, which was in effecton and prior to December 31, 2005. Compensation expense for the equity-basedpayment awards granted subsequent to December 31, 2005 is based on thegrant date fair value estimated in accordance with the provisions of SFAS No.123(R). Because equity-based compensation expense recognized for the year endedDecember 31, 2006 is based on awards ultimately expected to vest, it has beenreduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates. In the Company’s pro formainformation required under SFAS No. 123 for the periods prior toJanuary 1, 2006, the Company accounted for forfeitures as they occurred.

The following table illustrates how equity-based compensation wasallocated to the income statement as well as the effect on net income and netincome per share of all equity-based compensation recognized under SFAS No.123(R) (in thousands except per share data): 

|                                                     | ** ** | **Year Ended  December 31, 2006** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------|------------|
| Cost of revenue                                     |       | $                                                | 372        |   |
| Sales and marketing                                 |       | 1,995                                            |       |
| Research and  development                           |       | 840                                              |       |
| General and  administrative                         |       | 1,856                                            |       |
| Equity-based  compensation before income taxes      |       | 5,063                                            |       |
| Income tax  benefit                                 |       | (1,488                                           | )          |
| Total  equity-based compensation after income taxes |       | $                                                | 3,575      |   |
|                                                |       |                                             |       |
| Impact on basic  earnings per share                 |       | $                                                | .27        |   |
| Impact on diluted  earnings per share               |       | $                                                | .25        |   |

 

For purposes ofcalculating the fair value of options under SFAS No. 123(R), the weightedaverage fair value of options granted during 2006 was $13.58.  For purposes of calculating the fair value ofoptions under SFAS No. 123, the weighted average fair values of options grantedduring 2005 and 2004 were $10.31 and $8.30, respectively. The weighted averagefair values for the options were based on the fair values on the dates ofgrant. The fair values for the options were calculated using the Black-Scholesoption-pricing model with the following weighted-average assumptions andexpense was adjusted using the following expected forfeiture rate assumptions:

|                             | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected option  life       |       | 3.78 years                                                   |       | 5.00 years |   | 5.00 years |   |
| Expected  volatility factor |       | 52                                                           | %          | 67 | % | 83 | % |
| Expected  dividend yield    |       | 0                                                            | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 4.65                                                         | %          | 3.84 | % | 3.41 | % |
| Expected  forfeiture rate   |       | 1.12                                                         | %          | 0.00 | % | 0.00 | % |

 

Prior toMarch 9, 2006, the expected life of stock options was calculated byperforming a detailed analysis of all historical stock option informationavailable. On March 9, 2006, the Company began to grant options with afive-year legal life instead of the eight-year legal life that had historicallybeen used. As a result, the Company has elected to use the “simplified” methodas described in SAB 107, to estimate the expected life of options grantedon and after March 9, 2006. The Company will utilize the simplified methoduntil sufficient historical information becomes available on the five-yearlegal life options. The expected volatility is calculated based on thehistorical volatility of the Company’s common stock over the expected optionlife and other appropriate factors. The decrease in volatility is primarily dueto a shorter expected option life, over which the Company’s common stock pricewas less volatile. The expected dividend yield is based on the Company’s intentnot to issue dividends for the foreseeable future. Risk-free interest rates arecalculated based on continuously compounded U.S. Treasury risk-free rates forthe appropriate term. The expected forfeiture rate is estimated based on historicalexperience. In the Company’s pro forma information required under SFAS No. 123for the periods prior to January 1, 2006, the Company accounted forforfeitures as they occurred.

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As of December 31,2006, there was $7.6 million of unrecognized compensation expense related tostock options that is expected to be recognized over a weighted-average periodof 2.4 years.

The Company grantsnonvested shares of common stock (“restricted stock”) to certain employeesunder its 1997 Stock Option and Incentive Plan and 2006 Long-Term IncentivePlan. The restricted stock generally vests 25% annually beginning one yearafter the grant date. The Company records equity-based compensation expense equalto the fair market value of the common stock on the date of grant ratably overthe vesting period. Equity-based compensation expense related to restrictedstock was $728,000 and $335,000 for the years ended December 31, 2006 and 2005,respectively.

As of December 31,2006, there was $2.0 million of unrecognized compensation expense related torestricted stock awards that is expected to be recognized over aweighted-average period of 2.6 years. The aggregate fair value of restricted stock vested was $819,000 for theyear ended December 31, 2006. No restricted stock vested during 2005.

Employee StockPurchase Plan (“ESPP”) compensation expense was $106,000 for the year endedDecember 31, 2006.  Pro-forma stockcompensation expense related to the ESPP was $70,000 and $64,000 for the yearsended December 31, 2005 and 2004, respectively.

The fair value ofstock compensation expense associated with our ESPP was estimated on the dateof grant using the Black-Scholes option pricing model with the following weighted-averageassumptions:

|                                | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected life of ESPP  options |       | 3 months                                                     |       | 3 months |   | 3 months |   |
| Expected volatility  factor    |       | 50                                                           | %          | 38 | % | 38 | % |
| Expected dividend yield        |       | 0                                                            | %          | 0 | % | 0 | % |
| Risk-free interest rate        |       | 4.64                                                         | %          | 2.89 | % | 1.16 | % |

 

The following table illustrates the effect on net income and net incomeper share as if we had applied the fair value recognition provisions of SFASNo. 123 to equity-based compensation during periods prior to January 1, 2006(in thousands except per share data):
| ** **                                                                                                                               | ** ** | **Year Ended  December 31, 2005** | ** ** | **Year Ended  December 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Net income, as reported                                                                                                                  |       | $                                                | 5,801      |                                             | $          | 296 |   |
| Add: Equity-based  employee compensation expense included in reported net income, net of related  tax effects                            |       | 199                                              |       | —                                           |       |
| Deduct: Total  equity-based employee compensation expense determined under fair value method  for all awards, net of related tax effects |       | (2,078                                           | )          | (2,155                                           | )          |
| Pro forma net income                                                                                                                     |       | $                                                | 3,922      |                                             | $          | (1,859 | ) |
|                                                                                                                                     |       |                                             |       |                                             |       |
| Net income per share -  basic:                                                                                                           |       |                                             |       |                                             |       |
| As reported                                                                                                                              |       | $                                                | 0.47       |                                             | $          | 0.03 |   |
| Pro forma                                                                                                                                |       | $                                                | 0.32       |                                             | $          | (0.16 | ) |
|                                                                                                                                     |       |                                             |       |                                             |       |
| Net income per share -  diluted:                                                                                                         |       |                                             |       |                                             |       |
| As reported                                                                                                                              |       | $                                                | 0.44       |                                             | $          | 0.02 |   |
| Pro forma                                                                                                                                |       | $                                                | 0.30       |                                             | $          | (0.16 | ) |

 

Prior to the adoption of SFAS No. 123(R), the Company presented all taxbenefits resulting from the exercise of stock options and settlement ofrestricted stock awards as operating cash inflows in the consolidatedstatements of cash flows in accordance with the provisions of the EmergingIssues Task Force (“EITF”) Issue No 00-15, “Classification in the Statement ofCash Flows of the Income Tax Benefit Received by a Company upon Exercise of aNonqualified Employee Stock Option.” SFAS No. 123(R) requires the benefits oftax deductions in excess of the compensation cost recognized for those optionsand stock awards to be classified as financing cash inflows rather thanoperating cash inflows on a prospective basis. This amount is shown as “Excesstax benefit from stock transactions” on the Condensed Consolidated Statement ofCash Flows.

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The Company’s adoption ofSFAS No. 123(R) using the modified prospective application required the Companyto determine the amount of eligible windfall tax benefits (the pool of windfalltax benefits) that are available on the adoption date to offset future shortfalls.The Company has elected to calculate their historical pool of windfall taxbenefits (i.e., the amount that would have accumulated as of the adoption dateof SFAS No. 123(R)) using the alternative (“short-cut”) method, as provided inFSP No. FAS 123(R)-3, and the “tax law ordering approach” to determine when thehistoric tax benefits are realized (tax benefits realized based on provisionsin the tax law that identify the sequence in which stock option deductions areutilized for tax purposes). Subsequent to the adoption of SFAS No. 123(R), theCompany will continue to track the balance of the pool of windfall tax benefitsbased on windfalls or shortfalls incurred after the adoption date.

**Researchand development costs**

Costs related toresearch, design and development of products are charged to research anddevelopment 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. TheCompany uses the working model approach to determine technological feasibility.Generally, the Company’s products are released soon after technologicalfeasibility has been established. As a result, the Company has not capitalizedany software development costs, since such costs have not been significant.

**Incometaxes**

The Companyprovides for income taxes using the liability method under SFAS No. 109, “Accountingfor Income Taxes,” which requires recognition of deferred tax assets andliabilities for the expected future tax consequences of events that have beenincluded in the financial statements. Under this statement, deferred tax assetsand liabilities are determined based on the difference between the financialstatement and tax basis of assets and liabilities, using enacted tax rates ineffect for the year in which the differences are expected to reverse. Deferredtax assets are reduced by a valuation allowance when it is more likely than notthat some component or all of the deferred tax assets will not be realized. Taxrate changes are reflected in income during the period such changes areenacted.

**Computationof net income per share**

Basic earnings pershare is computed using net income and the weighted average number of commonshares outstanding. Diluted earnings per share reflect the weighted averagenumber of common shares outstanding plus any potentially dilutive sharesoutstanding during the period. Potentially dilutive shares consist of sharesissuable upon the exercise of stock options and warrants, as well as unvestedrestricted stock.

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The computationsfor basic and diluted net income per share are as follows (in thousands, exceptper share amounts):
| ** **                                                                                                          | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                          | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                                                                          |       |                                                         |       |   |   |   |   |
| Net income                                                                                                          |       | $                                                            | 6,583      |   | $ | 5,801 |   | $ | 296 |   |
|                                                                                                                |       |                                                         |       |   |   |   |   |
| Denominator:                                                                                                        |       |                                                         |       |   |   |   |   |
| Denominator for  weighted average common shares outstanding — basic                                            |       | 13,463                                                       |       | 12,379 |   | 11,632 |   |
|                                                                                                                |       |                                                         |       |   |   |   |   |
| Dilution  associated with common stock warrants                                                                     |       | —                                                       |       | — |   | 5 |   |
|                                                                                                                |       |                                                         |       |   |   |   |   |
| Dilution  associated with the company’sstock based compensation plans                                          |       | 779                                                          |       | 905 |   | 898 |   |
|                                                                                                                |       |                                                         |       |   |   |   |   |
| Dilution  associated with contingent stock consideration relating to acquisition of HInnovation,  Inc. (see note 3) |       | 17                                                           |       | — |   | — |   |
|                                                                                                                |       |                                                         |       |   |   |   |   |
| Denominator:                                                                                                        |       |                                                         |       |   |   |   |   |
| Denominator for  weighted average common shares outstanding — diluted                                          |       | 14,259                                                       |       | 13,284 |   | 12,535 |   |
|                                                                                                                |       |                                                         |       |   |   |   |   |
| Net income per share —  basic                                                                                  |       | $                                                            | 0.49       |   | $ | 0.47 |   | $ | 0.03 |   |
| Net income per share —  diluted                                                                                |       | $                                                            | 0.46       |   | $ | 0.44 |   | $ | 0.02 |   |
|                                                                                                                |       |                                                         |       |   |   |   |   |
| Antidilutive stock options and restricted stockawards excluded from  above calculation                              |       | 379                                                          |       | 230 |   | 545 |   |

 

**Comprehensiveincome**

Comprehensiveincome as defined by SFAS No. 130, “Reporting Comprehensive Income,”includes net income and items defined as other comprehensive income. SFASNo. 130 requires that items defined as other comprehensive income, such asforeign currency translation adjustments and unrealized gains and losses oncertain marketable securities, be separately classified in the financialstatements. Such items are reported in the consolidated statements ofstockholders’ equity as comprehensive income.

**Newaccounting pronouncements**

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements and prescribes a recognition threshold andmeasurement attribute for financial statement recognition and measurement of atax position taken or expected to be taken in a tax return. FIN 48 alsoprovides related guidance on derecognition, classification, interest andpenalties, accounting in interim periods and disclosure. FIN 48 is effectivefor the Company beginning January 1, 2007. The Company is currently evaluatingthe impact of FIN 48 and does not expect a significant or material impact fromits adoption.

InSeptember 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (“SFAS No. 157”), which defines fair value, establishes aframework for measuring fair value in accordance with generally acceptedaccounting principles and expands disclosures about fair value measurements.SFAS No. 157 applies to other accounting standards that require or permit fairvalue measurements. Accordingly, it does not require any new fair valuemeasurement. SFAS No. 157 will be effective for the Company on January 1,2008. The Company is currently evaluating the impact the adoption of SFAS No.157 will have on its financial position and results of operations.

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS No.159”), which permits entities to choose to measure many financial instrumentsand certain other items at fair value that are not currently required to bemeasured at fair value. SFAS No. 159 will be effective for the Company onJanuary 1, 2008. The Company is currently evaluating the impact theadoption of SFAS No.

 

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159 will have onits financial position and results of operations.

**3.****   Acquisition**

The followingacquisition was accounted for under the purchase method of accounting underSFAS No. 141, “Business Combinations,” and accordingly, the assets andliabilities acquired were recorded at their estimated fair values at theeffective date of the acquisition, and the results of operations have beenincluded in the consolidated statements of operations since the acquisitiondate. In accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets,” goodwill recorded as a result of the acquisition is subject to anannual impairment test.

**HInnovation, Inc.**

OnFebruary 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 provider ofsoftware solutions that allow physicians to use PCs or notebook computers toaccess 2D, 3D and 4D medical imaging applications securely over the Internet.The acquisition of HInnovation was made to acquire products and technology thatwill enable the Company to more effectively compete in the distributedcomputing market for 2D/3D/4D visualization and analysis software.

The total purchaseprice of the HInnovation acquisition was approximately $12.6 million. TheCompany acquired all of the outstanding common stock of HInnovation in exchangefor $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. The Company’s stock was valued at $16.2375 pershare, which was equal to the average of the closing sale prices of one shareof the Company’s stock as reported on the Nasdaq National Market (now known asthe Nasdaq Global Market) for the two consecutive trading days occurring beforethe first public announcement of the signing of the Acquisition Agreement andthe two consecutive trading days occurring immediately after such publicannouncement date. The Company incurred $360,000 in direct costs of theacquisition and assumed $382,000 of liabilities. The Company did not assume anystock options or warrants.

The Company had acontingent consideration agreement related to its acquisition of HInnovation inFebruary 2004. The maximum potential contingent consideration was initially $6.0million with three different contingent consideration criteria.  Two of the contingent consideration criteria,based upon achieving revenue targets for the HInnovation products by March 2005and licensing products using patents held by HInnovation by February 2006, werenot met and expired.  The thirdcontingent consideration criteria, based on the commercial launch of certainVitrea® software capabilities within the ViTALConnect® software platform, whichis the successor to HInnovation’s platform application known as “Iconnection,”were met on August 30, 2006.  As aresult, the Company paid to the former shareholders of HInnovation contingentstock consideration consisting of 106,398 shares of the Company’s common stock,which, per the Acquisition Agreement, was determined by dividing $3.0 millionby the average closing price of the Company’s common stock on the tenconsecutive trading days ended on August 29, 2006, which is the day immediatelyprior to August 30, 2006.  The commonstock was valued at $3.1 million for accounting purposes, which was based onthe average of the closing sale prices of the Company’s common stock forseveral consecutive trading days occurring immediately before and immediatelyafter August 30, 2006. The contingent payments resulted in a $3.1 millionincrease in goodwill.  The AcquisitionAgreement provides for no additional consideration to be paid to the formerHInnovation shareholders.

The purchase pricewas allocated to the identified assets of HInnovation. A third-party appraisalfirm assisted the Company with the valuation of the identified intangibleassets. The valuation resulted in the allocation of $6.9 million toidentifiable intangible assets, which will be amortized over periods rangingfrom three to seven years. The valuation also resulted in the identification of$1.0 million of acquired in-process research and development (“IPR&D”)costs, which were immediately expensed on the closing date and represent anon-deductible charge for income tax purposes.

At the time ofacquisition, HInnovation had development projects in process, including thecollaboration module of its Web-based product (the “Collaboration ModuleProject”). The Collaboration Module Project involves the design and developmentof innovative features for Web-based consultation meetings with interactive andsynchronized viewing of full-quality images, annotation and mouse movement. TheCollaboration Module Project includes significant and innovative advancementsto the HInnovation software platform in the areas of networksynchronization of high quality images and user privilege management for onlinecollaboration. The design, verification and other processes involved in theCollaboration Module Project require tools and skills that are new toHInnovation. The appraisal referenced above estimated that $1.0 million of thepurchase price represents the fair value of purchased IPR&D related to theCollaboration Module Project that has not yet reached technological 

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feasibility andhas no alternative future uses. This amount was expensed as a non-recurring,non-tax-deductible charge upon consummation of the acquisition.

The appraisal firmapplied the income valuation approach to assist the Company in determining theestimated fair value of the purchased IPR&D. These estimates were based onthe following assumptions:

·                  Theestimated revenue was based upon HInnovation’s estimate of revenue growth overthe next seven years from the revenue growth of primarily the CollaborationModule Project.

·                  Theestimated gross margin of 65% to 78% was based upon gross margin for comparableproducts.

·                  Theestimated selling, general and administrative expenses were based on aconsideration of historical operating expenses as a percentage of revenue andHInnovation’s projected operating expenses.

·                  Thecost to complete each project was based on estimated remaining labor hours anda fully-burdened labor cost and other direct expenses.

·                  Thediscount rate used in the alternative income valuation approach was based onthe weighted average cost of capital (“WACC”). The WACC calculation producesthe average 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 inherent risks inthe development of the products, the risks of the products being completed onschedule, and the risk of the eventual sales of the product meeting theexpectations of HInnovation.

The first phase ofthe Collaboration Module Project was released in the third quarter of 2004. Thefirst phase provided basic collaboration between users, allowing one user topresent to another user. The second phase of the Collaboration Module Projectprovided two-way collaboration between users, allowing both users to interactwith the data, and was released in the third quarter of 2005.

The total initialpurchase price is as follows (in thousands, except share amounts):

| Fair value of common stock  issued (376,262 shares) |   | $     | 6,109  |   |
|-----------------------------------------------------|--------|-------|--------|--------|
| Cash paid to  HInnovation shareholders              |   | 5,753 |   |
| Direct acquisition  costs                           |   | 360   |   |
| Liabilities assumed                                 |   | 382   |   |
|                                                |   | $     | 12,604 |   |

 

The allocation ofthe total purchase price is as follows (in thousands):

| Existing software  technology, subject to amortization - 5 year life      |   | $      | 3,400  |   |
|---------------------------------------------------------------------------|--------|--------|--------|--------|
| Patent and patent  applications, subject to amortization - 7 year life    |   | 3,000  |   |
| Non-compete/employment  agreements, subject to amortization - 3 year life |   | 500    |   |
| Goodwill                                                                  |   | 6,053  |   |
| In-process research and  development costs                                |   | 1,000  |   |
| Deferred tax  liabilities, net                                            |   | (1,405 | )      |
| Fair value of assets  acquired                                            |   | 51     |   |
| Fair value of cash  acquired                                              |   | 5      |   |
|                                                                      |   | $      | 12,604 |   |

 

The followingfactors contributed to a purchase price that resulted in the recognition ofgoodwill:

·                  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 ofthe acquired IPR&D.

 

53

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The following unaudited pro forma condensed consolidated incomestatements have been prepared as if the acquisition of HInnovation had occurredas of the beginning of the periods presented. Pro forma adjustments relate toamortization of identified intangible assets, acquired IPR&D and incometaxes. The unaudited pro forma condensed consolidated results of operations arefor comparative purposes only and are not necessarily indicative of resultsthat would have occurred had the acquisition occurred as of the beginning ofthe periods presented, nor are they necessarily indicative of future results.

 
|                                | ** ** | **For the Year Ended  December 31, 2004 (in  thousands, except per  share amount)** | ** ** |
|--------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|
| Revenue                        |       | $                                                                                                                                | 36,150     |   |
| Net income                     |       | 1,173                                                                                                                            |       |
| Net income per share - diluted |       | $                                                                                                                                | 0.09       |   |

 

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

**Allowancefor doubtful accounts**

The allowance fordoubtful accounts activity was as follows (in thousands):
|                   | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------|------------|--------------------------------------------------------------|------------|
| ** **        | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Beginning balance |       | $                                                            | 320        |   | $ | 767 |   | $ | 235 |   |
| Provision         |       | 25                                                           |       | (159 | ) | 627 |   |
| Write-offs        |       | (87                                                          | )          | (288 | ) | (95 | ) |
| Recoveries        |       | 8                                                            |       | — |   | — |   |
| Ending balance    |       | $                                                            | 266        |   | $ | 320 |   | $ | 767 |   |

 

**Propertyand equipment, net**

The components ofproperty and equipment were as follows (in thousands):
|                                                 | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Equipment                                       |       | $                     | 11,207     |   | $ | 7,496 |   |
| Furniture and fixtures                          |       | 3,042                 |       | 2,173 |   |
| Computer software                               |       | 2,291                 |       | 1,105 |   |
| Leasehold improvements                          |       | 2,300                 |       | 1,312 |   |
| Total property  and equipment                   |       | 18,840                |       | 12,086 |   |
| Less accumulated  depreciation and amortization |       | (9,598                | )          | (6,725 | ) |
| Property and equipment,  net                    |       | $                     | 9,242      |   | $ | 5,361 |   |

 

Depreciation andamortization expense was $2.9 million, $2.1 million and $1.6 million for theyears ended December 31, 2006, 2005 and 2004, respectively.

**Licensedtechnology, net**

In July 2001,the Company entered into an agreement to license technology from a third party.The Company paid an aggregate of $750,000 to the licensor in 2001. The Companyrecorded this $750,000 purchase as licensed technology and is amortizing itover the estimated useful life of the technology of 75 months. Thisamortization expense is reported as cost of revenue for license fees. Aspart of this agreement, the Company is also obligated to pay the licensorroyalties on the sales of certain products as defined in the agreement. During2006, 2005 and 2004, $1.8 million, $1.4 million and $1.0 million, respectively,of such royalties were incurred and were reported as cost of revenue forlicense fees.

 

54

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The components oflicensed technology were as follows (in thousands):

 
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Licensed  technology           |       | $                     | 750        |   | $ | 750 |   |
| Less accumulated  amortization |       | (660                  | )          | (540 | ) |
| Licensed  technology, net      |       | $                     | 90         |   | $ | 210 |   |

 

Amortizationexpense was $120,000 for each of the years ended December 31, 2006, 2005and 2004.

**Otherintangible assets, net**

Acquiredintangible assets subject to amortization were as follows (in thousands):
| ** **                                             | ** ** | **December 31, 2006** | ** ** | **December 31, 2005**     | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **Gross Carrying  Value**  | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying   Value** | ** ** | **Gross Carrying   Value** | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying   Value** | ** ** |
|  Existing software technology                     |       | $                               | 3,400      |                                | $          | (1,966 | ) | $ | 1,434 |   | $ | 3,400 |   | $ | (1,282 | ) | $ | 2,118 |   |
|  Patents and patent applications                  |       | 3,000                           |       | (1,242                              | )          | 1,758 |   | 3,000 |   | (810 | ) | 2,190 |   |
|  Non-compete/employment agreements                |       | 500                             |       | (483                                | )          | 17 |   | 500 |   | (315 | ) | 185 |   |
|  Total intangible assets  subject to amortization |       | $                               | 6,900      |                                | $          | (3,691 | ) | $ | 3,209 |   | $ | 6,900 |   | $ | (2,407 | ) | $ | 4,493 |   |

 

Intangible assetssubject to amortization are amortized on a straight-line basis over theestimated period of benefit. Amortization expense was $1.3 million, $1.3million and $1.1 million for the years ended December 31, 2006, 2005 and2004, respectively.  The estimated futureannual amortization expense for identified intangible assets is as follows (inthousands):
| 2007   |   | $     | 1,133  |   |
|--------|--------|-------|--------|--------|
| 2008   |   | 1,116 |   |
| 2009   |   | 498   |   |
| 2010   |   | 432   |   |
| 2011   |   | 30    |   |
|   |   | $     | 3,209  |   |

 

The precedingexpected amortization expense is an estimate. Actual amortization expensemay differ from estimates due to additional intangible asset acquisitions,impairment of intangible assets, accelerated amortization of intangible assets,and other events.

**Goodwill**

The changes in thecarrying amount of goodwill for the year ended December 31, 2006 are asfollows (in thousands):
| Balance as of December 31,  2005                             |   | $     | 6,053  |   |
|--------------------------------------------------------------|--------|-------|--------|--------|
| Contingent  consideration earned (see note 3)                |   | 3,084 |   |
| Reversal of tax  valuation allowance relating to HInnovation |   | (48   | )      |
| Balance as of December 31, 2006                              |   | $     | 9,089  |   |

 

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**Deferredrevenue**

The components ofdeferred revenue were as follows (in thousands):

 
|                                        | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Maintenance and support                |       | $                     | 10,750     |   | $ | 7,137 |   |
| Training                               |       | 4,272                 |       | 3,529 |   |
| Installation                           |       | 476                   |       | 224 |   |
| Software                               |       | 409                   |       | 592 |   |
| Hardware and other                     |       | 398                   |       | 394 |   |
| Total deferred  revenue                |       | 16,305                |       | 11,876 |   |
| Less current  portion                  |       | (15,131               | )          | (11,231 | ) |
| Long-term portion of  deferred revenue |       | $                     | 1,174      |   | $ | 645 |   |

 

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

**Operatinglease commitments**

The Company rents officespace and certain office equipment under operating leases. In addition tominimum lease payments, the office leases require payment of a proportionateshare of real estate taxes and building operating expenses. Total rent expense,including an allocation of the lessor’s operating costs, was $1.2 million,$635,000 and $715,000 for the years ended December 31, 2006, 2005 and2004, respectively.

InMarch 2004, the Company signed a non-cancelable operating lease for a newoffice facility in Minnetonka, Minnesota. The new lease term started inFebruary 2005 and expires in January 2012. The Company moved into theMinnetonka location and moved out of its Plymouth, Minnesota location inFebruary 2005. The Company’s office lease in Plymouth expired onJuly 31, 2005 with the exception of a small portion of the space that wasunder lease until May 31, 2006. Under the terms of the new lease, theMinnetonka lessor paid the monthly base rent payments and taxes and operatingcost rent obligation payments for the Company’s former office facility inPlymouth beginning February 2005.

The Companyrecorded deferred rent of $1.6 million in the first quarter of 2005 relating toestimated payments by the Minnetonka lessor for the benefit of the Company.Such payments are considered lease incentives under FASB Technical Bulletin (“FTB”)88-1, “Issues Relating to Accounting for Leases,” and are amortized as areduction of rent expense over the term of the Minnetonka lease. Payments bythe Minnetonka lessor for the benefit of the Company consisted of thefollowing:

·                  $405,000 relating to lease paymentsmade by the Minnetonka lessor to the Plymouth lessor; under FTB 88-1, suchpayments were recorded as a lease loss by the Company in the first quarter of2005. Additionally, the Company recorded $88,000 of other costs relating to thePlymouth lease, resulting in a total loss on operating lease of $493,000.

·                  $205,000 relating to moving costsreimbursed to the Company by the Minnetonka lessor; moving costs were expensedas incurred during the first quarter of 2005.

·                  $975,000 relating to leaseholdimprovements paid for by the Minnetonka lessor; under FTB 88-1, such leaseholdimprovements were recorded as an asset by the Company and amortized over theshorter of their estimated useful lives or the remaining terms of the relatedleases.

During the yearended December 31, 2006, the Company expanded its Minnetonka headquarters andreceived leasehold improvements paid for by the Minnetonka lessor of $561,000.Such leasehold improvements were recorded as an asset by the Company andamortized over the shorter of their estimated useful lives or the remainingterms of the related leases with a corresponding amount recorded as deferredrent and amortized as a reduction of rent expense over the term of theMinnetonka lease.

The deferred rentbalance was $1.8 million ($313,000 was classified as current) and $1.4 million($187,000 was classified as current) as of December 31, 2006 and 2005,respectively.

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The minimum lease payments,excluding estimated taxes and operating cost rent obligations, areapproximately (in thousands):

 
| 2007  |   | $   | 1,010  |   |
|-------|--------|-----|--------|--------|
| 2008  |   | 902 |   |
| 2009  |   | 869 |   |
| 2010  |   | 888 |   |
| 2011  |   | 907 |   |
| 2012  |   | 76  |   |
| Total |   | $   | 4,652  |   |

 

**Agreementwith R2 Technology, Inc.**

In April 2005, theCompany entered into an agreement with R2 Technology, Inc. (“R2”) to market R2’slung nodule CAD software product to the Company’s customers. The April 2005agreement replaced the Company’s November 2002 agreement with R2. Under theApril 2005 agreement, the Company committed to provide R2 with certain minimumquarterly sales (“Applicable Minimums”) from certain R2 lung CAD relatedproducts and services (“R2 Lung CAD Products”) over a 12-quarter period endingJune 30, 2008. The Company will receive a commission based on sales of R2 LungCAD Products to the Company’s customers. To the extent the quarterly ApplicableMinimum is not met, the Company will pay R2 the difference between theApplicable Minimum and the actual R2 Lung CAD Product sales achieved.

The ApplicableMinimums for the quarters ended September 30, 2005, December 31, 2005 and March31, 2006 were $414,000 per quarter. Beginning in the quarter ended June 30,2006 and for each subsequent quarter thereafter, the Applicable Minimum will beequal to the immediately preceding quarter unless the Applicable Minimum forthe immediately preceding quarter was not met, at which time the ApplicableMinimum will be reduced to the lower of:

i.      the Applicable Minimum ofthe preceding quarter multiplied by the percent by which the product salesgenerated in the preceding quarter fell below that quarter’s ApplicableMinimum, up to a maximum decline of twenty-three percent (23%); or

ii.   two times the product salesgenerated by R2 during the preceding quarter through all other sales, marketingand distribution channels, excluding product sales generated under theagreement.

If at any timeduring the remainder of the agreement term, the Applicable Minimum is less than$414,000 and R2 Lung CAD Product sales for a quarter exceed $414,000, theApplicable Minimum for the next quarter will revert to $414,000. Thereafter,the Applicable Minimums will be subject to the above adjustment. Additionally,at the end of every fourth quarter under the agreement, if the aggregate salesgenerated under the agreement in the previous four quarters exceeded thatperiod’s aggregate Applicable Minimums, the remaining Applicable Minimum perquarter will be reduced by the amount of the excess divided by the number ofquarters remaining under the agreement.

The ApplicableMinimum for the quarter ended June 30, 2006 was not met by approximately$255,000.  As a result, the Companyrecorded a $167,000 expense to sales and marketing expense in the quarter endedJune 30, 2006 to cover actual losses through June 30, 2006. The $167,000expense was based on the second quarter of 2006 shortfall of $255,000 offset by$88,000 of deferred commission fees on sales as of June 30, 2006.  Additionally, based on information availableto the Company, R2 had not generated any R2 Lung CAD Product sales during thequarter ended June 30, 2006 through any other sales, marketing and distributionchannels, other than sales generated from customers under this agreement.  As a result, the Applicable Minimum for thequarter ended September 30, 2006 was $0. The Applicable Minimum will be adjusted only if at any time during theremainder of the agreement R2 Lung CAD Product sales for a quarter exceeds$414,000, as described above.  R2 LungCAD Product sales for the quarter ended September 30, 2006 were approximately$135,000; as a result, the Applicable Minimum for the quarter ended December31, 2006 was $0. R2 Lung CAD Product sales for the quarter ended December 31,2006 were approximately $203,000; as a result, the Applicable Minimum for thequarter ending March 31, 2007 is $0.

The ApplicableMinimum for the quarter ended December 31, 2005 was not met by approximately$314,000 and, based on the then current estimates utilizing all informationavailable, management believed it was probable that the estimated ApplicableMinimum would not be met for the quarter ended March 31, 2006. Additionally,management estimated that the Applicable Minimum would be $0 after March 31,2006 because, based on information available to the Company, R2 had notgenerated any R2 Lung CAD Product sales through any other sales, marketing anddistribution channels, other than R2 Lung CAD Product sales generated fromcustomers under this agreement. As a result, the Company recorded a $410,000expense to sales and marketing expense in the quarter ended December 31, 2005relating to this agreement to cover estimated losses through March 31, 2006.The $410,000 expense was based on the fourth quarter of 2005 shortfall of$314,000 and first quarter of 2006 Applicable Minimum of $414,000 offset byestimated forecasted sales of $140,000, deferred commission fees on sales as ofDecember 31, 2005 of $142,000 and estimated deferred commission fee onforecasted sales of $36,000.  TheApplicable Minimum for the quarter ended March 31, 2006 was met. Based on thethen current estimates utilizing all information available, management believedthat it was probable that the estimated Applicable Minimum would be met for thequarter ended June 30, 

57

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2006, and therewas no indication as of March 31, 2006 that the estimated aggregate ApplicableMinimums for subsequent quarters under the agreement would not be met.  As a result, during the quarter ended March31, 2006, the Company reversed $236,000 of the $410,000 expense recorded tosales and marketing expense recorded in the fourth quarter of 2005.  The remaining expense of $174,000 was basedon the fourth quarter of 2005 shortfall of $314,000 offset by the $140,000 of deferredcommission fees on sales as of December 31, 2005.

The estimatedfuture aggregate Applicable Minimums is a highly subjective determination, andactual results and any changes to estimates could have an adverse impact on theCompany’s financial position and results of operations.  The Company may not generate sufficient salesto meet the minimum contractual commitment for any particular quarter, and thusit may have to pay cash to R2 for the deficit. As of December 31, 2006, the remaining potential aggregate ApplicableMinimums ranged from a minimum of $0 to a maximum of approximately $2.1million.  If the Company foresees that itwill not be able to attain the minimum contractual commitment on a continuedbasis, it may have to take a charge to earnings, which could be up to theamount of the maximum remaining total commitment.  Any future losses would be recorded underSFAS No. 5, “Accounting for Contingencies,” which requires the amount to beprobable and estimable.

The Company hasnot recognized any commission revenue relating to this agreement, as it was notconsidered to be fixed or determinable due to the potential for payments by theCompany to R2 relating to the Applicable Minimums.

As of July 13,2006, R2 was acquired by Hologic, Inc.

**Otheritems**

Under generalcontract terms, the Company includes an indemnification clause in its softwarelicensing agreement that indemnifies the licensee against liability and damagesarising from any claims of patent, copyright, trademark or trade secretinfringement by the Company’s software. The Company has incurred insignificantcosts as a result of this type of indemnification clause, and the Company doesnot maintain a product warranty liability related to such indemnificationclauses.

The Company hasentered into various employment agreements with certain executives of theCompany, which include provisions for severance payments subject to certainconditions and events.

The Company isinvolved in various claims and legal actions in the normal course of business.Management is of the opinion that the outcome of such legal actions will nothave a significant adverse effect on the Company’s financial position, resultsof operations or cash flows. Notwithstanding management’s belief, anunfavorable resolution of some or all of these matters could materially affectour future results of operations or cash flows.

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

**Background**

OnOctober 28, 1996, the Board of Directors of Bio-Vascular, Inc. (“Bio-Vascular”),now known as Synovis Life Technologies, Inc., the former parent of theCompany, approved a plan to spin off and establish the Company as anindependent, publicly-owned company. On May 12, 1997 (the “DistributionDate”), Bio-Vascular distributed all of the shares of the Company to theshareholders of Bio-Vascular (the “Distribution”), and on that date the Companybegan operating as an independent public company. All Bio-Vascular shareholdersof 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.

**Privateplacement**

In June 2003, the Company completed a private placement of 1.5million shares of common stock at $13.50 per share for total gross proceeds of$20.3 million. After deducting offering costs of $1.3 million, the Companyreceived net proceeds of $19.0 million. A registration statement covering theresale of these shares was declared effective on September 29, 2003 by theSecurities and Exchange Commission. Effective March 1, 2006, wede-registered the resale of these shares not already sold.

**Publicoffering of common stock**

During the fourth quarter of 2006, the Company completed a publicoffering of 3.4 million shares of common stock at $31.00 per share for totalgross proceeds of $104.0 million.  Afterdeducting offering costs of $6.3 million, the Company received net proceeds of$97.7 million.

 

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**Stockoption plans**

In May 1997, Bio-Vascular, Inc., which is now known asSynovis Life Technologies, Inc., 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 of the Stock Option Plan, the Board ofDirectors or a committee of the Board may grant options and otherequity-based awards to key employees to purchase shares of the Company’s commonstock at an option exercise price equal to or greater than 85% of the fairmarket value on the date of grant. The options are exercisable at such times,in installments or otherwise, as the Board of Directors or a committee of theBoard may determine. Generally, these options have a term of five or eightyears and are exercisable as to 28% of the total grant one year after the dateof grant and 2% per month thereafter. The total number of shares of commonstock that may be issued or awarded under the Stock Option Plan is4,100,000 shares. As of December 31, 2006, there were 395,005 sharesavailable for grant under the Stock 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”), which became effective on the DistributionDate. The Director Plan provides non-employee directors with automatic grantsof stock options and allows the Board of Directors to make additionaldiscretionary option grants to any or all directors. Options that are grantedunder the Director Plan are granted with an option price equal to the fairmarket value on the date of grant, have a term of five or eight years, arenon-qualified options and become exercisable in three equal annual installmentsbeginning on the first occurring December 31 after the date of grant. Thetotal number of shares of common stock that may be issued or awarded underthe Director Plan is 500,000 shares. As of December 31, 2006, there were135,000 shares available for grant under the Director Plan.

On May 4,2006, the shareholders of the Company approved the Vital Images, Inc. 2006Long-Term Incentive Plan (the “2006 Plan”). The 2006 Plan provides that thetotal number of shares of the Company’s common stock that may be subjectto options, restricted stock awards and other equity awards granted under the2006 Plan shall not exceed 900,000 shares. The 2006 Plan provides the Board ofDirectors or a committee of the Board the authority to grant incentive stockoptions qualified as such under Section 422 of the Internal Revenue Codeof 1986 and nonqualified stock options, awards of restricted stock, stockappreciation rights, other equity-based awards, cash-based awards or anycombination of such awards subject to the terms of the 2006 Plan. As ofDecember 31, 2006, there were 900,000 shares available for the grant of awardsunder the 2006 Plan.

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The followingtable summarizes stock option activity for 2006, 2005 and 2004:
| ** **                                      | ** ** | **Shares Underlying  Options** | ** ** | **Weighted-Average  Exercise Price Per  Share** | ** ** | **Weighted-Average  Remaining  Contractual Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value  (in thousands)** | ** ** |
|-------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| 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 cancelled                               |       | (172,017                            | )          | $                                                         | 9.80       |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Total  outstanding as of December 31, 2004 |       | 2,326,675                           |       | $                                                         | 8.54       |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Options granted                                 |       | 509,315                             |       | $                                                         | 17.60      |                                                                    |       |                                                 |       |   |
| Options exercised                               |       | (711,288                            | )          | $                                                         | 6.33       |                                                                    |       |                                                 |       |   |
| Options cancelled                               |       | (127,427                            | )          | $                                                         | 11.45      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Total  outstanding as of December 31, 2005 |       | 1,997,275                           |       | $                                                         | 11.45      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Options granted                                 |       | 383,300                             |       | $                                                         | 31.15      |                                                                    |       |                                                 |       |   |
| Options exercised                               |       | (564,286                            | )          | $                                                         | 9.17       |                                                                    |       |                                                 |       |   |
| Options cancelled                               |       | (19,110                             | )          | $                                                         | 23.33      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Total  outstanding as of December 31, 2006 |       | 1,797,179                           |       | $                                                         | 16.24      |                                                                    | 4.54       |                                                 | $          | 33,359 |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Options  exercisable as of:                     |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| December 31, 2004                          |       | 1,409,650                           |       | $                                                         | 6.74       |                                                                    |       |                                                 |       |   |
| December 31, 2005                          |       | 1,185,463                           |       | $                                                         | 9.03       |                                                                    |       |                                                 |       |   |
| December 31,  2006                         |       | 1,064,923                           |       | $                                                         | 11.39      |                                                                    | 4.02       |                                                 | $          | 24,927 |   |

 

Various priceranges and weighted average information for options outstanding and exercisableas of December 31, 2006 are as follows:
| ** **                              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                                 | ** ** |
|-----------------------------------------|------------|------------------------------|------------|------------------------------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding**      | ** ** | **Weighted Average  Remaining  Contractual Life  (in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $4.09 - $5.70                           |       | 116,750                      |       | 1.63                                                                         |       | $ | 4.93 |   | 116,750 |   | $ | 4.93 |   |
| $5.75 - $7.25                           |       | 267,815                      |       | 3.18                                                                         |       | $ | 7.23 |   | 267,635 |   | $ | 7.23 |   |
| $7.34 - $9.94                           |       | 239,659                      |       | 3.21                                                                         |       | $ | 8.82 |   | 229,463 |   | $ | 8.79 |   |
| $9.95 - $15.40                          |       | 314,835                      |       | 5.42                                                                         |       | $ | 13.13 |   | 158,158 |   | $ | 12.94 |   |
| $15.50 - $16.98                         |       | 228,430                      |       | 5.87                                                                         |       | $ | 16.64 |   | 131,005 |   | $ | 16.72 |   |
| $17.75 - $19.64                         |       | 246,300                      |       | 6.25                                                                         |       | $ | 19.33 |   | 135,604 |   | $ | 19.30 |   |
| $19.80 - $32.14                         |       | 327,390                      |       | 4.44                                                                         |       | $ | 30.44 |   | 20,308 |   | $ | 26.66 |   |
| $32.46 - $35.00                         |       | 56,000                       |       | 5.54                                                                         |       | $ | 33.86 |   | 6,000 |   | $ | 35.00 |   |
|                                    |       | 1,797,179                    |       | 4.54                                                                         |       | $ | 16.24 |   | 1,064,923 |   | $ | 11.39 |   |

 

The aggregateintrinsic value of options (the amount by which the market price of the stockon the date of exercise exceeded the exercise price of the option) exercisedduring the years ended December 31, 2006, 2005 and 2004 was $12.8 million, $9.0million and $4.3 million, respectively. Cash received from the exercise ofstock options for the years ended December 31, 2006, 2005 and 2004 was $5.2million, $4.5 million and $2.0 million, respectively. The total tax benefitrealized for the tax deductions from options exercised for the years endedDecember 31, 2006, 2005 and 2004 was $4.4 million, $3.4 million and $1.4million, respectively.

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**Restrictedstock**

The Company grants nonvested shares of common stock (“restricted stock”)to certain employees under the Stock Option Plan. The restricted stockgenerally vests 25% annually beginning one year after the grant date.  The following table summarizes the restrictedstock activity for the year ended December 31, 2006 and 2005:
| ** **                                 | ** ** | **Restricted Shares** | ** ** | **Weighted-Average  Grant Date Fair  Value Per Share** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|----------------------------------------------------------------------------|------------|
| Total  outstanding as of December 31, 2004 |       | —                     |       |                                                                       |       |
| Shares granted                             |       | 119,245                    |       | $                                                                          | 17.54      |   |
| Shares vested                              |       | —                     |       |                                                                       |       |
| Shares forfeited/cancelled                 |       | (3,777                     | )          | $                                                                          | 15.99      |   |
| Total  outstanding as of December 31, 2005 |       | 114,770                    |       | $                                                                          | 17.61      |   |
| Shares granted                             |       | 33,910                     |       | $                                                                          | 31.76      |   |
| Shares vested                              |       | (29,226                    | )          | $                                                                          | 17.51      |   |
| Shares forfeited/cancelled                 |       | (3,777                     | )          | $                                                                          | 21.44      |   |
| Total outstanding as of  December 31, 2006 |       | 115,677                    |       | $                                                                          | 21.65      |   |

 

The total taxbenefit realized for the tax deductions from restricted stock vested during theyear ended December 31, 2006 was $315,000.

**Employeestock purchase plan**

The 1997 Employee Stock Purchase Plan (the “ESPP”) was approved andadopted by Bio-Vascular, as the sole shareholder of the Company, inMay 1997. The ESPP, which became effective on July 1, 1997, enableseligible employees to purchase the Company’s common stock at a price equal to85% of the fair market value of the stock on the date an offering periodcommences or on the date an offering period terminates, whichever is lower.Under the ESPP, an aggregate of up to 250,000 shares of common stock can beissued and sold to participating employees of the Company through a series ofthree-month offering periods, beginning July 1, 1997. The ESPP coverssubstantially all employees, subject to certain limitations. Each employeemay elect to have up to 10% of his or her base pay withheld and appliedtoward the purchase of shares in each such offering period.   As of December 31, 2006, there were 52,451shares of common stock reserved for future purchases under the ESPP.

**Rightsplan**

InApril 1997, the Company declared a dividend distribution of one PreferredStock Purchase Right for each outstanding share of the Company’s common stock(the “Rights”). With certain exceptions, the Rights become exercisable only ifone of the following events occurs: (i) an acquiring party accumulates 15%or more of the Company’s common stock, (ii) a party announces an offer toacquire 15% or more of the Company’s common stock, or (iii) theacquisition of a substantial amount of the Company’s common stock by a personwhom the Board of Directors has determined is an “Adverse Person” as defined inthe underlying Rights Agreement. Each Right entitles the holder to purchaseone-thousandth of a share of the Company’s Series A Junior Preferred Stockat a price of $20.00 (the “Exercise Price”). If a person or group becomes thebeneficial owner of 15% or more of the Company’s common stock or the Board ofDirectors determines that a person is an Adverse Person, each holder of a Rightshall thereafter have the right to receive preferred stock having a fair marketvalue equal to two times the Exercise Price. Upon the occurrence of certainmergers, combinations or acquisitions of the Company’s assets, each holder of aRight shall thereafter have the right to receive that number of shares ofcommon stock of the acquiring company which equals the Exercise Price of the Rightdivided by one-half of the current market price of such common stock as of thedate of the occurrence of the event. The Company is generally entitled toredeem the Right at $.001 per Right at any time until 10 days following theacquisition of 15% or more of the Company’s common stock or 10 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 onApril 30, 2007 if not previously redeemed or exercised.

61

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**7.****     Incometaxes**

The components ofincome before income taxes were as follows (in thousands):
| ** **                   | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income before  income taxes: |       |                                                         |       |   |   |   |   |
| U.S.                         |       | $                                                            | 9,951      |   | $ | 8,571 |   | $ | 1,027 |   |
| International                |       | 322                                                          |       | 61 |   | (144 | ) |
|                         |       | 10,273                                                       |       | 8,632 |   | 883 |   |
|                              |            |                                                              |            |  |  |  |  |  |  |  |

 

The income taxprovision included the following components (in thousands):
| ** **                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current income  taxes:      |       |                                                         |       |   |   |   |   |
| Federal                     |       | $                                                            | 91         |   | $ | 48 |   | $ | 25 |   |
| State                       |       | 48                                                           |       | 36 |   | 5 |   |
| Foreign                     |       | 79                                                           |       | — |   | — |   |
|                        |       | 218                                                          |       | 84 |   | 30 |   |
| Deferred income  taxes:     |       |                                                         |       |   |   |   |   |
| Federal                     |       | 3,181                                                        |       | 2,613 |   | 513 |   |
| State                       |       | 218                                                          |       | 159 |   | 44 |   |
| Foreign                     |       | 73                                                           |       | (25 | ) | — |   |
|                        |       | 3,472                                                        |       | 2,747 |   | 557 |   |
| Provision for income  taxes |       | $                                                            | 3,690      |   | $ | 2,831 |   | $ | 587 |   |

 

A reconciliationof the Company’s income tax provision computed using the federal statutory rateto the tax provision reported in the Company’s statements of operations is asfollows (in thousands):
| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Tax provision  computed at the federal statutory rate |       | $                                                            | 3,493      |   | $ | 2,935 |   | $ | 300 |   |
| State taxes, net  of federal benefit                  |       | 378                                                          |       | 299 |   | 94 |   |
| Increase  (decrease) in tax from:                     |       |                                                         |       |   |   |   |   |
| Stock-based compensation                              |       | 334                                                          |       | — |   | — |   |
| Research and development tax credits                  |       | (562                                                         | )          | (362 | ) | (319 | ) |
| Business meals and entertainment                      |       | 75                                                           |       | 41 |   | 46 |   |
| Extraterritorial income exclusion                     |       | (38                                                          | )          | (27 | ) | — |   |
| Foreign tax rate differential                         |       | (5                                                           | )          | (5 | ) | — |   |
| Acquired in-process research and development          |       | —                                                       |       | — |   | 340 |   |
| Change in state tax rate                              |       | —                                                       |       | (104 | ) | (54 | ) |
| Change in valuation allowance                         |       | (25                                                          | )          | 47 |   | 226 |   |
| Other, net                                            |       | 40                                                           |       | 7 |   | (46 | ) |
| Provision for income  taxes                           |       | $                                                            | 3,690      |   | $ | 2,831 |   | $ | 587 |   |

 

62

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The significantcomponents of the Company’s tax-effected net deferred tax assets were asfollows (in thousands):

|                                                    | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Current:                                           | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accrued expenses and allowances                    |       | $                     | 465        |   | $ | 555 |   |
| Stock-based compensation                           |       | 1,196                 |       | 162 |   |
| Total current                                      |       | $                     | 1,661      |   | $ | 717 |   |
|                                               |       |                  |       |   |   |
| Noncurrent:                                        |       |                  |       |   |   |
| Net operating loss carryforwards                   |       | $                     | 6,218      |   | $ | 7,760 |   |
| Research and development tax credit carryforwards  |       | 2,896                 |       | 2,365 |   |
| Depreciation and amortization                      |       | 633                   |       | 516 |   |
| Deferred revenue                                   |       | 428                   |       | 235 |   |
| Identified intangible assets                       |       | (1,172                | )          | (1,641 | ) |
| Other, net                                         |       | 151                   |       | 3 |   |
| Net deferred tax assets before valuation allowance |       | 9,154                 |       | 9,238 |   |
| Less valuation allowance                           |       | (185                  | )          | (289 | ) |
| Total noncurrent                                   |       | $                     | 8,969      |   | $ | 8,949 |   |

 

**Netoperating loss carryforwards and other tax credit carryforwards as ofDecember 31, 2006**

The Company had federal tax loss carryforwards of approximately $17.7million, representing a $6.0 million deferred tax asset as of December 31,2006. Of the total federal tax loss carryforward, $10.0 million was generatedthrough the exercise of stock options. The federal tax loss carryforwards willexpire in 2010 through 2023 if not utilized. The Company estimates that it ismore likely than not that this deferred tax asset will be realized prior toexpiration.

The Company had state tax loss carryforwards of approximately $3.7million, representing a $211,000 deferred tax asset as of December 31,2006. The state tax loss carryforwards will expire at various dates through2023 if not utilized. The Company had a $22,000 valuation allowance related tothis deferred tax asset as of December 31, 2006 due to the uncertainty inrealization prior to expiration.

The Company had other federal and state tax credits and carryforwards ofapproximately $2.9 million, representing a $2.7 million deferred tax asset asof December 31, 2006. The federal and state credits and carryforwards willexpire in 2007 through 2025 if not utilized. The Company had a $163,000valuation allowance related to this deferred tax asset as of December 31,2006 due to the uncertainty in realization prior to expiration.

During the yearended December 31, 2006, the Company reversed $25,000 of the valuationallowance relating to state tax losscarryforwards as it was more likely than not that the deferred tax assetwould be realized prior toexpiration.  During the year endedDecember 31, 2006, the Company wrote-off $79,000 to the valuation allowancerelated to research and development tax credits that had expired prior torealization.

**Activityduring the year ended December 31, 2006**

The Company’s methodology for determining the realizability of itsdeferred tax assets involves estimates of future taxable income from its corebusiness, the estimated impact of future tax deductions from the exercise ofstock options outstanding as of December 31, 2006, and the expirationdates and amounts of net operating loss carryforwards and other tax credits.These estimates are projected through the life of the related deferred taxassets based on assumptions which management believes to be reasonable andconsistent with current operating results.

Although the Company had cumulative pre-tax income for financialreporting purposes for the three years ended December 31, 2006, theCompany did not pay any significant income taxes over that period due to taxdeductions from the exercise of stock options as well as its utilization of netoperating losses. In assessing the realizability of its deferred tax assets asof December 31, 2006, the Company considered evidence regarding itsability to generate sufficient future taxable income to realize its deferredtax assets. The primary evidence considered included the cumulative pre-taxincome for financial reporting purposes for the past three years; the estimatedimpact of future tax deductions from the exercise of stock options outstandingas of December 31, 2006; and the estimated future taxable income based onhistorical operating results.

After giving consideration to these factors, the Company concluded thatit was more likely than not that the tax loss carryforwards will be realizedprior to expiration and that other tax credits that expire prior to 2010 willnot be 

63

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utilized due to the estimated future tax deductions from the exercise ofstock options outstanding as of December 31, 2006 as well as utilizationof tax loss carryforwards. The Company had a valuation allowance of $185,000 asof December 31, 2006 relating to net operating losses and tax credits thatexpire prior to 2010.

The Company also concluded that it was more likely than not that the netdeferred tax assets of $10.6 million as of December 31, 2006 and theestimated future tax deductions from the exercise of stock options outstandingas of December 31, 2006 would be utilized prior to expiring. Based on thisconclusion, the Company would require approximately $53.6 million in cumulativefuture taxable income to be generated at various times over the next 20 yearsto realize the related net deferred tax assets of $10.6 million as ofDecember 31, 2006 as well as the estimated future tax deductions from theexercise of stock options outstanding and in-the-money as of December 31,2006.

If the Companyadjusts either its estimates of future taxable income or tax deductions fromthe exercise of stock options down, or the Company’s stock price increasessignificantly without an increase in taxable income, causing the Company tobelieve that its deferred tax assets will not be utilized, the Companymay need to establish additional valuation allowances on its deferred taxassets, which could materially impact its financial position and results ofoperations.

**Activityduring the year ended December 31, 2005**

The Company concluded that it was more likely than not that tax losscarryforwards that expire in 2006 and other tax credits that expire prior to2010 would not be utilized due to the estimated future tax deductions from theexercise of stock options outstanding as of December 31, 2005. As aresult, the Company recorded a valuation allowance of $47,000 for the yearended December 31, 2005 relating to state tax loss carryforwards due tothe uncertainty in realization prior to expiration.

**Activityduring the year ended December 31, 2004**

The Company concluded that it was more likely than not that tax losscarryforwards that expire in 2005 and other tax credits that expire prior to2010 would not be utilized due to the estimated future tax deductions from theexercise of stock options outstanding as of December 31, 2004. As a result,the Company recorded a valuation allowance of $183,000 for the year endedDecember 31, 2004. The Company also recorded a valuation allowance of$43,000 relating to 2004 foreign net operating losses that are subject touncertainty regarding utilization.

**Netoperating loss carryforward limitations**

Under Section 382 of the Internal Revenue Code of 1986, certainstock transactions which significantly change ownership, including the sale ofstock and the granting of options to purchase stock, could limit the amount ofnet operating loss carryforwards that may be utilized on an annual basisto offset taxable income in future periods. Management does not believe therehave been any past changes in ownership, as defined by Section 382, whichcould materially impact the Company’s ability to utilize loss carryforwards.

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

The Companymaintains the Vital Images, Inc. Salary Savings Plan (the “Plan”), whichis intended to qualify under Section 401(k) of the Internal Revenue Code,as amended. The Plan covers substantially all employees. Each employeemay elect to contribute to the Plan through payroll deductions up to 100%of his or her salary, subject to certain limitations. At the discretion of theBoard of Directors, the Company may make matching contributions equal to apercentage of the salary reduction contributions or other discretionaryamounts. The Company paid $214,000, $103,000 and $44,000 in matchingcontributions in 2006, 2005 and 2004, respectively.

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

Customers accounting for more than 10% of the Company’s total revenue areas follows (in thousands):

|                                      | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                 |       |                                                         |       |   |   |   |   |
| Toshiba Medical  Systems Corporation |       | $                                                            | 28,879     |   | $ | 24,307 |   | $ | 18,130 |   |
| Percentage of  total revenue         |       | 41                                                           | %          | 47 | % | 50 | % |
|                                 |       |                                                         |       |   |   |   |   |
| McKesson  Corporation                |       | $                                                            | 7,314      |   | $ | 3,800 |   | $ | 744 |   |
| Percentage of total  revenue         |       | 10                                                           | %          | 7 | % | 2 | % |

 

64

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As ofDecember 31, 2006 and 2005, Toshiba Medical Systems Corporation accountedfor 41% and 36% of accounts receivable, respectively. As of December 31,2006 and 2005, McKesson Corporation accounted for 14% and 7% of accountsreceivable, respectively.

All significantlong-lived assets of the Company are located in the United States.

Export revenueaccounted for 15%, 16% and 17% of total revenue for the years endedDecember 31, 2006, 2005 and 2004, respectively. Substantially all of theCompany’s export sales are negotiated, invoiced and paid in U.S. dollars.

Sales bygeographic area are summarized as follows (in thousands):

|                         | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------|------------|--------------------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                    |       |                                                         |       |   |   |   |   |
| United States           |       | $                                                            | 59,640     |   | $ | 43,552 |   | $ | 30,032 |   |
| Europe                  |       | 5,713                                                        |       | 4,461 |   | 3,692 |   |
| Asia-Pacific            |       | 2,520                                                        |       | 2,277 |   | 1,320 |   |
| Other foreign countries |       | 2,639                                                        |       | 1,427 |   | 1,078 |   |
|                    |       | $                                                            | 70,512     |   | $ | 51,717 |   | $ | 36,122 |   |

 

65

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**10.Selected quarterly financial data (unaudited)**

The followingsummarized unaudited quarterly financial data has been prepared using thefinancial statements of the Company (in thousands, except per share data):
| ** **                            | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|---------------------------------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|
|                                  |       |                   |       |                    |       |                   |       |                    |       |
| **2006**                              |       |                   |       |                    |       |                   |       |                    |       |
| Total revenue                         |       | $                      | 15,796     |                    | $          | 16,913                 |       | $                       | 17,781     |   | $ | 20,022 |   |
| Gross profit                          |       | $                      | 12,592     |                    | $          | 13,414                 |       | $                       | 14,311     |   | $ | 15,984 |   |
| Net income                            |       | $                      | 1,427      |                    | $          | 1,247                  |       | $                       | 1,624      |   | $ | 2,284 |   |
| Earnings per share — basic (2)   |       | $                      | 0.11       |                    | $          | 0.09                   |       | $                       | 0.12       |   | $ | 0.15 |   |
| Earnings per share — diluted (2) |       | $                      | 0.10       |                    | $          | 0.09                   |       | $                       | 0.12       |   | $ | 0.15 |   |
|                                  |       |                   |       |                    |       |                   |       |                    |       |
| **2005**                              |       |                   |       |                    |       |                   |       |                    |       |
| Total revenue                         |       | $                      | 11,325     |                    | $          | 11,948                 |       | $                       | 13,160     |   | $ | 15,284 |   |
| Gross profit                          |       | $                      | 8,653      |                    | $          | 8,918                  |       | $                       | 10,264     |   | $ | 12,322 |   |
| Net income                            |       | $                      | 1,023      | (1)                     | $          | 734                    |       | $                       | 1,621      |   | $ | 2,421 |   |
| Earnings per share — basic (2)   |       | $                      | 0.08       |                    | $          | 0.06                   |       | $                       | 0.13       |   | $ | 0.19 |   |
| Earnings per share — diluted (2) |       | $                      | 0.08       |                    | $          | 0.06                   |       | $                       | 0.12       |   | $ | 0.18 |   |

----

(1)          Includes a loss onoperating lease of $493 related to the Company’s facility move in the firstquarter of 2005.

(2)          The sum of the quarterly earnings per share may not equal theannual earnings per share due to changes in average shares outstanding.

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**VitalImages, 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. |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 3.1       |       | Articles of Incorporation of the Company,  incorporated by reference to Exhibit 3.1 to the Company’s Registration  Statement on Form 10 dated March 13, 1997 (“Form 10”).                                                                                                                                             |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 3.2       |       | By-laws of the Company, incorporated by reference to  Exhibit 3.2 to the Form 10.                                                                                                                                                                                                                                                              |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 4.1       |       | Form of common stock certificate of the Company,  incorporated by reference to Exhibit 4.3 to the Form 10.                                                                                                                                                                                                                                |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 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 Form 10.                                                                                       |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 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 Form 10.                                                                                                                                                                          |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.1      |       | Employee Stock Purchase Plan, incorporated by  reference to Exhibit 10.10 to the Form 10.*                                                                                                                                                                                                                                                     |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.2      |       | 1997 Stock Option and Incentive Plan, as amended,  incorporated by reference to Exhibit 10.11 to the Form 10 and  Exhibit 99.9 to the Company’s Registration Statement on Form S-8 dated  May 23, 2005.*                                                                                                                   |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.3      |       | 1997 Director Stock Option Plan, as amended,  incorporated by reference to Exhibit 10.12 to the Form 10 and  Exhibit 99.14 to the Company’s Registration Statement on Form S-8  dated May 23, 2005.*                                                                                                                       |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.4      |       | Marketing and Distribution Agreement between Vital  Images, Inc. and Toshiba Corporation, Medical Systems Company,  incorporated by reference to Exhibit 10.35 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended March 31, 2002.**                                                                          |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.5      |       | Amendment No. 1 to Marketing and Distribution  Agreement between Vital Images, Inc. and Toshiba Corporation, Medical  Systems Company, incorporated herein by reference to Exhibit 10.37 to  the Company’s Annual Report on Form 10-K for the year ended  December 31, 2002.**                                             |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.6      |       | Amendment No. 2 to Marketing and Distribution  Agreement between Vital Images, Inc. and Toshiba Medical Systems  Corporation, incorporated herein by reference to Exhibit 10.44 to the  Company’s Annual Report on Form 10-K for the year ended  December 31, 2003.**                                                      |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.7      |       | Amendment No. 3 to Marketing and Distribution  Agreement between Vital Images, Inc. and Toshiba Medical Systems  Corporation, incorporated herein by reference to Exhibit 10.1 to the  Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,  2005.**                                                    |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.8      |       | Employment Agreement dated February 9, 2002  between Vital Images, Inc. and Jay D. Miller, incorporated by reference  to Exhibit 10.39 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2002.*                                                                                                 |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |
| 10.9      |       | Form of Change in Control Agreement between  Vital Images, Inc. and Steven P. Canakes and Jay D. Miller, incorporated  by reference to Exhibit 10.40 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2000.*                                                                                   |
|      |       |                                                                                                                                                                                                                                                                                                                                                     |

 

67

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| Item  No. | ** ** | **Description**                                                                                                                                                                                                                                                                   |
|-----------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |       |                                                                                                                                                                                                                                                                              |
| 10.10     |       | Employment Agreement dated September 8, 2005 by  and between Vital Images, Inc. and Dr. Susan A. Wood, incorporated  by reference to Exhibit 99.4 to the Company’s Current Report on  Form 8-K dated September 12, 2005.*                      |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.11     |       | Change in Control Agreement dated September 8,  2005 by and between Vital Images, Inc. and Dr. Susan A. Wood,  incorporated by reference to Exhibit 99.5 to the Company’s Current  Report on Form 8-K dated September 12, 2005.*               |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.12     |       | Employment Agreement dated September 8, 2005 by  and between Vital Images, Inc. and Philip I. Smith, incorporated by  reference to Exhibit 99.6 to the Company’s Current Report on  Form 8-K dated September 12, 2005.*                             |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.13     |       | Employment Agreement dated September 8, 2005 by  and between Vital Images, Inc. and Steven P. Canakes, incorporated by  reference to Exhibit 99.7 to the Company’s Current Report on  Form 8-K dated September 12, 2005.*                           |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.14     |       | Employment Agreement dated May 16, 2005 by and  between Vital Images, Inc. and Michael H. Carrel, incorporated by  reference to Exhibit 99.2 to the Company’s Current Report on  Form 8-K dated May 19, 2005.*                                      |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.15     |       | Change in Control Agreement dated May 16, 2005,  by and between Vital Images, Inc. and Michael H. Carrel, incorporated by  reference to Exhibit 99.4 to the Company’s Current Report on  Form 8-K dated May 19, 2005.*                              |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.16     |       | Agreement dated February 16, 2006 by and  between Vital Images, Inc. and Dr. Vincent Argiro, incorporated by  reference to Exhibit 99.2 to the Company’s Current Report on  Form 8-K dated February 16, 2006.*                                 |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.17     |       | Employment Agreement dated October 24, 2005 by  and between Vital Images, Inc. and Jeremy A. Abbs, incorporated by  reference to Exhibit 10.21 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2005 (“2005 Annual Report”). |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.18     |       | Form of Change in Control Agreement between  Vital Images, Inc. and Philip I. Smith and Jeremy A. Abbs, incorporated  by reference to Exhibit 10.22 to the Company’s 2005 Annual Report.                                                                           |
|      |       |                                                                                                                                                                                                                                                                              |
| 10.19     |       | 2006 Long Term Incentive Plan.                                                                                                                                                                                                                                                    |
|      |       |                                                                                                                                                                                                                                                                              |
| 21.1      |       | Subsidiaries of Registrant, filed herewith.                                                                                                                                                                                                                                       |
|      |       |                                                                                                                                                                                                                                                                              |
| 23.1      |       | Consent of PricewaterhouseCoopers LLP, filed  herewith.                                                                                                                                                                                                                           |
|      |       |                                                                                                                                                                                                                                                                              |
| 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.                                                                      |
|      |       |                                                                                                                                                                                                                                                                              |
| 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.                                                                      |
|      |       |                                                                                                                                                                                                                                                                              |
| 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.                                                                                                    |
|      |       |                                                                                                                                                                                                                                                                              |
| 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.                                                                                                    |

 

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*                 Indicates a management contract orcompensatory plan or arrangement.

**          Portionsof such exhibit are treated as confidential pursuant to a request for thatconfidential treatment filed with the Commission by Vital Images.

68

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