**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

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

 

**For the fiscal year ended December 31, 2007**

 

**OR**

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

 

**For the transition period from             to**

 

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

 

**VitalImages, Inc.**

(Exact name of registrant as specified in its charter)

 
| **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 |   | Nasdaq Global Select Market |
|------------------------------|--------|-----------------------------|

 

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

 

**Not applicable.**

(Former name, former address and former fiscal year, if changed sincelast report)

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.Yes  o          No  x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act.Yes  o           No  x

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.    Yes x         Noo

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.   o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

 

| Large  accelerated filer o                                               | Accelerated  filer x         |
|-------------------------------------------------------------------------------|-----------------------------------|
|                                                                          |                              |
| Non-accelerated  filer o

(Do  not check if a smaller reporting company) | Smaller  reporting company o |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).   Yes o   Nox

 

As of June 30, 2007, the last day of the registrant’smost recently completed second fiscal quarter, the aggregate market value ofthe registrant’s common stock held by non-affiliates of the registrant was$464,975,696. The common stock is the registrant’s only class of votingstock.

 

Thenumber of shares outstanding of the issuer’s class of common stock as of March 10,2008 was 17,149,008 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portionsof registrant’s definitive Proxy Statement in connection with the AnnualMeeting of Stockholders to be held May 29, 2008 (“2008 Proxy Statement”)are incorporated 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 | 2 |
| Item 1A.      |   | Risk Factors | 10 |
| Item 1B.      |   | Unresolved Staff  Comments | 18 |
| Item 2.       |   | Properties | 18 |
| Item 3.       |   | Legal Proceedings | 18 |
| Item 4.       |   | Submission of  Matters to a Vote of Security Holders | 18 |
|          |   |   |   |
| Part II  |   |
|          |   |   |   |
| Item 5.       |   | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of  Equity Securities | 19 |
| Item 6.       |   | Selected  Financial Data | 21 |
| Item 7.       |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 22 |
| Item 7A.      |   | Quantitative  and Qualitative Disclosures About Market Risk | 34 |
| Item 8.       |   | Financial  Statements and Supplementary Data | 34 |
| Item 9.       |   | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure | 34 |
| Item 9A.      |   | Controls and  Procedures | 34 |
| Item 9B.      |   | Other Information | 35 |
|          |   |   |   |
| Part III |   |
|          |   |   |   |
| Item 10.      |   | Directors,  Executive Officers and Corporate Governance | 36 |
| Item 11.      |   | Executive  Compensation | 36 |
| Item 12.      |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters | 36 |
| Item 13.      |   | Certain  Relationships and Related Transactions, and Director Independence | 36 |
| Item 14.      |   | Principal  Accountant Fees and Services | 36 |
|          |   |   |   |
| Part IV  |   |
|          |   |   |   |
| Item 15.      |   | Exhibits and  Financial Statement Schedules | 37 |
|          |   |   |   |
| Signatures    |   |   | 38

  |

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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 us oron our behalf may include forward-looking statements that reflect ourcurrent views with respect to future events and future financial performance.**Certainstatements in this Annual Report on Form 10-K are “forward-lookingstatements”**within the meaning of Section 27(a) ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Actof 1934. You can identify these forward-looking statements by our use of thewords “believes,” “anticipates,” “forecasts,” “projects,” “could,” “plans,” “expects,”“may,” “will,” “would,” “intends,” “estimates” and similar expressions, whetherin the negative or affirmative.**We wish to caution you that anyforward-looking statements made by us or on our behalf are subject touncertainties and other factors that could cause such statements to be wrong.**We cannot guarantee that we actually will achievethese plans, intentions or expectations. Actual results or events could differmaterially from the plans, intentions and expectations disclosed in theforward-looking statements that we make.Thesestatements are only predictions and speak only of our views as of the date thestatements were made. Although we believe that the expectations reflected inthe forward-looking statements are reasonable, we cannot guarantee futureresults, levels of activity, and/or performance of achievements. We do notassume any obligation to update or revise any forward-looking statements thatwe make, whether as a result of new information, future events or otherwise.*

 

*Factors thatmay impact forward-looking statements include, among others,**ourabilities to maintain the technological competitiveness of our currentproducts, develop new products, successfully market our products, respond tocompetitive developments, develop and maintain partnerships with providers ofcomplementary technologies, manage our costs and the challenges thatmay come with growth of our business, and attract and retain qualifiedsales, technical and management employees. We are also affected by the growthand regulation of the medical technology industry, including the acceptance ofenterprise-wide advanced visualization by hospitals, clinics, and universities,product clearances and approvals by the United States Food and DrugAdministration and similar regulatory bodies outside the United States, andreimbursement and regulatory practices by Medicare, Medicaid, and privatethird-party payer organizations. We are also affected by other factorsidentified in our filings with the Securities and Exchange Commission, some ofwhich are set forth in the section entitled “Item 1A. Risk Factors” inthis Annual Report on Form 10-K (and many of which we have discussed inprior filings).**Although we have attemptedto list comprehensively these important factors, we also wish to cautioninvestors that other factors may prove to be important in the future inaffecting our operating results. New factors emerge from time to time, and itis not possible for us to predict all of these factors, nor can we assess theimpact each factor or combination of factors may have on our business.*

 

**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, customer education, 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 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, scanners, and can be integrated intopicture archive 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.

 

Wewere founded and incorporated in Iowa in September 1988, and were-incorporated in Minnesota in March 1997. Our principal executiveoffices are located at 5850 Opus Parkway, Suite 300, Minnetonka, MN 55343(telephone (952) 487-9500, facsimile (952) 487-9510, e-mail —info@vitalimages.com ). From May 24, 1994 through May 11, 1997, wewere a wholly-owned subsidiary of Bio-Vascular, Inc., which is now knownas Synovis Life Technologies, Inc.

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Our corporate websiteaddress is www.vitalimages.com. To access 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 free ofcharge, go to the “Investors” section of our website, then to the “FinancialInfo & Filings” category, and then to the “SEC Filings” subcategory,where we make such filings available as soon as reasonably practicable afterthey are filed with or furnished to the SEC. The “Corporate Governance”category of the Investors section of our website also contains free copiesof the Charters for the Audit Committee, Compensation Committee, and GovernanceCommittee of our Board of Directors, as well as our Code of Business Conductand 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 on our websiteis not incorporated by reference into this Annual Report on Form 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®software*, our flagship software product, is an easy-to-use,intuitive, high-speed volume rendering technology that creates interactivetwo-dimensional, or 2D, three-dimensional, or 3D, and four-dimensional, or 4D,images from information generated by standard CT scanners. *Vitrea*is commonly deployed on standalone workstations, as well as on PACS, usingstandard computer hardware, and provides advanced visualization forradiological, cardiac, oncological and surgical applications. *Vitrea* renders vibrant, clear, color images at high speedsand enables 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. *VitreaACCESS*TMsoftware provides physicians remote access to the full suite of advancedvisualization and analysis tools provided by *Vitrea*software. It offers a cost effective solution designed to enable users toleverage workstations by allowing secure access to *Vitrea*applications from any personal computer in a facility or from externallocations through a virtual private network, or VPN.

 

*ViTALConnect®software*, our Web-based solution, allows multiple physiciansto collaboratively use enterprise-wide advanced visualization in their medicalpractices. It provides radiologists and referring physicians anywhere, anytimeaccess to interactive 2D, 3D and 4D medical images and the ability to measure,rotate, analyze and segment those images. Our latest release includes featurespreviously available only on multimodality workstations, such as a variety ofmulti-planar reformat, or MPR, modes, thick slab rendering in MPR, 3Dvolumetric visualization with simple point of interest navigation, 4D datasetvisualization, CT/PET fusion and advanced analysis tools.

 

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We also offer enterprise-wide advanced visualization options that canexpand the relevance of our products beyond the radiology department toreferring physicians and surgical specialists, particularly in the areas ofcardiology, cardiovascular, oncology, neurology and gastroenterology. Ouradvanced visualization options allow physicians to customize their *Vitrea* software according to their uniquerequirements. Most options are proprietary; however, *Vitrea* also serves as an integration platform for theapplications offered by our visualization technology partners. *Vitrea’s* add-on options include:

 

| **Vitrea  Option**                       | ** ** | **Clinical Use**                                                                                          | ** ** |
|------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|
| ·Vscore                             |       | —Quantifies calcium in the four major coronary arteries                                              |       |
| ·CT Brain Perfusion                 |       | —Analyzes the blood flow of stroke victims                                                           |       |
| ·Innerview GI (virtual colonoscopy) |       | —Locates and analyzes polyps in the colon                                                            |       |
| ·Automated Vessel Measurements      |       | —Characterizes the course and dimensions of diseased blood vessels                                   |       |
| ·CT Cardiac                         |       | —Determines the extent of obstructive coronary artery disease                                        |       |
| ·SUREPlaqueTM                   |       | —Aids in evaluating, characterizing and quantifying plaque inside the  coronary arteries             |       |
| ·Vessel Probe                       |       | —Defines vascular anatomy  and the extent of obstruction in vessels other than the coronary arteries |       |
| ·CT Lung and Lung Tools             |       | —Visualizes and measures nodules in the lungs                                                        |       |
| ·ImageChecker® CT              |       | —Detects pulmonary nodules in the chest                                                              |       |
| ·Fusion7DTM                     |       | —Visualizes images and fuse studies from multiple modalities, such as  MR and PET                    |       |
| ·CADstreamTM                    |       | —Analyzes MR breast exams                                                                            |       |
| ·QMassTM MR                     |       | —Analyzes MR cardiac images                                                                          |       |
| ·EP Planning                        |       | —3D advanced visualization and modeling tool for the  electrophysiology lab                          |       |

 

Oursoftware solutions are used with medical diagnostic equipment, primarily inclinical analysis and therapy planning. Our software applies proprietarytechnologies to a variety of data supplied by CT 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,cardiologists, surgeons, other specialized physicians, primary care physiciansand medical researchers. Our main customers are hospitals and clinics,university medical schools and diagnostic imaging companies. We market ourproducts and services to these customers both directly through our own salesforce and indirectly through digital imaging equipment manufacturers and PACScompanies, who sell our products with products they either manufacture oracquire from third parties.

 

Ourproducts work with equipment from all major manufacturers of diagnostic imagingsystems, including Toshiba Medical Systems Corporation (“Toshiba”), GE MedicalSystems, Siemens Medical Systems, Inc. and Philips Medical Systems. Ourproducts may also be integrated into PACS, such as those marketed byMcKesson Corporation (“McKesson”), Sectra AB and DR Systems, Inc., andthey run on off-the-shelf third-party computer hardware.

 

**Maintenanceand Support**

 

Inaddition to system and software products, we market maintenance and supportservices, as well as certain other services, such as installation and customereducation. In connection 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, customer education and otherservices, whether on- or off-site, which can be purchased separately.

 

**MarketOpportunity**

 

Webelieve the expansion in the number and complexity of medical imagingexaminations associated with CT scanners creates a substantial opportunity forus in the radiology market. Historically, imaging equipment generatedcomparatively low amounts of image data that was typically viewed using film.However, current generation CT scanners are capable of quickly generating asmany as 10,000 discrete images, or slices, in a single imaging exam,

 

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whichis more than 20 times as many images as were generally attained in exams as fewas five years ago. This substantial data output cannot be analyzed in a timelyor cost-effective manner using film or manual workflow and necessitates digitalsolutions capable of handling these large data sets efficiently and accurately.Radiologists, who are in short supply, require advanced visualization solutionsthat can quickly render 2D, 3D and 4D images to improve their productivity.

 

Advancedvisualization applications are becoming more commonly used by physicianspecialists who are not radiologists. For example, although radiologists have historically used our cardiologyand cardiovascular applications, cardiologists are beginning to own and operatetheir own CT scanners. This growing interest among cardiologists in cardiac CTimaging procedures expands our potential end-user market. In addition tocardiology, we believe other clinical specialties are increasingly usingadvanced visualization and analysis tools to improve productivity andfacilitate less invasive patient care, including neurology, women’s health,respiratory and pulmonary medicine and gastroenterology.

 

Wealso expect to benefit as medical images are increasingly used throughout thehealthcare enterprise and in new, innovative ways. In addition to use byspecialists beyond radiologists, images are now being used by referringphysicians to educate patients, plan treatment and monitor patient progress.Physicians also use imaging technology on an increasing basis in connectionwith their review of possible patient medical conditions, such as lung or coloncancer. This shift has created demand for advanced visualization solutions thatcan be accessed by physicians throughout the enterprise. We facilitateenterprise-wide advanced visualization by distributing images and certainanalysis tools directly using *ViTALConnect*and *VitreaACCESS*, which allow remote accessto *Vitrea’s* toolset, as well as through ourability to integrate with PACS.

 

Historically,the market has been marked by strong demand, which we believe resultedprimarily from the following factors:

 

·                  increasing number of imagingexams performed due to the expanded use of CT imaging procedures by physiciansand an aging U.S. population;

 

·                  technological advancementsenabling CT scanners to generate thousands of images per exam;

 

·                  demand from radiologists andreferring physicians for enterprise-wide advanced visualization solutions thatcan improve productivity, optimize clinical workflow and enhance treatmentplanning;

 

·                  increasing use of imagingtechnology in departments outside of radiology, in part due to the integrationof advanced visualization with PACS; and

 

·                  growing importance ofintegrating advanced visualization and analysis tools into the clinicalenterprise to facilitate collaboration among physicians, increase access toinformation and improve workflow productivity.

 

During2007, market demand decreased.  Webelieve the decrease in market demand in 2007 was caused primarily by thefollowing factors:

 

·                  a reduction in purchases ofCT scanners, as customers were anticipating the next generation of scannertechnology;

 

·                  decreases in reimbursementfor imaging procedures, typified by the reductions of reimbursement to imagingcenters resulting from the Deficit Reduction Act of 2005;

 

·                  proposed rules from theCenter for Medicare and Medicaid Services to reduce or eliminate reimbursementfor certain cardiac imaging procedures; and

 

·                  a maturing of the PACSmarket, as most large hospitals have previously installed PACS, resulting inthe PACS market being a replacement market instead of a new installationmarket.

 

Weexpect many of the factors affecting the market in 2007 to continue into 2008.Because national elections are being held in 2008, we do not expect significantchange this year in the areas of reimbursement and regulatory matters. However,we do believe that the market for CT scanners will rebound during the secondhalf of 2008, with Toshiba’s release of the AquillionONETM dynamic volume CTscanner, which will allow an organ — including the heart and brain — to bescanned in one rotation.

 

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**Strengths**

 

One of our key competitive differentiators from other advancedvisualization providers is our focus on, and investment in, developingintuitive, user-friendly software. Each of our software products is designed toautomate common elements of physician visualization workflow, which makes oursoftware simple to use and facilitates user adoption. We believe our optimizedworkflow automation is an important factor that customers consider whenchoosing our advanced visualization solutions. We believe that the followingadditional competitive strengths also contribute to our success:

 

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

·                  our ability torender integrated 2D, 3D and 4D images at high speeds and with interactivenavigation capabilities using a relatively low-cost standard computer;

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

·                  our ability todistribute our applications throughout a healthcare enterprise using PACSintegration, *VitreaACCESS* and our *ViTALConnect* Web-based solution.

 

Theadvanced visualization market is highly competitive and subject to rapidchange. Our products compete based on quality, performance, functionality andfeatures, quality of support and service, reputation, brand and price. Ourprimary competitors include diagnostic imaging equipment manufacturers, whichare typically large, multinational companies with greater financial andtechnical resources. These companies, including GE Healthcare, Siemens MedicalSystems, Inc. and Philips Medical Systems, develop and market imagingequipment that may be purchased with integrated visualization capabilities. Wealso face competition from PACS vendors, which may provide visualizationcapabilities in addition to their image archiving and networking products.Other advanced visualization suppliers, such as TeraRecon, Inc., competeon the basis of visualization technologies, specific applications or marketniches.

 

**Strategy**

 

Ourgoal is to be a leading provider of enterprise-wide advanced visualization andimage analysis solutions that we believe can improve clinical outcomes andreduce costs. To achieve this goal, we intend to implement the following keystrategies:

 

·                  develop and maintainleading-edge, enterprise-wide advanced visualization technology;

·                  increase penetration of ourexisting customer base;

·                  further expand our presencein the enterprise-wide advanced visualization market either selling directly orthrough PACS integration;

·                  continue to build ourinternational direct sales and marketing efforts;

·                  grow our collaborativepartnerships with leading medical technology companies; and

·                  selectively pursue strategicacquisitions.

 

**Marketing and Distribution**

 

Wemarket *Vitrea* and *ViTALConnect* both as standalone softwarepackages and as part of integrated software and hardware systems toradiologists, surgeons, primary care physicians and medical researchers. Wemarket our products directly to end-user customers and through several businesspartners, including diagnostic imaging equipment manufacturers, PACS companies,and software developers, all of whom sell our products with products theyeither manufacture or acquire from third parties.

 

Ourmarketing partners include Toshiba, which markets *Vitrea* to**itscustomers through its subsidiaries and distributors in more than 50 countriesthroughout the world. Our agreement with Toshiba commenced in 2001, and it hasbeen extended four times, most recently through December 31, 2008. Salesthrough Toshiba are a material portion of our revenues, comprisingapproximately 47% of our 2007 revenues, 41% of our 2006 revenues and 47% of our2005 revenues. We also have a joint distribution agreement with McKesson, aprovider of PACS, under which McKesson may distribute our products to itscustomers. Sales through McKesson represented approximately 9% of our 2007revenues, 10% of our 2006 revenues and 7% of our 2005 revenues. See “Item 1A.Risk Factors - Dependence on Major Customers.”

 

 

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Wealso have marketing and reseller agreements with several other companies, suchas Sectra AB and Cerner Corp., under which these companies may resell ourproducts to their customers as add-on components to their products.

 

Welicense software and sell products and services to end users and alsoindirectly through original equipment manufacturers, value-added resellers andindependent distributors. Payment terms for the resellers do not generallydiffer from those we provide to end users. See Note 8 to the FinancialStatements, “Major Customers and Geographic Data,” for information regardingour export sales. As of December 31, 2007, we had 50 salespeople in theU.S., six salespeople in Europe, one salesperson supporting national accounts,and one salesperson supporting our international resellers outside of Europe.

 

**CollaborativeRelationships**

 

Wehave formed collaborative relationships with 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:

 

·                  identify new clinicalapplications where noninvasive imaging software can improve clinical outcomesand reduce costs;

·                  assist in the development ofclinical routines that incorporate our clinical solutions in normal diagnosticand therapy planning practices;

·                  consult in the developmentof new features that facilitate and improve analysis and therapy planning forour future products;

·                  assess the clinical value ofour clinical solutions for given applications; and

·                  develop automated clinicalprotocols 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.

 

Wealso face competition from PACS vendors and other suppliers of medical imagingsystems and software. PACS companies sometimes provide medical imagingcapability in addition to their image archiving and networking products. Someof the diagnostic equipment manufacturers, including GE Medical Systems andPhilips Medical Systems, also offer PACS. Vendors of hospital, clinical andradiology information systems have also diversified into the PACS and medical imagingproduct lines, either through internal development or business development andpartnership channels. These companies, which may be large or small,attempt to offer an integrated system covering a full range of administrative,clinical and radiology information management capabilities to healthcareproviders. Other suppliers of medical imaging systems and software, such asTeraRecon, Inc., compete on the basis of volume rendering or othervisualization technologies, specific applications or market niches.

 

Ourcompetitive strength is based on several factors, including our ability to dothe following:

 

·                  providedifferentiated solutions that operate in multi-vendor network and image sourceenvironments;

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

·                  build userinterfaces that are easy for physicians and clinicians to use so that they donot need to be advanced technology experts to derive value from enterprise-wideadvanced visualization analysis and solutions;

·                  integrateclinical knowledge from our collaborative clinical partners into our products;

·                  leverage ourvisualization and analysis technology across multiple clinical disciplines;

·                  offer a “DICOMclient” product, which can operate on any network conforming to the DigitalImaging and Communications in Medicine (DICOM) standard, independent of theimaging system and network provider;

 

 

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·                  serve originalequipment manufacturers (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 ourmarket-leading clinical applications into the broadening clinical enterprisethrough Web-based deployable solutions.

 

Webelieve that product quality, performance, functionality and features, qualityof support and service, reputation, brand and price are also importantcompetitive factors. We believe that customers will prefer our solutionsbecause they are the best-in-class productivity tools for doctors.Although price has been less significant than other factors, increasingcompetition in the market may result in price reductions and reduced grossmargins. In particular, if one or more of the diagnostic imaging systemsuppliers or PACS vendors, many of which have greater scale and resources thanwe do, provides or distributes more competitive medical imaging products thanours, our business, financial condition and results of operations could bematerially adversely affected.

 

**Customersand Customer Support**

 

ThroughDecember 31, 2007, we had sold approximately 4,700 separate softwarelicenses for *Vitrea* and *ViTALConnect*foruse in hospitals and teaching hospitals, clinics and imaging centers in majorcities and smaller population areas.

 

Weare committed to rapid response to customer service requests. Customer supportrepresentatives are available during business hours and on an on-call basis toanswer questions about the operation, maintenance and repair of our products.

 

**IntellectualProperty**

 

Werely primarily on a combination of trade secret and copyright law, employee andthird-party nondisclosure agreements and other protective measures to protectintellectual property rights pertaining to our products and technologies.Because of the rapid pace of technological change in the medical softwareindustry, we believe that the knowledge, ability and experience of our personnel;new product developments and enhancements; and ongoing, reliable productmaintenance and support will enhance our competitive position.

 

Wedo not own all of the software and other technologies used in our products, butwe believe we have the necessary licenses from third parties for using thattechnology in our current products. It may be necessary to renegotiatewith such third parties for any new versions of current products or any newproducts. Such third-party licenses may not be available on reasonableterms, or at all.

 

**Manufacturingand Service**

 

Ourmanufacturing efforts are limited to the production, quality assurance anddistribution of our software, which is distributed on CD-ROM. After we sendsoftware to our customers, it is loaded into a workstation, either by ourpersonnel, personnel from one of our authorized resellers, or our customers’personnel. If our personnel load the software, it is as part of ourinstallation services. In addition to loading software into the workstation, ourinstallation services generally include implementation of *Vitrea*and *ViTALConnect* software into customers’computer networks, configuring the network requirements and verifying softwareoperability on site.

 

Weprovide customer education services for our customers, both in connection withtheir acquisition of our software and as independent purchases.  A license of one copy of our *Vitrea* software entitles the customer to place two people atno additional charge in an intensive three-day customer education program heldat our headquarters in Minnetonka, Minnesota. We also conduct customer education programs for our software atcustomers’ locations and at various designated locations through the UnitedStates.  Some customers defer attendingcustomer education sessions for several months after the purchase of oursoftware or decline to attend the customer education sessions. Additionally, weoffer standalone customer education programs, which are separately purchased bycustomers, for advanced education in the uses of our software and for specificclinical applications, such as cardiology.

 

Werely primarily on our own software development as our core competence. Weobtain certain application 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.

 

 

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Wehave also signed reseller distribution agreements that allow us to distributeproducts from certain third parties. These third-party products include R2Technology, Inc.’s ImageChecker® CT software applications for thedetection of lung nodules; Siemens Molecular Imaging Fusion 7DTM softwareapplication for the anatomical alignment of two different image data sets fromtwo different types of diagnostic equipment, such as combining images from CTand PET scanners; Confirma Inc.’s CADstreamTM breast MRI software; and MedisInc.’s QMass® MR software.

 

**GovernmentalRegulation**

 

Asmedical devices, our software solutions are subject to extensive and rigorousregulation by numerous governmental authorities, principally the U.S. 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 a 510(k) pre-marketnotification. The process of obtaining a 510(k) clearance typically cantake 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 the manufacturersubmit a pre-market approval (“PMA”) application that must be reviewed andapproved by the FDA prior to the sale and marketing of the device in the UnitedStates. The process of obtaining a PMA can be expensive, uncertain and lengthy,frequently requiring anywhere from one to several years from the date of FDAsubmission, if approval is obtained at all. Moreover, a PMA, if granted,may include significant limitations on the indicated uses for which aproduct may be marketed.

 

*Vitrea* and *ViTALConnect* are classified as Class II medical devicesand have received marketing clearances from the FDA as the result of 510(k) pre-marketnotifications. Specifically, *Vitrea, ViTALConnect*andour add-on options have been cleared to be marketed for use with CT, MR and PETscanners. Future products, add-on options to existing software, and expandedclaims of efficacy will likely require additional 510(k) pre-marketnotifications.

 

Therecan be no assurance that future FDA review processes will not involve delays orthat clearances will be granted on a timely basis. If our current or futureproducts become classified as Class III devices, they could be subject toa more expensive, uncertain and lengthy approval process, and approval, ifgranted, could include significant limitations on the indicated uses for whicha product may be marketed.

 

Weare also subject to regulation in foreign countries in which we sell ourproducts. Many of the regulations applicable to our products in such countriesare similar to those of the FDA. Our ability to successfully market and sellour products in foreign markets depends in large part on our ability tocomply with such foreign 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.

 

Weare also subject to periodic inspections by the FDA and similar foreignregulatory agencies, whose primary purpose is to audit our compliance withquality system regulations established by the FDA and other applicablegovernment standards. Regulatory action may be initiated in response toaudit deficiencies or product performance problems. We believe that ourmanufacturing and quality control procedures comply with all applicablerequirements of the FDA and foreign regulatory agencies in countries in whichwe sell our products. We have received and maintain ISO 13485: 2003Certification.

 

Medicareand Medicaid 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 distributionpractices currently comply with all current applicable fraud and abuse andphysician anti-referral laws and regulations.

 

 

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**Third-PartyReimbursement and Cost Containment**

 

Ourproducts are purchased primarily by hospitals, clinics, imaging centers andother users that bill various third-party payers for the services provided tothe patients. These payers, which include Medicare, Medicaid, private insurancecompanies and managed care organizations, reimburse part or all of thecosts and fees associated with the diagnostic procedures utilizing ourproducts. The medical imaging services performed using our software, except fordisease screening procedures, are covered by current CPT codes (CurrentProcedural Terminology, as defined by the Centers for Medicare &Medicaid Services). As such, hospitals providing services using ourenterprise-wide advanced visualization solutions can seek reimbursement forsuch services by using existing approved CPT codes. Medicare and Medicaidreimbursement for hospitals is based on a fixed amount for treating a patientwith a specific diagnosis. Because of this fixed reimbursement method,hospitals have incentives to use less costly methods in treating Medicare andMedicaid patients, and they will frequently make capital expenditures to takeadvantage of less costly treatment technologies. Often, reimbursement isreduced to reflect the availability of a new procedure or technique and, as a result, hospitals aregenerally willing to implement new cost-saving technologies before thesedownward adjustments take effect. Likewise, because the rate of reimbursementfor certain physicians who perform certain procedures has been, andmay in the future be, reduced in the event of changes in theresource-based relative value scale method of payment calculation, physiciansmay seek greater cost efficiency in treatment to minimize any negativeimpact of reduced reimbursement. Any amendments to existing reimbursement rules andregulations that restrict or terminate the reimbursement eligibility (or theextent or amount of coverage) of medical procedures using our products or theeligibility (or the extent or amount of coverage) of our products could have amaterial adverse impact on our business.

 

Inresponse to the focus of national attention on rising health care costs, anumber of changes to reduce costs have been proposed or have begun to emerge.There have been, and may continue to be, proposals by legislators andregulators and third-party payers to reduce these costs. There has also been asignificant increase in the number of Americans enrolling in some form ofmanaged care plan and, in addition, many hospitals participate in or haveagreements with HMOs (health maintenance organizations). It has become atypical practice for hospitals to affiliate themselves with as many managedcare plans as possible. Higher managed care penetration typically drives downthe prices of healthcare procedures, which in turn places pressure on medicalsupply prices. This causes hospitals to implement tighter vendor selection andcertification processes by reducing the number of vendors used, purchasing moreproducts from fewer vendors and trading discounts on price for guaranteedhigher volumes to vendors. Hospitals have also sought to control and reducecosts 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.

 

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

 

TheHIPAA regulations cause our customers to request that we sign “businessassociate” agreements with them. A “business associate” is a person or entitythat performs certain functions or activities that involve the use ordisclosure of protected health information on behalf of, or provides servicesto, a covered entity. By law, the HIPAA Privacy Rule applies only tocovered entities — health plans, health care clearinghouses, and certain healthcare providers. However, most health care providers do not carry out all oftheir health care activities and functions by themselves. Instead, they oftenuse the services 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 entitiesmay disclose protected health information to an entity in its role as abusiness associate only to helpthe covered entity carry out its health care functions — not for the businessassociate’s independent use or purposes, except as needed for the propermanagement and administration of the business associate.

 

**Employees**

 

Asof December 31, 2007, we had 327 full-time employees, with 118 involved inresearch and development, 103 in sales and marketing, 54 in technical supportfunctions and 52 in administrative functions. We believe our relationship withour employees is good.

 

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

 

Discussionof our business and operations included in this annual report on Form 10-Kshould be read together with the risk factors set forth below. They describevarious risks and uncertainties to which we are or may become subject. Theserisks and uncertainties, together with other factors described elsewhere inthis report, have the potential to affect our business, financial condition,results of operations, cash flows, strategies or prospects in a material andadverse manner.  New risks may emerge atany time, and we cannot predict those risks or estimate the extent to whichthey may affect financial performance. Each of the risks described below couldadversely impact the 

 

 

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valueof our securities.  These statements,like all statements in this report, speak only as of the date of this report(unless another date is indicated), and we undertake no obligation to update orrevise 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.*

 

Oursuccess depends on our ability to successfully market *Vitrea*and *ViTALConnect* software for clinical use,and on the ability and willingness of physicians to use enterprise-wideadvanced visualization medical imaging software in clinical analysis andtherapy planning. The enterprise-wide advanced visualization software offeredby *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 terms as the business is currently conducted. Further, although wehave undertaken efforts to develop direct relationships with customers inmarkets outside the United States, we may not be successful in doing so at asufficient level. The loss of or adverse changes in our relationships with ourthird-party business partners, and our failure to establish sufficient directrelationships with customers outside the United States, would have a materialadverse impact on our business, financial condition and results of operations.

 

*Asubstantial portion of our revenue is derived from sales of our Vitrea softwareand related software options, and any decline in the sales of our Vitreasoftware would have a material adverse effect on our results of operations andfinancial condition.*

 

Revenuerelated to sales of our *Vitrea* softwareand related software options (which includes software, hardware and maintenanceand services) constituted 95% of our total revenues for the year ended December 31,2007, 97% of our total revenues for the year ended December 31, 2006, and95% of our total revenues for the year ended December 31, 2005. Weanticipate that revenue from the sale of *Vitrea* willcontinue to account for a substantial portion of our revenue for theforeseeable future. As such, any decline in sales of *Vitrea*would have a material adverse impact on our business, financial condition andresults of operations. Sales of *Vitrea* coulddecline for a number of reasons, including the availability of alternativeproducts that may be, or may be perceived to be, more effective, safer, easierto use or less costly than *Vitrea*; anyreduction or discontinuance of reimbursement from healthcare payors forprocedures using *Vitrea*; the failure of physiciansto adopt *Vitrea*; a reduction in demand bycustomers for advanced visualization technologies; or other reasons discussedin these risk factors.

 

*Wepresently depend on Toshiba and McKesson for a significant portion of our totalrevenues. A reduction in the business from Toshiba could adversely affect ourrevenues and could seriously harm our business.*

 

Alimited number of large customers may continue to account for asignificant portion of our revenue during any given period for the foreseeablefuture. One of our principal distribution channels is to sell our *Vitrea*medical imaging software in connection with medicalimaging equipment sold by Toshiba. Sales to Toshiba accounted for 47% of ourtotal revenue for the year ended December 31, 2007, 41% of our totalrevenue for the year ended December 31, 2006, and 47% of our total revenuefor the year ended December 31, 2005. Toshiba’s accounts receivablerepresented 34% of our accounts receivable at December 31, 2007 and 41% atDecember 31, 2006. Exceptfor our agreement with Toshiba, we have no significant purchase commitmentsfrom any of our customers or business partners, and we generally make salespursuant to individual transactions. Our joint distribution agreement withToshiba commenced in 2001 and has been extended four times, most recentlythrough December 31, 2008. We also have a distribution agreement withMcKesson, a primary provider of PACS, under which McKesson may distribute ourproducts. Sales through McKesson represented approximately 9% of our 2007revenues, 10% of our 2006 revenues, and 7% of our 2005 revenues. McKesson’saccounts receivable represented 6% of our accounts receivable at December 31,2007 and 14% at December 31, 2006. A reduction, delay, or cancellation oforders 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.

 

 

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

 

Theenterprise-wide advanced visualization industry in which we market our productsis currently faced with regulatory, technical and market challenges.  State and federal governmental agencies andprivate payors are putting pressure on reimbursement rates for advancedvisualization examinations, which can negatively affect demand for ourproducts.  Many of the major hospitalsand medical research centers within the United States have already purchasedscanners, PACS and advanced visualization technologies, causing future sales tobe upgrades or replacements instead of new installations, potentiallylengthening the sales cycles as customers feel less urgency to purchase andimplement new systems.  We believe thatthe market for advanced visualization technologies is still developing, withgrowth opportunities outside the United States and among specialists beyondradiology.

 

However,given the uncertainties associated with the developing stage of many of thesemarkets, there can be no assurance that they will develop in the manner weanticipate or that they will not require a level of investment greater than weexpect.  Additionally, some of ourcustomers finance their acquisitions through third-party lenders.  With the recent tightening in the lendingmarket, some customers who would otherwise purchase our products may not beable to obtain sufficient financing and therefore will not complete theirpurchases. Accordingly, there can be no assurance that the enterprise-wideadvanced visualization industry will provide growth opportunities for us andour software products or that our business strategies will be successful as theindustry continues to evolve. Ultimately, if the enterprise-wide advancedvisualization industry fails to develop as we expect, our business, results ofoperations and financial condition will be materially and adversely affected.

 

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

 

We face intense competition in the enterprise-wide advancedvisualization industry. We expect technology to continue to develop rapidly,and our success will depend to a large extent on our ability to maintain acompetitive position with our products. Our competitors in the enterprise-wideadvanced visualization industry include large, established manufacturers of CTand MR imaging equipment. Companies such as GE Healthcare, Siemens MedicalSystems, Inc. and Philips Medical Systems typically offer their ownenterprise-wide advanced visualization software and workstations as part oftheir integrated imaging and scanner systems. Our software works on theproducts offered by each of these companies. To win business against equipmentmanufacturers, we must convince customers to buy our software solutionsseparately from their purchase of imaging equipment instead of buyingintegrated systems from our competitors.

 

Inaddition to having a competitive advantage in marketing enterprise-wideadvanced visualization tools as an integrated part of their imaging products,our competitors have significantly greater capital and staffing resources forresearch and development that are critical to success in the dynamicenterprise-wide advanced visualization industry, more recognizable brand names,and more well-established marketing and distribution networks. Although pricehas been less significant than other factors, increasing competition may resultin price reductions and reduced gross margins. Additionally, we facecompetition from other entities, such as PACS vendors and developers ofcompetitive or ancillary software packages. We may not be able to competeeffectively with such manufacturers or competing entities on each or anyparticular 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 ofour continuing 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:

 

·                  we may have difficultyintegrating the purchased operations, technologies or products;

 

 

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·                  we may incur substantialunanticipated integration costs;

·                  assimilating the acquiredbusinesses may divert significant management attention and financial resourcesfrom our other operations and could disrupt our ongoing business;

·                  acquisitions could result inthe loss of key employees, particularly those of the acquired operations;

·                  we may have difficulty retainingor developing the acquired businesses’ customers;

·                  acquisitions could adverselyaffect our existing business relationships with suppliers and customers;

·                  we may fail to realize thepotential cost savings or other financial benefits and/or the strategicbenefits of the acquisitions; and

·                  we may incur liabilitiesfrom the acquired businesses for infringement of intellectual property rightsor other claims, and we may not be successful in seeking indemnification forsuch liabilities or claims.

 

Inconnection with these acquisitions or investments, we could incur debt,amortization expenses related to intangible assets, large and immediatewrite-offs, assume liabilities, or issue stock that would dilute our currentshareholders’ percentage of ownership. We may not be able to completeacquisitions or integrate the operations, products or personnel gained throughany such acquisition without a material adverse effect on our business,financial condition and results of operations.

 

*We sell our products internationally and are subject to various risksrelating to such international activities, which could harm our internationalsales and profitability.*

 

During the years ended December 31, 2007, December 31, 2006and December 31, 2005, 19%, 15% and 16% of our total revenues wereattributable to international sales. Toshiba has been the primary source of ourinternational sales. We are also developing direct international sales andmarketing efforts. By doing business in international markets, we are exposedto risks separate and distinct from those we face in our domestic operations.Our international business may be adversely affected by changing economicconditions in foreign countries. Because most of our sales are currentlydenominated in U.S. dollars, if the value of the U.S. dollar increases relativeto foreign currencies, our products could become more costly to theinternational consumer and therefore less competitive in international markets,which could adversely affect our profitability. Furthermore, although currentlyonly a small percentage of our sales are denominated in non-U.S. currency, thispercentage may increase in the future, in which case fluctuations in exchangerates could affect demand for our products. Engaging in international business inherentlyinvolves a number of other difficulties and risks, including:

 

·                  export restrictions andcontrols relating to technology;

·                  the availability and levelof reimbursement within prevailing foreign healthcare payment systems;

·                  pricing pressure that we mayexperience internationally;

·                  required compliance withexisting and new foreign regulatory requirements and laws;

·                  laws and business practicesfavoring local companies;

·                  longer payment cycles;

·                  difficulties in enforcingagreements and collecting receivables through foreign legal systems;

·                  political and economic instability;

·                  potentially adverse taxconsequences, tariffs and other trade barriers;

·                  international terrorism andanti-American sentiment;

·                  difficulties and costs ofstaffing and managing foreign operations;

·                  changes in currency exchangerates; and

·                  difficulties in enforcingintellectual property rights.

 

Ourexposure to each of these risks may increase our costs, lengthen our salescycle and require significant management attention. We cannot assure you thatone or more of 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.*

 

UnderSection 404 of the Sarbanes-Oxley Act of 2002, we are required to evaluateand determine the effectiveness of our internal controls over financialreporting. We have dedicated a significant amount of time and resources toensure compliance with this legislation for the years ended December 31,2007, 2006 and 2005 and will continue to do so for future periods. Wemay encounter problems or delays in completing the review and evaluation,the implementation of improvements, and the receipt of a positive attestation,or any attestation at all, from our independent registered public accountingfirm. In addition, our assessment of our internal controls may identifydeficiencies that need to be addressed in our internal controls over financialreporting or other matters that may raise concerns for investors andtherefore adversely affect our stock price.

 

 

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

 

Wehave in the past experienced, and may in the future experience, significantfluctuations in annual and quarterly operating results. If these fluctuationsoccur, they may result in volatility in the price of our common stock.Quarterly revenue and operating results may fluctuate as a result of a varietyof factors that are outside of our control including, but not limited to, thetiming of significant orders, the timing of product enhancements and newproduct introductions by us or our competitors, the pricing of our products, changesin customers’ budgets and competitive conditions. Our quarterly license andservices revenue may fluctuate and may be difficult to forecast for a varietyof reasons, including the following:

 

·                  a significant number of ourexisting and prospective clients’ decisions regarding whether to enter intolicense agreements with us are made within the last few weeks or days of eachquarter;

·                  the size and number oflicense transactions can vary significantly;

·                  our dependence on Toshiba orany other major customer for a significant portion of our revenues;

·                  a decrease in license feerevenue which may likely result in a decrease in services revenue in the sameor subsequent quarters;

·                  clients unexpectedlypostponing or cancelling projects due to changes in their strategic priorities,project objectives, budget or personnel;

·                  the uncertainty caused bypotential business combinations in the software industry causing clients andprospective clients to cancel, postpone or reduce capital spending projects onsoftware;

·                  client evaluations andpurchasing processes that vary significantly from company to company, and aclient’s internal approval and expenditure authorization process that isdifficult and time consuming to complete, even after selection of a vendor;

·                  the number, timing andsignificance of software product enhancements and new software productannouncements;

·                  existing clients decliningto renew support for our products, and market pressures that limit our abilityto increase support fees or require clients to upgrade from older versions ofour products; or

·                  prospective clientsdeclining or deferring the purchase of new products or releases if we do nothave sufficient client references for those products.

 

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

 

Ourproducts are subject to regulation by the United States Food and DrugAdministration, or the FDA, and by comparable agencies in foreign countries. Inthe United States, the FDA regulates the development, introduction,manufacturing, labeling and record keeping procedures for medical devices,including 3D medical imaging software and systems. Our medical devices requireclearance or approval by the FDA before they can be commercially distributed inthe United States. Modifications and enhancements to a medical device alsorequire a new FDA clearance or approval if they could significantly affect itssafety or effectiveness or would constitute a major change in its intended use,design or manufacture. The FDA requires every manufacturer to make thisdetermination in the first instance, but the FDA may review any manufacturer’sdecision and may require a new clearance or approval for the modification if itdisagrees with the manufacturer’s decision. If the FDA requires us to seekclearance or approval for the modification of a previously cleared product forwhich we have concluded that new clearances or approvals are unnecessary, wemay be required to cease marketing or to recall the modified product until weobtain clearance or approval, and we may be subject to significant regulatoryfines or penalties, which could have a material adverse effect on our financialresults and competitive position. The process of obtaining marketing clearancefrom the FDA for new products and new applications for existing products can betime-consuming and expensive. All of our current products are marketed pursuantto 510(k) pre-market clearance from the FDA. *Vitrea*and *ViTALConnect* and our add-on options havebeen cleared to be marketed for use with CT, MR and PET scanners. The FDA maynot grant clearance with respect to our future products or enhancements, orfuture FDA review may involve delays that could adversely affect our ability tomarket such future products or enhancements. In addition, our future productsor enhancements may be subject to a more lengthy and expensive pre-marketapproval process with the FDA.

 

 

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Evenif we obtain regulatory clearances and approvals to market a product from theFDA, these approvals may entail limitations on the indicated uses of theproduct. Product clearances and approvals by the FDA can also be withdrawn dueto failure to comply with regulatory standards or the occurrence of unforeseenproblems following initial approval. The FDA could also limit or prevent thedistribution of our products and has the power to require the recall of suchproducts. FDA regulations depend 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.

 

Wemarket our products both domestically and internationally. Internationalregulatory bodies have established varying regulations governing productstandards, packaging requirements, labeling requirements, import restrictions,tariff regulations, duties and tax requirements. Our inability or failure tocomply with the varying regulations, or the imposition of new regulations,could restrict our ability to sell our products internationally and couldadversely affect our business.

 

*The imposition of requirements under the Health Insurance Portabilityand Accountability Act of 1996, or HIPAA, could adversely affect our business.*

 

The HIPAA regulations cause our customers to request that we sign “businessassociate” agreements with them. A “business associate” is a person or entitythat performs certain functions or activities that involve the use ordisclosure of protected health information on behalf of, or that providesservices to, a covered entity. By law, the HIPAA Privacy Rule applies onlyto covered entities—health plans, healthcare clearinghouses, and certainhealthcare providers. However, most healthcare providers do not carry out allof their healthcare activities and functions by themselves. Instead, they oftenuse the services 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.

 

*We are subjectto various federal and state “fraud and abuse” laws, and if we are unable tofully comply with such laws, we could face substantial penalties, which mayadversely affect our business.*

 

Weare subject to various federal and state laws pertaining to health care fraudand abuse, including the following:

 

·                  the federal Anti-KickbackStatute, which prohibits persons from knowingly and willfully soliciting,offering, receiving or providing remuneration, directly or indirectly, in cashor in kind, to induce either the referral of an individual, or furnishing orarranging for a good or service, for which payment may be made under federalhealth care programs (such as Medicare and Medicaid);

·                  the federal False ClaimsAct, which prohibits anyone from knowingly presenting or causing to bepresented a false or fraudulent claim for payment to the federal government;

·                  HIPAA, which prohibitsexecuting a scheme to defraud any health care benefit program;

·                  the federal False StatementsStatute, which prohibits knowingly and willfully falsifying, concealing orcovering up a material fact or making any materially false statement inconnection with the delivery of or payment for health care benefits, items orservices; and

·                  state law equivalents tothese federal laws, which may not be limited to government reimbursed items,and may not contain identical exceptions.

 

Ifour past or present operations are found to be in violation of any of the lawsdescribed above or the other similar governmental regulations to which we aresubject, we may be subject to the applicable penalty associated with theviolation, including civil and criminal penalties, damages, fines, exclusionfrom federal health care programs and/or the curtailment or restructuring ofour operations. Similarly, if the physicians or other providers or entities with

 

 

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whomwe do business 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.*

 

Althoughwe have received patents and have filed patent applications with respect tocertain aspects of our technology, we generally do not rely on patentprotection with respect to our products and technologies. Instead, we relyprimarily on a combination of trade secret and copyright law, employee andthird-party nondisclosure agreements and other protective measures to protectintellectual property rights pertaining to our products and technologies. Suchmeasures may not provide meaningful protection of our trade secrets, know-howor other intellectual property in the event of any unauthorized use,misappropriation or disclosure. Others may independently develop similartechnologies or duplicate our technologies. In addition, to the extent that weapply for any patents, such applications may not result in issued patents or,if issued, such patents may not be valid or of value. Third parties could, inthe future, assert infringement or misappropriation claims against us withrespect to our current or future products and technologies, or we may need toassert claims of infringement against third parties. Any infringement ormisappropriation claim by us or against us could place significant strain onour financial resources, divert management’s attention from our business andharm our reputation. The costs of prosecuting or defending an intellectualproperty claim could be substantial and could adversely affect our business,even if we are ultimately successful in prosecuting or defending any suchclaims. If our products or technologies are found to infringe the rights of athird party, we could be required to pay significant damages or license fees orcease production, any of which could have a material adverse effect on ourbusiness.

 

*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.*

 

Ourbusiness exposes us to the risk of product liability claims that is inherent inthe manufacturing and marketing of medical devices, including those which mayarise from the misuse or malfunction of, or design flaws in, our products. Wemay be subject to product liability claims if our products cause, or merelyappear to have caused, an injury. Claims may be made by patients, healthcareproviders or others selling our products. Although we have product liabilityand errors and omissions insurance that we believe is appropriate, thisinsurance is subject to deductibles and coverage limitations. Our currentproduct liability insurance may not continue to be available to us onacceptable terms, if at all, and, if available, the coverages may not beadequate to protect us against any future product liability claims. Further, ifadditional products are approved for marketing, we may seek additionalinsurance coverage. If we are unable to obtain insurance at an acceptable costor on acceptable terms with adequate coverage or otherwise protect againstpotential product liability claims, we will be exposed to significantliabilities, which may harm our business. A product liability claim, recall orother claim with respect to uninsured liabilities or for amounts in excess ofinsured liabilities could result in significant costs and significant harm toour business.

 

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

 

Recruitingand retaining talented personnel in the future will be critical to our success.There is intense competition from other companies, research and academicinstitutions, government entities and other organizations for qualified personnelin the areas of our activities. If we fail to identify, attract, retain andmotivate these highly skilled personnel, we may be unable to continue ourmarketing and development activities.

 

*If wedo not 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.*

 

Ourability to grow successfully requires an effective planning and managementprocess. The expansion and growth of our business could place a significantstrain on our management systems, infrastructure and other resources. To manageour growth successfully, we must continue to improve and expand our systems andinfrastructure in a timely and efficient manner. Our controls, systems,procedures and resources may not be adequate to support a changing and growingcompany. If our management fails to respond effectively to changes and growthin our business, including acquisitions, such failure could have a materialadverse effect on our business.

 

 

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*Wedepend on third-party reimbursement. A reduction or other change inreimbursement from third parties could negatively affect our business.*

 

Ourproducts are purchased by hospitals, clinics, imaging centers and other users,which bill various third-party payers, such as government health programs,private health insurance plans, managed care organizations and other similarprograms, for the healthcare goods and services provided to their patients.There are currently Current Procedural Terminology, or CPT, reimbursement codesthat describe most of the diagnostic procedures that use our products. However,the amount of reimbursement from third-party payers varies by site of serviceand geographic location and is subject to change. Payers may deny reimbursementif they determine that a product used in a procedure was not used in accordancewith established payer protocol regarding cost-effective treatment methods orwas used for an unapproved indication. Third-party payers are increasinglychallenging the prices charged for medical services and, in some instances,have put pressure on service providers to lower their prices or reduce theirservices. 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,imposes caps on Medicare payment rates for certain imaging services, includingMR and PET, furnished in physicians’ offices and other non-hospital basedsettings. Under the caps, payments for specified imaging services cannot exceedthe hospital outpatient payment rates for these services. This change appliesto services 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.*

 

Thelevels of revenue and profitability of medical technology companies may beaffected by the efforts of government and third-party payers to contain orreduce the costs of healthcare through various means. In the United States,there have been, and we expect that there will continue to be, a number offederal, state and private proposals to control healthcare costs. Theseproposals include legislative, regulatory and other initiatives and may containmeasures intended to control public and private spending on healthcare as wellas to provide universal public access to the healthcare system. If enacted,these proposals may result in a substantial restructuring of the healthcaredelivery system. For example, in Canada, which has universal public access tohealthcare, imaging procedures are relatively rare. Significant changes in thenation’s healthcare system could have a substantial impact on the manner inwhich we conduct business and could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

*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.*

 

OurArticles of Incorporation authorize our Board of Directors, without any actionby the holders of our common stock, to establish the rights and preferences ofup to 5,000,000 shares of currently undesignated preferred stock. These sharesof preferred stock could possess voting and conversion rights that couldadversely affect the voting power of the holders of the common stock or dilutetheir ownership rights, and it may have the effect of delaying, deferringor preventing a change in control of Vital Images. No shares of preferred stockor other senior equity securities are currently designated, and currently wehave no 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.*

 

Weare subject to anti-takeover provisions of the Minnesota Business CorporationAct.  These provisions may deter ordiscourage takeover attempts and other changes in control that are not approvedby our Board of Directors, and they may have a depressive effect on any marketfor our stock. As a result, our shareholders may lose opportunities to disposeof their shares at the higher prices typically available in takeover attemptsor that may be available under a merger proposal. In addition, these provisionsmay have the effect of permitting our current directors to retain theirpositions and place them in a better position to resist changes that ourshareholders may wish to make if they are dissatisfied with the conduct of ourbusiness.

 

 

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*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.*

 

Wehave not paid cash dividends on our common stock in the past, and we do notintend to do so in the foreseeable future. Consequently, our shareholders’ onlyopportunity to achieve a return on their investment in our common stock will beif the market price of our common stock appreciates and they sell their sharesat a profit.

 

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

 

Aspermitted by Minnesota law, our Articles of Incorporation provide that membersof our Board of Directors shall not be personally liable to our company or ourshareholders for monetary damages for breach of fiduciary duty as a director,with certain exceptions. These provisions may discourage shareholders from bringingsuit against a director for breach of fiduciary duty and may reduce thelikelihood of derivative litigation brought by shareholders on behalf of ourcompany against a director. In addition, our Bylaws provide for mandatoryindemnification of directors and officers to the fullest extent permitted byMinnesota law.

 

**Item 1B. Unresolved Staff Comments**

 

None.

 

**Item 2.  Properties**

 

Ourprincipal office is located in an office building in Minnetonka, Minnesota,where we currently occupy approximately 72,000 square feet under a lease thatexpires January 31, 2012. We also lease small offices in Den Haag, theNetherlands, and Beijing, China, for our operations in those countries.

 

Weconsider our current facilities adequate for our current needs, but any continuedgrowth in headcount or our expansion internationally could require us to obtainadditional space. We believe that suitable additional space will be availableas and if needed.

 

**Item 3.  Legal Proceedings**

 

Weare not engaged in any legal proceedings at this time.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

Therewas no matter submitted to the vote of security holders during the fourthquarter of the fiscal year ended December 31, 2007.

 

 

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**Part II**

 

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

 

VitalImages, Inc.’s (the “Company’s”) common stock is quoted on The NasdaqGlobal Select Market under the symbol “VTAL.” The table below reflects the high and low per share closing sale pricesof our common stock as reported by The Nasdaq Global Select Market for each ofthe periods indicated. Such prices reflect inter-dealer prices, do not includeadjustments for retail mark-ups, markdowns or commissions, and may notnecessarily represent actual transactions.

 

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| 2007           |       |     |       |    |       |
| Fourth Quarter |       | $        | 23.05      |    | $          | 16.18 |   |
| Third Quarter  |       | $        | 27.74      |    | $          | 17.30 |   |
| Second Quarter |       | $        | 33.51      |    | $          | 25.44 |   |
| First Quarter  |       | $        | 36.48      |    | $          | 30.16 |   |
|           |       |     |       |    |       |
| 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 |   |

 

 

Wehave never paid or declared any cash dividends on our common stock and do notintend to pay dividends on our common stock in the foreseeable future. Weexpect to retain our future anticipated earnings to finance development andexpansion of our business. As of March 10, 2008, there were approximately8,100 beneficial owners and approximately 735 registered holders of record ofour common stock.

 

**Performance Graph**

 

SinceApril 24, 2007, the Company’s common stock has been quoted on The NasdaqGlobal Select Market. From June 9, 2003 through April 23, 2007, theCompany’s stock was quoted on The Nasdaq Global Market. From September 29,2000 through June 6, 2003, the Company’s common stock was quoted on TheNasdaq SmallCap Market (now known as The Nasdaq Capital Market). The followinggraph shows changes during the period from December 31, 2002 to December 31,2007 in the value of $100 invested in: (1) the Company’s common stock; (2) theCRSP Total Return Index for The Nasdaq Composite; and (3) NasdaqNon-Financial Stocks. The values of each investment as of the dates indicatedare based on share prices plus any dividends paid in cash, with the dividendsreinvested on the date they were paid. The calculations exclude tradingcommissions and taxes.

 

Notwithstandinganything to the contrary set forth in any of our previous or future filingsunder the Securities Act of 1933 or the Securities Exchange Act of 1934 thatmight incorporate future filings by reference, including this Annual Report on Form 10-K,in whole or in part, the following performance graph shall not be deemed to beincorporated by reference into any such filings and shall not otherwise bedeemed filed under such acts.

 

 

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*$100invested on 12/31/02 in stock or index-including reinvestment of dividends.

Fiscalyear ending December 31.

 

| ** **              | ** ** | **12/31/02** | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** |
|-------------------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| Vital Images, Inc. |       | $            | 100.00     |         | $          | 199.11       |       | $            | 186.73     |         | $          | 291.53       |       | $ | 387.96 |   | $ | 201.45 |   |
| NASDAQ Composite        |       | $            | 100.00     |         | $          | 149.66       |       | $            | 164.53     |         | $          | 168.45       |       | $ | 187.69 |   | $ | 204.59 |   |
| NASDAQ Non- Financial   |       | $            | 100.00     |         | $          | 150.74       |       | $            | 163.58     |         | $          | 164.78       |       | $ | 179.59 |   | $ | 198.27 |   |

 

 

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**Item 6.****                                  ****SelectedFinancial Data (in thousands, except per share data)**

 
| **Years ended December 31:** | ** ** | **2007**   | **(1)**    | **2006**   | **(1)**    | **2005**   | **(1)**    | **2004**   | **(1)**    | **2003**   | **(1)**    |
|-----------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| Revenue                           |       | $          | 70,176     |       | $          | 70,512     |       | $          | 51,717     |       | $          | 36,122 |   | $ | 27,300 |   |
| Gross profit                      |       | 54,587     |       | 56,302     |       | 40,157     |       | 25,675     |       | 20,229     |       |
|                              |       |       |       |       |       |       |       |       |       |       |       |
| Operating expenses                |       | 61,755     | (2)        | 49,371     |       | 32,592     | (3)        | 25,161     | (4)        | 18,294     |       |
| Operating income (loss)           |       | (7,168     | )          | 6,931      |       | 7,565      |       | 514        |       | 1,935      |       |
|                              |       |       |       |       |       |       |       |       |       |       |       |
| Net income                        |       | $          | 1,367      |       | $          | 6,583      |       | $          | 5,801      |       | $          | 296 |   | $ | 8,462 | (5) |
|                              |       |       |       |       |       |       |       |       |       |       |       |
| Net income per share–basic   |       | $          | 0.08       |       | $          | 0.49       |       | $          | 0.47       |       | $          | 0.03 |   | $ | 0.83 |   |
|                              |       |       |       |       |       |       |       |       |       |       |       |
| Weighted average common  shares   |       | 16,972     |       | 13,463     |       | 12,379     |       | 11,632     |       | 10,189     |       |
|                              |       |       |       |       |       |       |       |       |       |       |       |
| Net income per share–diluted |       | $          | 0.08       |       | $          | 0.46       |       | $          | 0.44       |       | $          | 0.02 |   | $ | 0.71 |   |
|                              |       |       |       |       |       |       |       |       |       |       |       |
| Weighted average common  shares   |       | 17,457     |       | 14,259     |       | 13,283     |       | 12,536     |       | 11,848     |       |
|                              |       |       |       |       |       |       |       |       |       |       |       |
| **At December 31:**          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Working capital                   |       | $          | 173,905    |       | $          | 162,202    |       | $          | 45,604     |       | $          | 30,996 |   | $ | 31,915 |   |
| Total assets                      |       | $          | 230,996    |       | $          | 219,730    |       | $          | 91,151     |       | $          | 69,284 |   | $ | 53,063 |   |
| Long-term debt                    |       | $          | —     |       | $          | —     |       | $          | —     |       | $          | — |   | $ | — |   |
| Total stockholders’ equity   |       | $          | 202,216    |       | $          | 190,902    |       | $          | 68,789     |       | $          | 54,554 |   | $ | 44,594 |   |

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| (1) |   | Includes equity-based compensation of $5,987, $5,063, $335, $12 and  $137 for the fiscal years 2007, 2006, 2005, 2004 and 2003, respectively.                                                           |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Includes an $885 charge related to the separation of Jay D. Miller,  our former Chief Executive Officer, in the fourth quarter of 2007.                                                                 |
| (3) |   | Includes a loss on operating lease of $493 related to the Company’s  relocation of its corporate headquarters in the first quarter of 2005.                                                        |
| (4) |   | Includes $1,000 of acquired in-process research and development  charge relating to the acquisition of HInnovation, Inc. in  February 2004.                                                   |
| (5) |   | Includes a net tax benefit of $6,313 resulting from the reversal of  the Company’s valuation allowance for its net deferred tax assets, net of  other current year state and federal income taxes. |

 

 

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

 

**Executivesummary**

 

VitalImages, Inc. (also referred to as “we”, “us” and “our”) summary resultswere as follows:

·                  Total revenue of $70.2million for 2007 was in line with 2006 revenue of $70.5 million.

·                  Gross margin was 78% for2007, compared to 80% for 2006.

·                  Operating expenses for 2007totaled $61.8 million, compared to $49.4 million for 2006.

·                  2007 net income was $1.4million, or $0.08 per diluted share, compared with 2006 net income of $6.6million, or $0.46 per diluted share.

 

Ourbalance sheet remained strong in 2007. Total cash, cash equivalents andmarketable securities were $178.4 million as of December 31, 2007,compared to $166.0 million as of December 31, 2006. Working capital(defined as current assets less current liabilities) was $173.9 million as of December 31,2007, compared to $162.2 million as of December 31, 2006.  The increase in cash, cash equivalents andmarketable securities and working capital was due primarily to our operatingactivities.

 

Althoughthese results did not meet our expectations for 2007, our revenue was in linewith the prior year’s revenue and we remained profitable for 2007.  Our results were significantly affected by anindustry-wide slowdown that saw the high-end CT market and reimbursementpressures brought on by the Deficit Reduction Act.

 

Ourthree top priorities for 2008 are to re-ignite sales growth, continue to developand deploy industry-leading software solutions, and take exceptional care ofour customers.  We have sold more than 4,700 licenses for our products,giving us one of the largest customer bases in our industry.  With ouroutstanding balance sheet and partnerships with Toshiba and McKesson, we arewell-positioned in the enterprise-wide advanced visualization marketplace.

 

Wewill maintain our investments in research and development, service andinternational growth. However, we are assessing every part of the organizationto determine ways we can be more productive. With less than ideal marketdynamics, the benefits of these strategic investments may not be immediatelyapparent, but these investments support our long-term strategy.

 

Throughoutour history, a significant portion of our revenue has been generated from theU.S. radiology computed tomography, or CT, market. Going forward, we anticipatea growing 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**

 

Weare a leading provider of enterprise-wide advanced visualization and imageanalysis solutions for use by medical professionals in clinical analysis andtherapy planning for medical conditions. We provide software, customereducation, software maintenance, professional services and, on occasion,third-party hardware to our customers. Our technology rapidly transformscomplex data generated by diagnostic imaging equipment into functional digitalimages that can be manipulated and analyzed using our specialized applicationsto better understand internal anatomy and pathology. Our solutions are designedto improve physician workflow and productivity, enhance the ability to makeclinical decisions, facilitate less invasive patient care, and complement oftensignificant capital investments in diagnostic imaging equipment made by ourcustomers. Our software is compatible with equipment from all majormanufacturers of diagnostic imaging equipment, such as CT, scanners, and can beintegrated into PACS. Many hospitals use PACS to acquire, distribute andarchive medical images and diagnostic reports, reducing the need for film andincreasing reliance on advanced visualization solutions such as ours. We alsooffer a Web-based solution that provides physicians with anywhere, anytimeaccess to medical images and visualization tools through any Internet-enabledcomputer.

 

Weoperate and manage our business as a single business segment — the developmentand marketing 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 Select Market under the symbol “VTAL.”

 

 

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**Criticalaccounting policies and estimates**

 

Ourdiscussion and analysis of financial condition and results of operations arebased upon our Consolidated Financial Statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The notes to the Consolidated Financial Statements contained inthis Annual Report describe our significant accounting policies used in thepreparation of the Consolidated Financial Statements. The preparation of thesefinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. Actual resultscould differ from those estimates. We continually evaluate our criticalaccounting policies and estimates.

 

Webelieve the critical accounting policies listed below reflect significantjudgments, estimates and assumptions used in the preparation of ourConsolidated Financial Statements.

 

*Allowancefor doubtful accounts*

 

We maintain an allowance fordoubtful accounts at an amount estimated to be sufficient to provide adequateprotection against losses resulting from extending credit to our customers. Injudging the adequacy of the allowance for doubtful accounts, we considermultiple factors, including historical bad debt experience, the generaleconomic environment, the need for specific client reserves and the aging ofour outstanding receivables. A portion of this provision is included inoperating expenses as a general and administrative expense and a portion ofthis provision is included as a reduction of license revenue. A considerableamount of judgment is required in assessing these factors. If the factorsutilized in determining the allowance do not reflect future performance, then achange in the allowance for doubtful accounts would be necessary in the periodsuch determination has been made, which would impact future results ofoperations.  As of December 31,2007, the allowance for doubtful accounts was $505,000 for gross accounts receivableof $16.5 million.

 

*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, we must include an expense within thetax provision in the statement of operations. As of December 31, 2007, theconsolidated balance sheet included net deferred tax assets of $12.1 million.

 

Our methodology for determining the realizability ofour deferred tax assets involves estimates of future taxable income from ourcore business, the estimated impact of future tax deductions from the exerciseof stock options outstanding as of each balance sheet date, 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 we believe to be reasonable and consistentwith current operating results.

 

Although we had cumulative pre-tax income forfinancial reporting purposes for the three years ended December 31, 2007,we did not pay any significant income taxes for that period due to taxdeductions from the exercise of stock options as well as our utilization of netoperating losses. In assessing the realizability of our deferred tax assets asof each balance sheet date, we considered evidence regarding our ability togenerate sufficient future taxable income to realize our deferred tax assets.The primary evidence considered included the cumulative pre-tax income forfinancial reporting purposes for the past three years; the estimated impact offuture tax deductions from the exercise of stock options outstanding as of December 31,2007; and the estimated future taxable income based on historical operatingresults.

 

After giving consideration to these factors, weconcluded that it was more likely than not that the tax loss carryforwards willbe realized prior to their expiration and that other tax credits that expireprior to 2010 will not be utilized due to the estimated future tax deductionsfrom the exercise of stock options outstanding as of December 31, 2007 aswell as utilization of tax loss carryforwards. As a result, we have a valuationallowance of $139,000 as of December 31, 2007 relating to tax credits andnet operating loss carryforwards that expire prior to 2010.

 

We also concluded that it was more likely than notthat the net deferred tax assets of $12.1 million as of December 31, 2007and the estimated future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2007 would be utilized prior to expiring.Based on this conclusion, we will require approximately $29.1 million incumulative future taxable income to be generated at various times over the next20 years to realize the related net deferred tax assets of $12.1 million as of December 31,2007 as well as the estimated future tax deductions from the exercise of stockoptions outstanding and in-the-money as of December 31, 2007.

 

 

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Ifwe decrease either our estimates of future taxable income or tax deductionsfrom the exercise of stock options, or if our stock price increasessignificantly without an increase in taxable income, causing us to believe thatour deferred tax assets will not be utilized, we may need to establishadditional valuation allowances on our deferred tax assets, which couldmaterially impact our financial position and results of operations.

 

*Long-lived assets*

 

We review long-lived assetsfor impairment whenever events or changes in circumstances indicate thecarrying amount may not be recoverable, in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” Events or changes incircumstances that indicate the carrying amount may not be recoverable include,but are not limited to, a significant decrease in the market value of thebusiness or asset acquired, a significant adverse change in the extent ormanner in which the business or asset acquired is used, or a significantadverse change in the business climate. If such events or changes incircumstances are present, the undiscounted cash flows method is used todetermine whether the asset is impaired. Cash flows would include the estimatedterminal value of the asset and exclude any interest charges. To the extent thecarrying value of the asset exceeds the undiscounted cash flows over theestimated remaining life of the asset, the impairment is measured using thediscounted cash flows. The discount rate utilized would be based on our bestestimate of the related risks and return at the time the impairment assessmentis made.

 

Ourlong-lived assets consist of property and equipment of $11.2 million and otherintangible assets subject to amortization of $1.9 million as of December 31,2007. A patent acquired in the HInnovation, Inc. acquisition having a$882,000 net book value as of December 31, 2007 is currently under reviewby the Patent Office.

 

*Goodwill*

 

Weaccount for goodwill in accordance with the provisions of SFAS No. 142, “Goodwilland Other 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 the goodwill.If the carrying value of the goodwill exceeds the implied fair value of thegoodwill, an impairment loss would be recognized in an amount equal to theexcess. 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, 2007, in which no impairment was identified. Goodwill was$9.1 million as of December 31, 2007.

 

*RevenueRecognition*

 

Wefollow specific and detailed guidelines in determining the proper amount ofrevenue to be recorded; however, certain judgments affect the application ofour revenue recognition policy. Revenue results are difficult to predict, andany shortfall in revenue or delay in recognizing revenue could cause ouroperating results to vary significantly from period to period.

 

Thesignificant judgments for revenue recognition typically involve whethercollectability can be considered probable and whether fees are fixed ordeterminable.  Significant judgment isalso required when evaluating and assessing revenue recognition relating to ourdistribution agreements with original equipment manufacturers, value-addedresellers and independent distributors (collectively, “Resellers”). Inaddition, our transactions often consist of multiple element arrangements, whichmust be analyzed to determine the fair value of each element, the amount ofrevenue to be recognized upon shipment, if any, and the period and conditionsunder which deferred revenue should be recognized. As a result, if facts andcircumstances change that affect our current judgments, our revenue could bematerially different in the future.

 

 

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Werecognize 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 Bulletin No. 104.We recognize revenue when it is realized or realizable and earned. We considerrevenue realized or realizable and earned when we have persuasive evidence ofan arrangement, the product has been shipped or the services have been providedto the customer, the sales price is fixed or determinable, and collectabilityis probable.

 

*Equity-basedcompensation*

 

EffectiveJanuary 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R),using the modified prospective transition method, and therefore have notrestated prior periods’ results. Under this method, we recognize compensationexpense for all equity-based payments granted or modified on or after January 1,2006 and prior to but not yet vested as of January 1, 2006 in accordancewith SFAS No. 123(R). Under the fair value recognition provisions of SFAS No. 123(R),we recognize equity-based compensation net of an estimated forfeiture rate andrecognize compensation cost only for those shares expected to vest over therequisite service period of the award. Prior to SFAS No.123(R) adoption,we accounted for equity-based payments under Accounting Principles BoardOpinion 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 commonstock on the date of grant.

 

Thefair value of each option award is estimated on the date of grant using theBlack-Scholes option valuation model. The Black-Scholes option valuation modelrequires the development of assumptions that are input into the model. Theseassumptions are the expected stock volatility, the risk-free interest rate, theoption’s expected 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 life ofstock 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 expected forfeiturerate is estimated based on historical experience.

 

Determiningthe appropriate 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 Consolidated Financial Statements for a further discussion ofequity-based compensation.

 

 

25

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**Results of Operations**

 

The following table sets forth information from our Statements ofOperations, expressed as a percentage of total revenue.

 

| ** **                 | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|                       |       |                                      |       |   |   |   |   |
| Revenue:                   |       |                                      |       |   |   |   |   |
| License fees               |       | 56.5                                      | %          | 65.7 | % | 68.1 | % |
| Maintenance and services   |       | 42.0                                      |       | 32.1 |   | 27.7 |   |
| Hardware                   |       | 1.5                                       |       | 2.2 |   | 4.2 |   |
| Total revenue              |       | 100.0                                     |       | 100.0 |   | 100.0 |   |
|                       |       |                                      |       |   |   |   |   |
| Cost of revenue:           |       |                                      |       |   |   |   |   |
| License fees               |       | 6.7                                       |       | 7.1 |   | 9.1 |   |
| Maintenance and services   |       | 14.2                                      |       | 11.4 |   | 10.7 |   |
| Hardware                   |       | 1.0                                       |       | 1.7 |   | 2.6 |   |
| Impairment of patent       |       | 0.3                                       |       | — |   | — |   |
| Total cost of revenue      |       | 22.2                                      |       | 20.2 |   | 22.4 |   |
|                       |       |                                      |       |   |   |   |   |
| Gross profit               |       | 77.8                                      |       | 79.8 |   | 77.6 |   |
|                       |       |                                      |       |   |   |   |   |
| Operating expenses:        |       |                                      |       |   |   |   |   |
| Sales and marketing        |       | 45.6                                      |       | 36.0 |   | 32.7 |   |
| Research and development   |       | 21.7                                      |       | 18.6 |   | 15.8 |   |
| General and administrative |       | 20.7                                      |       | 15.4 |   | 13.5 |   |
| Loss on operating lease    |       | —                                    |       | — |   | 1.0 |   |
| Total operating expenses   |       | 88.0                                      |       | 70.0 |   | 63.0 |   |
|                       |       |                                      |       |   |   |   |   |
| Operating income (loss)    |       | (10.2                                     | )          | 9.8 |   | 14.6 |   |
|                       |       |                                      |       |   |   |   |   |
| Interest income            |       | 12.6                                      |       | 4.7 |   | 2.1 |   |
| Income before income taxes |       | 2.4                                       |       | 14.5 |   | 16.7 |   |
|                       |       |                                      |       |   |   |   |   |
| Provision for income taxes |       | 0.5                                       |       | 5.2 |   | 5.5 |   |
|                       |       |                                      |       |   |   |   |   |
| Net income                 |       | 1.9                                       | %          | 9.3 | % | 11.2 | % |

 

**Revenue (dollars in thousands)**

** **
| ** **               | ** ** | **For the Years Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------|------------|-------------------------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **2007**                                  | ** ** | **2006**                | ** ** | **2005**                        | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** |
| Revenues:                |       |                                      |       |                    |       |                            |       |   |   |   |   |   |   |   |   |
| License fees             |       | $                                         | 39,673     |                    | $          | 46,332                          |       | $ | 35,228 |   | $ | (6,659 | ) | $ | 11,104 |   | (14 | )% | 32 | % |
| Maintenance and services |       | 29,487                                    |       | 22,615                  |       | 14,324                          |       | 6,872 |   | 8,291 |   | 30 | % | 58 | % |
| Hardware                 |       | 1,016                                     |       | 1,565                   |       | 2,165                           |       | (549 | ) | (600 | ) | (35 | )% | (28 | )% |
| Total revenue            |       | $                                         | 70,176     |                    | $          | 70,512                          |       | $ | 51,717 |   | $ | (336 | ) | $ | 18,795 |   | 0 | % | 36 | % |

 

For2008, we expect revenue of $74.0 million to $78.0 million, or a 5% to 11%increase over full-year 2007 revenue.

 

 

26

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**License fee revenue (dollars in thousands)**

 
| ** **                              | ** ** | **For the Years Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **2007**                                  | ** ** | **2006**                | ** ** | **2005**                        | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** |
| License fee revenue:                    |       |                                      |       |                    |       |                            |       |   |   |   |   |   |   |   |   |
| Vitrea licenses                         |       | $                                         | 12,853     |                    | $          | 18,585                          |       | $ | 14,453 |   | $ | (5,732 | ) | $ | 4,132 |   | (31 | )% | 29 | % |
| Vitrea options and third party software |       | 24,967                                    |       | 26,486                  |       | 19,389                          |       | (1,519 | ) | 7,097 |   | (6 | )% | 37 | % |
| Other                                   |       | 1,853                                     |       | 1,261                   |       | 1,386                           |       | 592 |   | (125 | ) | 47 | % | (9 | )% |
| Total license fee revenue               |       | $                                         | 39,673     |                    | $          | 46,332                          |       | $ | 35,228 |   | $ | (6,659 | ) | $ | 11,104 |   | (14 | )% | 32 | % |

 

Thedecrease in 2007 license fee revenue resulted from a 16% decrease in the numberof Vitrea licenses sold in 2007 compared to 2006. During 2006, sales of Vitreaoptions and third-party software grew faster than Vitrea sales due to increasedoption sales both upfront and as add-on purchases from our installed base ofexisting customers. Top-selling options in 2007, 2006 and 2005 were GeneralVessel Probe, Automated Vessel Measurement and CT Cardiac — all cardiovascularsolutions. As of December 31, 2007, we had sold approximately 4,700separate software licenses for our solutions, compared to approximately 3,800and 2,750 as of December 31, 2006 and 2005, respectively. License feerevenue by source is as follows:

 

| ** **                       | ** ** | **For the Years Ended December 31,**  | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| License fee revenue:             |       |                                       |       |   |   |   |   |
| Direct                           |       | $                                          | 14,202     |   | $ | 20,273 |   | $ | 14,805 |   |
| Toshiba                          |       | 22,141                                     |       | 20,414 |   | 17,226 |   |
| McKesson                         |       | 3,330                                      |       | 5,645 |   | 3,197 |   |
| Total license fees               |       | $                                          | 39,673     |   | $ | 46,332 |   | $ | 35,228 |   |
|                             |       |                                       |       |   |   |   |   |
| ** **                       | ** ** | **For the  Years Ended December 31,** | ** ** |
|                             | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Percent of license fee  revenue: |       |                                       |       |   |   |   |   |
| Direct                           |       | 36                                         | %          | 44 | % | 42 | % |
| Toshiba                          |       | 56                                         |       | 44 |   | 49 |   |
| McKesson                         |       | 8                                          |       | 12 |   | 9 |   |
| Total license fee revenue        |       | 100                                        | %          | 100 | % | 100 | % |

 

**Maintenance and servicesrevenue (dollars in thousands)**

** **
| ** **                        | ** ** | **For the Years Ended December 31,** | ** ** | **Increase** | ** ** | **Percent Increase** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|--------------|------------|----------------------|------------|
| ** **                        | ** ** | **2007**                                  | ** ** | **2006**     | ** ** | **2005**             | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** |
| Maintenance and services revenue: |       |                                      |       |         |       |                 |       |   |   |   |   |   |   |   |   |
| Maintenance and support           |       | $                                         | 22,811     |         | $          | 16,379               |       | $ | 9,808 |   | $ | 6,432 |   | $ | 6,571 |   | 39 | % | 67 | % |
| Customer education                |       | 5,590                                     |       | 5,178        |       | 3,718                |       | 412 |   | 1,460 |   | 8 | % | 39 | % |
| Installation                      |       | 1,086                                     |       | 1,058        |       | 798                  |       | 28 |   | 260 |   | 3 | % | 33 | % |
| Total maintenance and services    |       | $                                         | 29,487     |         | $          | 22,615               |       | $ | 14,324 |   | $ | 6,872 |   | $ | 8,291 |   | 30 | % | 58 | % |

 

Theincrease in maintenance and support revenue in 2007 was primarily driven by anincrease in the number of customers on maintenance contracts, as well as byincreased pricing on maintenance and support. The increase in maintenance andsupport revenue in 2006 was primarily driven by the increase in licenses soldand by an increase in the number of customers on maintenance contracts, as wellas by increased pricing on maintenance related services.  The increase in customer education revenueand installation revenue in 2007 was due in part to customer education revenuerecognized in 2007 related to strong Vitrea license sales near the end of 2006.The increase in customer education revenue and installation revenue in 2006 wasdue to an increase in the number of Vitrea licenses sold in 2006 as compared to2005. Also contributing to the increase in customer education revenue is thatin the fourth quarter of 2005, we put in place an expiration policy for unusedcustomer education. The 2006 fourth quarter was the first period we recognizedrevenue from the expiration of unused customer education. Additionally, in the2006 fourth quarter, we reached an agreement with one of our partners on anexpiration period for customer education. As a result, maintenance and servicesrevenue during the fourth quarter of 2006 included approximately $490,000 ofnon-recurring revenue relating to unused customer education that expired.

 

 

27

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**Hardwarerevenue**

 

Hardwarerevenue decreased 35% to $1.0 million in 2007, compared to $1.6 million in2006, which was a 28% decrease from $2.2 million in 2005. We sellhardware as a convenience to our customers, and fluctuations are driven byindividual customer purchasing preferences. Sales of hardware systems are notcore to our strategy and will fluctuate from period to period depending uponthe needs of our customers.

 

**Cost ofrevenue and gross profit**

 

Grossprofit decreased 3% to $54.6 million in 2007, compared to $56.3 million in2006, which was a 40% increase from $40.2 million in 2005. Gross marginpercentage decreased slightly to 78% in 2007 from 80% in 2006.  Gross margin was 78% in 2005.

 

Acomparison of gross profit and gross margin by revenue category is as follows(dollars in thousands):

 

| ** **               | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------|------------|-------------------------------------------|------------|
| ** **               | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| Gross profit:            |       |                                      |       |   |   |   |   |
| License fees             |       | $                                         | 34,948     |   | $ | 41,341 |   | $ | 30,546 |   |
| Maintenance and services |       | 19,559                                    |       | 14,592 |   | 8,765 |   |
| Hardware                 |       | 322                                       |       | 369 |   | 846 |   |
| Impairment of patent     |       | (242                                      | )          | — |   | — |   |
| Total gross profit       |       | $                                         | 54,587     |   | $ | 56,302 |   | $ | 40,157 |   |
|                     |       |                                      |       |   |   |   |   |
| Gross margin:            |       |                                      |       |   |   |   |   |
| License fees             |       | 88                                        | %          | 89 | % | 87 | % |
| Maintenance and services |       | 66                                        | %          | 65 | % | 61 | % |
| Hardware                 |       | 32                                        | %          | 24 | % | 39 | % |
| Total gross margin       |       | 78                                        | %          | 80 | % | 78 | % |

 

Fluctuationsin license fee gross margin are generally a result of changes in the mixbetween direct sales and sales to distribution partners, which tend to carrylower margins.

 

Maintenanceand services gross margin increased during 2007 and 2006 due to increases inthe percentage of our customers who purchase maintenance services, as well assome increases in our pricing, without an increase in costs at a similar rate. We willcontinue to invest in our customer education, installation, professionalservices and customer support areas in the future to adequately support ourgrowing installed base of customers.

 

Grossmargin for hardware increased in 2007 compared to 2006 because we offered apromotion in 2006 under which purchasers of maintenance services could receivea discount on hardware, which lowered our hardware margins that year.

 

Duringthe third quarter 2007, we recognized a $242,000 patent impairment chargerelated to a patent application acquired in the HInnovation, Inc.acquisition in February 2004. This patent application was rejected by theUnited States Patent and Trademark Office (“Patent Office”) on August 23,2007, and we decided not to pursue this application further.  The impairment was recorded as a separateitem in cost of revenue, and is included in the total gross margin percentageabove.

 

During2008, we expect total gross margin to be approximately 77% to 78%.

 

 

28

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**Operating expenses**

 

The following is a comparison of operating expenses as a percent ofrevenue as well as the percent increase or decrease in the total expense:

 
| ** **                 | ** ** | **Percent of Revenue for the**    | ** ** | ** **           | ** ** |
|----------------------------|------------|-----------------------------------|------------|----------------------|------------|
| ** **                 | ** ** | **Years Ended December 31,** | ** ** | **Percent Increase** | ** ** |
| ** **                 | ** ** | **2007**                          | ** ** | **2006**             | ** ** | **2005** | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** |
| Operating expenses:        |       |                              |       |                 |       |   |   |   |   |   |   |
| Sales and marketing        |       | 45.6                              | %          | 36.0                 | %          | 32.7 | % | 26.1 | % | 49.9 | % |
| Research and development   |       | 21.7                              |       | 18.6                 |       | 15.8 |   | 16.1 |   | 60.7 |   |
| General and administrative |       | 20.7                              |       | 15.4                 |       | 13.5 |   | 33.5 |   | 55.4 |   |
| Loss on operating lease    |       | —                            |       | —               |       | 1.0 |   | — |   | N/A |   |
| Total operating expenses   |       | 88.0                              | %          | 70.0                 | %          | 63.0 | % | 25.1 | % | 51.5 | % |

 

**Sales and marketing**

 

Salesand marketing expenses increased $6.6 million to $32.0 million in 2007,compared to $25.4 million in 2006, which was an $8.4 million increase from$16.9 million in 2005.  The change insales and marketing expense is as follows (dollars in thousands):

 
| ** **                       | ** ** | **Year-over-year**     | ** ** | **Year-over-year Percent** | ** ** |
|----------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **Change from Fiscal** | ** ** | **Change from Fiscal**     | ** ** |
| ** **                       | ** ** | **2006 to 2007**       | ** ** | **2005 to 2006**           | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** |
| Salaries, benefits and  bonus    |       | $                      | 3,064      |                       | $          | 2,939 |   | 36 | % | 54 | % |
| Overhead and other  expenses     |       | 1,285                  |       | 1,115                      |       | 38 | % | 35 | % |
| Travel, meals and  entertainment |       | 1,155                  |       | 818                        |       | 46 | % | 48 | % |
| Trade shows and  advertising     |       | 774                    |       | 836                        |       | 27 | % | 61 | % |
| Depreciation                     |       | 574                    |       | 275                        |       | 71 | % | 52 | % |
| Equity-based compensation        |       | 397                    |       | 1,869                      |       | 20 | % | 1483 | % |
| R2 Technology, Inc  contract     |       | —                 |       | (479                       | )          | N/A |   | (117 | )% |
| Commissions                      |       | (632                   | )          | 1,069                      |       | (12 | )% | 25 | % |
| Total                            |       | $                      | 6,617      |                       | $          | 8,442 |   | 26 | % | 50 | % |

 

Theincrease in expenses during both periods was due to an increase in compensationcosts as a result of additional personnel, higher travel and entertainmentcosts, and higher costs for attending U.S. and European industry tradeshows.Commission expense for 2007 decreased due to lower direct revenue compared to2006. Total expenses for 2006 also included higher sales commission expensesresulting from significantly increased revenue. We had 103, 75 and 50 sales andmarketing personnel as of December 31, 2007, 2006 and 2005, 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, inthe first quarter of 2006, we reversed $236,000 of the $410,000 expenserecorded in the fourth quarter of 2005 relating to our agreement with R2Technology, Inc., or R2. In the second quarter of 2006, we recorded a$167,000 expense relating to our agreement with R2. See Note 4 to the ConsolidatedFinancial Statements for further discussion.

 

Weexpect sales and marketing expenses to be between 44% and 46% of total revenuefor the year ending December 31, 2008.

 

 

29

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**Research and development**

 

Research and development expenses increased $2.1 million to $15.2million in 2007 compared to $13.1 million in 2006, which was an increase of$4.9 million from $8.1 million in 2005. The change in research and developmentexpense is as follows (dollars in thousands):

 

| ** **                    | ** ** | **Year-over-year**     | ** ** | **Year-over-year Percent** | ** ** |
|-------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                    | ** ** | **Change from Fiscal** | ** ** | **Change from Fiscal**     | ** ** |
| ** **                    | ** ** | **2006 to 2007**       | ** ** | **2005 to 2006**           | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** |
| Salaries, benefits and  bonus |       | $                      | 2,016      |                       | $          | 2,961 |   | 24 | % | 56 | % |
| Depreciation                  |       | 273                    |       | 283                        |       | 37 | % | 63 | % |
| Overhead and other  expenses  |       | 257                    |       | 745                        |       | 11 | % | 44 | % |
| Equity-based compensation     |       | (111                   | )          | 797                        |       | (13 | )% | 1853 | % |
| Consulting                    |       | (323                   | )          | 158                        |       | (40 | )% | 24 | % |
| Total                         |       | $                      | 2,112      |                       | $          | 4,944 |   | 16 | % | 61 | % |

 

Theincreases in expenses for both periods were due in part to increases incompensation costs as a result of additional personnel focused on productinnovation and development. We had 118, 100 and 62 research and developmentpersonnel as of December 31, 2007, 2006 and 2005, respectively. Salaries,benefits and bonus for the year ended December 31, 2006 included a$284,000 one-time charge related to the retirement of Vincent Argiro, our ChiefTechnology Officer and founder, which was recorded in the first quarter of2006. Of this charge, $138,000 is included in salaries, benefits and bonusabove and $146,000 is included in equity-based compensation. The increase inequity-based compensation costs during 2006 was the result of our adoption ofSFAS No. 123(R) as of January 1, 2006.

 

During2006 and 2005, we required a significant amount of temporary consultingservices to complete certain research and development activities, specificallyin the area of software testing and validation. We reduced these external expenses during 2007 by hiring additionalresearch and development personnel.

 

Weexpect research and development expenses to continue to increase in futureperiods primarily as a result of hiring additional personnel to support theexpansion of our product development activities so that we can maintain ourstatus as an industry leader in advanced visualization. We expect research anddevelopment expenses to be between 24% and 25% of total revenue for the yearending December 31, 2008.

 

**General and administrative**

 

Generaland administrative expenses increased 34% to $14.6 million in 2007, compared to$10.9 million in 2006, which was an increase of 55% from $7.0 million in 2005.The change in general and administrative expense is as follows (dollars inthousands):

 

| ** **                            | ** ** | **Year-over-year**     | ** ** | **Year-over-year Percent** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **Change from Fiscal** | ** ** | **Change from Fiscal**     | ** ** |
| ** **                            | ** ** | **2006 to 2007**       | ** ** | **2005 to 2006**           | ** ** | **2006 to 2007** | ** ** | **2005 to 2006** | ** ** |
| Salaries, benefits and  bonus         |       | $                      | 847        |                       | $          | 1,376 |   | 17 | % | 40 | % |
| Equity-based compensation             |       | 621                    |       | 1,712                      |       | 33 | % | 1189 | % |
| Professional and  consulting services |       | 1,446                  |       | (8                         | )          | 83 | % | 0 | % |
| Overhead and other  expenses          |       | 741                    |       | 806                        |       | 30 | % | 49 | % |
| Total                                 |       | $                      | 3,655      |                       | $          | 3,886 |   | 34 | % | 55 | % |

 

Salaries,benefits and bonus for the year ended December 31, 2007 included an$885,000 pre-tax charge related to the separation of Jay D. Miller, our formerChief Executive Officer, which was recorded in the fourth quarter of 2007. Ofthis charge, $580,000 is included in salaries, benefits and bonus and $305,000is included in equity-based compensation. Professional and consulting services for 2007 increased due tointernational expansion and higher accounting, audit and legal expenses. Theincrease in total expenses during 2006 was primarily due to higher equity-basedcompensation costs as a result of our adoption of SFAS No. 123(R) asof January 1, 2006. Overhead expenses increased both years due to thegrowth of the business. We had 52, 50 and 30 general and administrativepersonnel as of December 31, 2007, 2006 and 2005, respectively.

 

 

30

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Weexpect general and administrative expenses to increase moderately in futureperiods primarily as a result of hiring additional personnel and increasingadministrative costs associated with various company initiatives to build theinfrastructure for a larger business, as well as international expansion. Weexpect general and administrative expenses to be approximately 17% to 18% oftotal revenue for the year ending December 31, 2008.

 

**Otheritems**

 

InMarch 2004, we signed a non-cancelable operating lease for a new officefacility in Minnetonka, Minnesota. The new lease term started in February 2005and expires in January 2012. We moved into the Minnetonka location andmoved out of the Plymouth, Minnesota location in February 2005. Our leasefor the office facility in Plymouth expired on July 31, 2005, with theexception of a small portion of the space that was under lease until May 31,2006. Under the terms of the Minnetonka lease, since February 2005, thelessor paid the monthly base rent payments and taxes and operating cost rentobligation payments for our former office facility in Plymouth.  In the first quarter of 2005, we recorded alease loss of $493,000 related to the abandonment of the Plymouth office. Theestimated lease payments to be made by the Minnetonka landlord to the Plymouthlandlord are considered a lease incentive and recorded as an immediate chargeand deferred rent, which is amortized as a reduction of rent expense throughthe term of the lease.

 

**Interestincome**

 

Wegenerated $8.9 million of interest income in 2007, compared with $3.3 millionin 2006 and $1.1 million in 2005. During the fourth quarter of 2006, wecompleted a public offering of 3.4 million shares of common stock, resulting innet proceeds of $97.7 million, which significantly increased interest income.In addition to the increased interest income resulting from the offering, theincreases were primarily due to increases in cash, cash equivalents andmarketable securities, which were generated from increased cash flows in allperiods.

 

Interestincome is significantly impacted by changes in interest rates. We anticipatesignificantly lower interest rates in 2008 compared to 2007 due to generalmarket conditions; further interest rate changes would have a significantimpact on results.

 

**Income taxes**

 

Oureffective income tax rate was 20%, 36% and 33% in 2007, 2006 and 2005,respectively. The decrease in our effective tax rate in 2007 from 2006 was dueprimarily to the relative impact of research and development credits on lowertaxable income for 2007. The increase in our effect tax rate in 2006 from 2005was due to the non-deductibility of incentive stock options, for which the taxbenefit is recorded only upon a disqualifying disposition. This was a result ofthe adoption of SFAS No. 123(R) on January 1, 2006, which requiresthat we recognize compensation expense for all equity-based payments granted ormodified on or after January 1, 2006 and prior to but not yet vested as ofJanuary 1, 2006.

 

Oureffective income tax rate may fluctuate significantly from quarter to quarterdue to the relative proximity of results before taxes to break even. 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 federal income taxes for the next two to three years.Actual results could accelerate or defer the utilization of our deferred taxassets. Additionally, if we are unable to generate sufficient taxable income,causing us to believe that our deferred tax assets will not be utilized,additional valuation allowances may need to be established on our deferred taxassets, which could materially impact our financial position and results ofoperations.

 

Ourmethodology for determining our ability to realize our deferred tax assetsinvolves 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 decrease our estimates of future taxable income or taxdeductions from the exercise of stock options, or our stock price increasessignificantly without an increase in taxable income, causing us to believe thatour deferred tax assets will not be utilized, we may need to establishadditional valuation allowances on our deferred tax assets, which couldmaterially impact our financial position and results of operations.

 

 

31

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**Liquidity and capital resources**

 

Asof December 31, 2007, we had $146.7 million in cash and cash equivalents,$31.7 million in marketable securities, working capital of $173.9 million andno borrowings, as compared to $144.4 million in cash and cash equivalents,$21.6 million in marketable securities, working capital of $162.2 million andno borrowings as of December 31, 2006.

 

*Operatingactivities*

 

During2007, cash provided by operations was $13.9 million, which consisted of netincome of $1.4 million, a decrease of $2.8 million in working capital, anincrease of $199,000 in deferred rent relating to payments made by ourMinnetonka landlord for our benefit, and an increase of $9.6 million from othernon-cash operating activities. Changes in working capital were primarily adecrease in accounts receivable of $3.4 million, an increase in deferredrevenue of $1.4 million, and a decrease in accrued expenses and otherliabilities of $1.1 million. Days’ sales outstanding (calculated by dividingending net accounts receivable by revenue per day) were 83 and 101 as of December 31,2007 and 2006. Our receivables aging remains relatively current, with less than10% receivables greater than 90 days past due as of December 31, 2007 and2006. We use days’ sales outstanding as an activity measure which placesemphasis and focus on accounts receivable, but this measure is not definedunder U.S. generally accepted accounting principles, and similarly titledmeasures may not be computed in the same way by other companies. Otherchanges in working capital accounts included an increase of $513,000 in prepaidand other current assets and a decrease of $363,000 in accounts payable due toincreased operating costs and general timing of payments to vendors.

 

During2006, cash provided by operations was $14.8 million, which consisted of netincome of $6.6 million, a decrease of $526,000 in working capital, an increaseof $561,000 in deferred rent relating to payments and estimated payments to bemade by our Minnetonka landlord for our benefit, and an increase of $8.2million from other non-cash operating activities. Changes in working capitalwere primarily an increase in accounts receivable of $5.3 million and anincrease in deferred revenue of $4.4 million. Days’ sales outstanding was 101as of December 31, 2006 and 2005. Our receivables aging was relatively current, with less than 10%receivables greater than 90 days past due as of December 31, 2006 and2005. Other changes in working capital accounts included an increase of$701,000 in prepaid and other current assets and an increase of $836,000 inaccounts payable due to increased operating costs and general timing ofpayments to vendors.

 

*Investingactivities*

 

Weused $15.9 million of cash in investing activities in 2007. Net cash providedby investing activities was $1.4 million in 2006. We used $21.7 million of cashin investing activities in 2005.

 

Weused $6.6 million, $6.4 million and $4.3 million for purchases of propertyand equipment in 2007, 2006 and 2005, respectively. Thepurchases for all periods were principally to expand our facilities and upgradecomputer equipment and to purchase computer equipment for new personnel.Additionally, in 2007, we began the implementation of an enterprise resourceplanning (ERP) system. We anticipate that we will continue to purchase propertyand equipment in the normal course of business. The amount and timing of thesepurchases and the related cash outflows in future periods are difficult topredict and depend on a number of factors, including the hiring of employeesand the rate of change of computer hardware.

 

Weused $60.0 million, $29.5 million and $38.8 million to purchase investments inmarketable securities during 2007, 2006 and 2005, respectively.We realized $50.7 million, $37.4 million and $21.4 million of proceeds frommaturities and sales of marketable securities during 2007, 2006 and 2005, respectively.The marketable securities consist of U.S. government obligations, U.S.government agency obligations, corporate commercial obligations andcertificates of deposits.

 

*Financingactivities*

 

Cashprovided by financing activities totaled $4.3 million, $107.4 million and $4.7million for 2007, 2006 and 2005, respectively. The cashprovided by financing activities in 2006 related primarily to the $97.7 millionin net proceeds from our public offering of 3.4 million shares of commonstock.  The cash provided by financingactivities in 2007 and 2005 resulted primarily from the exercise of stockoptions granted under our stock plans and upon the exercise of warrants.

 

Wehave never paid or declared any cash dividends and do not intend to paydividends in the near future.

 

 

32

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Thefollowing summarizes our contractual obligations at December 31, 2007 andthe effect such obligations are expected to have on our liquidity and cash flowin future periods (in thousands).

 

| ** **       | ** ** | ** ** | ** ** | ** **         | ** ** | ** **       | ** ** | ** **       | ** ** | **More than 5** | ** ** |
|------------------|------------|------------|------------|--------------------|------------|------------------|------------|------------------|------------|-----------------|------------|
| ** **       | ** ** | **Total**  | ** ** | **1 Year or Less** | ** ** | **1 to 3 Years** | ** ** | **3 to 5 Years** | ** ** | **Years**       | ** ** |
|             |       |       |       |               |       |             |       |             |       |            |       |
| Operating leases |       | $          | 4,000      |               | $          | 1,154            |       | $                | 1,863      |            | $          | 983 |   | $ | — |   |
|                  |            |            |            |                    |            |                  |            |                  |            |                 |            |  |  |  |  |  |

 

Off-balance-sheetarrangements

 

Wedid not have any off-balance sheet arrangements as of December 31, 2007 or2006.

 

Purchasecommitments

 

Wehad no significant outstanding purchase orders as of December 31, 2007. Wehave entered into a number of technology licensing agreements that provide forthe payment of royalties when we sell *Vitrea* and *ViTALConnect*; we are not obligated for any minimum paymentsunder such agreements.

 

**Foreigncurrency transactions**

 

Substantiallyall of our foreign transactions are negotiated, invoiced and paid in U.S.dollars.

 

**Inflation**

 

Webelieve inflation has not had a material effect on our operations or financialcondition.

 

**Recentaccounting pronouncement**

 

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 accounting principlesgenerally accepted in the United States, and expands disclosures about fairvalue measurements. SFAS No. 157 is effective for financial assets andliabilities for fiscal years beginning after November 15, 2007. In February 2008,the FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157.”FSP 157-2 delays the effective date of SFAS No. 157 for all non-financialassets and non-financial liabilities that are not re-measured at fair value ona recurring basis until fiscal years beginning after November 15, 2008.Any amounts recognized upon adoption of this rule as a cumulative effectadjustment will be recorded to the opening balance of retained earnings in theyear of adoption.  SFAS 157 will beeffective for our financial statements after January 1, 2008. We arecurrently evaluating the impact of SFAS 157, but we do not expect SFAS No. 157to have a material impact on our consolidated income statements or financialcondition.

 

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair ValueOption for Financial Assets and Financial Liabilities” (“SFAS 159”), whichpermits entities to choose to measure many financial instruments and certainother items at fair value that are not currently required to be measured atfair value. SFAS 159 will be effective for our financial statements after January 1,2008. We are currently evaluating the impact of SFAS 159, but we do not expectSFAS No. 159 to have a material impact on our consolidated incomestatements or financial condition.

 

InDecember 2007, the FASB issued SFAS No. 141R, “Business Combinations,”which changes how business acquisitions are accounted. SFAS No. 141Rrequires the acquiring entity in a business combination to recognize all (andonly) the assets acquired and liabilities assumed in the transaction andestablishes the acquisition-date fair value as the measurement objective forall assets acquired and liabilities assumed in a business combination. Certainprovisions of this standard will, among other things, impact the determinationof acquisition-date fair value of consideration paid in a business combination(including contingent consideration); exclude transaction costs fromacquisition accounting; and change accounting practices for acquiredcontingencies, acquisition-related restructuring costs, in-process research anddevelopment, indemnification assets, and tax benefits.  SFAS No. 141Rwill be effective for us for business combinations and adjustments to anacquired entity’s deferred tax asset and liability balances occurring after December 31,2008. We are currently evaluating the impact of SFAS No. 141R.

 

InDecember 2007, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 110 (SAB 110), which extends certain provisions ofSAB No. 107. SAB 110 allows public companies which do not havehistorically sufficient experience to provide a reasonable estimate to continueuse of the “simplified” method for estimating the expected term of “plainvanilla” share option grants after  December 31,2007. SAB 110 is effective January 1, 2008. We plan to continue utilizingthe simplified method for our “plain vanilla” share options until we havesufficient historical experience to estimate the expected term for shareoptions issued.

 

 

33

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

 

Marketrisk refers to the risk that a change in the level of one or more marketprices, interest rates, indices, volatilities, correlations or other marketfactors such as liquidity will result in losses for a certain financialinstrument or group of financial instruments. We do not hold or issue financialinstruments for trading purposes, and we do not enter into forward financialinstruments to manage and reduce the impact of changes in foreign currencyrates because, as disclosed above, substantially all of our foreigntransactions are negotiated, invoiced and paid in U.S. dollars. Based on thecontrols in place and the relative size of the financial instruments enteredinto, we believe the risks associated with not using these instruments wouldnot have a material adverse effect on our consolidated financial position orresults of operations.

 

Inaddition, we do not engage in speculative transactions and do not usederivative instruments or engage in hedging activities. See the Notes to theConsolidated Financial Statements for a description of our accounting policiesand other information related to these financial instruments.

 

Inthe normal course of business, we are exposed to market risks, includingchanges in interest rates and price changes, which could affect our operatingresults. As of December 31, 2007, fluctuations in interest rates, exchangerates and price changes would not have had a material effect on our financialposition or operating results.

 

**Interest rate risk**

 

Weplace our cash, cash equivalents and marketable securities, which generallyhave a term of less than one year, with a high-quality financial institutionand have investment guidelines relative to diversification and maturitiesdesigned to maintain safety and liquidity. As of December 31, 2007, we hadcash, cash equivalents and marketable securities totaling $178.4 million. If,during 2007, average short-term interest rates decreased by 1.0% from 2007average rates, based on our quarterly average balance of cash, cash equivalentsand marketable securities, our projected interest income from short-terminvestments would have decreased by approximately $1.7 million.

 

**Foreign currency risk**

 

Substantiallyall of our foreign transactions are negotiated, invoiced and paid in U.S.dollars. Therefore, fluctuations in the value of the dollar as compared toother foreign currencies have not had an effect on our results of operations orfinancial condition.

 

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

 

Ourfinancial statements, supplemental schedule and Report of IndependentRegistered Public Accounting Firm thereon, all of which are included in thisAnnual Report on 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**

 

Notapplicable.

 

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

 

**Evaluation of disclosure controlsand procedures**

 

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in the reports that we file or submit under the SecuritiesExchange Act of 1934, as amended (“Exchange Act”), is recorded, processed,summarized and reported within the time periods specified in the rules andforms of the Securities and Exchange Commission, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required financial disclosure.

 

Our management, under thesupervision of and with the participation of our Chief Executive Officer andChief Financial Officer, has evaluated the effectiveness of our disclosurecontrols and procedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, as of the end of the period covered by this report. Based onsuch evaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that, as of the end of the period covered by this report, ourdisclosure controls and procedures were effective.

 

 

34

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** **

**Management’sreport on internal control over financial reporting**

 

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting. Our internal control over financial reporting is a processdesigned to 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 not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions or that the degree of compliance withestablished policies or procedures may deteriorate.

 

Ourmanagement, under the supervision of and with the participation of our ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof our internal control over financial reporting as of the end of the periodcovered by this report based on the criteria established in *Internal Control — Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO). Basedon the results of this evaluation, we concluded that our internal control overfinancial reporting was effective as of the end of the period covered by thisreport.

 

The effectiveness of ourinternal control over financial reporting as of December 31, 2007 has beenaudited by PricewaterhouseCoopers LLP, an independent registered publicaccounting firm, as stated in their report which is included in Item 15(a)(1) ofthis Annual Report on Form 10-K.

 

**Changesin internal control over financial reporting**

 

During the third quarter of2007, we implemented the general ledger, purchasing, accounts payable andmaterials management modules of our new enterprise resource planning, or ERP,system. We plan to implement additional modules in 2008 to support the majorityof our other processes and operations. We believe the phased-in approach we aretaking reduces the risks associated with the implementation. We have taken thenecessary steps to monitor and maintain appropriate internal controls duringthis period of change. These steps include providing training related tobusiness process changes and the ERP system software to individuals using theERP system to carry out their job responsibilities as well as those who rely onthe financial information. Oversight activities have increased during thetransition period, and a support organization has been established to monitorsystem operations, answer user questions, resolve issues in a timely manner,and report trends to management. Also, redundant controls have been establishedin key areas to assure the accuracy of financial reporting. We anticipate thatthe implementation of the ERP will strengthen the overall system of internalcontrols due to enhanced automation and integration of related processes. Therewere no changes in internal control over financial reporting as of the end ofthe period covered by this report that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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

 

None.

 

35

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**Part III**

 

Certaininformation required by Part III is omitted from this Annual Report on Form 10-Kbecause we will file a definitive Proxy Statement relating to our 2008 AnnualMeeting of Stockholders pursuant to Schedule 14A (the “Proxy Statement”)not later than 120 days after the end of the fiscal year covered by thisAnnual Report on Form 10-K, and certain information included therein isincorporated herein by reference as indicated below.

 

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

 

Theinformation required by this Item 10 will be included under the captions “Electionof Directors” and “Information Concerning Directors, Nominees and ExecutiveOfficers” in our Proxy Statement for our 2008 annual meeting of shareholders.Information concerning the compliance of our officers, directors and 10%shareholders with Section 16(a) of the Securities Exchange Act of1934 is incorporated by reference to the information to be contained in the2008 proxy statement under the caption “Information Concerning DirectorsNominees and Executive Officers — Section 16(a) Beneficial OwnershipReporting Compliance.”  The informationregarding Audit Committee members and “Audit Committee Financial Experts” isincorporated by reference to the information to be contained in the 2008 proxystatement under the caption “Information Concerning Directors Nominees andExecutive Officers — Board Committees.” The information regarding our Code of Business Ethics is incorporated byreference to the information to be contained in the 2008 proxy statement underthe heading “Information Concerning Directors Nominees and Executive Officers —Code of Business Conduct and Ethics.”

 

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

 

Theinformation under the captions “Information Concerning Directors Nominees andExecutive Officers — Executive Compensation” and “Information ConcerningDirectors Nominees and Executive Officers — Director Compensation” to becontained in the 2008 proxy statement is incorporated herein by reference.

 

Thefollowing information is being provided instead of reporting the informationunder Item 5.02(e) of a Current Report on Form 8-K:

 

OnMarch 11, 2008, our Compensation Committee (the “Committee”) approved 2008 basesalaries, target bonuses under the 2008 Management Incentive Plan (“MIP”) andgrants of stock options under the 2006 Long-Term Incentive Plan for each of ourexecutive officers, including our principal executive officer, principalfinancial officer and each of our other "named executive officers"(as defined in Regulation S-K Item 402(a)(3)) to be identified in our proxystatement for our 2008 annual meeting of shareholders, other than thoseexecutive officers who are no longer employees. Specifically, the Compensation Committeeapproved the following salaries, effective March 1, 2008: Michael H. Carrel,the Company’s President and Chief Executive Officer ($310,000), Peter J.Goepfrich, its Chief Financial Officer ($210,000), Steven P. Canakes, itsExecutive Vice President – Global Sales ($213,200), Philip I. Smith, itsExecutive Vice President – Corporate Development ($205,000) and Susan A. Wood,Ph.D., its Executive Vice President – Marketing and Clinical Development($225,000). The Committee also approved grants of options for the followingnumbers of shares: Mr. Carrel (15,000), Mr. Goepfrich (10,000), Mr. Canakes(30,000) and Ms. Wood (50,000). All options were granted at an exercise priceof $15.11 (the closing price of our common stock on the Nasdaq Global SelectMarket on the grant date). All options vest with respect to 28% of the shareson March 11, 2009 and, as to the remaining shares, with respect to 2% of theshares on each monthly anniversary thereafter so long as the executive officeris an employee of our Company. All options have a term of five years from thedate of grant.

 

OnMarch 11, 2008, the Committee approved target bonuses for our executiveofficers under the MIP for the year ending December 31, 2008. The MIP providesfor payment of a bonus based on achievement of revenue, adjusted EBITDA(earnings before interest, taxes, depreciation, amortization and equity-basedcompensation), customer support, customer satisfaction, product development andpersonal objectives. The total bonus is weighted 35% for achieving the revenueobjective, 25% for achieving the adjusted EBITDA objective, 10% for achievingthe customer support objective, 10% for achieving the customer satisfactionobjective, 10% for achieving the product development objective, and 10% forachieving the personal objectives. The bonus payable under the plan ispro-rated for achievement above the minimum threshold and increases withpercentage achievement relative to the objectives, and 75% of the target bonuswill be paid at 100% achievement of the plan objectives. The maximum bonuspayable under the plan for objectives other than personal objectives will be250% of the target bonus at 110% achievement of the revenue objective, 250% ofthe target bonus at 167% achievement of the adjusted EBITDA objective, 250% ofthe target bonus at 110% achievement of the customer support objective, and150% for overachievement on the customer satisfaction and product developmentobjectives.

 

Theplan provides for payment under the revenue and adjusted EBITDA objectives onlyif performance is at least 90% of the corresponding target, and under thecustomer support objective only if performance is more than 96% of thetarget.  Payment under the customersatisfaction and product development objectives may be made if achievement doesnot meet the target but does meet minimum measurements. The target bonus for2008 for the company's principal executive officer is 65% of base salary, andthe targets bonus for 2008 for the company’s principal financial officer andeach other named executive officer is 50% of base salary. 

 

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

 

Theinformation under 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 2008 proxystatement is incorporated herein by reference.

 

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

 

Notapplicable.

 

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

 

Theinformation under the caption “Ratification of Appointment ofPricewaterhouseCoopers LLP as Independent Registered Public Accounting Firm” tobe contained in the 2008 proxy statement is incorporated herein by reference.

 

36

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**Part IV**

 

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

 

(a)          The following Consolidated Financial Statements ofVital Images, Inc. and Report of Independent Registered Public AccountingFirm thereon are included herein:

 

(1)          Financial Statements

 
| Report  of Independent Registered Public Accounting Firm                                                                                        | 39 |
|-------------------------------------------------------------------------------------------------------------------------------------------------|----|
| Consolidated  Balance Sheets as of December 31, 2007 and 2006                                                                              | 40 |
| Consolidated  Income Statements for the years ended December 31, 2007, 2006 and 2005                                                       | 41 |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income for the years ended  December 31, 2007, 2006  and 2005 | 42 |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2007, 2006 and 2005                                                | 43 |
| Notes to Consolidated Financial Statements                                                                                                      | 44 |

 

(2)          All other schedules to the Consolidated FinancialStatements required by Article 12 of Regulation S-X are not required underthe related instructions or are inapplicable and therefore have been omitted.

 

(3)          Listing of Exhibits

 

TheExhibits required to be a part of this Report are listed in the Index toExhibits.

 

(b)            Exhibits

 

Includedin Item 15(a)(3) above.

 

37

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**Signatures**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this Report to be signed on itsbehalf by the undersigned, thereunto duly authorized, in Minneapolis, Minnesota,on the 17th day of March, 2008.

 
|   |   |   | Vital  Images, Inc.                                                                 |   |
|--------|--------|--------|------------------------------------------------------------------------------------------|--------|
|   |   |   |                                                                                     |   |
|   |   | By:    | /s/Peter  J. Goepfrich                                                                   |   |
|   |   |   | Peter  J. Goepfrich                                                                      |   |
|   |   |   | Chief  Financial Officer (Principal Financial Officer and Principal Accounting  Officer) |   |

 

Pursuantto the requirement of the Securities Exchange Act of 1934, this Report has beensigned by the following persons in the capacities and on the dates indicated.

 

 
| **Signature**                 | ** ** | **Title**                                                       | ** ** | **Date**             | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------|------------|----------------------|------------|
|                          |       |                                                            |       |                 |       |
| /s/  Michael H. Carrel        |       | President,  Chief Executive Officer and Director                |       | March 17,  2008 |       |
| Michael  H. Carrel            |       | (Principal Executive Officer)                                   |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/Peter  J. Goepfrich        |       | Chief  Financial Officer and Treasurer                          |       | March 17,  2008 |       |
| Peter  J. Goepfrich           |       | (Principal Financial Officer and Principal  Accounting Officer) |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/Douglas  M. Pihl           |       | Chairman  of the Board and Director                             |       | March 17,  2008 |       |
| Douglas  M. Pihl              |       |                                                            |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/James  B. Hickey, Jr. |       | Director                                                        |       | March 17,  2008 |       |
| James  B. Hickey, Jr.    |       |                                                            |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/Richard  W. Perkins        |       | Director                                                        |       | March 17,  2008 |       |
| Richard  W. Perkins           |       |                                                            |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/Michael  W. Vannier        |       | Director                                                        |       | March 17,  2008 |       |
| Michael  W. Vannier           |       |                                                            |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/Sven  A. Wehrwein          |       | Director                                                        |       | March 17,  2008 |       |
| Sven  A. Wehrwein             |       |                                                            |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/Gregory  J. Peet           |       | Director                                                        |       | March 17,  2008 |       |
| Gregory  J. Peet              |       |                                                            |       |                 |       |
|                          |       |                                                            |       |                 |       |
| /s/Jay  D. Miller             |       | Director                                                        |       | March 17,  2008 |       |
| Jay  D. Miller                |       |                                                            |       |                 |       |
|                          |       |                                                            |       |                 |       |

 

38

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**Report of Independent RegisteredPublic Accounting Firm**

 

Tothe Board of Directors and Stockholders of Vital Images, Inc.:

 

Inour opinion, the accompanying consolidated balance sheets and the relatedconsolidated statements of income,,of stockholders’ equity and comprehensiveincome and of cash flows present fairly, in all material respects, thefinancial position of Vital Images, Inc. and its subsidiaries at December 31,2007 and December 31, 2006, and the results of their operations and theircash flows for each of the three years in the period ended December 31,2007 in conformity with accounting principles generally accepted in the UnitedStates of America.  Also in our opinion,the Company maintained, in all material respects, effective internal controlover financial reporting as of December 31, 2007, based on criteriaestablished in *Internal Control - Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO).  The Company’s management isresponsible for these financial statements, for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting, included in Management’s Report onInternal Control over Financial Reporting appearing under Item 9A.  Our responsibility is to express opinions onthese financial statements and on the Company’s internal control over financialreporting based on our integrated audits. We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audits to obtain reasonable assurance about whether the financialstatements are free of material misstatement and whether effective internalcontrol over financial reporting was maintained in all material respects.  Our audits of the financial statements includedexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  Our audit ofinternal control over financial reporting included obtaining an understandingof internal control over financial reporting, assessing the risk that amaterial weakness exists, and testing and evaluating the design and operatingeffectiveness of internal control based on the assessed risk.  Our audits also included performing suchother procedures as we considered necessary in the circumstances.  We believe that our audits provide areasonable basis for our opinions.

 

Asdiscussed in Note 2 to the consolidated financial statements, the Companychanged the manner in which it accounts for share-based compensation in 2006.

 

Acompany’s internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (i) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

PricewaterhouseCoopersLLP

Minneapolis,MN

March 14,2008

 

39

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

**(In thousands, except per share amounts)**

 

| ** **                                                                                                                                                                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **Assets**                                                                                                                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                    |       | $                     | 146,685    |   | $ | 144,382 |   |
| Marketable securities                                                                                                                                                                        |       | 31,709                |       | 20,821 |   |
| Accounts receivable, net                                                                                                                                                                     |       | 15,962                |       | 19,589 |   |
| Deferred income taxes                                                                                                                                                                        |       | 3,472                 |       | 1,661 |   |
| Prepaid expenses and other current assets                                                                                                                                                    |       | 2,441                 |       | 1,928 |   |
| Total current assets                                                                                                                                                                         |       | 200,269               |       | 188,381 |   |
| Marketable securities                                                                                                                                                                        |       | —                |       | 750 |   |
| Property and equipment,  net                                                                                                                                                                 |       | 11,165                |       | 9,242 |   |
| Deferred income taxes                                                                                                                                                                        |       | 8,621                 |       | 8,969 |   |
| Licensed technology, net                                                                                                                                                                     |       | —                |       | 90 |   |
| Other intangible assets,  net                                                                                                                                                                |       | 1,852                 |       | 3,209 |   |
| Goodwill                                                                                                                                                                                     |       | 9,089                 |       | 9,089 |   |
| Total assets                                                                                                                                                                                 |       | $                     | 230,996    |   | $ | 219,730 |   |
|                                                                                                                                                                                         |       |                  |       |   |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                         |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                             |       | $                     | 3,330      |   | $ | 3,830 |   |
| Accrued compensation                                                                                                                                                                         |       | 3,092                 |       | 3,977 |   |
| Accrued royalties                                                                                                                                                                            |       | 1,113                 |       | 1,158 |   |
| Other current liabilities                                                                                                                                                                    |       | 2,282                 |       | 2,083 |   |
| Deferred revenue                                                                                                                                                                             |       | 16,547                |       | 15,131 |   |
| Total current liabilities                                                                                                                                                                    |       | 26,364                |       | 26,179 |   |
| Deferred revenue                                                                                                                                                                             |       | 1,140                 |       | 1,174 |   |
| Deferred rent                                                                                                                                                                                |       | 1,276                 |       | 1,475 |   |
| Total liabilities                                                                                                                                                                            |       | 28,780                |       | 28,828 |   |
|                                                                                                                                                                                         |       |                  |       |   |   |
| Commitments and  contingencies (Note 4)                                                                                                                                                      |       |                  |       |   |   |
|                                                                                                                                                                                         |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                                   |       |                  |       |   |   |
| Preferred stock: $0.01 par value; 5,000 shares authorized; none  issued or outstanding                                                                                                       |       | —                |       | — |   |
| Common stock: $0.01 par value; 40,000 shares authorized; 17,153  issued and outstanding as of December 31, 2007; and 16,908 shares issued  and outstanding as of December 31, 2006 |       | 172                   |       | 169 |   |
| Additional paid-in capital                                                                                                                                                                   |       | 199,625               |       | 189,669 |   |
| Retained earnings                                                                                                                                                                            |       | 2,420                 |       | 1,053 |   |
| Accumulated other comprehensive income (loss)                                                                                                                                                |       | (1                    | )          | 11 |   |
| Total stockholders’ equity                                                                                                                                                              |       | 202,216               |       | 190,902 |   |
| Total liabilities and stockholders’ equity                                                                                                                                              |       | $                     | 230,996    |   | $ | 219,730 |   |

 

The accompanying notes are an integral part of the ConsolidatedFinancial Statements.

 

40

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

**(In thousands, except for per share amounts)**

 

| ** **                                                 | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                 | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                       |       |                                     |       |   |   |   |   |
| Revenue:                                                   |       |                                     |       |   |   |   |   |
| License fees                                               |       | $                                        | 39,673     |   | $ | 46,332 |   | $ | 35,228 |   |
| Maintenance and services                                   |       | 29,487                                   |       | 22,615 |   | 14,324 |   |
| Hardware                                                   |       | 1,016                                    |       | 1,565 |   | 2,165 |   |
| Total revenue                                              |       | 70,176                                   |       | 70,512 |   | 51,717 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Cost of revenue:                                           |       |                                     |       |   |   |   |   |
| License fees                                               |       | 4,725                                    |       | 4,991 |   | 4,682 |   |
| Maintenance and services                                   |       | 9,928                                    |       | 8,023 |   | 5,559 |   |
| Hardware                                                   |       | 694                                      |       | 1,196 |   | 1,319 |   |
| Impairment of patent                                       |       | 242                                      |       | — |   | — |   |
| Total cost of revenue                                      |       | 15,589                                   |       | 14,210 |   | 11,560 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Gross profit                                               |       | 54,587                                   |       | 56,302 |   | 40,157 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Operating expenses:                                        |       |                                     |       |   |   |   |   |
| Sales and marketing                                        |       | 31,991                                   |       | 25,374 |   | 16,932 |   |
| Research and development                                   |       | 15,204                                   |       | 13,092 |   | 8,148 |   |
| General and administrative                                 |       | 14,560                                   |       | 10,905 |   | 7,019 |   |
| Loss on operating lease                                    |       | —                                   |       | — |   | 493 |   |
| Total operating expenses                                   |       | 61,755                                   |       | 49,371 |   | 32,592 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Operating income (loss)                                    |       | (7,168                                   | )          | 6,931 |   | 7,565 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Interest income                                            |       | 8,886                                    |       | 3,342 |   | 1,067 |   |
| Income before income taxes                                 |       | 1,718                                    |       | 10,273 |   | 8,632 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Provision for income taxes                                 |       | 351                                      |       | 3,690 |   | 2,831 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Net income                                                 |       | $                                        | 1,367      |   | $ | 6,583 |   | $ | 5,801 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Net income per share —  basic                         |       | $                                        | 0.08       |   | $ | 0.49 |   | $ | 0.47 |   |
| Net income per share —  diluted                       |       | $                                        | 0.08       |   | $ | 0.46 |   | $ | 0.44 |   |
|                                                       |       |                                     |       |   |   |   |   |
| Weighted average common  shares outstanding — basic   |       | 16,972                                   |       | 13,463 |   | 12,379 |   |
| Weighted average common  shares outstanding — diluted |       | 17,457                                   |       | 14,259 |   | 13,283 |   |
|                                                       |       |                                     |       |   |   |   |   |

 

The accompanying notes are an integral part of the ConsolidatedFinancial Statements.

 

41

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

**(In thousands)**

 
| ** **                                                                                                                  | ** ** | ** **        | ** ** | ** **  | ** ** | ** **     | ** ** | ** **       | ** ** | **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, 2004                                                                                      |       | 12,007            |       | $           | 120        |           | $          | 65,813           |       | $                 | —     |                   | $          | (11,331           | )          | $          | (48        | ) | $ | 54,554 |   |   |   |
|                                                                                                                        |       |              |       |        |       |           |       |             |       |              |       |                   |       |              |       |       |       |
| 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  and release of restricted stock                                    |       |              |       |        |       | 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      |   |
|                                                                                                                        |       |              |       |        |       |           |       |             |       |              |       |                   |       |              |       |       |       |
| Issuance of  common stock upon  exercise of stock  options                                                             |       | 221               |       | 3           |       | 2,352          |       |             |       |              |       |                   |       | 2,355             |       |       |       |
| Tax benefit  related to exercise of stock  options  and release of restricted stock                                    |       |              |       |        |       | 1,443          |       |             |       |              |       |                   |       | 1,443             |       |       |       |
| Issuance of  common stock under  employee stock  purchase plan                                                         |       | 27                |       | —      |       | 521            |       |             |       |              |       |                   |       | 521               |       |       |       |
| Grant of  restricted stock to  employees, net                                                                          |       | 14                |       | —      |       | —         |       |             |       |              |       |                   |       | —            |       |       |       |
| Common stock  surrendered for payment of  payroll tax  liability resulting from the  vesting  of restricted stock |       | (17               | )          | —      |       | (347           | )          |             |       |              |       |                   |       | (347              | )          |       |       |
| Stock-based  compensation                                                                                                   |       |              |       |        |       | 5,987          |       |             |       |              |       |                   |       | 5,987             |       |       |       |
| Change in  unrealized loss on investments,  net of  tax                                                                |       |              |       |        |       |           |       |             |       |              |       | (8                     | )          | (8                | )          | $          | (8         | ) |
| Cumulative  translation adjustment                                                                                          |       |              |       |        |       |           |       |             |       |              |       | (4                     | )          | (4                | )          | (4         | )          |
| Net income                                                                                                                  |       |              |       |        |       |           |       |             |       | 1,367             |       |                   |       | 1,367             |       | 1,367      |       |
| Balances as of  December 31, 2007                                                                                      |       | 17,153            |       | $           | 172        |           | $          | 199,625          |       | $                 | —     |                   | $          | 2,420             |       | $          | (1         | ) | $ | 202,216 |   | $ | 1,355 |   |

 

The accompanying notes are an integral part of the ConsolidatedFinancial Statements.

 

42

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**Vital Images, Inc.**

**Consolidated Statements of CashFlows**

**(In thousands)**

** **
| ** **                                                                              | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                              | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                    |       |                                     |       |   |   |   |   |
| Cash flows from operating activities:                                                   |       |                                     |       |   |   |   |   |
| Net income                                                                              |       | $                                        | 1,367      |   | $ | 6,583 |   | $ | 5,801 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |       |                                     |       |   |   |   |   |
| Depreciation and amortization of property and equipment                                 |       | 4,517                                    |       | 2,910 |   | 2,143 |   |
| Amortization of identified intangible assets                                            |       | 1,205                                    |       | 1,404 |   | 1,404 |   |
| Impairment of patent                                                                    |       | 242                                      |       | — |   | — |   |
| Provision for doubtful accounts                                                         |       | 239                                      |       | 25 |   | (159 | ) |
| Deferred income taxes                                                                   |       | (16                                      | )          | 3,472 |   | (600 | ) |
| Tax benefit from stock option transactions                                              |       | —                                   |       | — |   | 3,359 |   |
| Excess tax benefit from stock transactions                                              |       | (1,395                                   | )          | (4,143 | ) | — |   |
| Amortization of discount and accretion of premium on marketable  securities             |       | (857                                     | )          | (382 | ) | 24 |   |
| Employee stock-based compensation                                                       |       | 5,987                                    |       | 5,045 |   | 314 |   |
| Non-employee stock-based compensation                                                   |       | —                                   |       | 18 |   | 21 |   |
| Loss on operating lease                                                                 |       | —                                   |       | — |   | 493 |   |
| Amortization of deferred rent                                                           |       | (338                                     | )          | (195 | ) | (163 | ) |
| Changes in operating assets and liabilities, net of effect from  acquisition:           |       |                                     |       |   |   |   |   |
| Accounts receivable                                                                     |       | 3,388                                    |       | (5,284 | ) | (6,080 | ) |
| Prepaid expenses and other assets                                                       |       | (513                                     | )          | (701 | ) | (135 | ) |
| Accounts payable                                                                        |       | (363                                     | )          | 836 |   | 740 |   |
| Accrued and other liabilities                                                           |       | (1,142                                   | )          | 193 |   | 1,913 |   |
| Deferred revenue                                                                        |       | 1,382                                    |       | 4,429 |   | 3,461 |   |
| Deferred rent                                                                           |       | 199                                      |       | 561 |   | 1,180 |   |
| Net cash provided by operating activities                                               |       | 13,902                                   |       | 14,771 |   | 13,716 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Cash flows from investing activities:                                                   |       |                                     |       |   |   |   |   |
| Purchases of property and equipment                                                     |       | (6,577                                   | )          | (6,436 | ) | (4,275 | ) |
| Purchases of marketable securities                                                      |       | (59,974                                  | )          | (29,545 | ) | (38,845 | ) |
| Proceeds from maturities of marketable securities                                       |       | 49,931                                   |       | 35,987 |   | 21,417 |   |
| Proceeds from sales of marketable securities                                            |       | 750                                      |       | 1,376 |   | — |   |
| Net cash (used in) provided by investing activities                                     |       | (15,870                                  | )          | 1,382 |   | (21,703 | ) |
|                                                                                    |       |                                     |       |   |   |   |   |
| Cash flows from financing activities:                                                   |       |                                     |       |   |   |   |   |
| Proceeds from sale of common stock under stock plans                                    |       | 2,876                                    |       | 5,538 |   | 4,713 |   |
| Proceeds from sale of common stock, net of offering costs                               |       | —                                   |       | 97,703 |   | — |   |
| Excess tax benefit from stock transactions                                              |       | 1,395                                    |       | 4,143 |   | — |   |
| Net cash provided by financing activities                                               |       | 4,271                                    |       | 107,384 |   | 4,713 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Net increase (decrease) in cash and cash equivalents                                    |       | 2,303                                    |       | 123,537 |   | (3,274 | ) |
|                                                                                    |       |                                     |       |   |   |   |   |
| Cash and cash equivalents, beginning of year                                            |       | 144,382                                  |       | 20,845 |   | 24,119 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Cash and cash equivalents, end of year                                                  |       | $                                        | 146,685    |   | $ | 144,382 |   | $ | 20,845 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Supplemental cash flow information:                                                     |       |                                     |       |   |   |   |   |
| Purchases of property and equipment with accounts payable                               |       | $                                        | 525        |   | $ | 662 |   | $ | 308 |   |
| Non-cash investing and financing activities:                                            |       |                                     |       |   |   |   |   |
| Common stock issued relating to acquisition of HInnovation, Inc.  (see Note 3)     |       | $                                        | —     |   | $ | 3,084 |   | $ | — |   |

 

The accompanying notes are an integral part of the ConsolidatedFinancial Statements.

 

43

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** **

**Vital Images, Inc.**

**Notes toConsolidated Financial Statements**

 

**1.****             ****Businessdescription**

 

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, customer education, software maintenance,professional services and, on occasion, third-party hardware to its customers.The Company’s technology rapidly transforms complex data generated bydiagnostic imaging equipment into functional digital images that can bemanipulated and analyzed using its specialized applications to betterunderstand internal anatomy and pathology. The Company’s solutions are designedto improve physician workflow and productivity, enhance the ability to makeclinical decisions, facilitate less invasive patient care, and complement oftensignificant capital investments in diagnostic imaging equipment made by itscustomers. The Company’s software is compatible with equipment from all majormanufacturers of diagnostic imaging equipment, such as computed tomography, orCT, scanners, and can be integrated into picture archiving and communicationsystems, or PACS. Many hospitals use PACS to acquire, distribute and archivemedical images and diagnostic reports, reducing the need for film andincreasing reliance on advanced visualization solutions such as the Company’s.The Company also offers a Web-based solution that provides physicians withanywhere, anytime access to medical images and visualization tools through anyInternet-enabled computer.

 

TheCompany views its operations and manages its business as one reportable segment— the development 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.

 

**2.****             ****Summaryof significant accounting policies**

 

**Basis of presentation**

 

The Consolidated Financial Statements include the accounts of theCompany and its wholly-owned subsidiaries. All intercompany accounts andtransactions have been eliminated.

 

**Use of estimates**

 

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

 

**Fair value of financial instruments**

 

The Company’s financial instruments consist primarily of cash, cashequivalents, and marketable securities, for which the current carrying amountsapproximate fair market values.

 

**Cash and cash equivalents**

 

Cash and cash equivalents consist of cash and temporary investmentswith maturities of 90 days or less when purchased. The carrying amount of cashequivalents approximates fair value due to the short maturity of theseinstruments.

 

**Marketable securities**

 

Management determines the appropriate classification of marketablesecurities at the time of purchase and reevaluates such designation as of eachbalance sheet date. Currently, all marketable securities held by the Companyare classified as available-for-sale. Available-for-sale securities are carriedat fair value as determined by quoted market prices or, in the case of theCompany’s Corporate Debt, using matrix pricing techniques, with unrealizedgains and losses, net of tax, reported as a separate component of stockholders’equity. If an unrealized loss for any investment is considered to beother-than-temporary, the loss will be recognized in the consolidated incomestatement in the period the determination is made. The cost basis of securitiessold is determined using the specific

 

 

44

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identification method. The cost of marketable securities is adjustedfor amortization of premiums and accretion of discounts to maturity. Suchamortization and accretion is included in interest income. Interest anddividends on securities classified as available-for-sale are included ininterest income. As of December 31, 2007, all investments mature withinone year.

 

Asof December 31, 2007 and 2006, the Company’s marketable securities were asfollows (in thousands):

 
| ** **                   | ** ** | **December 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | **Adjusted**               | ** ** | **Aggregate**              | ** ** | **Net Unrealized** | ** ** | **Adjusted** | ** ** | **Aggregate** | ** ** | **Net Unrealized** | ** ** |
| ** **                   | ** ** | **Cost Basis**             | ** ** | **Fair Value**             | ** ** | **Gains / (Losses)** | ** ** | **Cost Basis** | ** ** | **Fair Value** | ** ** | **Gains / (Losses)** | ** ** |
| Corporate debt (short  term) |       | $                          | 9,993      |                       | $          | 9,975 |   | $ | (18 | ) | $ | 20,810 |   | $ | 20,821 |   | $ | 11 |   |
| Corporate debt (long term)   |       | —                     |       | —                     |       | — |   | 750 |   | 750 |   | — |   |
| Government debt              |       | 21,717                     |       | 21,734                     |       | 17 |   | — |   | — |   | — |   |
|                         |       | $                          | 31,710     |                       | $          | 31,709 |   | $ | (1 | ) | $ | 21,560 |   | $ | 21,571 |   | $ | 11 |   |

 

Asof December 31, 2007 and 2006, the Company’s gross unrealized gains andlosses were as follows (in thousands):

 
| ** **                   | ** ** | **December 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | **Gross**                  | ** ** | **Gross**                  | ** ** | **Net** | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Net** | ** ** |
| ** **                   | ** ** | **Unrealized**             | ** ** | **Unrealized**             | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** |
| ** **                   | ** ** | **Gains**                  | ** ** | **(Losses)**               | ** ** | **Gains / (Losses)** | ** ** | **Gains** | ** ** | **(Losses)** | ** ** | **Gains / (Losses)** | ** ** |
| Corporate debt (short  term) |       | $                          | 2          |                       | $          | (20 | ) | $ | (18 | ) | $ | 26 |   | $ | (15 | ) | $ | 11 |   |
| Corporate debt (long term)   |       | —                     |       | —                     |       | — |   | — |   | — |   | — |   |
| Government debt              |       | 17                         |       | —                     |       | 17 |   | — |   | — |   | — |   |
|                         |       | $                          | 19         |                       | $          | (20 | ) | $ | (1 | ) | $ | 26 |   | $ | (15 | ) | $ | 11 |   |

 

Thecarrying values of available-for-sale securities approximates fair value. Therewere no material realized gains or losses on any investments for the yearsended December 31, 2007, 2006 or 2005.

 

Corporatedebt included $2,993 and $11,790 of asset-backed securities as of December 31,2007 and 2006, respectively. The net unrealized gains (losses) on asset-backedsecurities were ($19) and $10 as of December 31, 2007 and 2006,respectively. All asset-backed securities held by the Company are rated AAA andare current on scheduled pay downs with expected full maturity within the nexttwelve months. Given the current conditions of the credit markets, there issome risk the unrealized losses as of December 31, 2007 could increase ifthe credit markets continue to deteriorate. Further, liquidity in the creditmarkets is currently reduced, such that if the Company were to choose to sellthese investments before their scheduled pay downs, the Company could beexposed to additional losses, which are currently estimated to be immaterial.

 

TheCompany analyzes its investments for impairment on an ongoing basis. Factorsconsidered in determining whether an unrealized loss is a temporary loss or another-than-temporary loss include the length of time and extent to which thesecurities have been in an unrealized loss position and the Company’s abilityand intent to hold the investment for a period of time sufficient to allow forany anticipated market recovery. The Company has the ability and intent to holdthese investments until anticipated recovery of fair value, which may bematurity, and therefore the Company does not consider these investments to beimpaired as of December 31, 2007.

 

 

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**Accounts receivable and allowance for doubtful accounts**

 

Accounts receivable are initially recorded at a selling price, whichapproximates fair value upon the sale of goods or services to customers. TheCompany maintains an allowance for doubtful accounts to reflect accountsreceivable at net realizable value. In judging the adequacy of the allowancefor doubtful accounts, the Company considers multiple factors, includinghistorical bad debt experience, the general economic environment, the need forspecific client reserves and the aging of the Company’s receivables. A portionof 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.

 

**Concentration of credit risk**

 

Financial instruments that potentially subject the Company toconcentrations of credit risk consist primarily of cash and cash equivalentsand trade accounts receivable. Deposits with the Company’s bank may exceedthe amount of insurance provided on such deposits. Generally, these depositsmay be redeemed upon demand and, therefore, bear minimal risk. Financialinstruments that potentially subject the Company to concentrations of creditrisk consist principally of marketable securities. Marketable securitiesconsist of corporate debt and government debt. The Company’s investment policy,approved by its Investment Committee, limits the amount the Companymay invest in any one type of investment, thereby reducing credit riskconcentrations. A significant portion of the Company’s accounts receivablerelates to Toshiba Medical Systems Corporation and McKesson Corporation. TheCompany reviews the creditworthiness of its customers prior to product shipmentand generally does not require collateral.

 

**Property and equipment**

 

Property and equipment are recorded at cost. Depreciation is computedusing the straight-line method over the related asset’s estimated useful life,generally three to seven years. Equipment is generally depreciated over threeto seven years, furniture and fixtures are generally depreciated over sevenyears, computer software is generally depreciated over three to seven years andleasehold improvements are amortized over the shorter of their estimated usefullives or the 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-lived assets**

 

The Company reviews long-lived assets for impairment whenever events orchanges in circumstances indicate the carrying amount may not berecoverable, in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”Events or changes in circumstances that indicate the carrying amountmay not be recoverable include, but are not limited to, a significantdecrease in the market value of the business or asset acquired, a significantadverse change in the extent or manner in which the business or asset acquiredis used, or a significant adverse change in the business climate. If suchevents or changes in circumstances are present, the undiscounted cash flowsmethod is used to determine whether the asset is impaired. Cash flows wouldinclude the estimated terminal value of the asset and exclude any interestcharges. To the extent the carrying value of the asset exceeds the undiscountedcash flows over the estimated remaining life of the asset, the impairment ismeasured using the discounted cash flows. The discount rate utilized would bebased on management’s best estimate of the related risks and return at the timethe impairment assessment is made.

 

**Goodwill**

 

The Company accounts for goodwill in accordance with the provisions ofSFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142,goodwill and intangible assets with indefinite lives are reviewed forimpairment annually or more frequently if events or changes in circumstancesindicate that the asset might be impaired. The first step of the goodwillimpairment test, used to identify potential impairment, compares the fair valueof a reporting unit with its carrying amount, including goodwill. The Company operatesas one reporting unit and therefore compares the book value to the market value(market capitalization plus a control premium). If the market value exceeds thebook value, goodwill is considered not impaired, and thus the second step ofthe impairment test is not necessary. If the Company’s book value exceeds themarket value, the second step of the goodwill impairment test is performed tomeasure the amount of impairment loss, if any. The second step of the goodwillimpairment test, used to measure the amount of impairment loss, compares theimplied fair value of the

 

 

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goodwill with the book value of the goodwill. If the carrying value ofthe goodwill exceeds the implied fair value of the goodwill, an impairment losswould be recognized in an amount equal to the excess. Any loss recognizedcannot exceed the carrying amount of goodwill. After a goodwill impairment lossis recognized, the adjusted carrying amount of goodwill is its new accounting basis.Subsequent reversal of a previously recognized goodwill impairment loss isprohibited once the measurement of that loss is completed. The Companycompleted the annual goodwill impairment assessment as of December 31,2007, in which no impairment was recorded.

 

**Revenue recognition**

 

The Company recognizes revenue in accordance with American Institute ofCertified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2,Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, as well as TechnicalPractice Aids issued from time to time by the AICPA and SEC Staff AccountingBulletin No. 104. The Company recognizes revenue when it is realized orrealizable and earned. The Company considers revenue realized or realizable andearned when it has persuasive evidence of an arrangement, the product has beenshipped or the services have been provided to the customer, the sales price isfixed or determinable, and collectability is probable.

 

Licensefee revenue is derived from the licensing of computer software. Hardwarerevenue is derived from the sale of system hardware, including peripheralequipment. Maintenance and service revenue is derived from software maintenanceand from telephone support, installation, customer education and consulting services.The Company’s software licenses are generally sold as part of anarrangement that includes maintenance and support and often installation andcustomer education services.

 

TheCompany licenses 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 allother revenue recognition criteria in the arrangement have been met. If 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 basisif the Reseller i) assumes all risk of the purchase, ii) has the ability andobligation to pay regardless of receiving payment from the end user, and iii)all other revenue recognition criteria are met. The majority of revenuegenerated through Resellers has been on a sell-in basis. The following areother revenue recognition criteria applied by the Company:

 

·                  Software andHardware — Revenue from license fees and hardware is recognized when shipmentof the product has occurred, no significant Company obligations with regard toimplementation remain and the Company’s services are not considered essentialto 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 fromcustomer education, installation and consulting services is recognized as theservices are provided to customers or upon contractual expiration of suchservices.

·                  Multiple-ElementArrangements — The Company enters into arrangements with customers that includea combination of software products, system hardware, maintenance and support(which includes unspecified upgrades), or installation and customer educationservices. For such arrangements, the Company recognizes revenue using theresidual method. The Company allocates the total arrangement fee among thevarious elements of the arrangement based on the fair value of each of theundelivered elements determined by vendor-specific objective evidence. The fairvalue of installation and customer education services and maintenance andsupport services is established based upon sold separately pricing for theservices or stated renewal rate. In software arrangements for which the Companydoes not have vendor-specific objective evidence of fair value for allelements, revenue is deferred until the earlier of when vendor-specificobjective evidence is determined for the undelivered elements (residual method)or when all elements for which the Company does not have vendor-specificobjective evidence of fair value have been delivered.

 

 

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**Equity-based compensation**

 

On January 1, 2006, the Company adoptedStatement of Financial Accounting Standards (“SFAS”) No. 123 (revised2004), “Share-Based Payment” (“SFAS No. 123(R)”), which requires themeasurement and recognition of compensation expense for all equity-basedpayment awards made to employees and directors, including employee stockoptions, restricted stock and employee stock purchases related to the EmployeeStock Purchase Plan, based on estimated fair values. SFAS No. 123(R) supersedesthe Company’s previous accounting under Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB 25”), for periods beginning in2006. In March 2005, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123(R).The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

 

The Companyadopted SFAS No. 123(R) using the modified prospective transitionmethod, which requires the application of the accounting standard as of January 1,2006. The Company’s Consolidated Financial Statements as of and for the yearsended December 31, 2007 and 2006 reflect the impact of SFAS No. 123(R).In accordance with the modified prospective transition method, the Company’sConsolidated Financial Statements for prior periods have not been restated toreflect, and do not include, the impact of SFAS No. 123(R). Equity-basedcompensation expense recognized under SFAS No. 123(R) for the yearsended December 31, 2007 and 2006 was $6.0 million and $5.1 million,respectively. Equity-based compensation expense of $335,000 related torestricted stock awards was recorded as expense for the year ended December 31,2005. There were no equity-based compensation expenses related to employeestock options and employee stock purchases prior to fiscal 2006. Applying SFAS No. 123,“Accounting for Stock-Based Compensation” (“SFAS No. 123”), on a pro formabasis, equity-based compensation expense was $3.5 million for the year ended December 31,2005.

 

SFAS No. 123(R) requirescompanies to estimate the fair value of equity-based payment awards on the dateof grant using an option-pricing model. The Company uses the Black-Scholesoption-pricing model, which requires the input of assumptions, including anestimate of the average period of time employees will retain vested stockoptions before exercising them, the estimated volatility of the Company’scommon stock price over the expected term, and the number of options that willultimately be forfeited before completing vesting requirements. Changes in theassumptions can materially affect the estimate of fair value of equity-basedcompensation and, consequently, the related expense recognized. The value ofthe portion of the award that is ultimately expected to vest is recognized asexpense over the requisite vesting period. Prior to the adoption of SFAS No. 123(R),the Company accounted for equity-based awards to employees and directors usingthe intrinsic value method in accordance with APB 25 as allowed underSFAS No. 123.

 

Under theintrinsic value method, no equity-based compensation expense had beenrecognized related to employee stock options because the exercise price of theCompany’s stock options granted to employees and directors equaled the fairmarket value of the underlying stock at the date of grant.

 

Equity-based compensationexpense recognized for the years ended December 31, 2007 and 2006 includedcompensation expense for equity-based payment awards granted on or prior to December 31,2005 but not yet vested as of that date. The compensation expense for these awardsis based on the grant date fair value estimated in accordance with the proforma provisions of SFAS No. 123, which was in effect on and prior to December 31,2005. Compensation expense for the equity-based payment awards granted ormodified subsequent to December 31, 2005 is based on the grant date fairvalue estimated in accordance with the provisions of SFAS No. 123(R).Because equity-based compensation expense recognized for the years ended December 31,2007 and 2006 is based on awards ultimately expected to vest, it has beenreduced for estimated forfeitures. SFAS No. 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. In theCompany’s pro forma information required under SFAS No. 123 for theperiods prior to January 1, 2006, the Company accounted for forfeitures asthey occurred.

 

The followingtable illustrates how equity-based compensation was allocated to the incomestatement as well as the effect on net income and net income per share of allequity-based compensation recognized under SFAS No. 123(R) (inthousands, except per share data):

 

 

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| ** **                                          | ** **               | **Year Ended  December 31, 2007** | ** ** | **Year Ended  December 31, 2006** | ** ** |
|-----------------------------------------------------|--------------------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Cost of revenue                                     |                     | $                                                | 389        |                                   | $          | 372 |   |
| Sales and marketing                                 |                     | 2,392                                            |       | 1,995                                            |       |
| Research and development                            |                     | 729                                              |       | 840                                              |       |
| General and administrative                          |      | 2,477                                            |       | 1,856                                            |       |
| Equity-based compensation  before income taxes      |                     | 5,987                                            |       | 5,063                                            |       |
| Income tax benefit                                  |                     | (1,964                                           | )          | (1,488                                           | )          |
| Total equity-based  compensation after income taxes |                     | $                                                | 4,023      |                                             | $          | 3,575 |   |
|                                                |                     |                                             |       |                                             |       |
| Impact on basic earnings  per share                 |                     | $                                                | 0.24       |                                             | $          | 0.27 |   |
| Impact on diluted earnings  per share               |                     | $                                                | 0.23       |                                             | $          | 0.25 |   |

 

Forpurposes of calculating the fair value of options under SFAS No. 123(R),the weighted average fair value of options granted during 2007 and 2006 were$13.47 and $13.58, respectively.  Forpurposes of calculating the fair value of options under SFAS No. 123, theweighted average fair values of options granted during 2005 was $10.31. Theweighted average fair values for the options were based on the fair values onthe dates of grant. The fair values for the options were calculated using theBlack-Scholes option-pricing model with the following weighted-averageassumptions and expense adjusted using the following expected forfeiture rateassumptions:

 

| ** **                 | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected option life       |       | 3.75  years                                        |       | 3.78  years |   | 5.00  years |   |
| Expected volatility factor |       | 52                                                 | %          | 52 | % | 67 | % |
| Expected dividend yield    |       | 0                                                  | %          | 0 | % | 0 | % |
| Risk-free interest rate    |       | 4.46                                               | %          | 4.65 | % | 3.84 | % |
| Expected forfeiture rate   |       | 1.06                                               | %          | 1.12 | % | 0.00 | % |

 

Priorto March 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 it hadpreviously used. As a result, the Company has elected to use the “simplified”method as described in SAB 107 to estimate the expected life of optionsgranted on and after March 9, 2006. The Company will utilize thesimplified method until sufficient historical information becomes available onthe five-year legal life options. The expected volatility is calculated basedon the historical volatility of the Company’s common stock over the expectedoption life and other appropriate factors. The decrease in volatility from 2005to 2006 was primarily due to a shorter expected option life, over which theCompany’s common stock price was less volatile. The expected dividend yield isbased on the Company’s intent not to issue dividends for the foreseeablefuture. Risk-free interest rates are calculated based on continuouslycompounded U.S. Treasury risk-free rates for the appropriate term. The expectedforfeiture rate is estimated based on historical experience. In the Company’spro forma information required under SFAS No. 123 for the periods prior toJanuary 1, 2006, the Company accounted for forfeitures as they occurred.

 

Asof December 31, 2007, there was $8.5 million of unrecognized compensationexpense related to stock options that is expected to be recognized over aweighted-average period of 2.5 years.

 

TheCompany has granted nonvested shares of common stock (“restricted stock”) tocertain employees under its 1997 Stock Option and Incentive Plan and 2006Long-Term Incentive Plan. Restricted stock granted before 2007 generally vests25% annually beginning one year after the grant date. The Company recordsequity-based compensation expense equal to the fair market value of the commonstock on the date of grant ratably over the vesting period. Equity-basedcompensation expense related to restricted stock was $741,000 and $728,000 forthe years ended December 31, 2007 and 2006, respectively.

 

Inthe first quarter of 2007, the Company granted shares of restricted stock withperformance-based vesting to certain employees. The Company granted a total of13,500 restricted shares with a total grant-date fair value of $464,000. Theawards vest upon achievement of certain Company performance metrics for fiscalyears 2007 through 2009. One-third of each award will vest on each of theCompany’s Form 10-K filing dates for the years ending December 31,2007, 2008 and 2009 if the performance metrics are met for the respectivefiscal year.  If the

 

 

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performancemetrics are not met for a given year, the unvested portion will carry forwardto the next fiscal year and may vest if that year’s metric is met. As of theCompany’s Form 10-K filing date for the year ending December 31,2009, any unvested portion of the award will be forfeited. The performancemetrics were not achieved for the year ended December 31, 2007. Therefore,no equity-based compensation expense for the awards was recognized for the yearended December 31, 2007. The amount of the expense related to the awardsnot recognized as of December 31, 2007 but which may be recognized infuture periods if performance metrics are met was $103,000. The first quarterof 2007 was the first period in which the Company granted restricted stockawards with performance-based vesting.

 

Asof December 31, 2007, there was $1.2 million of unrecognized compensationexpense related to restricted stock awards that is expected to be recognizedover a weighted-average period of 1.6 years. The aggregate fair value of restricted stock vested was $1.0 million and$819,000 for the years ended December 31, 2007 and 2006, respectively. Norestricted stock vested during 2005.

 

EmployeeStock Purchase Plan (“ESPP”) compensation expense was $161,000 and $106,000 forthe years ended December 31, 2007 and 2006, respectively.  Pro-forma stock compensation expense relatedto the ESPP was $70,000 for the year ended December 31, 2005.

 

Thefair value of stock compensation expense associated with the Company’s ESPP wasestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted-average assumptions:

 

| ** **                     | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| ** **                     | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life of ESPP  options |       | 3  months                                |       | 3  months |   | 3  months |   |
| Expected volatility factor     |       | 51                                       | %          | 50 | % | 38 | % |
| Expected dividend yield        |       | 0                                        | %          | 0 | % | 0 | % |
| Risk-free interest rate        |       | 4.59                                     | %          | 4.64 | % | 2.89 | % |

 

The following table illustrates the effect on net income and net incomeper share as if the Company had applied the fair value recognition provisionsof SFAS No. 123 to equity-based compensation during periods prior to January 1,2006 (in thousands, except per share data):

 

| ** **                                                                                                                               | ** ** | **Year Ended  December 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Net income, as reported                                                                                                                  |       | $                                                | 5,801      |   |
| 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                                           | )          |
| Pro forma net income                                                                                                                     |       | $                                                | 3,922      |   |
|                                                                                                                                     |       |                                             |       |
| Net income per share -  basic:                                                                                                           |       |                                             |       |
| As reported                                                                                                                              |       | $                                                | 0.47       |   |
| Pro forma                                                                                                                                |       | $                                                | 0.32       |   |
|                                                                                                                                     |       |                                             |       |
| Net income per share -  diluted:                                                                                                         |       |                                             |       |
| As reported                                                                                                                              |       | $                                                | 0.44       |   |
| Pro forma                                                                                                                                |       | $                                                | 0.30       |   |

 

Prior to theadoption of SFAS No. 123(R), the Company presented all tax benefitsresulting from the exercise of stock options and settlement of restricted stockawards as operating cash inflows in the consolidated statements of cash flowsin accordance with the provisions of the Emerging Issues Task Force (“EITF”)Issue No 00-15, “Classification in the Statement of Cash Flows of the IncomeTax Benefit Received by a Company upon Exercise of a Nonqualified EmployeeStock Option.” SFAS No. 123(R) requires the benefits of taxdeductions in excess of the compensation cost recognized for those options andstock awards to be classified as financing cash inflows rather than operatingcash inflows on a prospective basis. This amount is shown as “Excess taxbenefit from stock transactions” on the Consolidated Statement of Cash Flows.

 

 

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TheCompany’s adoption of SFAS No. 123(R) using the modified prospectiveapplication required the Company to determine the amount of eligible windfalltax benefits (the pool of windfall tax benefits) that are available on theadoption date to offset future shortfalls. The Company has elected to calculateits historical pool of windfall tax benefits (that is, the amount that wouldhave accumulated as of the adoption date of SFAS No. 123(R)) using thealternative (“short-cut”) method, as provided in FSP No. FAS 123(R)-3, andthe “tax law ordering approach” to determine when the historic tax benefits arerealized (tax benefits realized based on provisions in the tax law thatidentify the sequence in which stock option deductions are utilized for taxpurposes). The Company will continue to track the balance of the pool ofwindfall tax benefits based on windfalls or shortfalls incurred after theadoption date.

 

**Research and development costs**

 

Costs related to research, design and development of products arecharged to research and development expense as incurred. Software developmentcosts are capitalized beginning when a product’s technological feasibility hasbeen established and ending when a product is available for general release tocustomers. The Company uses the working model approach to determinetechnological feasibility. Generally, the Company’s products are released soonafter technological feasibility has been established. As a result, the Companyhas not capitalized any software development costs because such costs have notbeen significant.

 

**Income taxes**

 

The Company provides for income taxes using the liability method underSFAS No. 109, “Accounting for Income Taxes,” which requires recognition ofdeferred tax assets and liabilities for the expected future tax consequences ofevents that have been included in the financial statements. Under thisstatement, deferred tax assets and liabilities are determined based on thedifference between the financial statement and tax basis of assets andliabilities using enacted tax rates in effect for the year in which thedifferences are expected to reverse. Deferred tax assets are reduced by avaluation allowance when it is more likely than not that some component or allof the deferred tax assets will not be realized. Tax rate changes are reflectedin income during the period such changes are enacted.

 

**Computation of net income per share**

 

Basic earnings per share is computed using net income and the weightedaverage number of common shares outstanding. Diluted earnings per share reflectthe weighted average number of common shares outstanding plus any potentiallydilutive shares outstanding during the period. Potentially dilutive sharesconsist of shares issuable upon the exercise of stock options and warrants, aswell as unvested restricted stock.

 

 

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The computations for basicand diluted net income per share are as follows (in thousands, except per shareamounts):

 
| ** **                                                                                                              | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                                                                              |       |                                     |       |   |   |   |   |
| Net income                                                                                                              |       | $                                        | 1,367      |   | $ | 6,583 |   | $ | 5,801 |   |
|                                                                                                                    |       |                                     |       |   |   |   |   |
| Denominator:                                                                                                            |       |                                     |       |   |   |   |   |
| Denominator for weighted average common shares outstanding — basic                                                 |       | 16,972                                   |       | 13,463 |   | 12,379 |   |
|                                                                                                                    |       |                                     |       |   |   |   |   |
| Dilution associated with the company’s stock based compensation plans                                              |       | 485                                      |       | 779 |   | 904 |   |
|                                                                                                                    |       |                                     |       |   |   |   |   |
| 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                                               |       | 17,457                                   |       | 14,259 |   | 13,283 |   |
|                                                                                                                    |       |                                     |       |   |   |   |   |
| Net income per share — basic                                                                                       |       | $                                        | 0.08       |   | $ | 0.49 |   | $ | 0.47 |   |
| Net income per share —  diluted                                                                                    |       | $                                        | 0.08       |   | $ | 0.46 |   | $ | 0.44 |   |
|                                                                                                                    |       |                                     |       |   |   |   |   |
| Antidilutive stock options and restricted stock awards excluded from  above calculation                                 |       | 809                                      |       | 379 |   | 230 |   |

 

**Comprehensive income**

 

Comprehensive income as defined by SFAS No. 130, “ReportingComprehensive Income” (“SFAS No. 130”), includes net income and itemsdefined as other comprehensive income. SFAS No. 130 requires that itemsdefined as other comprehensive income, such as foreign currency translationadjustments and unrealized gains and losses on certain marketable securities,be separately classified in the financial statements. Such items are reportedin the consolidated statements of stockholders’ equity as comprehensive income.

 

**New accounting pronouncements**

 

In September 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 accounting principlesgenerally accepted in the United States, and expands disclosures about fairvalue measurements. SFAS No. 157 is effective for financial assets andliabilities for fiscal years beginning after November 15, 2007. In February 2008,the FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157.”FSP 157-2 delays the effective date of SFAS No. 157 for all non-financialassets and non-financial liabilities that are not re-measured at fair value ona recurring basis until fiscal years beginning after November 15, 2008.Any amounts recognized upon adoption of this rule as a cumulative effectadjustment will be recorded to the opening balance of retained earnings in theyear of adoption.  SFAS No. 157 waseffective for the Company on January 1, 2008. The Company is currentlyevaluating the impacts and disclosures of this standard, but it does not expectSFAS No. 157 to have a material impact on its consolidated incomestatements or financial condition.

 

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair ValueOption for Financial Assets and Financial Liabilities” (“SFAS No. 159”),which permits entities to choose to measure many financial instruments andcertain other items at fair value that are not currently required to bemeasured at fair value. SFAS No. 159 was effective for the Company onJanuary 1, 2008.  The Company iscurrently evaluating the impacts and disclosures of this standard, but it doesnot expect SFAS No. 159 to have a material impact on its consolidatedincome statements or financial condition.

 

 

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InDecember 2007, the FASB issued SFAS No. 141R, “Business Combinations”(“SFAS No. 141R”), which changes the accounting for businessacquisitions. SFAS No. 141R requires the acquiring entity in abusiness combination to recognize all (and only) the assets acquired andliabilities assumed in the transaction and establishes the acquisition-datefair value as the measurement objective for all assets acquired and liabilitiesassumed in a business combination. Certain provisions of this standard will,among other things, impact the determination of acquisition-date fair value ofconsideration paid in a business combination (including contingentconsideration); exclude transaction costs from acquisition accounting; andchange accounting practices for acquired contingencies, acquisition-relatedrestructuring costs, in-process research and development, indemnificationassets, and tax benefits. For the Company, SFAS No. 141R is effectivefor business combinations and adjustments to an acquired entity’s deferred tax assetand liability balances occurring after December 31, 2008. The Companyis currently evaluating the impact the adoption of SFAS No. 141R will haveon its financial position and results of operations.

 

InDecember 2007, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 110 (SAB 110), which extends certain provisions ofSAB No. 107. SAB 110 allows public companies which do not havehistorically sufficient experience to provide a reasonable estimate to continueuse of the “simplified” method for estimating the expected term of “plainvanilla” share option grants after  December 31,2007. SAB 110 is effective January 1, 2008. The Company plans to continueutilizing the simplified method for its “plain vanilla” share options until theCompany has sufficient historical experience to estimate the expected term forshare options issued.

 

**3.****             ****Financialstatement components**

 

**Allowancefor doubtful accounts**

 

Theallowance for doubtful accounts activity was as follows (in thousands):

 

| ** **        | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------|------------|------------------------------------------|------------|
| ** **        | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|              |       |                                     |       |   |   |   |   |
| Beginning balance |       | $                                        | 266        |   | $ | 320 |   | $ | 767 |   |
| Provision         |       | 239                                      |       | 25 |   | (159 | ) |
| Write-offs        |       | —                                   |       | (87 | ) | (288 | ) |
| Recoveries        |       | —                                   |       | 8 |   | — |   |
| Ending balance    |       | $                                        | 505        |   | $ | 266 |   | $ | 320 |   |

 

**Propertyand equipment, net**

 

Thecomponents of property and equipment were as follows (in thousands):

 

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                            |       |                  |       |   |   |
| Equipment                                       |       | $                     | 13,776     |   | $ | 11,207 |   |
| Furniture and fixtures                          |       | 3,813                 |       | 3,042 |   |
| Computer software                               |       | 4,543                 |       | 2,291 |   |
| Leasehold improvements                          |       | 2,780                 |       | 2,300 |   |
| Total property and equipment                    |       | 24,912                |       | 18,840 |   |
| Less accumulated  depreciation and amortization |       | (13,747               | )          | (9,598 | ) |
| Property and equipment, net                     |       | $                     | 11,165     |   | $ | 9,242 |   |

 

Depreciationand amortization expense was $4.5 million, $2.9 million and $2.1 million forthe years ended December 31, 2007, 2006 and 2005, respectively.

 

**Licensed technology, net**

 

In July 2001, the Company entered into an agreement to licensetechnology from a third party. The Company paid an aggregate of $750,000 to thelicensor in 2001. The Company recorded this $750,000 purchase as licensedtechnology and is amortizing it over the estimated useful life of thetechnology of 75 months. This amortization expense is reported as cost ofrevenue for license fees. As part of this agreement, the Company is alsoobligated to 

 

53

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pay the licensor royalties on the sales of certain products as definedin the agreement. During 2007, 2006 and 2005, $1.5 million, $1.8 million and$1.4 million, respectively, of such royalties were incurred and were reportedas cost of revenue for license fees.

 

Thecomponents of licensed technology were as follows (in thousands):

 

| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                           |       |                  |       |   |   |
| Licensed technology            |       | $                     | 750        |   | $ | 750 |   |
| Less accumulated  amortization |       | (750                  | )          | (660 | ) |
|                           |       |                  |       |   |   |
| Licensed technology, net       |       | $                     | —     |   | $ | 90 |   |

 

Amortizationexpense was $90,000 for the year ended December 31, 2007 and $120,000 foreach of the years ended December 31, 2006 and 2005.

 

**Otherintangible assets, net**

 

Acquiredintangible assets subject to amortization were as follows (in thousands):

 
| ** **                                      | ** ** | **December 31, 2007** | ** ** | **December 31, 2006**   | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | **Gross Carrying Value**   | ** ** | **Accumulated Amortization** | ** ** | **Net Carrying Value** | ** ** | **Gross Carrying Value** | ** ** | **Accumulated Amortization** | ** ** | **Net Carrying Value** | ** ** |
| ** **                                      | ** ** | ** **                 | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Existing software technology                    |       | $                          | 3,400      |                         | $          | (2,650 | ) | $ | 750 |   | $ | 3,400 |   | $ | (1,966 | ) | $ | 1,434 |   |
| Patents and patent applications                 |       | 2,500                      |       | (1,398                       | )          | 1,102 |   | 3,000 |   | (1,242 | ) | 1,758 |   |
| Non-compete/employment agreements               |       | 500                        |       | (500                         | )          | — |   | 500 |   | (483 | ) | 17 |   |
| Total intangible assets subject to amortization |       | $                          | 6,400      |                         | $          | (4,548 | ) | $ | 1,852 |   | $ | 6,900 |   | $ | (3,691 | ) | $ | 3,209 |   |

 

Duringthe third quarter 2007, the Company recognized a $242,000 patent impairmentcharge related to a patent application acquired in the HInnovation, Inc.acquisition in February 2004. This patent application was rejected by theUnited States Patent and Trademark Office (“Patent Office”) on August 23,2007, and the Company decided not to pursue this application further.

 

Intangibleassets subject to amortization are amortized on a straight-line basis over theestimated period of benefit. Amortization expense was $1.2 million, $1.3million and $1.3 million for the years ended December 31, 2007, 2006 and2005, respectively.  The estimated futureannual amortization expense for identified intangible assets is as follows (inthousands):

 

| 2008   |   | $   | 1,044  |   |
|--------|--------|-----|--------|--------|
| 2009   |   | 426 |   |
| 2010   |   | 360 |   |
| 2011   |   | 22  |   |
|   |   | $   | 1,852  |   |

 

Thepreceding expected amortization expense is an estimate. Actual amortizationexpense may differ from estimates due to additional intangible assetacquisitions, impairment of intangible assets, accelerated amortization ofintangible assets, and other events.  Apatent acquired in the HInnovation, Inc. acquisition having a $882,000 netbook value as of December 31, 2007 is currently under review by the PatentOffice.

 

54

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**Goodwill**

 

There were no changes to thecarrying value of goodwill for the year ended December 31, 2007. Thechanges in the carrying amount of goodwill for the year ended December 31,2006 are as follows (in thousands):

 

| Balance as of  December 31, 2005                                   |   | $     | 6,053  |   |
|-------------------------------------------------------------------------|--------|-------|--------|--------|
| Contingent consideration earned                                         |   | 3,084 |   |
| Reversal of tax valuation allowance relating to  Hinnovation, Inc. |   | (48   | )      |
| Balance as of  December 31, 2006 and 2007                          |   | $     | 9,089  |   |

 

Theincrease in goodwill during the year ended December 31, 2006 resulted fromcontingent consideration paid through the issuance of 106,000 shares of commonstock valued at $3.1 million in connection with the acquisition of HInnovation, Inc.on February 18, 2004.

 

**Deferredrevenue**

 

Thecomponents of deferred revenue were as follows (in thousands):

 

| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                  |       |                  |       |   |   |
| Maintenance and support               |       | $                     | 12,376     |   | $ | 10,750 |   |
| Customer education                    |       | 3,311                 |       | 4,272 |   |
| Installation                          |       | 762                   |       | 476 |   |
| Software                              |       | 755                   |       | 409 |   |
| Hardware and other                    |       | 483                   |       | 398 |   |
| Total deferred revenue                |       | 17,687                |       | 16,305 |   |
| Less current portion                  |       | (16,547               | )          | (15,131 | ) |
| Long-term portion of deferred revenue |       | $                     | 1,140      |   | $ | 1,174 |   |

 

**4.****             ****Commitmentsand contingencies**

 

**Operatinglease commitments**

 

TheCompany rents office space and certain office equipment under operating leases.In addition to minimum lease payments, the office leases require payment of aproportionate share of real estate taxes and building operating expenses. Totalrent expense, including an allocation of the lessor’s operating costs, was $1.7million, $1.2 million and $635,000 for the years ended December 31, 2007,2006 and 2005, respectively.

 

InMarch 2004, the Company signed a non-cancelable operating lease for a newoffice facility in Minnetonka, Minnesota. The new lease term started in February 2005and expires in January 2012. The Company moved into the Minnetonkalocation and moved out of its Plymouth, Minnesota location in February 2005.The Company’s office lease in Plymouth expired on July 31, 2005 with theexception of a small portion of the space that was under lease until May 31,2006. Under the terms of the new lease, the Minnetonka lessor paid the monthlybase rent payments and taxes and operating cost rent obligation payments forthe Company’s former office facility in Plymouth beginning February 2005.

 

TheCompany recorded deferred rent of $1.6 million in the first quarter of 2005relating to estimated payments by the Minnetonka lessor for the benefit of theCompany. Such payments are considered lease incentives under FASB TechnicalBulletin (“FTB”) 88-1, “Issues Relating to Accounting for Leases,” and areamortized as a reduction of rent expense over the term of the Minnetonka lease.Payments by the Minnetonka lessor for the benefit of the Company consisted ofthe following:

 

·                  $405,000relating to lease payments made by the Minnetonka lessor to the Plymouthlessor; under FTB 88-1, such payments were recorded as a lease loss by theCompany in the first quarter of 2005. Additionally, the Company recorded$88,000 of other costs relating to the Plymouth lease, resulting in a totalloss on operating lease of $493,000.

 

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

 

55

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·                  $975,000relating to leasehold improvements paid for by the Minnetonka lessor; under FTB88-1, 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.

 

Duringthe years ended December 31, 2007 and 2006, the Company expanded itsMinnetonka headquarters and received leasehold improvements paid for by theMinnetonka lessor of $199,000 and $561,000, respectively. 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 related leaseswith a corresponding amount recorded as deferred rent and amortized as areduction of rent expense over the term of the Minnetonka lease.

 

Thedeferred rent balance was $1.7 million ($375,000 was classified as current) and$1.8 million ($313,000 was classified as current) as of December 31, 2007and 2006, respectively.

 

Theminimum lease payments, excluding estimated taxes and operating cost rentobligations, are approximately (in thousands):

 

| 2008  |   | $   | 1,154  |   |
|-------|--------|-----|--------|--------|
| 2009  |   | 975 |   |
| 2010  |   | 888 |   |
| 2011  |   | 907 |   |
| 2012  |   | 76  |   |
| Total |   | $   | 4,000  |   |

 

**Agreementwith R2 Technology, Inc.**

 

InApril 2005, the Company entered into an agreement with R2 Technology, Inc.(“R2”) to market R2’s lung nodule CAD software product to the Company’scustomers. Under the agreement, the Company committed to provide R2 withcertain minimum quarterly sales (“Applicable Minimums”) from certain R2 lungCAD related products and services (“R2 Lung CAD Products”) over a 12-quarterperiod ending June 30, 2008. The Company will receive a commission basedon sales of R2 Lung CAD Products to the Company’s customers. To the extent thequarterly Applicable Minimum was not met, the Company would pay R2 thedifference between the Applicable Minimum and the actual R2 Lung CAD Productsales achieved. As of July 13, 2006, R2 was acquired by Hologic, Inc.

 

TheApplicable Minimum for each quarter through the second quarter of 2006 was$414,000. For each subsequent quarter, the Applicable Minimum was adjustedbased on actual results but could never exceed $414,000. From the third quarterof 2006 through the second quarter of 2007, the Applicable Minimum everyquarter was $0.  On June 30 each year during the term of theagreement, the aggregate sales of R2 Lung CAD Products in excess of theprevious year aggregate Applicable Minimums were applied to the remainingpotential future aggregate Applicable Minimums.  As of June 30, 2007,aggregate sales of R2 Lung CAD Products in excess of the previous aggregateApplicable Minimums exceeded the remaining potential future aggregate ApplicableMinimums. As a result, as of June 30, 2007, the remaining potentialaggregate Applicable Minimums was $0 through the term of the agreement whichends June 30, 2008.

 

Inthe first quarter of 2007, the Company reversed $54,000 of the $167,000 expenserecorded to sales and marketing in the second quarter of 2006 relating to ashortfall from the Applicable Minimum. In the first quarter of 2006, theCompany reversed $236,000 of the $410,000 expense recorded in the fourthquarter of 2005 relating to a shortfall from the Applicable Minimum.

 

**Otheritems**

 

Undergeneral contract terms, the Company sometimes includes an indemnificationclause in its software licensing agreement providing that the Company willindemnify the licensee against liability and damages arising from any claims ofpatent, copyright, trademark or trade secret infringement by the Company’ssoftware. The Company has incurred insignificant costs as a result of this typeof indemnification clause, and the Company does not maintain a product warrantyliability related to such indemnification clauses.

 

TheCompany has entered into various employment agreements with certain executivesof the Company, which include provisions for severance payments subject tocertain conditions and events.

 

56

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TheCompany recorded a $885,000 charge in the fourth quarter of 2007 related to theresignation of Jay D. Miller, the company’s former president and chiefexecutive officer, of which $580,000 related to future cash payments and$305,000 related to equity-based compensation.

 

TheCompany is involved in various claims and legal actions in the normal course ofbusiness. Management is of the opinion that the outcome of such legal actionswill not have a significant adverse effect on the Company’s financial position,results of operations or cash flows. Notwithstanding management’s belief, anunfavorable resolution of some or all of these matters could materially affectthe Company’s future results of operations or cash flows.

 

**5.****             ****Stockholders’equity**

 

**Background**

 

On October 28, 1996,the Board of Directors of Bio-Vascular, Inc. (“Bio-Vascular”), now knownas Synovis Life Technologies, Inc., the former parent of the Company,approved a plan to spin off and establish the Company as an independent,publicly-owned company. On May 12, 1997 (the “Distribution Date”),Bio-Vascular distributed all of the shares of the Company to the shareholdersof Bio-Vascular (the “Distribution”), and on that date the Company beganoperating as an independent public company. All Bio-Vascular shareholders ofrecord as of May 5, 1997 received one share of the Company’s common stockfor each two shares of Bio-Vascular stock held on that date and cash in lieu offractional shares.

 

**Public offering of common stock**

 

Duringthe fourth quarter of 2006, the Company completed a public offering of 3.4million shares of common stock at $31.00 per share for total gross proceeds of$104.0 million.  After deducting offeringcosts of $6.3 million, the Company received net proceeds of $97.7 million.

 

**Stock option plans**

 

In May 1997,Bio-Vascular, Inc., which is now known as Synovis Life Technologies, Inc.,as the sole shareholder of the Company, approved and adopted the Vital Images, Inc.1997 Stock Option and Incentive Plan (the “Stock Option Plan”), which becameeffective on the Distribution Date. Under the terms of the Stock Option Plan,the Board of Directors or a committee of the Board may grant options andother equity-based awards to key employees to purchase shares of the Company’scommon stock at an option exercise price equal to or greater than 85% of thefair market value on the date of grant. The options are exercisable at suchtimes, in installments or otherwise, as the Board of Directors or a committeeof the Board may determine. Generally, these options have a term of fiveor eight years and are exercisable as to 28% of the total grant one year afterthe date of grant and 2% per month thereafter. The total number of shares ofcommon stock that may be issued or awarded under the Stock Option Plan was4,100,000 shares. The Stock Option Plan expired on March 19, 2007 and nomore rights to obtain shares will be granted from it.

 

Also in May 1997,Bio-Vascular, as the sole shareholder of the Company, approved and adopted theVital Images, Inc. 1997 Director Stock Option Plan (the “Director Plan”),which became effective on the Distribution Date. The Director Plan providesnon-employee directors with automatic grants of stock options and allows theBoard of Directors to make additional discretionary option grants to any or alldirectors. Options that are granted under the Director Plan are granted with anoption price equal to the fair market value on the date of grant, have a termof five or eight years, are non-qualified options and become exercisable inthree equal annual installments beginning on the first occurring December 31after the date of grant. The total number of shares of common stock thatmay be issued or awarded under the Director Plan was 500,000 shares. TheDirector Plan expired on March 19, 2007, and no more rights to obtainshares will be granted from it.

 

OnMay 4, 2006, the shareholders of the Company approved the Vital Images, Inc.2006 Long-Term Incentive Plan (the “2006 Plan”). The 2006 Plan provides thatthe total number of shares of the Company’s common stock that may besubject to options, restricted stock awards and other equity awards grantedunder the 2006 Plan shall not exceed 900,000 shares. The 2006 Plan provides theBoard of Directors or a committee of the Board the authority to grant incentivestock options qualified as such under Section 422 of the Internal RevenueCode of 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 of December 31,2007, 822,765 shares remained available for the grant of awards under the 2006Plan.

 

57

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The following table summarizes stock option activity for 2007, 2006 and2005:

 
| ** **                                      | ** ** | **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, 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      |                                                       |       |                                         |       |   |
|                                            |       |                          |       |                                          |       |                                                       |       |                                         |       |
| Options granted                                 |       | 469,595                       |       | $                                             | 30.99      |                                                       |       |                                         |       |   |
| Options exercised                               |       | (220,604                      | )          | $                                             | 10.68      |                                                       |       |                                         |       |   |
| Options cancelled                               |       | (64,766                       | )          | $                                             | 26.66      |                                                       |       |                                         |       |   |
|                                            |       |                          |       |                                          |       |                                                       |       |                                         |       |
| Total outstanding as of  December 31, 2007 |       | 1,981,404                     |       | $                                             | 20.03      |                                                       | 3.75       |                                         | $          | 6,796 |   |
| Options exercisable as of:                      |       |                          |       |                                          |       |                                                       |       |                                         |       |
| December 31, 2005                          |       | 1,185,463                     |       | $                                             | 9.03       |                                                       |       |                                         |       |   |
| December 31, 2006                          |       | 1,064,923                     |       | $                                             | 11.39      |                                                       |       |                                         |       |   |
| December 31, 2007                          |       | 1,206,104                     |       | $                                             | 14.71      |                                                       | 3.44       |                                         | $          | 6,542 |   |

 

Various price ranges and weighted average information for optionsoutstanding and exercisable as of December 31, 2007 are as follows:

 
| ** **          | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **          | ** ** | ** **              | ** ** | **Weighted Average**    | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **          | ** ** | ** **              | ** ** | **Remaining**           | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**        | ** ** | **Number**              | ** ** | **Contractual Life**    | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **Outstanding**         | ** ** | **(in years)**          | ** ** | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
| $                   | 4.38       | -                       | $          | 7.63                    |       | 377,045 |   | 1.72 |   | $ | 6.82 |   | 377,045 |   | $ | 6.82 |   |
| $                   | 8.00       | -                       | $          | 15.40                   |       | 373,495 |   | 4.03 |   | $ | 12.06 |   | 330,493 |   | $ | 11.80 |   |
| $                   | 15.50      | -                       | $          | 19.64                   |       | 445,586 |   | 5.04 |   | $ | 18.01 |   | 318,898 |   | $ | 17.97 |   |
| $                   | 19.80      | -                       | $          | 31.38                   |       | 348,932 |   | 4.00 |   | $ | 29.65 |   | 49,827 |   | $ | 26.52 |   |
| $                   | 31.50      | -                       | $          | 32.64                   |       | 357,651 |   | 3.61 |   | $ | 32.29 |   | 103,261 |   | $ | 32.11 |   |
| $                   | 32.65      | -                       | $          | 35.70                   |       | 78,695 |   | 4.36 |   | $ | 34.15 |   | 26,580 |   | $ | 34.05 |   |
|                |       |                    |       |                    |       | 1,981,404 |   | 3.75 |   | $ | 20.03 |   | 1,206,104 |   | $ | 14.71 |   |

 

Theaggregate intrinsic value of options (that is, the amount by which the marketprice of the stock on the date of exercise exceeded the exercise price of theoption) exercised during the years ended December 31, 2007, 2006 and 2005was $4.4 million, $12.8 million and $9.0 million, respectively. Cash receivedfrom the exercise of stock options for the years ended December 31, 2007,2006 and 2005 was $2.4 million, $5.2 million and $4.5 million, respectively.The total tax benefit realized for the tax deductions from options exercisedfor the years ended December 31, 2007, 2006 and 2005 was $1.5 million,$4.4 million and $3.4 million, respectively.

 

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**Restrictedstock**

 

Thecompany grants nonvested shares of common stock (“restricted stock”) to certainemployees under the Stock Option Plan and the 2006 Plan.  The restricted stock generally vests 25%annually beginning one year after the grant date.  The following table summarizes the restrictedstock activity for the year ended December 31, 2007 and 2006:

 

| ** **                                      | ** ** | **Restricted  Shares** | ** ** | **Weighted-Average Grant Date Fair Value Per Share** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|--------------------------------------------------------------------------|------------|
| 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      |   |
| Shares granted                                  |       | 14,250                 |       | $                                                                        | 34.21      |   |
| Shares vested                                   |       | (35,677                | )          | $                                                                        | 20.88      |   |
| Shares forfeited/cancelled                      |       | (4,647                 | )          | $                                                                        | 24.53      |   |
| Total outstanding as of  December 31, 2007 |       | 89,603                 |       | $                                                                        | 23.81      |   |

 

Thetotal tax benefit realized for the tax deductions from restricted stock vestedduring the years ended December 31, 2007 and 2006 was $368,000 and$315,000, respectively.

 

**Employee stock purchase plan**

 

The 1997 Employee Stock Purchase Plan (the “ESPP”)was approved and adopted by Bio-Vascular, as the sole shareholder of theCompany, in May 1997. The ESPP, which became effective on July 1,1997, enables eligible employees to purchase the Company’s common stock at aprice equal to 85% of the fair market value of the stock on the date anoffering period commences or on the date an offering period terminates,whichever is lower. Under the ESPP, an aggregate of up to 250,000 shares ofcommon stock can be issued and sold to participating employees of the Companythrough a series of three-month offering periods, beginning July 1,1997. The ESPP covers substantially all employees, subject to certainlimitations. Each employee may elect to have up to 10% of his or her basepay withheld and applied toward the purchase of shares in each such offeringperiod. As of December 31, 2007, 25,730 shares of common stock remainedreserved for future purchases under the ESPP.

 

**6.****             ****Incometaxes**

 

Effective January 1,2007, the Company adopted Financial Accounting Standards Board (“FASB”)Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN48”). FIN 48 prescribes a recognition threshold and measurement attribute forrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. The adoption of FIN 48 did not have a material impact on theCompany’s Consolidated Financial Statements. Additionally, the adoption of FIN48 had no impact on retained earnings or the gross liability for uncertain taxpositions.  The Company had no uncertaintax positions as of December 31, 2007 and 2006.

 

TheCompany did not have any material unrecognized tax benefits as of the date ofthe adoption of FIN 48 or as of December 31, 2007. The Company recognizespotential accrued interest and penalties related to unrecognized tax benefitsas a component of income tax expense. To the extent interest and penalties arenot assessed with respect to uncertain tax positions, amounts accrued will bereduced and reflected as a reduction of the overall income tax provision. TheCompany recorded no interest and penalties during the year ended December 31,2007 and had no accrued interest and penalties as of December 31, 2007.The Company is no longer subject to U.S. federal tax examinations by taxauthorities for tax years before 2003. The Company is open to state tax auditsuntil the applicable statute of limitations expires.

 

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The components of incomebefore income taxes were as follows (in thousands):

 

| ** **                   | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income before income  taxes: |       |                                     |       |   |   |   |   |
| U.S.                         |       | $                                        | 1,313      |   | $ | 9,951 |   | $ | 8,571 |   |
| International                |       | 405                                      |       | 322 |   | 61 |   |
|                         |       | 1,718                                    |       | 10,273 |   | 8,632 |   |
|                              |            |                                          |            |  |  |  |  |  |  |  |

 

Theincome tax provision included the following components (in thousands):

 

| ** **                 | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Current income taxes:      |       |                                     |       |   |   |   |   |
| Federal                    |       | $                                        | 112        |   | $ | 91 |   | $ | 48 |   |
| State                      |       | 140                                      |       | 48 |   | 36 |   |
| Foreign                    |       | 115                                      |       | 79 |   | — |   |
|                       |       | 367                                      |       | 218 |   | 84 |   |
| Deferred income taxes:     |       |                                     |       |   |   |   |   |
| Federal                    |       | 93                                       |       | 3,181 |   | 2,613 |   |
| State                      |       | (109                                     | )          | 218 |   | 159 |   |
| Foreign                    |       | —                                   |       | 73 |   | (25 | ) |
|                       |       | (16                                      | )          | 3,472 |   | 2,747 |   |
| Provision for income taxes |       | $                                        | 351        |   | $ | 3,690 |   | $ | 2,831 |   |

 

Areconciliation of the Company’s income tax provision computed using the federalstatutory rate to the tax provision reported in the Company’s statements ofoperations is as follows (in thousands):

 

| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                            | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Tax provision computed at  the federal statutory rate |       | $                                        | 584        |   | $ | 3,493 |   | $ | 2,935 |   |
| State taxes, net of  federal benefit                  |       | 96                                       |       | 378 |   | 299 |   |
| Increase (decrease) in tax  from:                     |       |                                     |       |   |   |   |   |
| Stock-based compensation                              |       | 244                                      |       | 334 |   | — |   |
| Research and development tax credits                  |       | (682                                     | )          | (562 | ) | (362 | ) |
| Business meals and entertainment                      |       | 119                                      |       | 75 |   | 41 |   |
| Extraterritorial income exclusion                     |       | —                                   |       | (38 | ) | (27 | ) |
| Foreign tax rate differential                         |       | (23                                      | )          | (5 | ) | (5 | ) |
| Change in state tax rate                              |       | —                                   |       | — |   | (104 | ) |
| Change in valuation allowance                         |       | (4                                       | )          | (25 | ) | 47 |   |
| Other, net                                            |       | 17                                       |       | 40 |   | 7 |   |
| Provision for income taxes                            |       | $                                        | 351        |   | $ | 3,690 |   | $ | 2,831 |   |

 

60

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The significant componentsof the Company’s tax-effected net deferred tax assets were as follows (inthousands):

 

| ** **                                                     | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Current:                                                       |       |                  |       |   |   |
| Accrued expenses and allowances                                |       | $                     | 829        |   | $ | 465 |   |
| Stock-based compensation                                       |       | 2,643                 |       | 1,196 |   |
| Total current deferred tax asset                               |       | 3,472                 |       | 1,661 |   |
| Noncurrent:                                                    |       |                  |       |   |   |
| Net operating loss carryforwards                               |       | 4,221                 |       | 6,218 |   |
| Research and development tax credit carryforwards              |       | 3,579                 |       | 2,896 |   |
| Depreciation and amortization                                  |       | 952                   |       | 633 |   |
| Deferred revenue                                               |       | 416                   |       | 428 |   |
| Identifed intangible assets                                    |       | (677                  | )          | (1,172 | ) |
| Other                                                          |       | 269                   |       | 151 |   |
| Total noncurrent deferred tax asset before valuation allowance |       | 8,760                 |       | 9,154 |   |
| Less valuation allowance                                       |       | (139                  | )          | (185 | ) |
| Total net noncurrent deferred tax asset                        |       | 8,621                 |       | 8,969 |   |
| Total net deferred tax asset                                   |       | $                     | 12,093     |   | $ | 10,630 |   |

 

**Netoperating loss carryforwards and other tax credit carryforwards as of December 31,2007**

 

The Company had federal tax loss carryforwards ofapproximately $12.1 million, representing a $4.1 million deferred tax asset asof December 31, 2007. The federal tax loss carryforwards will expire in2019 through 2026 if not utilized. The Company estimates that it is more likelythan not that this deferred tax asset will be realized prior to expiration.

 

The Company had state tax loss carryforwards ofapproximately $1.9 million, representing a $108,000 deferred tax asset as of December 31,2007. The state tax loss carryforwards will expire at various dates through2023 if not utilized. The Company had a $17,000 valuation allowance related tothis deferred tax asset as of December 31, 2007 due to the uncertainty inrealization prior to expiration.

 

The Company had other federal and state tax creditsand carryforwards of approximately $3.8 million, representing a $3.8 milliondeferred tax asset as of December 31, 2007. The federal and state creditsand carryforwards will expire in 2008 through 2027 if not utilized. The Companyhad a $122,000 valuation allowance related to this deferred tax asset as of December 31,2007 due to the uncertainty in realization prior to expiration.

 

Duringthe year ended December 31, 2007, the Company reversed $4,000 of thevaluation allowance relating to statetax loss carryforwards as it was more likely than not that the deferredtax asset would be realized prior toexpiration. During the year ended December 31, 2007, the Company wrote off$42,000 to the valuation allowance related to research and development taxcredits that had expired prior to realization.

 

**Activity during the year ended December 31, 2007**

 

The Company’s methodology for determining therealizability of its deferred tax assets involves estimates of future taxableincome from its core business, the estimated impact of future tax deductionsfrom the exercise of stock options outstanding as of December 31, 2007,and the expiration dates and amounts of net operating loss carryforwards andother tax credits. These estimates are projected through the life of therelated deferred tax assets based on assumptions which management believes tobe reasonable and consistent with current operating results.

 

Although the Company had cumulative pre-tax incomefor financial reporting purposes for the three years ended December 31,2007, the Company did not pay any significant income taxes over that period dueto tax deductions from the exercise of stock options as well as its utilizationof net operating losses. In assessing the realizability of its deferred taxassets as of December 31, 2007, the Company considered evidence regardingits ability to generate sufficient future taxable income to realize itsdeferred tax assets. The primary evidence considered included the cumulativepre-tax income for financial reporting purposes for the past three years; theestimated impact of future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2007; and the estimated future taxableincome based on historical operating results.

 

61

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After giving consideration to these factors, theCompany concluded that it was more likely than not that the tax losscarryforwards will be realized prior to their expiration and that other taxcredits that expire prior to 2010 will not be utilized due to the estimatedfuture tax deductions from the exercise of stock options outstanding as of December 31,2007 as well as utilization of tax loss carryforwards. The Company had avaluation allowance of $139,000 as of December 31, 2007 relating to netoperating losses and tax credits that expire prior to 2010.

 

The Company also concluded that it was more likelythan not that the net deferred tax assets of $12.1 million as of December 31,2007 and the estimated future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2007 would be utilized prior to expiring.Based on this conclusion, the Company would require approximately $29.1 millionin cumulative future taxable income to be generated at various times over thenext 20 years to realize the related net deferred tax assets of $12.1 millionas of December 31, 2007 as well as the estimated future tax deductionsfrom the exercise of stock options outstanding and in-the-money as of December 31,2007.

 

Ifthe Company adjusts either its estimates of future taxable income or taxdeductions from the exercise of stock options, or if the Company’s stock priceincreases significantly without an increase in taxable income, causing theCompany to believe that its deferred tax assets will not be utilized, theCompany may need to establish additional valuation allowances on itsdeferred tax assets, which could materially impact its financial position andresults of operations.

 

**Activity during the year ended December 31, 2006**

 

Duringthe year ended December 31, 2006, the Company reversed $25,000 of thevaluation allowance relating to statetax loss carryforwards, as it was more likely than not that the deferredtax asset would be realized prior toexpiration. During the year ended December 31, 2006, the Company wrote-off$79,000 to the valuation allowance related to research and development taxcredits that had expired prior to realization.

 

**Activity during the year ended December 31, 2005**

 

The Company concluded that it was more likely thannot that tax loss carryforwards that expire in 2006 and other tax credits thatexpire prior to 2010 would not be utilized due to the estimated future taxdeductions from the exercise of stock options outstanding as of December 31,2005. As a result, the Company recorded a valuation allowance of $47,000 forthe year ended December 31, 2005 relating to state tax loss carryforwardsdue to the uncertainty in realization prior to expiration.

 

**Net operating loss carryforward limitations**

 

Under Section 382 of the Internal Revenue Codeof 1986, certain stock transactions which significantly change ownership,including the sale of stock and the granting of options to purchase stock,could limit the amount of net operating loss carryforwards that may beutilized on an annual basis to offset taxable income in future periods.Management believes that any past changes in ownership, as defined by Section 382,would not materially impact the Company’s ability to utilize losscarryforwards.

 

**7.****             ****Employeebenefit plan**

 

TheCompany maintains the Vital Images, Inc. Salary Savings Plan (the “Plan”),which is intended to qualify under Section 401(k) of the InternalRevenue Code of 1986, as amended. The Plan covers substantially all employees.Each employee may elect to contribute to the Plan through payrolldeductions up to 100% of his or her salary, subject to certain limitations. Atthe discretion of the Board of Directors, the Company may make matchingcontributions equal to a percentage of the salary reduction contributions orother discretionary amounts. The Company paid matching contributions of$410,000, $214,000 and $103,000 in 2007, 2006 and 2005, respectively.

 

62

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**8.****  ****Majorcustomers and geographic data**

 

Customers accounting for more than 10% of theCompany’s total revenue are as follows (in thousands):

 

 

| ** **                           | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                 |       |                                     |       |   |   |   |   |
| Toshiba Medical Systems  Corporation |       | $                                        | 32,710     |   | $ | 28,879 |   | $ | 24,307 |   |
| Percentage of total  revenue         |       | 47                                       | %          | 41 | % | 47 | % |
|                                 |       |                                     |       |   |   |   |   |
| McKesson Corporation                 |       | $                                        | 6,061      |   | $ | 7,314 |   | $ | 3,800 |   |
| Percentage of total  revenue         |       | 9                                        | %          | 10 | % | 7 | % |

 

Asof December 31, 2007 and 2006, Toshiba Medical Systems Corporationaccounted for 34% and 41% of accounts receivable, respectively. As of December 31,2007 and 2006, McKesson Corporation accounted for 6% and 14% of accountsreceivable, respectively.

 

Themajority of the Company’s long-lived assets are located in the United States.

 

Exportrevenue accounted for 19%, 15% and 16% of total revenue for the years ended December 31,2007, 2006 and 2005, respectively. Substantially all of the Company’s exportsales are negotiated, invoiced and paid in U.S. dollars.

 

Salesby geographic area are summarized as follows (in thousands):

 

| ** **              | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------|------------|------------------------------------------|------------|
| ** **              | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|                    |       |                                     |       |   |   |   |   |
| United States           |       | $                                        | 56,630     |   | $ | 59,640 |   | $ | 43,552 |   |
| Europe                  |       | 8,378                                    |       | 5,713 |   | 4,461 |   |
| Asia-Pacific            |       | 2,380                                    |       | 2,520 |   | 2,277 |   |
| Other foreign countries |       | 2,788                                    |       | 2,639 |   | 1,427 |   |
|                    |       | $                                        | 70,176     |   | $ | 70,512 |   | $ | 51,717 |   |

 

63

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

 

Thefollowing summarized unaudited quarterly financial data has been prepared usingthe financial statements of the Company (in thousands, except per share data):

 
| ** **                                    | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|--------------------|------------|-------------------|------------|--------------------|------------|
|                                          |       |              |       |               |       |              |       |               |       |
| **2007**                                      | ** ** | ** **        | ** ** | ** **         | ** ** | ** **        | ** ** | ** **         | ** ** |
| Total revenue                                 |       | $                 | 20,825     |               | $          | 15,534            |       | $                  | 17,115     |   | $ | 16,702 |   |
| Gross profit                                  |       | $                 | 16,480     |               | $          | 11,842            |       | $                  | 13,329     |   | $ | 12,936 |   |
| Net income (loss)                             |       | $                 | 2,372      |               | $          | (379              | )          | $                  | 927        |   | $ | (1,553 | ) |
| Earnings (loss) per share  — basic (1)   |       | $                 | 0.14       |               | $          | (0.02             | )          | $                  | 0.05       |   | $ | (0.09 | ) |
| Earnings (loss) per share  — diluted (1) |       | $                 | 0.14       |               | $          | (0.02             | )          | $                  | 0.05       |   | $ | (0.09 | ) |
|                                          |       |              |       |               |       |              |       |               |       |
| **2006**                                      | ** ** | ** **        | ** ** | ** **         | ** ** | ** **        | ** ** | ** **         | ** ** |
| Total revenue                                 |       | $                 | 15,796     |               | $          | 16,913            |       | $                  | 17,781     |   | $ | 20,022 |   |
| Gross profit                                  |       | $                 | 12,592     |               | $          | 13,415            |       | $                  | 14,311     |   | $ | 15,285 |   |
| Net income                                    |       | $                 | 1,427      |               | $          | 1,247             |       | $                  | 1,624      |   | $ | 2,285 |   |
| Earnings per share — basic  (1)          |       | $                 | 0.11       |               | $          | 0.09              |       | $                  | 0.12       |   | $ | 0.15 |   |
| Earnings per share —  diluted (1)        |       | $                 | 0.10       |               | $          | 0.09              |       | $                  | 0.12       |   | $ | 0.15 |   |

----

(1)      The sum of the quarterlyearnings (loss) per share may not equal the annual earnings per share dueto changes in average shares outstanding.

 

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**VitalImages, Inc.Form 10-K**

 

**Index to Exhibits**

 
| **Item No.** | ** ** | **Description**                                                                                                                                                                                                                                              |
|--------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                                                                                                                                                         |
| 3.1          |       | Articles of Incorporation  of the Company, incorporated by reference to Exhibit 3.1 to the  Company’s Registration Statement on Form 10 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.                                                                                                                                   |
|         |       |                                                                                                                                                                                                                                                         |
| 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         |       | Form of Change in  Control Agreement between Vital Images, Inc. and Steven P. Canakes,  incorporated by reference to Exhibit 10.40 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2000.*         |
|         |       |                                                                                                                                                                                                                                                         |
| 10.5         |       | 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.* |

 

65

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| 10.6   |   | 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.*                                       |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.7   |   | 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.*                                                     |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.8   |   | 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.*                                                   |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.9   |   | 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.*                                                      |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.10  |   | 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”).         |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.11  |   | 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.                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.12  |   | 2006 Long Term Incentive  Plan, as amended, incorporated by reference to Exhibit 10.19 to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2006 and  Exhibit 99.1to the Company’s Registration Statement on Form S-8  dated September 08, 2006.*   |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.13  |   | Employment  Agreement dated January 12, 2008 by and between Vital Images, Inc.  and Michael H. Carrel, filed herewith.*                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.14  |   | Employment  Agreement dated January 12, 2008 by and between Vital Images, Inc.  and Peter J. Goepfrich, filed herewith.*                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.15  |   | Marketing  and Distribution Agreement between Vital Images, Inc. and Toshiba  Corporation, Medical Systems Company dated March 30, 2007, incorporated  by reference to Exhibit 10.1 to the Company’s Quarterly Report on  Form 10-Q for the quarter ended March 31, 2007.** |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.16  |   | Amendment  No. 1 to Marketing and Distribution Agreement between Vital  Images, Inc. and Toshiba Corporation, Medical Systems Company, dated November  26, 2007, filed herewith.**                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.17  |   | Amendment  No. 2 to Marketing and Distribution Agreement between Vital  Images, Inc. and Toshiba Corporation, Medical Systems Company, dated November  26, 2007, filed herewith.**                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.18  |   | Amendment  No. 3 to Marketing and Distribution Agreement between Vital  Images, Inc. and Toshiba Corporation, Medical Systems Company, dated  March, 2008, filed herewith.**                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 10.19  |   | Separation and Non-Compete  Agreement dated January 16, 2008 by and between Vital Images, Inc.  and Jay D. Miller, filed herewith.*                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                      |
| 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.                                                                                             |

 

66

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|   |   |                                                                                                                                                                                                          |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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.                               |

----

*                 Indicates a management contract orcompensatory plan or arrangement.

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

 

67

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