**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-K**

 

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

 

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**VITALIMAGES, INC.**

(Exact name ofRegistrant as specified in its charter)

 

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

 

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

 

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

 

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

 

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

 

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

 

DOCUMENTSINCORPORATED BY REFERENCE

 

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

 

 

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VITAL IMAGES, INC.

FORM 10-K

 

TABLE OF CONTENTS

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

 

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Item 1.                                     BUSINESS

 

Vital Images, Inc.(“Vital Images” or the “Company”) was incorporated in Iowa in September 1988.  In March 1997, the Companyre-incorporated under the laws of the state of Minnesota.  The Company’s principal executive officesare located at 3300 Fernbrook Lane N., Suite 200, Plymouth, MN 55447 (telephone(763) 852-4100, facsimile (763) 852-4110, e-mail – info@vitalimages.com ).  From May 24, 1994 through May 11, 1997, theCompany was a wholly-owned subsidiary of Bio-Vascular, Inc., now known asSynovis Life Technologies, Inc.

 

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

 

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

 

Business Description

 

Vital Images develops,markets and supports 3D medical imaging software for use primarily in clinicaldiagnosis, disease screening and therapy planning.  The Company’s software applies proprietary computer graphics andimage processing technologies to a wide variety of data supplied by computedtomography (“CT”) and magnetic resonance (“MR”) scanners.  Vital Images’ products allow clinicians tocreate 2D, 3D and 4D views of human anatomy and to non-invasively navigatewithin these images to better visualize and understand internal structures andpathologies.  The Company believes thatits high-speed visualization technology and customized protocolscost-effectively bring 3D visualization and analysis into the routine,day-to-day practice of medicine.  TheCompany, which operates in a single business segment, markets its products to healthcareproviders and to manufacturers of diagnostic imaging systems and picturearchive and communication systems (“PACS”) through a direct sales force in theUnited States and independent distributors in international markets.

 

*Vitrea®*, Vital Images’ advanced 3D medicalimaging product for radiological and surgical applications, received FDAclearance in November 1996 and was released for sale inOctober 1997.  Due to its speed andease-of-use, management believes that *Vitrea*was the first 3D medical imaging product with the ability toappeal primarily to the clinical market. Historically, 3D medical imaging software was slow, difficult to use,and operated only on expensive workstations. Consequently, the functionality of such software was appealing only forresearch applications.  The Company’s *Vitrea*softwarecombined speed with ease-of-use to enable a physician to access, manipulate andanalyze 3D images, typically in less than five to ten minutes.  The Company has released several updates to *Vitrea*each year, and inDecember 2003 released *Vitrea 2 Version 3.4*, which has improvedquality, reliability and usability features to meet the diagnostic andtreatment planning needs of busy radiology departments. The Company offers *Vitrea 2*both as an integrated software and hardware system, consisting of *Vitrea 2*software installed on a computer workstation, and as a stand-alone softwarepackage.  To date, the Company haslicensed over 1,300 copies of *Vitrea*and*Vitrea 2* to hospitals, clinics, imaging centers and othersites.

 

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The Company believes thatgrowing acceptance of 3D medical imaging offers Vital Images numerous marketexpansion opportunities.  Research anddevelopment efforts are currently focused on using the Company’s base ofvisualization technology to expand to other imaging modalities, such as x-rayangiography, as well as expanding the features and functions in the currentmodalities.  Vital Images is alsodeveloping and enhancing its 3D medical imaging software tools forless-invasive screening applications, such as CT colonography for colon cancerscreening and CT cardiac for diagnosis of heart disease.

 

The Company has amarketing and distribution agreement with Toshiba Medical Systems Corporation(“Toshiba”), which names *Vitrea 2*as Toshiba’s primary 3D software for use with their CT scanners in the UnitedStates and in more than 50 countries in North and South America, Europe, theMiddle East, Africa, Australia and Asia, except Japan. The agreement runsthrough December 31, 2004.  Salesby the Company to Toshiba accounted for approximately 42%, 34% and 27% of theCompany’s total revenue for the years ended December 31, 2003, 2002 and2001, respectively.  See “Business –Marketing and Distribution” and “– Dependence on Major Customers.”

 

The diagnostic medicalimaging market continues to expand both its geographic boundaries and itsdefinitive boundaries.  Long defined asthe market for CT, MR, ultrasound and other imaging modalities, the diagnosticimaging market has grown to include both PACS and 3D imaging systems, whichhave become integral technologies for many radiology practices around theworld.

 

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

 

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

 

Technology

 

The two core technologiesunderlying the Company’s products are “customized protocols,” which make*Vitrea 2*simple to use, and a visualization technique known as “volume rendering.”  A feature critical to *Vitrea 2’s* speed andease-of-use is its customized protocols, which provide automated 2D, 3D and 4Drenderings of scanner data, optimized for individual clinicalapplications.  Vital Images’ engineersand clinical collaborators have selected specific views for each type of exam *Vitrea 2*supports in order to provide immediate, useful 2D, 3D and 4D views for theuser.  4D is defined as 3D imagesshowing changes over time, such as images of a beating heart.  After the selected patient data has beenretrieved, *Vitrea2* provides the clinician with up to six views with all visualizationparameters pre-set for the specific type of clinical exam.  The visualization settings for these viewsare stored in *Vitrea 2’s* software and are automatically and adaptivelyapplied to each patient study, optimizing the views displayed.  By applying this proprietary protocoltechnique, the system anticipates the clinician’s needs and providesimmediately useful views of the patient data. The use of customized protocols automates the complex and time-consumingapproaches inherent in many competing 3D medical imaging products andeliminates the need for the user to be proficient in operating complex graphicsprograms.  The Company has been issuedPatent No. 5,986,662 from the U.S. Patent and Trademark Office for itsmechanism for automated protocol selection, Patent No. 6,130,671 for themechanism to calculate simulated lighting in 3D images, and Patent No.6,219,059 for the user interface and mechanism used to control the relativetransparency of 3D data in volume renderings of medical images.

 

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Volume rendering is anadvanced technique for displaying three-dimensional views on a computer monitorthat the Company believes has significant advantages over the alternativetechnique, known as “surface rendering.” Volume rendering permits the direct display of all of the imaging datawithout mathematical modeling and allows interactive control of the level of“transparency” of the data.  Bycomparison, surface rendering requires the creation of artificial surfacesbased on selected imaging data, and the usefulness of the resulting visualimage is largely dependent on where these surfaces are “set” by the clinicaltechnician.  Volume rendering is notdependent on the creation of artificial surfaces and allows visualization ofvarying components that might otherwise be eliminated from a surface renderedimage due to surface approximation. Because volume rendering uses all of the data and information collectedby the imaging equipment, the Company believes visualization processes that usevolume rendering provide clinicians with better images to define and displaypathology and anatomy in a more useful manner.

 

In the early years ofmedical imaging, most medical imaging companies largely overlooked volumerendering because the computer power necessary to perform volume rendering wassignificantly more expensive and intensive than the requirements for surface rendering.  The Company’s experience with volumerendering has its basis in the efforts of Vincent J. Argiro, Ph.D., the founderof the Company, who developed three-dimensional visualization software usingvolume rendering as an aid in his research in developmental neuroscience.  Dr. Argiro focused on accelerating theperformance of volume rendering on standard computer platforms.  As a result of his work, he developedexpertise in accelerated volume rendering, which forms the core of theCompany’s volume rendering technology. Because the performance of standard computer platforms has increasedwhile the relative cost of such performance has decreased, the Company believesthat volume rendering has become a more accessible imaging solution for routineclinical applications.

 

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

 

Industry Background

 

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

 

CT and MR imaging technologiescapture data that provide a physician with a graphical representation of theinside of the human body.  These imageshave traditionally been viewed as a series of two-dimensional, cross-sectionalslices on x-ray-type film.  As computerprocessing speed increased, software performance improved and networkingtechnologies developed, manufacturers of scanning equipment began offeringintegrated systems that allowed clinicians to view, analyze and manipulatethese medical images in a digital environment.

 

Medical imaging systemsfirst visualized individual slices, or pictures, on a computer monitor andlater provided views of multiple slices. More recently, medical imaging systems began to permit viewing andmanipulation of large, multiple slice data sets as a single, three-dimensionalimage on a computer workstation.  Today,the 3D medical imaging industry involves the creation, visualization,manipulation, analysis and communication of medical images in two, three andfour dimensions (collectively, “3D medical imaging software”).

 

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

 

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DICOM, promulgated by theAmerican College of Radiology and the National Electronic Manufacturer’sAssociation.  This standard permitsimaging, visualization, networking and archiving systems from different vendorsto work cooperatively within a single network. In addition, the cost-to-performance ratio of computer products used invisualization and PACS has improved dramatically, bringing the prices for 3Dmedical imaging capabilities and PACS within the grasp of most healthcareproviders.  The Company believes thatthe acceptance of industry standards such as DICOM and the improvements in thecost-to-performance ratio for clinical workstations will support continuedmarket growth in the 3D medical imaging and PACS industries.

 

Vital Images also expectsthat a number of other advantages of 3D medical imaging products will supportgrowth in the 3D medical imaging industry:

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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Markets

 

The Company participatesin the rapidly growing 3D medical imaging market.  The 3D medical imaging market also interrelates with a number ofother markets such as the diagnostic imaging equipment market, the PACS marketand the hospital and clinical information systems markets.  3D medical imaging software and systems haveapplication and/or potential in diagnostic screening and radiology, remotediagnosis and consultation (e.g., telemedicine), surgical assessment, planning,navigation and follow-up, radiation and chemotherapy treatment planning and medicaleducation.  The customers for theseapplications include radiology, surgery and oncology departments, as well asother clinical specialists, at hospitals and research centers, diagnosticimaging and screening centers, outpatient surgery centers, clinics andphysician groups.

 

The diagnostic medicalimaging market continues to expand its boundaries.  Long defined as the market for CT, MR, ultrasound and otherimaging modalities, the diagnostic imaging market has grown to include bothPACS and 3D imaging systems, which have become integral technologies for manyradiology practices around the world.

 

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

 

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

 

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

 

Strategy

 

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

 

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

 

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

 

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

 

•                        Furtherpenetrate the 3D medical imaging market. The Company intends to expand its sales and marketing staff and increaseits marketing efforts in order to continue building momentum for the acceptanceand purchase of *Vitrea 2* and its other products.  A key challenge for the Company involves reaching and educatingphysicians and clinicians as to the benefits of the *Vitrea 2* software.  By convincing the ultimate users of thebenefits of its system, the Company believes that it can successfully influencepurchasing decisions for medical institutions purchasing or upgrading theirimaging technology.  In addition, theCompany will work to expand its appeal by implementing additional 2D capabilityas well as ensuring that its technology will easily integrate into PACSnetworks.

 

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

 

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

 

Products and ProductDevelopment

 

*Vitrea**.*  In December 1995, the Company assessedits business strategy and determined that to optimize its dedicatedparticipation in the medical field, it needed to create a new product fordirect clinical application.  Theobjective for this new product effort was to produce an easy-to-use clinicalsoftware tool to allow radiologists and other clinicians to use two- andthree-dimensional visualization in their routine clinical processes.  Unlike its predecessor software, *VoxelView®*,the Company set out to design this new software product for users with clinicalknowledge rather than computer graphics expertise.  Specifications for this new product, called *Vitrea,* were developed inearly 1996, with software development beginning in late spring of thatyear.  The Company submitted 510(k)documentation in September 1996 for *Vitrea* and was granted marketing clearanceby the U.S. Food and Drug Administration (the “FDA”) in November 1996 foruse as a clinical diagnostic and surgical planning device when used with CT andMR medical imaging data.  *Vitrea*was first released for sale to customers in October 1997.  In December 1999, the Company released *Vitrea 2*,a Microsoft® Windows NT compatible version of its *Vitrea* software for 2D/3Dvisualization and analysis of medical image data.  *Vitrea 2* was Vital Images’ first 3D-volume medical imagingsoftware product available for the Microsoft Windows operating system andprovides the speed and ease-of-use the medical community demands for diagnosisand treatment planning in a clinical environment.  In December 2003, the Company released *Vitrea 2 Version 3.4*, whichhas improved usability and networking features to meet the diagnostic,screening and therapy planning needs of busy radiology departments and operateson the Microsoft Windows XP operating system.

 

*Vitrea 2* capitalizes on the Company’sexperience in 3D medical imaging and provides clinicians with an easy-to-usetool for disease screening, radiological diagnosis and therapy planning.  It represents the Company’s 

 

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most important step todate as a provider of a range of clinical tools for broad distribution to the3D medical imaging market.  *Vitrea 2’s*primary features are its high-speed rendering capability and its ability toprovide two- and three-dimensional viewing for routine diagnosis and therapyplanning without requiring the user to be trained in computer graphicstechniques.  The Company believes thatboth of these features - speed and ease-of-use - now make it possible to usethree-dimensional medical imaging in daily clinical routines.  A *Vitrea 2* user, following a built-inclinical workflow, can view the image data in two, three or four dimensionsusing visualization settings based on specific clinical applications storedwithin the system as dedicated visualization protocols.  The user may then interactively navigatearound, or “fly through,” the image to view clinically relevant anatomies andpathologies.  *Vitrea 2*software alsoallows the user to capture views by taking “snapshots,” which can be integratedinto customized reports for electronic transmission and archiving through aDICOM network or sent to another location via the Internet.

 

*Vitrea 2* software conforms to the latestmedical imaging and computer industry standards, such as *OpenGL*TM computer graphicsapplication programming interface and DICOM.

 

The Company offers *Vitrea 2*both as an integrated software and hardware system, consisting of *Vitrea 2*softwareinstalled on a personal computer (“PC”) and as a stand-alone software package.  Pursuant to purchasing arrangements betweenthe Company and computer resellers, the Company purchases personal computers ata nominal discount, installs its *Vitrea 2*software, and markets the packageas an integrated 3D medical imaging solution. Some customers prefer to purchase their own hardware.  For such customers, as well as when sellingto its diagnostic imaging OEM and PACS partners, the Company sells softwarelicenses only for use on hardware qualified by the Company for use with *Vitrea 2.*  Currently, *Vitrea 2* operates on PCworkstations from Omni Tech, Inc., Hewlett-Packard Company and Dell ComputerCorporation.  The list price for a basemodel integrated workstation and software package is approximately $87,000, andthe list price for the *Vitrea 2* software without a workstation isapproximately $75,000.

 

In addition to itsimmediate clinical applications, *Vitrea 2*software incorporates a number ofadditional technological advances, thereby making it adaptable to routineclinical use in surgical navigation and cancer treatment planning and forintegration into diagnostic imaging equipment and PACS networks manufacturedand sold by other companies.  Inparticular, *Vitrea2* software was written using advanced programming techniques, amodular, object-oriented design, C++ programming language, and a sharedmessaging structure.  The Companybelieves these characteristics make it practical to modify *Vitrea 2* software to suitthe clinical needs of surgical navigation and oncology, as well as allowingdiagnostic equipment and PACS network manufacturers to integrate *Vitrea 2*softwareinto their product offerings, thereby providing the Company with theopportunity to leverage the *Vitrea 2* software development investmentinto new commercial areas.

 

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

 

*VScoreTM*.  In August 1999, the Company introducedits *VScore*software for coronary artery calcium scoring.  The *VScore* software product was the Company’sfirst add-on option to the Company’s *Vitrea 2* 3D medical imaging softwareproduct.  The *VScore* option adds thefunctionality to non-invasively quantify calcium in the four major coronaryarteries using CT image data.

 

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

 

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

 

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Automated VesselMeasurements.  InOctober 2001, the Company introduced its Automated Vessel Measurementssoftware option to assist physicians in characterizing the course and dimensionsof diseased blood vessels.  TheAutomated Vessel Measurements option is designed to support activities such aspre-surgical diagnosis, evaluation and stent planning in the abdominal aorta,carotid arteries, coronary arteries and renal arteries.

 

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

 

Vessel Probe.  In December 2003, the Companyintroduced its Vessel Probe option as a complementary product to its CT Cardiacoption.  It is used to define vascularanatomy and the degree of luminary obstruction in vessels other than thecoronary arteries.  With this option,physicians can determine the extent of obstructive vascular disease and assessthe feasibility of various forms of therapy or surgical interventions.  

 

Concurrent License.  In December 2003, the Companyintroduced its Concurrent License option which gives multiple end users theability to share a single *Vitrea 2* license within a facility.  While limiting the number of simultaneoususers to the number of *Vitrea 2* licenses purchased, theConcurrent License option allows *Vitrea 2* software to be accessed frommultiple reading stations within an enterprise.

 

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

 

Maintenance and Support.  In addition to its system and softwareproducts, the Company also offers maintenance and support services to itscustomers, as well as certain other services such as installation andtraining.  In connection with thelicensing of *Vitrea 2*software, the Company markets annual maintenanceand support services for both *Vitrea 2* software and the integrated *Vitrea 2*system, pursuant to which the Company provides software updates, minor featureenhancements, error correction, telephone support and other general supportservices for an annual fee of approximately $9,000.  Outside of these maintenance services, the Company is required byFDA regulations to provide certain levels of support to end users as a resultof the use of its products as medical devices. Maintenance and support services currently marketed by the Company donot include installation, training and other services, whether on- or off-site,as such services are charged separately by the Company.

 

License fees accountedfor 69%, 67% and 66% of total revenue in each of the fiscal years endedDecember 31, 2003, 2002 and 2001, respectively.  Maintenance and services comprised 23%, 19% and 16% of totalrevenue for the years ended December 31, 2003, 2002 and 2001,respectively, while hardware sales accounted for 8%, 14% and 18% of totalrevenue for the years ended December 31, 2003, 2002 and 2001,respectively.

 

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

 

CollaborativeRelationships

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Competition

 

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

 

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

 

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

 

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

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

 

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

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

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

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

 

The Company believes thatproduct quality, performance, functionality and features, quality of supportand service, reputation and price are also important competitive factors.  The Company believes that customers willprefer *Vitrea2* because it is simple, fast and affordable.  While price has been less significant thanother factors, increasing competition in the 3D medical imaging market mayresult in price reductions and reduced gross margins.  In particular, should one or more of the diagnostic imagingsystem suppliers choose to provide or distribute more competitive medicalimaging products than those offered by the Company, the Company’s business,financial condition and results of operations could be materially adverselyaffected.

 

Marketing andDistribution

 

The Company markets *Vitrea 2*both as a software package and as part of an integrated software and hardwaresystem to radiologists, surgeons, primary care physicians and medicalresearchers.  The Company markets itsproducts directly to end-user customers, such as hospitals and clinics, as wellas to select diagnostic imaging companies, digital imaging equipmentmanufacturers and PACS companies for resale as a Vital Images brandedproduct.  In November 2001, theCompany signed a joint venture agreement to work collaboratively on productsand services in image-guided surgery and surgical planning with the SurgicalNavigation Technologies (“SNT”) division of Medtronic, Inc. Under thisagreement, the Company’s advanced visualization technology will be integratedinto Medtronic SNT’s image-guided surgery products, and the two companies willcollaborate on new surgical planning software and service offerings.  In October 2001, the Company signed anexclusive agreement with E-Z-EM, Inc. to develop and distribute a dedicated CTcolonography product.  InSeptember 2000, the Company signed a marketing and distribution agreementwith Toshiba America Medical Systems (“TAMS”), which named *Vitrea 2* as TAMS’ primary 3D software foruse with its CT scanners in the United States. In February 2002, the Company announced that it had entered into amarketing and distribution agreement with Toshiba Medical Systems Corporationto offer *Vitrea 2* to**its subsidiaries and distributors,including TAMS, in more than 50 countries in North and South America, Europe,the Middle East, Africa, Australia and Asia, except Japan. The agreement hastwice been amended. Most recently, in December 2003, the Company announcedthat it had renewed the agreement through December 31, 2004.  In July 2003, the Company signed a jointdistribution agreement with McKesson where each company was granted the rightto distribute the other party’s products. See “Business – Dependence on Major Customers.”

 

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

 

The Company markets itsproducts both domestically and internationally.  In the United States, the Company markets its products throughits direct sales force as well as through OEMs and resellers.  Internationally, the Company markets itsproducts through OEMs and resellers. See Note 8 to the Financial Statements - “Major Customers and GeographicData” for information regarding the Company’s export sales.  As of December 31, 2003, the Companyhad 29 field salespeople in the U.S., one international reseller salesperson,one OEM customer and 11 international resellers, many of whom are also Toshibaresellers.

 

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Customers and CustomerSupport

 

Through December 31,2003, the Company has sold over 1,300 separate software licenses for *Vitrea*,*Vitrea 2* and InnerviewGITM for use in over 1,000 different sites,including hospitals, clinics, imaging centers and other sites.  Due to the advantages of the *Vitrea 2*software – fast and easy-to-use - the Company’s customers include largeteaching hospitals in major cities in the United States as well as hospitalsand clinics in smaller population areas.

 

The Company is committedto rapid response to customer service requests.  Customer support representatives are available during theCompany’s business hours to answer questions about the operation, maintenanceand repair of the Company’s products.

 

Intellectual Property

 

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

 

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

 

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

 

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Manufacturing and Service

 

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

 

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

 

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

 

Governmental Regulation

 

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

 

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

 

*Vitrea 2* is classified as a Class IImedical device and has received marketing clearances from the FDA as the resultof 510(k) pre-market notifications. Specifically, *Vitrea 2* and the Company’s add-on optionshave been cleared to be marketed for use with CT and MR scanners.  Future products, add-on options to existingsoftware, and expanded claims of efficacy will likely require additional 510(k)pre-market notifications.

 

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

 

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

 

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

 

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

 

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

 

The financialarrangements through which the Company markets, sells and distributes itsproducts may be subject to certain federal and state laws and regulations inthe United States with respect to the provision of services or products topatients who are Medicare or Medicaid beneficiaries.  Violations of these laws and regulations may result in civil andcriminal penalties, including substantial fines and imprisonment.  In a number of states, the scope of theselaws and regulations have been extended to include the provision of services orproducts to all patients, regardless of the source of payment, although thereis variation from state to state as to the exact provisions of such laws orregulations.  In other states and, on anational level, several health care reform initiatives have been proposed whichwould have a similar impact.  TheCompany believes that its operations and its marketing, sales and distributionpractices currently comply with all current fraud and abuse and physiciananti-referral laws and regulations, to the extent they are applicable.

 

Third Party Reimbursementand Cost Containment

 

The Company’s productsare purchased primarily by hospitals, clinics, imaging centers and other usersthat bill various third party payers for the services provided to thepatients.  These payers, which includeMedicare, Medicaid, private insurance companies and managed care organizations,reimburse part or all of the costs and fees associated with the diagnosticprocedures utilizing the Company’s products. The medical imaging services performed using the Company’s software,except for disease screening procedures, are covered by current CPT codes(Current Procedural Terminology, as defined by the Centers for Medicare &Medicaid Services).  As such, hospitalsproviding services on the Company’s 3D medical imaging workstations can seekreimbursement by using existing approved CPT codes.  Medicare and Medicaid reimbursement for hospitals is based on afixed amount for admitting a patient with a specific diagnosis.  Because of this fixed reimbursement method,hospitals have incentives to use less costly methods in treating Medicare andMedicaid patients, and they will frequently make capital expenditures to takeadvantage of less costly treatment technologies.  Often, reimbursement is reduced to reflect the availability of anew procedure or technique and, as a result, hospitals are generally willing toimplement new cost-saving technologies before these downward adjustments takeeffect.  Likewise, because the rate ofreimbursement for certain physicians who perform certain procedures has been,and may in the future, be reduced in the event of changes in the resource-basedrelative value scale method of payment calculation, physicians may seek greatercost efficiency in treatment to minimize any negative impact of reducedreimbursement.  Any amendments toexisting reimbursement rules and regulations which restrict or terminate thereimbursement eligibility (or the extent or amount of coverage) of medicalprocedures using the Company’s products or the eligibility (or the extent oramount of coverage) of the Company’s products could have a material adverseimpact on business.

 

In response to the focusof national attention on rising health care costs, a number of changes toreduce costs have been proposed or have begun to emerge.  There have been, and may continue to be,proposals by legislators and regulators and third party payers to reduce thesecosts.  There has also been 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.  It has become atypical practice for hospitals to 

 

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

 

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

 

The HIPAA regulations arecausing customers of the Company to request that the Company sign “businessassociate” agreements with them.  A“business associate” is a person or entity that performs certain functions oractivities that involve the use or disclosure of protected health informationon behalf of, or provides services to, a covered entity.  By law, the HIPAA Privacy Rule applies onlyto covered entities – health plans, health care clearinghouses, and certainhealth care providers.  However, mosthealth care providers do not carry out all of their health care activities andfunctions by themselves.  Instead, theyoften use the services of a variety of other persons or businesses.  The Privacy Rule allows covered providersand health plans to disclose protected health information to these “businessassociates” if the providers or plans obtain satisfactory assurances that thebusiness associate will use the information only for the purposes for which itwas engaged by the covered entity, will safeguard the information from misuse,and will help the covered entity comply with some of the covered entity’sduties under the Privacy Rule.  Coveredentities may disclose protected health information to an entity in its role asa business associate *only* 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 

 

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

 

Acquisition ofHInnovation, Inc.

 

On February 18,2004, the Company completed the acquisition of HInnovation, Inc.(“HInnovation”) in accordance with the terms and conditions of an AcquisitionAgreement and Plan of Reorganization (the “Acquisition Agreement”) dated as ofJanuary 8, 2004 by and among Vital Images, HInnovation Acquisition, Inc.,a wholly-owned subsidiary of Vital Images (“HInnovation Acquisition”),HInnovation and Mr. Hui Hu and JMS Co., Ltd., the principal stockholders ofHInnovation.  Pursuant to the AcquistionAgreement, HInnovation was merged with and into HInnovation Acquisition, andHInnovation became a wholly-owned subsidiary of Vital Images.

 

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

 

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

 

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optimizing workflow,improving productivity, enhancing service and increasing revenue.  It obtained 510(k) marketing clearance forits product, iConnectionTM, from the FDA in November 2001.  HInnovation was awarded U.S. Patent No.6,621,918, which protects a server-based MPR/3D/4D software system anddesign.  The iConnection softwareenables physicians to use existing ordinary Internet-connected PCs to accessthe same 2D/3D/4D imaging applications and functionalities typically onlyavailable on 3D diagnostic workstations. With iConnection software, users can review and analyze patients’diagnostic images over the Internet whenever and wherever the need arises.

 

ImportantFactors

 

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

 

*Historical Operating Losses*

 

For the years endedDecember 31, 2003 and 2002, the Company had operating income of $1.4 millionand $677,000.  However, the Company hadan operating loss of $1.1 million for the year ended December 31, 2001and, with the exceptions of the fiscal years ended December 31, 2003 and2002 and October 31, 1995, has incurred operating losses each year since1990.  As of December 31, 2003, theCompany’s accumulated deficit was $12.0 million.  The Company’s ability to maintain annual profitability willdepend on, among other things, its ability to successfully market its products,make new product offerings, respond to competitive developments and attract andretain qualified sales, technical and management employees.  The Company may not be able to continue toachieve profitable operations on an annual basis.  See “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations.”

 

*Market Acceptance*

 

The Company’s successdepends on its ability to successfully market its *Vitrea 2* software forclinical use, and on the ability and willingness of physicians to use 2D, 3Dand 4D medical imaging software in disease screening, clinical diagnosis andtherapy planning.  The three-dimensionalmedical imaging software offered by *Vitrea 2* represents a new alternative tothe conventional methods traditionally used for viewing medical images in theclinical setting.  The acceptance of *Vitrea 2*by physicians and other clinicians will depend on the Company’s ability toeducate those users as to the speed, ease-of-use and other benefits offered bythe *Vitrea2* system, as well as the Company’s timely introduction of newfeatures and functions.  There can be noassurance that users will prefer three-dimensional medical imaging softwareover less expensive two-dimensional medical imaging software or that theCompany will succeed in its efforts to further develop, commercialize, andachieve market acceptance for its *Vitrea 2* product or for any other productin the clinical setting.  See“Business—Technology,” “—Industry Background,” “—Markets” and “—Competition.”

 

*Substantial Reliance on a Single Product*

 

Revenue from sales of the*Vitrea 2*system constituted 96% of the Company’s total revenue for the year endedDecember 31, 2003, 98% of the Company’s total revenue for the year endedDecember 31, 2002, and 96% of the Company’s total revenue for the yearended December 31, 2001.  TheCompany anticipates that revenue from the sale of *Vitrea 2* will continue toaccount for a substantial portion of the Company’s revenue for the foreseeablefuture.  As such, the failure ofphysicians to accept *Vitrea 2* would have a material adverseimpact on the Company’s results of operations and financial condition.

 

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*Dependence on Market Growth*

 

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

 

*Highly Competitive Industry*

 

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

 

*Risk of Technological Obsolescence*

 

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

 

*Dependence on Major Customers*

 

One of the Company’sprincipal distribution channels is to sell its *Vitrea 2* medical imagingsoftware for inclusion with the delivery of medical imaging equipment beingsold by Toshiba.  Sales by the Companyto Toshiba accounted for approximately 42%, 34% and 27% of the Company’s totalrevenue for the years ended December 31, 2003, 2002 and 2001,respectively.  Toshiba’s account receivablerepresented 7% of the Company’s accounts receivable at December 31, 2003and 21% at December 31, 2002. Management believes a limited number of large customers may continue toaccount for a significant portion of the Company’s

 

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

 

*Impact of Purchase Commitments*

 

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

 

*Fluctuations in Operating Results*

 

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

 

*Government Regulation*

 

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

 

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

 

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

 

The Company markets itsproducts both domestically and internationally.  International regulatory bodies have established varyingregulations governing product standards, packaging requirements, labelingrequirements, import restrictions, tariff regulations, duties and taxrequirements.  The inability or failureof the Company to comply with the varying regulations, or the imposition of newregulations, could restrict its ability to sell its products internationallyand could adversely affect the Company’s business.  See “Business—Governmental Regulation.”

 

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

 

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

 

*Uncertain Protection for Intellectual Property; PossibleClaims of Others*

 

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

 

20

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

 

*Product Liability Risk; Limited Insurance Coverage*

 

The manufacture and saleof products used in the practice of medicine entail significant risk of productliability claims.  The Company currentlymaintains product liability insurance in the amount of $11,000,000 peroccurrence and $12,000,000 in total and errors and omissions coverage in theamount of $11,000,000 per occurrence and in total.  However, the Company’s coverage limits may not be adequate toprotect the Company from any liabilities it might incur in connection with thesale of its products.  Further, theCompany may not be able to maintain this level of coverage in the future.  The Company also may need increased productliability coverage as it releases additional products and updates.  Such insurance is expensive and may not beavailable on acceptable terms, if at all. A successful product liability claim or series of such claims againstthe Company in excess of the Company’s insurance coverage could have a materialadverse effect on its business.

 

*Need to Hire Additional Personnel*

 

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

 

*Management of Growth*

 

TheCompany’s ability to grow successfully requires an effective planning andmanagement process.  The expansion andgrowth of its business could place a significant strain on the Company’smanagement systems, infrastructure and other resources.  To manage its growth successfully, theCompany must continue to improve and expand its systems and infrastructure in atimely and efficient manner.  Inaddition, the success of any acquisition, including the Company’s acquisitionof HInnovation, will depend on the Company’s ability to successfully integratethe acquired business with the Company’s business.  The Company’s controls, systems, procedures and resources may notbe adequate to support a changing and growing company.  If the Company’s management fails to respondeffectively to changes and growth in its business, including acquisitions, suchfailure could have a material adverse effect on its business.

 

*Dependence on Third-Party Reimbursement*

 

The Company’s productsare purchased by hospitals, clinics, imaging centers and other users, whichbill various third party payers, such as government health programs, privatehealth insurance plans, managed care organizations and other similar programs,for the health care goods and services provided to their patients.  There are currently Current ProceduralTerminology (CPT) reimbursement codes for most of the diagnostic proceduresthat use the Company’s products. However, the amount of such reimbursement varies by location and issubject to change.  Payers may denyreimbursement if they determine that a product used in a procedure was not usedin accordance with established payer protocol regarding cost-effectivetreatment methods or was used for an unapproved indication.  Third party payers are increasinglychallenging the prices charged for medical services and, in some instances,have put pressure on service providers to lower their prices or reduce theirservices.  The Company is unable topredict what changes will be made in the reimbursement methods used by thirdparty healthcare payers.  The proceduresin which the Company’s products are used may not be considered cost effectiveby third party payers.  Reimbursementfor such procedures may not be available or, if

 

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

 

*Uncertainty of Health Care Reform*

 

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

 

*Possible Issuances of Preferred Stock*

 

The Company’s Articles ofIncorporation authorize its Board of Directors, without any action by itsshareholders, to establish the rights and preferences of up to 5,000,000 sharesof currently undesignated preferred stock. These shares of preferred stock could possess voting and conversion rightsthat could adversely affect the voting power of the holders of the common stockand may have the effect of delaying, deferring or preventing a change incontrol of the Company.  No shares ofpreferred stock or other senior equity securities are currently designated, andcurrently the Company has no plan to designate or issue any such securities.

 

*Anti-Takeover Considerations*

 

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

 

*No Dividends*

 

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

 

*Limitations on Director Liability*

 

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

 

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

 

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Item 2.                                     PROPERTIES

 

The Company’s principaloffice is located in Plymouth, Minnesota, where the Company currently occupiesapproximately 27,000 square feet under a lease that expires July 31, 2005,with the exception of a small portion of the space that is under lease untilMay 2006. Under certain conditions contained in the lease, the Company has theoption to expand its facilities.

 

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

 

Item 3.                                     LEGAL PROCEEDINGS

 

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

 

Item 4.                                     SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

 

There was no mattersubmitted to the vote of security holders during the fourth quarter of 2003.

 

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PART II

 

Item 5.                                     MARKETFOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

The Company’s commonstock trades on The NASDAQ National Market under the symbol “VTAL.”  The table below reflects the high and lowper share closing sale prices of the Company’s common stock as reported by TheNASDAQ Stock Market for each of the periods indicated.  Such prices reflect inter-dealer prices, donot include adjustments for retail mark-ups, markdowns or commissions, and maynot necessarily represent actual transactions.

 
|            |   | **High** |   | **Low** |   |
|-----------------|--------|----------|--------|---------|--------|
| 2003            |   |     |   |    |   |
| Fourth  Quarter |   | $        | 21.05  |    | $      | 15.75 |   |
| Third  Quarter  |   | 24.55    |   | 17.42   |   |
| Second  Quarter |   | 19.09    |   | 11.12   |   |
| First  Quarter  |   | 12.90    |   | 9.05    |   |
|            |   |     |   |    |   |
| 2002            |   |     |   |    |   |
| Fourth  Quarter |   | $        | 9.80   |    | $      | 4.69 |   |
| Third  Quarter  |   | 6.95     |   | 5.15    |   |
| Second  Quarter |   | 9.40     |   | 6.23    |   |
| First  Quarter  |   | 11.25    |   | 6.75    |   |

 

The Company has neverpaid or declared any cash dividends on its common stock and does not intend topay dividends on its common stock in the near future.  To date, the Company has incurred cumulative operating losses andpresently expects to retain its future anticipated earnings to financedevelopment and expansion of its business. As of February 28, 2004, there were approximately 7,900 beneficialowners and approximately 800 registered holders of record of the Company’scommon stock.

 

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Item 6.                                     SELECTED FINANCIALDATA

 

The following selectedfinancial data for each of the fiscal years in the five-year period endedDecember 31, 2003 is derived from the audited financial statements of theCompany and the notes thereto.  Theinformation set forth below should be read in conjunction with the Company’sfinancial statements, including the notes thereto, and “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”which are included elsewhere in this Annual Report on Form 10-K.

 
|                                                       |   | **2003**                                      |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|------------------------------------------------------------|--------|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
|                                                       |   | **(In  thousands, except per share amounts)** |   |
| **Years ended December 31:**                          |   |                                          |   |     |   |     |   |     |   |     |   |
| Revenue                                                    |   | $                                             | 26,775 |     | $      | 21,116   |   | $        | 15,196 |     | $      | 10,628 |   | $ | 6,623 |   |
| Gross margin                                               |   | 19,704                                        |   | 14,808   |   | 10,723   |   | 7,168    |   | 4,303    |   |
|                                                       |   |                                          |   |     |   |     |   |     |   |     |   |
| Operating expenses:                                        |   |                                          |   |     |   |     |   |     |   |     |   |
| Selling, general and administrative                        |   | 13,124                                        |   | 9,988    |   | 8,420    |   | 6,919    |   | 5,081    |   |
| Research and development                                   |   | 5,169                                         |   | 4,143    |   | 3,358    |   | 3,036    |   | 2,525    |   |
| Operating income (loss)                                    |   | 1,411                                         |   | 677      |   | (1,055   | )      | (2,787   | )      | (3,303   | )      |
|                                                       |   |                                          |   |     |   |     |   |     |   |     |   |
| Net income (loss)                                          |   | $                                             | 8,132  | (1)      | $      | 790      |   | $        | (1,012 | )        | $      | (2,637 | ) | $ | (3,218 | ) |
|                                                       |   |                                          |   |     |   |     |   |     |   |     |   |
| Net income (loss) per share-basic                          |   | $                                             | 0.80   |     | $      | 0.09     |   | $        | (0.14  | )        | $      | (0.39 | ) | $ | (0.64 | ) |
|                                                       |   |                                          |   |     |   |     |   |     |   |     |   |
| Weighted average common shares outstanding – basic    |   | 10,189                                        |   | 8,861    |   | 7,075    |   | 6,760    |   | 5,046    |   |
|                                                       |   |                                          |   |     |   |     |   |     |   |     |   |
| Net income (loss) per share-diluted                        |   | $                                             | 0.69   |     | $      | 0.08     |   | $        | (0.14  | )        | $      | (0.39 | ) | $ | (0.64 | ) |
|                                                       |   |                                          |   |     |   |     |   |     |   |     |   |
| Weighted average common shares outstanding –  diluted |   | 11,848                                        |   | 9,822    |   | 7,075    |   | 6,760    |   | 5,046    |   |
|                                                       |   |                                          |   |     |   |     |   |     |   |     |   |
| **At December 31:**                                   |   |                                          |   |     |   |     |   |     |   |     |   |
| Working capital                                            |   | $                                             | 31,390 |     | $      | 9,219    |   | $        | 6,094  |     | $      | 2,344 |   | $ | 5,409 |   |
| Total assets                                               |   | 53,257                                        |   | 18,827   |   | 13,269   |   | 7,287    |   | 8,666    |   |
| Long-term debt                                             |   | —                                        |   | —   |   | —   |   | —   |   | —   |   |
| Total shareholders’ equity                            |   | 44,263                                        |   | 11,721   |   | 8,051    |   | 3,765    |   | 6,098    |   |
|                                                            |        |                                               |        |          |        |          |        |          |        |          |        |  |  |  |  |  |  |

 

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(1)          Includes a net tax benefit of $6,507 resulting fromthe reversal of the Company's valuation allowance for its net deferred taxassets, 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

 

**Executive Summary**

 

2003was a year of financial growth for Vital Images.  The Company reported revenue of $26.8 million, a 27% increaseover the prior year revenue of $21.1 million. Core revenue components, that is, software license fees and maintenanceand services, rose 36% in 2003 to $24.7 million from $18.2 million in2002.  In 2003, most of the Company’srevenue was generated from the U.S. CT market. Going forward, the Company anticipates a growing contribution from othersources, including an expanding picture archive and communicationsystems (“PACS”) market, salesof Web-based products and the Company’s installed base.

 

VitalImages recorded net income of $8.1 million, or $0.69 per diluted share, in 2003versus $790,000 of net income, or $0.08 per diluted share, in 2002.  Full-year earnings for 2003 include a nettax benefit of $6.5 million, or $0.55 per diluted share.

 

InJune 2003, the Company completed a private investment in public equityfinancing (“PIPE”) that netted $19.0 million from the sale of 1.5 millionshares of common stock.  The Companyplans to use the net proceeds to expand its business.  To that end, in early 2004, Vital Images acquired HInnovation,Inc., aprivately-held provider of software solutions that allow physicians to use PCsor notebook computers to access 2D, 3D and 4D medical imaging applicationssecurely over the Internet, as a significant step towardsexpanding its presence in the PACS and Web-based markets.  The Company also generated $4.4 million inpositive cash flow from operations in 2003. The PIPE and positive cash flow from operations helped increase cash, cashequivalents and marketable securities to $34.2 million as of December 31,2003, up from $10.6 million as of December 31, 2002.

 

**Overview**

 

Vital Images develops,markets and supports 3D medical imaging software for use primarily in clinicaldiagnosis, disease screening and therapy planning.  The Company’s software applies proprietary computer graphics andimage processing technologies to a wide variety of data supplied by computedtomography (“CT”) and magnetic resonance (“MR”) scanners.  Vital Images’ products allow clinicians tocreate 2D, 3D and 4D views of human anatomy and to non-invasively navigatewithin these images to better visualize and understand internal structures andpathologies.  The Company believes thatits high-speed visualization technology and customized protocols cost-effectivelybring 3D visualization and analysis into the routine, day-to-day practice ofmedicine.  The Company, which operatesin a single business segment, markets its products to healthcare providers andto manufacturers of PACS and diagnostic imaging systems through a direct salesforce in the United States and independent distributors in internationalmarkets.

 

On October 28, 1996,the Board of Directors of Bio-Vascular, Inc. (“Bio-Vascular”), now known asSynovis Life Technologies, Inc., the former parent company of Vital Images,approved a plan to spin off and establish Vital Images as an independent,publicly-owned company.  On May 12,1997, Bio-Vascular distributed all of the shares of Vital Images to theshareholders of Bio-Vascular, and on that date Vital Images began operating asan independent public company.  AllBio-Vascular shareholders of record as of May 5, 1997 received one share ofVital Images common stock for each two shares of Bio-Vascular stock held onthat date, and cash in lieu of fractional shares.  Vital Images’ common stock is currently traded on The NASDAQNational Market under the symbol VTAL.

 

**Critical Accounting Policies and Estimates**

 

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

 

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

 

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

 

*Deferred tax asset.* TheCompany records a valuation allowance to reduce its deferred tax assets to theamount that is more likely than not to be realized.  During 2003, the Company concluded that it is more likely thannot that substantially all of its net deferred tax assets would be realized andthe Company reversed substantially all of its valuation allowance for netdeferred tax assets, which resulted in the recording of a net tax benefit in2003.  The reversal of the deferred taxassets valuation allowance is based upon the Company’s historical operatingperformance and management’s expectation that the Company will generate taxableincome of at least $25 million in future periods to allow it to realize itsdeferred tax assets resulting from the tax benefits associated with its netoperating loss carryforwards and a significant portion of its research anddevelopment tax credit carryforwards, as well as certain other tax benefitsrelated to book and tax income timing differences.  The Company recorded a net increase in deferred tax assets of$9.8 million, $6.6 million of which was recorded as a tax benefit in thestatement of operations and represents the tax benefit of its net operatingloss and tax credit carryforwards, as well as certain other tax benefits relatedto book and tax income timing differences. The remaining $3.2 million increase in deferred tax assets was recordedas additional paid-in capital and represents the amount of deferred tax assetsgenerated from the exercise of stock options. Should the Company determine that it would not be able to realize all orpart of its net deferred tax asset in the future, an adjustment to record avaluation allowance to reduce the deferred tax assets would be charged toincome in the period such a determination was made.

 

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

 

*Revenue Recognition. *The Company licenses its software and sells products and services toend-users and also indirectly through OEMs and independent distributors. Termsoffered by the Company do not generally differ based on whether the customer isan end-user, OEM or independent distributor. The Company offers terms that require payment within 30 to 90 days afterproduct delivery.  The Company does notoffer rights of return, acceptance clauses or price protection to itscustomers.

 

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Licensefees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale ofsystem hardware, including peripheral equipment.  Maintenance and service revenue is derived from hardware and softwaremaintenance and from services consisting of telephone support, installation,training and engineering services. The Company’s software licenses are alwayssold as part of an arrangement that includes maintenance and support and ofteninstallation and training services. Engineering services consist of software modification or developmentservices that are sold separately to OEMs. The Company generally sells hardware as part of a system sale, but itoccasionally sells hardware as part of a system upgrade or additional productsale.

 

TheCompany recognizes revenue in accordance with AICPA Statement of Position(“SOP”) 97-2,  Software RevenueRecognition,  as amended by SOP 98-4 andSOP 98-9, as well as Technical Practice Aids issued from time to time by theAmerican Institute of Certified Public Accountants and Staff AccountingBulletin (SAB) No. 104.  The Companyrecognizes revenue when it is realized or realizable and earned.  The Company considers revenue realized orrealizable and earned when it has persuasive evidence of an arrangement, theproduct has been shipped or the services have been provided to the customer,the sales price is fixed or determinable, and collectibility is probable.

 

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

 

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

 

*Software and Hardware*

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

 

*Services*

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

 

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

 

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

 

*Multiple-ElementArrangements*

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

 

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

 
|                                       |   | **For the  Years Ended December 31,** |   |
|--------------------------------------------|--------|--------------------------------------------|--------|
|                                       |   | **2003**                                   |   | **2002** |   | **2001** |   |
|                                       |   |                                       |   |   |   |   |   |
| Revenue:                                   |   |                                       |   |   |   |   |   |
| License  fees                              |   | 68.7                                       | %      | 67.3 | % | 66.4 | % |
| Maintenance  and services                  |   | 23.6                                       |   | 19.0 |   | 16.1 |   |
| Hardware                                   |   | 7.7                                        |   | 13.7 |   | 17.5 |   |
| Total  revenue                             |   | 100.0                                      |   | 100.0 |   | 100.0 |   |
|                                       |   |                                       |   |   |   |   |   |
| Cost  of revenue:                          |   |                                       |   |   |   |   |   |
| License  fees                              |   | 6.8                                        |   | 5.9 |   | 4.6 |   |
| Maintenance  and services                  |   | 14.1                                       |   | 13.6 |   | 10.9 |   |
| Hardware                                   |   | 5.5                                        |   | 10.4 |   | 13.9 |   |
| Total  cost of revenue                     |   | 26.4                                       |   | 29.9 |   | 29.4 |   |
|                                       |   |                                       |   |   |   |   |   |
| Gross  margin                              |   | 73.6                                       |   | 70.1 |   | 70.6 |   |
|                                       |   |                                       |   |   |   |   |   |
| Operating  expenses:                       |   |                                       |   |   |   |   |   |
| Sales  and marketing                       |   | 34.8                                       |   | 32.2 |   | 37.9 |   |
| Research  and development                  |   | 19.3                                       |   | 19.6 |   | 22.1 |   |
| General  and administrative                |   | 14.2                                       |   | 15.1 |   | 17.5 |   |
| Total  operating expenses                  |   | 68.3                                       |   | 66.9 |   | 77.5 |   |
|                                       |   |                                       |   |   |   |   |   |
| Operating  income (loss)                   |   | 5.3                                        |   | 3.2 |   | (6.9 | ) |
|                                       |   |                                       |   |   |   |   |   |
| Interest  income, net                      |   | 0.8                                        |   | 0.6 |   | 0.3 |   |
| Income  (loss) before income taxes         |   | 6.1                                        |   | 3.8 |   | (6.6 | ) |
|                                       |   |                                       |   |   |   |   |   |
| Provision  (benefit) for income taxes, net |   | (24.3                                      | )      | 0.1 |   | (0.1 | ) |
|                                       |   |                                       |   |   |   |   |   |
| Net  income (loss)                         |   | 30.4                                       | %      | 3.7 | % | (6.7 | )% |

 

**Revenue**

 

Total revenue increased27% to $26,775,000 in 2003 from total revenue of $21,116,000 in 2002.  Total revenue increased 39% to $21,116,000in 2002 from total revenue of $15,196,000 in 2001.  The revenue growth was driven by the increase in the Company’score revenue components of software license fees and maintenance and service revenue.  License fee revenue increased 29% to$18,389,000 in 2003 and increased 41% to $14,212,000 in 2002 from $10,083,000in 2001.  The increase in softwarelicense fee revenue was driven by an increase in the number of *Vitrea*2 licenses sold, principally to Toshiba Medical Systems Corporation (“Toshiba”),and an increase in the number of Vitrea add-on options sold.  The installed base of Vitrea customersincreased from approximately 550 at December 31, 2001 to approximately 850at December 31, 2002 to approximately 1,300 at December 31,2003.  The number of Vitrea add-onmodules sold by the Company increased from approximately 70 in 2001, to 660 in2002 and 1,200 in 2003.

 

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

 

Maintenanceand services revenue increased 57% to $6,320,000 for 2003 compared to$4,019,000 for 2002 and increased 64% to $4,019,000 in 2002 from $2,450,000 in2001.  Of the $2,301,000 increase for2003 compared

 

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to2002, $1,622,000 consisted of an increase in maintenance revenue and $793,000was an increase in training revenue. The increases for 2003 were partially offset by an $80,000 decrease inengineering services rendered under product development agreements withMedtronic Surgical Navigation Technologies (“SNT”), E-Z-EM, Inc. and Toshibaand a $34,000 decrease in installation revenue due to Toshiba performing itsown installations of *Vitrea 2*. Of the $1,569,000 increase for 2002 compared to 2001, $716,000 consistedof an increase in maintenance revenue and $596,000 was an increase in trainingrevenue.  The increases in maintenancerevenue in both 2003 and 2002 were due to the Company adding new customers tothe installed base and renewing back maintenance from customers whosemaintenance arrangements had lapsed. The increases in training revenue in both 2003 and 2002 were due to anoverall increase in the number of training sessions sold with the customers’initial purchases of software.

 

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

 

**Gross Margin**

 

The Company’s grossmargin percentage was 74% in 2003, up from 70% in 2002. The gross marginpercentage was 71% in 2001.  Revenue in2003 included more higher margin software license fee revenue and less lowermargin hardware revenue than in 2002. In addition, there was a 57% increase in maintenance and servicesrevenue with only a 32% increase in cost of revenue for maintenance andservices.  The number of customersupport employees increased from 17 at December 31, 2002 to 22 atDecember 31, 2003.  The decrease inmargin in 2002 compared to 2001 was due to increasing costs for customersupport resulting from the Company’s growth, which was partially offset by thefavorable impact of sales mix.  Revenuein 2002 included more of higher margin software license fee revenue than in2001.  The number of customer supportemployees increased from 11 at December 31, 2001 to 17 atDecember 31, 2002.

 

The *Vitrea 2* system, consistingof *Vitrea2* software and third-party hardware and peripherals, is designed tooffer end users an integrated 3D medical imaging system.  The Company receives a nominal discount inpurchasing the third-party hardware and peripheral components of the *Vitrea 2*system,and the Company’s gross margin on the resale of these system componentsapproximates its discount.  During 2004,the Company will begin selling more third party software products, includinglung visualization products from R2 Technology, Inc. (“R2”) and a fusiontechnology product from Mirada Solutions, Limited.  The Company will receive a discount when purchasing thesethird-party software products, but such discounts will be considerably lessthan the gross margins the Company earns on its own internally-developedsoftware products.  Accordingly, theCompany anticipates that its gross margin on software license fee revenue, aswell as the overall gross margin for total revenue, will decrease in futureperiods.

 

**Sales and Marketing**

 

Sales and marketingexpenses were $9,318,000, $6,795,000 and $5,761,000 for 2003, 2002 and 2001,respectively.  The increases were mostly due to increases incompensation costs as a result of additional personnel required to supportrecent growth and increased sales commissions as a result of increasedrevenue.  Compensation costs, includingcommissions, increased $1,515,000 from 2002 to 2003 and $679,000 from 2001 to2002.  There were 40, 33 and 27 salesand marketing personnel as of December 31, 2003, 2002 and 2001, respectively.  Due to the increase in the number ofpersonnel from 2002 to 2003, travel and entertainment expenses increased$280,000 and hiring costs increased $141,000. There was a $356,000 increase in expenses related to utilizing outsideconsultants to help sell and promote *Vitrea 2* and related options for 2003 ascompared to 2002.  Tradeshow andmarketing brochure costs increased $65,000 and $147,000 from 2002 to 2003 and2001 to 2002, respectively, due to the Company purchasing more space at 

 

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

 

**Research and Development**

 

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

 

Totalresearch and development expenses increased from $3,359,000 in 2001 to$4,143,000 in 2002.  Of the $784,000increase in expense, $794,000 was due to increased compensation costs resultingfrom additional personnel supporting the development of *Vitrea 2*.  Total research anddevelopment personnel increased from 24 at December 31, 2001 to 33 atDecember 31, 2002.  Thecompensation increase from 2001 to 2002 was partially offset by a $211,000increase in expenses classified in cost of revenue during 2002 in connectionwith engineering services provided to certain third parties under variousproduct development agreements.  Therewas also a $59,000 increase in annual depreciation expense from 2001 to 2002 asthe result of equipment purchases to support the additional personnel and to upgradecomputer equipment.

 

TheCompany anticipates that research and development costs will increase in futureperiods as the Company develops software tools for applications with largepotential markets, such as cardiovascular disease, disease screeningapplications such as colon cancer, and surgical and therapy planning.

 

**General and Administrative**

 

General andadministrative expenses were $3,807,000, $3,193,000 and $2,658,000 in 2003,2002 and 2001, respectively.  Of the$614,000 increase from 2002 to 2003, $263,000 was due to an increase in compensationcosts related to additional personnel. Total general and administrative personnel increased from 17 atDecember 31, 2002 to 21 at December 31, 2003.  Legal fees increased $227,000 during 2003 ascompared to 2002 due to business development, patent work and SEC filingsrelated to the registration statement covering the resale of shares from aprivate placement in June 2003.  Inaddition, registration and filing fees increased $104,000 in 2003 as comparedto 2002, which includes a $100,000 NASDAQ National Market registrationfee.  This registration fee was paid forthe first time in June 2003 when the Company qualified for listing on theNASDAQ National Market.  There was alsoa $54,000 increase in 2003 as compared to 2002 due to higher audit costs,including assistance with SEC filings. These increases were partially offset by a $230,000 decrease due toseverance costs paid in 2002 to the Company’s former chief executive officer.  The $535,000 increase from 2001 to 2002 waslargely due to severance costs of $230,000 for the Company’s former chiefexecutive officer, an increase in consulting fees of $73,000, travel costs of$79,000 related to investor relations and business development and a $52,000increase in insurance costs due to the growth of the Company and premium rateincreases.  The decreases in general andadministrative expenses as a percentage of revenue during these periods reflectthe Company’s ability to limit operating costs while increasing revenue.  The Company believes that general andadministrative expenses will increase in future periods due to increasedinfrastructure costs as the business grows but that they will remain unchangedor decrease from the current percentage of total revenue.

 

32

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**Operating Income (Loss)**

 

The increasing revenuefrom *Vitrea2* and add-on software options and related service revenues, net ofthe increased expenses attributable to the development of the Company’sinfrastructure and the development and promotion of the *Vitrea 2*product, resultedin operating income of $1,411,000 for 2003 compared with $677,000 for 2002 andan operating loss of $1,055,000 for 2001.

 

**Interest Income**

 

There was $214,000 ofinterest income for 2003, compared with $135,000 in 2002 and $55,000 in2001.  The increases in interest incomefrom 2001 to 2002 and from 2002 to 2003 were primarily due to increases incash, cash equivalents and marketable securities.  The increases in cash, cash equivalents and marketable securitieswere due to the increased cash flows from operations from 2001 to 2002 and from2002 to 2003, the $18,991,000 of cash generated from the private placement inJune 2003, and the exercise of warrants for the purchase of common stock,which generated $1,725,000 and $4,491,000 in proceeds for the years endedDecember 31, 2002 and 2001, respectively.

 

**Income Taxes**

 

During2003, the Company concluded that it is more likely than not that substantiallyall of its net deferred tax assets would be realized, and the Company reversedsubstantially all of its valuation allowance for net deferred tax assets, whichresulted in the recording of a net tax benefit in 2003.  The reversal of the deferred tax assetsvaluation allowance is based upon the Company’s historical operating performanceand management’s expectation that the Company will generate taxable income ofat least $25 million in future periods to allow it to realize its deferred taxassets resulting from the tax benefits associated with its net operating loss(“NOL”) carryforwards and a significant portion of its research and developmenttax credit carryforwards, as well as certain other tax benefits related to bookand tax income timing differences. The reversal of the valuation allowanceresulted in a tax benefit of $7,171,000. This reversal net of other current year state and federal income taxesresulted in a net tax benefit of $6,507,000 in 2003.  The Company has a valuation allowance of $147,000 as ofDecember 31, 2003.  The Company’seffective tax rate for 2003, before the effect of the valuation allowancereversal, was approximately 5 percent, reflecting state income taxes andcertain state minimum fees.

 

Asof December 31, 2003, the Company had available NOL carryforwards ofapproximately $22.9 million and research and development tax creditcarryforwards of approximately $1.1 million expiring in varying amounts from2004 through 2023.

 

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

 

**Liquidityand Capital Resources**

 

As of December 31,2003, the Company had $30.1 million in cash and cash equivalents, $4.1 millionin marketable securities, working capital of $31.4 million and no borrowings.

 

Cash provided byoperations was $4.4 million for 2003 compared with cash provided by operationsof $2.4 million for 2002 and $771,000 for 2001.  During 2003, $14.3 million of cash was generated from increasesin net income, deferred revenue, accounts payable and non-cash expenses fordepreciation and the tax benefit from stock option transactions.  These increases were partially offset by a$9.8 million increase in the deferred income tax benefit.  During 2002, $3.7 million of cash fromoperations was generated from increases in net income, deferred revenue,non-cash depreciation and accrued expenses and other current liabilities.  These increases were partially offset by a$1.4 million increase in accounts receivable. During 2001, $2.6 million of cash was generated from operations as aresult of increases in deferred revenue, non-cash depreciation expense 

 

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

 

Of the $1.2 million, $1.6million and $1.1 million increases in deferred revenue for the years ended2003, 2002 and 2001, respectively, $927,000, $841,000 and $605,000, respectively, were due to volume increasesin *Vitrea2* sales and renewals of annual maintenance.  For the years ended 2003, 2002 and 2001,$345,000, $717,000 and $569,000, respectively, of the increase in deferredrevenue was due to volume increases in training and installation from increasedsales of *Vitrea2*.  The $500,000 increase in accounts payable for 2003 was dueto the timing of payments and the increasing level of expenses.  The$1.4 million increase and $728,000 increase in accounts receivable for 2002 and2001, respectively, were due to revenue increases.  The days sales outstanding improved from 92 days atDecember 31, 2001 to 90 days and 71 days at December 31, 2002 and2003, respectively.  The $384,000and $714,000 increases in accrued expenses and other liabilities in 2002 and2001, respectively, were primarily due to increases in incentive bonuses andsales commissions directly related to increased revenue and profitability.

 

The Company used $3.4million, $4.0 million and $1.5 million of cash in investing activities in 2003,2002 and 2001, respectively, of which $1.9 million, $1.5 million and $769,000, respectively, was usedfor purchases of property and equipment. The purchases for all periods were principally to upgrade computerequipment and to purchase computer equipment for new personnel.  In addition, the Company purchased furnitureand fixtures and leasehold improvements related to expansions of the Company’soffices in 2003 and 2002.  Managementanticipates that the Company will continue to purchase property and equipmentnecessary in the normal course of the Company’s business.  The amount and timing of these purchases andthe related cash outflows in future periods is difficult to predict and dependson a number of factors, including the hiring of employees and the rate ofchange of computer hardware.  TheCompany used $6.8 million and $8.0 million to purchase investments inmarketable securities during 2003 and 2002, respectively.  The Company realized $5.2 million and $5.5million of proceeds from maturities of marketable securities during 2003 and2002, respectively.  The marketablesecurities are invested in U.S. government obligations, U.S. government agencyobligations, corporate commercial obligations and certificates of deposits.

 

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

 

Cashprovided by financing activities totaled $21.1 million, $2.9 million and $5.3million for 2003, 2002 and 2001, respectively. Of the cash provided during 2003, $19.0 million consisted of net proceeds,after deducting offering costs of $1.3 million, from the Company’s privateplacement of 1.5 million shares of common stock at $13.50 per share.  A registration statement covering the resaleof these shares was declared effective on September 29, 2003 by theSecurities and Exchange Commission.

 

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

 

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

 

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

 

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

 

The following summarizesour contractual obligations, including purchase commitments, atDecember 31, 2003, and the effect such obligations are expected to have onour liquidity and cash flow in future periods.

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

 

----

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

 

(2) The merger consideration of HInnovation includes contingentmilestone cash payments of up to $3 million. The Company expects the contingent milestone cash payments to be made ascertain milestones are achieved over a 12 to 24 month period following the dateof the acquisition.

 

 

The Company had no significant outstanding purchase orders as ofDecember, 31 2003.  The Company hasentered into a number of technology licensing agreements that provide for thepayment of royalties when the Company sells *Vitrea2*. Except for the R2-purchase commitment discussed above, theCompany is not obligated for any minimum payments under such agreements.

 

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

 

**Foreign Currency Transactions**

 

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

 

**Inflation**

 

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

 

**Recent Accounting Pronouncements**

 

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

 

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

 

**Forward-Looking Statements**

 

This Annual Report onForm 10-K contains certain forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995 and information that is basedon management’s beliefs as

 

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well as on assumptionsmade by, and upon information currently available to, management.  When used in this Annual Report on Form10-K, the words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,”and “estimate” or similar expressions are intended to identify suchforward-looking statements.  However,this Annual Report on Form 10-K also contains other forward-lookingstatements.  Forward-looking statementsare not guarantees of future performance and are subject to certain risks,uncertainties and assumptions including, but not limited to, the following factors,which could cause the Company’s future results and shareholder values to differmaterially from those expressed in any forward-looking statements made by or onbehalf of the Company: the dependence on market growth of the industry in whichthe Company operates; the extent to which the Company’s products gain marketacceptance; the potential for litigation regarding patent and otherintellectual property rights; the introduction of competitive products byothers; dependence on major customers; fluctuations in quarterly results; theprogress of product development; the availability of third party reimbursement;and the receipt and timing of regulatory approvals and other factors detailedfrom time to time in the Company’s filings with the Securities and ExchangeCommission, including those set forth under the heading “Important Factors”included in Item 1 of this Annual Report on Form 10-K.

 

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Item 7A.                           QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market risk refers to therisk that a change in the level of one or more market prices, interest rates,indices, volatilities, correlations or other market factors such as liquiditywill result in losses for a certain financial instrument or group of financialinstruments.  The Company does not holdor issue financial instruments for trading purposes, and it does not enter intoforward financial instruments to manage and reduce the impact of changes inforeign currency rates because, as disclosed above, substantially all of theCompany’s foreign transactions are negotiated, invoiced and paid in U.S.dollars.  Based on the controls in placeand the relative size of the financial instruments entered into, the Companybelieves the risks associated with not using these instruments would not have amaterial adverse effect on the Company’s consolidated financial position orresults of operations.

 

In addition, the Companydoes not engage in speculative transactions and does not use derivativeinstruments or engage in hedging activities. See the Notes to Financial Statements for a description of the Company’saccounting policies and other information related to these financialinstruments.

 

In the normal course ofbusiness, the Company is exposed to market risks, including changes in interestrates and price changes that could affect the Company’s operating results.  As of December 31, 2003, fluctuationsin interest rates, exchange rates and price changes would not have a materialeffect on the Company’s financial position or operating results.

 

**InterestRate Risk**

 

The Company places itscash and cash equivalents, which generally have a term of less than 90 days,with a high-quality financial institution and has investment guidelinesrelative to diversification and maturities designed to maintain safety andliquidity.  As of December 31,2003, the Company had cash and cash equivalents investments totaling$30,112,000.  Due to the short-termnature of these instruments, the carrying value approximates market value.  If, during 2004, average short-term interestrates decreased by 1.0% over 2003 average rates, the Company’s projectedinterest income from short-term investments would decrease by approximately$300,000, assuming a similar level of investments in 2004.

 

**PriceRisk**

 

As of December 31,2003, the Company held marketable securities with an aggregate fair marketvalue of $4,079,000.  All of theCompany’s marketable securities are classified as available-for-sale and allmature in one year or less. Available-for-sale investments are recorded at market value, which isbased on quoted market prices, with unrealized holding gains and lossesincluded as a separate component of shareholders’ equity.  The Company uses a specific identificationcost method to determine the gross realized gains and losses on the sale of itssecurities.  Had market prices of suchsecurities declined 10% as of December 31, 2003, the values of theseinstruments would have decreased by $408,000.

 

**ForeignCurrency Risk**

 

Substantially all of theCompany’s foreign transactions are negotiated, invoiced and paid in U.S.dollars.  Therefore, fluctuations in thevalue of the dollar as compared to other foreign currencies have not had aneffect on the Company.

 

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Item 8.                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

The Company’s financialstatements, supplemental schedule and Report of Independent Auditorsthereon, all of which are included in this Annual Report on Form 10-K, arelisted in Item 15(a) (1) of this Form 10-K.

 

Item 9.                                     CHANGESIN AND DISAGREEMENTS WITH AUDITORS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

Not applicable.

 

Item 9A.                           CONTROLS AND PROCEDURES

 

TheCompany, under the supervision and with the participation of its management,including its Chief Executive Officer and the Chief Financial Officer,evaluated the effectiveness of the Company’s “disclosure controls andprocedures” (as defined in Rule 13a-15(e) under the Securities ExchangeAct) and internal control over financial reporting as of the end of the periodcovered by this report. Based on that evaluation, the Chief Executive Officerand the Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures are effective and that there has been no change in theCompany’s internal control over financial reporting during the quarter endedDecember 31, 2003 that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

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PART III

 

Certaininformation required by Part III is omitted from this Annual Reportbecause the Registrant will file a definitive Proxy Statement relating to our2004 Annual Meeting of Shareholders pursuant to Regulation 14A (the “ProxyStatement”) not later than 120 days after the end of the fiscal yearcovered by this Report on Form 10-K, and certain information includedtherein is incorporated herein by reference.

 

Item 10.                               DIRECTORSAND EXECUTIVE OFFICERS OF REGISTRANT

 

Theinformation concerning the “Executive Officers of the Registrant” required bythis Item 10 will be included under the captions “Election ofDirectors” and “Information Concerning Directors, Nominees and ExecutiveOfficers” in the Company’s 2004 Proxy Statement.  Informationconcerning the compliance of the Company’s officers, directors and 10%stockholders with Section 16(a) of the Securities Exchange Act of 1934 isincorporated by reference to the information to be contained in the ProxyStatement under the caption “Compliance with Section 16(a)” in theCompany’s 2004 Proxy Statement.  The information regarding Audit Committeemembers and “audit committee financial experts” is incorporated by reference tothe information to be contained in the Proxy Statement under the caption “BoardCommittees.”  The information regardingthe Company’s Code of Business Ethics is incorporated by reference to theinformation to be contained in the Proxy Statement under the heading “Code of Business Conduct and Ethics.”

 

Item 11.                               EXECUTIVE COMPENSATION

 

The information under thecaptions “Executive Compensation” and “Director Compensation” to be containedin the Company’s 2004 Proxy Statement is incorporated herein by reference.

 

Item 12.                               SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

 

The information under thecaptions “Beneficial Ownership of Common Stock” and “Equity Compensation PlanInformation” to be contained in the Company’s 2004 Proxy Statement isincorporated herein by reference.

 

Item 13.                               CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

 

There are no reportabletransactions.

 

Item 14.                               PRINCIPALACCOUNTANT FEES AND SERVICES

 

The information under thecaption “Independent Auditors” to be contained in the Company’s 2004 ProxyStatement is incorporated herein by reference.

 

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PART IV

 

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

 

The following financialstatements and supplemental schedule of Vital Images, Inc. and Report ofIndependent Auditors thereon are included herein:

 

(a) (1)       FINANCIAL STATEMENTS

 
| Report of Independent  Auditors                                                                     |   |
|-----------------------------------------------------------------------------------------------------|--------|
| Balance Sheets as of December 31,  2003 and 2002                                               |   |
| Statements  of Operations for the years ended December 31, 2003, 2002 and 2001                 |   |
| Statements of  Shareholders’ Equity for the years ended December 31, 2003, 2002 and  2001 |   |
| Statements of Cash Flows for  the years ended December 31, 2003, 2002 and 2001                 |   |
| Notes to Financial  Statements                                                                      |   |
|                                                                                                |   |
| (a) (2) Schedule II. Valuation and Qualifying Accounts                                         |   |

 

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

 

(a) (3)       LISTING OF EXHIBITS

 

The Exhibits required tobe a part of this Report are listed in the Index to Exhibits, which follows theFinancial Statement Schedule on page 65.

 

(b)   REPORTS ON FORM 8-K

 

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

 

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

 

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

 

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

 

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

 

40

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

 

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

 

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

 

(c)                                  EXHIBITS

 

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

 

41

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SIGNATURES

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized, in Minneapolis, Minnesota, on the15th day of March, 2004.

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

 

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

 
| **Signature**           |   | **Title**                                        |                                             | **Date** |
|-------------------------|--------|--------------------------------------------------|--------------------------------------------------|----------|
|                    |   |                                             |                                             |     |
| /s/Jay D. Miller        |   |                                             | President, Chief Executive  Officer and Director |     | March 15, 2004 |
| Jay D. Miller           |   | (Principal  Executive Officer)                   |                                             |     |
|                    |   |                                             |                                             |     |
| /s/Gregory S. Furness   |   |                                             | Chief Financial  Officer,                        |     | March 15, 2004 |
| Gregory S. Furness      |   | Vice  President-Finance, Treasurer and Secretary |                                             |     |
|                    |   | (Chief  Accounting Officer)                      |                                             |     |
|                    |   |                                             |                                             |     |
| /s/Douglas M. Pihl      |   |                                             | Chairman of the Board  and Director              |     | March 15, 2004 |
| Douglas M. Pihl         |   |                                             |                                             |     |
|                    |   |                                             |                                             |     |
| /s/Vincent J. Argiro    |   |                                             | Chief Technology  Officer, Founder and Director  |     | March 15, 2004 |
| Vincent J. Argiro       |   |                                             |                                             |     |
|                    |   |                                             |                                             |     |
| /s/James B. Hickey, Jr. |   |                                             | Director                                         |     | March 15, 2004 |
| James B. Hickey, Jr.    |   |                                             |                                             |     |
|                    |   |                                             |                                             |     |
| /s/Richard W. Perkins   |   |                                             | Director                                         |     | March 15, 2004 |
| Richard W. Perkins      |   |                                             |                                             |     |
|                    |   |                                             |                                             |     |
| /s/Michael W. Vannier   |   |                                             | Director                                         |     | March 15, 2004 |
| Michael W. Vannier      |   |                                             |                                             |     |
|                    |   |                                             |                                             |     |
| /s/Sven A. Wehrwein     |   |                                             | Director                                         |     | March 15, 2004 |
| Sven A. Wehrwein        |   |                                             |                                             |     |

 

42

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**REPORT OF INDEPENDENT AUDITORS**

 

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

 

In our opinion, thefinancial statements listed in the index appearing under Item 15(a)(1) presentfairly, in all material respects, the financial position of Vital Images, Inc.(the Company) at December 31, 2003 and 2002, and the results of itsoperations and its cash flows for each of the three years in the period ended December 31,2003 in conformity with accounting principles generally accepted in the UnitedStates of America.  In addition, in ouropinion, the financial statement schedule listed in the index appearing underItem 15(a)(2) presents fairly, in all material respects, the information setforth therein when read in conjunction with the related financialstatements.  These financial statementsand financial statement schedule are the responsibility of the Company’s management;our responsibility is to express an opinion on these financial statements andfinancial statement schedule based on our audits. We conducted our auditsof these statements in accordance with auditing standards generally accepted inthe United States of America, which require that we plan and perform the auditto obtain reasonable assurance about whether the financial statements are freeof material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts and disclosuresin the financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

 
| /s/  PricewaterhouseCoopers LLP                                                       |   |
|---------------------------------------------------------------------------------------|--------|
|                                                                                  |
| Minneapolis, Minnesota                                                                |
| February 6, 2004,  except Note 15 as to which the date is February 18, 2004 |

 

43

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**VITALIMAGES, INC.BALANCE SHEETS**

 
|                                                                                                                                                                       |   | **As of  December 31,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                                                                                                                       |   | **2003**                     |       | **2002** |   |
|                                                                                                                                                                       |   |                         | ** ** |   | ** ** |
| **ASSETS**                                                                                                                                                                 |   |                         | ** ** |   | ** ** |
| Current  assets:                                                                                                                                                           |   |                         |       |   |   |
| Cash  and cash equivalents                                                                                                                                                 |   | $                            | 30,111,613 |   | $ | 8,122,547 |   |
| Marketable  securities                                                                                                                                                     |   | 4,078,587                    |       | 2,508,113 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $235,000 and $240,000  as of December 31, 2003 and 2002, respectively                                 |   | 4,982,362                    |       | 4,971,079 |   |
| Deferred  income taxes                                                                                                                                                     |   | 275,000                      |       | — |   |
| Prepaid  expenses and other current assets                                                                                                                                 |   | 672,072                      |       | 498,692 |   |
| Total  current assets                                                                                                                                                      |   | 40,119,634                   |       | 16,100,431 |   |
| Property  and equipment, net                                                                                                                                               |   | 3,043,239                    |       | 2,156,835 |   |
| Licensed  technology, net                                                                                                                                                  |   | 450,000                      |       | 570,000 |   |
| Deferred  income taxes                                                                                                                                                     |   | 9,500,000                    |       | — |   |
| Other  assets                                                                                                                                                              |   | 144,346                      |       | — |   |
|                                                                                                                                                                       |   |                         |       |   |   |
| TOTAL  ASSETS                                                                                                                                                              |   | $                            | 53,257,219 |   | $ | 18,827,266 |   |
|                                                                                                                                                                       |   |                         |       |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                             |   |                         | ** ** |   | ** ** |
| Current  liabilities:                                                                                                                                                      |   |                         |       |   |   |
| Accounts  payable                                                                                                                                                          |   | $                            | 1,485,451  |   | $ | 757,715 |   |
| Accrued  payroll                                                                                                                                                           |   | 1,347,464                    |       | 1,486,654 |   |
| Deferred  revenue                                                                                                                                                          |   | 5,054,804                    |       | 3,870,958 |   |
| Accrued  royalties                                                                                                                                                         |   | 556,494                      |       | 546,593 |   |
| Other  current liabilities                                                                                                                                                 |   | 285,121                      |       | 219,036 |   |
| Total  current liabilities                                                                                                                                                 |   | 8,729,334                    |       | 6,880,956 |   |
| Deferred  revenue                                                                                                                                                          |   | 264,691                      |       | 225,539 |   |
| Total  liabilities                                                                                                                                                         |   | 8,994,025                    |       | 7,106,495 |   |
|                                                                                                                                                                       |   |                         |       |   |   |
| Commitments  (Notes 5, 13 and 15)                                                                                                                                          |   |                         |       |   |   |
|                                                                                                                                                                       |   |                         |       |   |   |
| Shareholders’  equity:                                                                                                                                                |   |                         |       |   |   |
| Preferred  stock: $0.01 par value; 5,000,000 shares authorized; none issued or  outstanding as of December 31, 2002 and 2001                                          |   | —                       |       | — |   |
| Common  stock: $0.01 par value; 20,000,000 shares authorized; 11,140,380 and  8,987,009 shares issued and outstanding as of December 31, 2003 and  2002, respectively |   | 111,404                      |       | 89,870 |   |
| Additional  paid-in capital                                                                                                                                                |   | 56,108,590                   |       | 31,719,371 |   |
| Accumulated  deficit                                                                                                                                                       |   | (11,956,800                  | )          | (20,088,470 | ) |
| Total  shareholders’ equity                                                                                                                                           |   | 44,263,194                   |       | 11,720,771 |   |
|                                                                                                                                                                       |   |                         |       |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                           |   | $                            | 53,257,219 |   | $ | 18,827,266 |   |

 

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

 

44

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**VITALIMAGES, INC.STATEMENTS OF OPERATIONS**

 
|                                                       |   | **For the  Years Ended December 31,** |       |
|------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                       |   | **2003**                                   |       | **2002** |   | **2001** |   |
|                                                       |   |                                       |       |   |   |   |   |
| Revenue:                                                   |   |                                       |       |   |   |   |   |
| License  fees                                              |   | $                                          | 18,388,794 |   | $ | 14,211,640 |   | $ | 10,082,897 |   |
| Maintenance  and services                                  |   | 6,319,999                                  |       | 4,019,639 |   | 2,450,037 |   |
| Hardware                                                   |   | 2,066,454                                  |       | 2,884,795 |   | 2,662,702 |   |
| Total  revenue                                             |   | 26,775,247                                 |       | 21,116,074 |   | 15,195,636 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Cost  of revenue:                                          |   |                                       |       |   |   |   |   |
| License  fees                                              |   | 1,818,353                                  |       | 1,250,426 |   | 703,593 |   |
| Maintenance  and services                                  |   | 3,773,794                                  |       | 2,862,459 |   | 1,656,207 |   |
| Hardware                                                   |   | 1,478,914                                  |       | 2,195,182 |   | 2,112,982 |   |
| Total  cost of revenue                                     |   | 7,071,061                                  |       | 6,308,067 |   | 4,472,782 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Gross  margin                                              |   | 19,704,186                                 |       | 14,808,007 |   | 10,722,854 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Operating  expenses:                                       |   |                                       |       |   |   |   |   |
| Sales  and marketing                                       |   | 9,317,766                                  |       | 6,795,377 |   | 5,761,416 |   |
| Research  and development                                  |   | 5,168,695                                  |       | 4,143,257 |   | 3,358,506 |   |
| General  and administrative                                |   | 3,806,914                                  |       | 3,192,735 |   | 2,657,998 |   |
| Total  operating expenses                                  |   | 18,293,375                                 |       | 14,131,369 |   | 11,777,920 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Operating  income (loss)                                   |   | 1,410,811                                  |       | 676,638 |   | (1,055,066 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Interest  income, net                                      |   | 213,859                                    |       | 134,870 |   | 55,089 |   |
| Income  (loss) before income taxes                         |   | 1,624,670                                  |       | 811,508 |   | (999,977 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Provision  (benefit) for income taxes, net                 |   | (6,507,000                                 | )          | 22,000 |   | 12,000 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Net  income (loss)                                         |   | $                                          | 8,131,670  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Net  income (loss) per share – basic                  |   | $                                          | 0.80       |   | $ | 0.09 |   | $ | (0.14 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Weighted  average common shares outstanding – basic   |   | 10,189,114                                 |       | 8,861,132 |   | 7,074,906 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Net  income (loss) per share – diluted                |   | $                                          | 0.69       |   | $ | 0.08 |   | $ | (0.14 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Weighted  average common shares outstanding – diluted |   | 11,848,268                                 |       | 9,821,798 |   | 7,074,906 |   |

 

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

 

45

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

 
|                                                                                            |   |       |   | **Additional****Paid-In  Capital** |    | **Accumulated  Deficit** |   | **Total  Shareholders’  Equity** |   |
|-------------------------------------------------------------------------------------------------|--------|------------|--------|------------------------------------|---------|--------------------------|--------|---------------------------------------|--------|
| **Common Stock**                                                                                |
| **Shares**                                                                                      |   | **Amount** |
|                                                                                            |   |       |   |                               |    |                     |   |                                  |   |   |   |
| Balances as of December 31, 2000                                                           |   | 6,823,106  |   | $                                  | 68,231  |                     | $      | 23,562,444                            |   | $ | (19,866,001 | ) | $ | 3,764,74 |   |
|                                                                                            |   |       |   |                               |    |                     |   |                                  |   |   |   |
| Stock-based compensation                                                                        |   |       |   |                               |    | 10,447                   |   |                                  |   | 10,447 |   |
| Issuance of common stock upon exercise of stock  options                                        |   | 49,520     |   | 495                                |    | 153,073                  |   |                                  |   | 153,568 |   |
| Issuance of common stock under Employee Stock Purchase  Plan                                    |   | 25,487     |   | 255                                |    | 91,397                   |   |                                  |   | 91,652 |   |
| Issuance of common stock upon exercise of stock  warrants                                       |   | 1,205,647  |   | 12,057                             |    | 4,478,744                |   |                                  |   | 4,490,801 |   |
| Issuance of common stock (Note 11)                                                              |   | 82,332     |   | 823                                |    | 550,801                  |   |                                  |   | 551,624 |   |
| Net and comprehensive loss                                                                      |   |       |   |                               |    |                     |   | (1,011,977                            | )      | (1,011,977 | ) |
| Balances as of December 31, 2001                                                           |   | 8,186,092  |   | 81,861                             |    | 28,846,906               |   | (20,877,978                           | )      | 8,050,789 |   |
|                                                                                            |   |       |   |                               |    |                     |   |                                  |   |   |   |
| Stock-based compensation                                                                        |   |       |   |                               |    | 18,279                   |   |                                  |   | 18,279 |   |
| Issuance of common stock upon exercise of stock  options                                        |   | 288,008    |   | 2,880                              |    | 1,003,321                |   |                                  |   | 1,006,201 |   |
| Issuance of common stock under Employee Stock Purchase  Plan                                    |   | 24,539     |   | 245                                |    | 130,363                  |   |                                  |   | 130,608 |   |
| Issuance of common stock upon exercise of stock  warrants                                       |   | 488,370    |   | 4,884                              |    | 1,720,502                |   |                                  |   | 1,725,386 |   |
| Net and comprehensive income                                                                    |   |       |   |                               |    |                     |   | 789,508                               |   | 789,508 |   |
| Balances as of December 31, 2002                                                           |   | 8,987,009  |   | 89,870                             |    | 31,719,371               |   | (20,088,470                           | )      | 11,720,771 |   |
|                                                                                            |   |       |   |                               |    |                     |   |                                  |   |   |   |
| Stock-based compensation                                                                        |   |       |   |                               |    | 137,485                  |   |                                  |   | 137,485 |   |
| Issuance of common stock upon exercise of stock  options                                        |   | 559,006    |   | 5,590                              |    | 1,690,005                |   |                                  |   | 1,695,595 |   |
| Tax benefit related to exercise of stock options                                                |   |       |   |                               |    | 3,189,000                |   |                                  |   | 3,189,000 |   |
| Issuance of common stock under Employee Stock Purchase  Plan                                    |   | 12,995     |   | 130                                |    | 150,437                  |   |                                  |   | 150,567 |   |
| Issuance of common stock upon exercise of stock  warrants                                       |   | 81,370     |   | 814                                |    | 246,777                  |   |                                  |   | 247,591 |   |
| Issuance of common stock in connection with private  placement, net of offering costs (Note 12) |   | 1,500,000  |   | 15,000                             |    | 18,975,515               |   |                                  |   | 18,990,515 |   |
| Net and comprehensive income                                                                    |   |       |   |                               |    |                     |   | 8,131,670                             |   | 8,131,670 |   |
| Balances as of December 31, 2003                                                           |   | 11,140,380 |   | $                                  | 111,404 |                     | $      | 56,108,590                            |   | $ | (11,956,800 | ) | $ | 44,263,194 |   |

 

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

 

46

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**VITALIMAGES, INC.STATEMENTS OF CASH FLOWS**

 
|                                                                                      |   | **For the  Years Ended December 31,** |       |
|-------------------------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                                      |   | **2003**                                   |       | **2002** |   | **2001** |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                    |   |                                       |       |   |   |   |   |
| Net  income (loss)                                                                        |   | $                                          | 8,131,670  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |   |                                       |       |   |   |   |   |
| Depreciation                                                                              |   | 1,220,468                                  |       | 894,814 |   | 746,727 |   |
| Stock-based  compensation                                                                 |   | 137,485                                    |       | 18,279 |   | 10,447 |   |
| Provision  for uncollectible accounts receivable                                          |   | 46,000                                     |       | 64,000 |   | 114,000 |   |
| Tax  benefit from stock option transactions                                               |   | 3,189,000                                  |       | — |   | — |   |
| Deferred  income taxes                                                                    |   | (9,775,000                                 | )          | — |   | — |   |
| Amortization  of licensed technology                                                      |   | 120,000                                    |       | 120,000 |   | 60,000 |   |
| Changes  in operating assets and liabilities:                                             |   |                                       |       |   |   |   |   |
| Accounts  receivable                                                                      |   | (57,283                                    | )          | (1,397,125 | ) | (727,655 | ) |
| Prepaid  expenses and other current assets                                                |   | (173,380                                   | )          | 59,141 |   | (116,333 | ) |
| Other  assets                                                                             |   | (144,346                                   | )          | — |   | — |   |
| Accounts  payable                                                                         |   | 499,981                                    |       | (106,670 | ) | (155,513 | ) |
| Deferred  revenue                                                                         |   | 1,222,998                                  |       | 1,611,323 |   | 1,137,477 |   |
| Accrued  expenses and other current liabilities                                           |   | (63,204                                    | )          | 383,822 |   | 714,136 |   |
| Net  cash provided by operating activities                                                |   | 4,354,389                                  |       | 2,437,092 |   | 771,309 |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                    |   |                                       |       |   |   |   |   |
| Purchases  of property and equipment                                                      |   | (1,879,117                                 | )          | (1,499,533 | ) | (769,155 | ) |
| Payment  for licensed technology                                                          |   | —                                     |       | — |   | (750,000 | ) |
| Purchases  of marketable securities                                                       |   | (6,775,592                                 | )          | (8,047,536 | ) | — |   |
| Sales  of marketable securities                                                           |   | 5,205,118                                  |       | 5,539,423 |   | — |   |
| Net  cash used in investing activities                                                    |   | (3,449,591                                 | )          | (4,007,646 | ) | (1,519,155 | ) |
|                                                                                      |   |                                       |       |   |   |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                    |   |                                       |       |   |   |   |   |
| Proceeds  from sale of common stock, net of offering costs                                |   | 18,990,515                                 |       | — |   | 551,624 |   |
| Proceeds  from sale of common stock under stock plans                                     |   | 1,846,162                                  |       | 1,136,809 |   | 245,220 |   |
| Proceeds  from sale of common stock under stock warrants                                  |   | 247,591                                    |       | 1,725,386 |   | 4,490,801 |   |
| Net  cash provided by financing activities                                                |   | 21,084,268                                 |       | 2,862,195 |   | 5,287,645 |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| NET  INCREASE IN CASH AND CASH EQUIVALENTS                                                |   | 21,989,066                                 |       | 1,291,641 |   | 4,539,799 |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| CASH  AND CASH EQUIVALENTS, BEGINNING OF YEAR                                             |   | 8,122,547                                  |       | 6,830,906 |   | 2,291,107 |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| CASH  AND CASH EQUIVALENTS, END OF YEAR                                                   |   | $                                          | 30,111,613 |   | $ | 8,122,547 |   | $ | 6,830,906 |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                      |   |                                       |       |   |   |   |   |
| Cash  paid during the year for interest                                                   |   | $                                          | —     |   | $ | — |   | $ | 17,730 |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| Cash  paid during the year for income taxes                                               |   | $                                          | 68,157     |   | $ | 57,974 |   | $ | 9,042 |   |
|                                                                                      |   |                                       |       |   |   |   |   |
| Purchases  of property and equipment with accounts payable                                |   | $                                          | 227,755    |   | $ | — |   | $ | — |   |

 

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

 

47

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

 

**(1) Business Description andBackground**

 

*Business Description*

 

Vital Images develops,markets and supports 3D medical imaging software for use primarily in clinicaldiagnosis, disease screening and therapy planning.  The Company’s software applies proprietary computer graphics andimage processing technologies to a wide variety of data supplied by computedtomography (“CT”) and magnetic resonance (“MR”) scanners.  Vital Images’ products allow clinicians tocreate 2D, 3D and 4D views of human anatomy and to non-invasively navigatewithin these images to better visualize and understand internal structures andpathologies.  The Company believes thatits high-speed visualization technology and customized protocolscost-effectively bring 3D visualization and analysis into the routine,day-to-day practice of medicine.  TheCompany, which operates in a single business segment, markets its products tohealthcare providers and to manufacturers of diagnostic imaging systems andpicture archive and communication systems (“PACS”) through a direct sales forcein the United States and independent distributors in international markets.

 

*Background*

 

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

 

**(2) Summary of Significant AccountingPolicies**

 

*Use of Estimates*

 

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

 

*Cash Equivalents and MarketableSecurities*

 

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

 

Management determines theappropriate classification of marketable securities at the time of purchase andreevaluates such designation at each balance sheet date.  Marketable securities as ofDecember 31, 2003 are classified as “available-for-sale.”  Available-for-sale securities are carried atfair value, with the unrealized gains and losses reported in a separatecomponent of shareholders’ equity.  Asof December 31, 2003 and 2002, the Company had no unrealized gains and losses.  The cost of debt securities in this categoryis adjusted for amortization of premiums and accretion of discounts tomaturity. Such amortization and accretion is included in interest income.  Realized gains and losses and declines invalue judged to be other-than-temporary on available-for-sale securities areincluded in net income.  The cost ofsecurities sold is based on the specific identification method.  Interest and dividends on securitiesclassified as available-for-sale are included in interest income.

 

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*Concentration of Credit Risk*

 

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

 

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

 

*TradeAccounts Receivable and Allowance for Doubtful Accounts*

 

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

 

*Property and Equipment*

 

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

 

*Impairmentof Long-Lived Assets*

 

The Company periodically reviews the carrying amountsof property and equipment and intangible assets purchased in the normal courseof business, to determine whether current events or circumstances, as definedin Statement of Financial Accounting Standards No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” warrant adjustments to suchcarrying amounts.  In reviewing thecarrying values of property and equipment and intangible assets, the Companyconsiders, among other things, the future undiscounted cash flows expected fromthe use of the asset.  The Company reviews its intangible assetspurchased in the normal course of business and other long-lived assets forimpairment whenever an event or change in circumstances indicates that thecarrying value of an asset may not be recoverable.  If such an event or change in circumstances occurs and potentialimpairment is indicated because the carrying values exceed the estimated futureundiscounted cash flows, the Company would measure the impairment loss as theamount by which the carrying value of the asset exceeds its fair value.

 

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*ComprehensiveIncome (Loss)*

 

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

 

*         **RevenueRecognition*

 

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

 

Licensefees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale ofsystem hardware, including peripheral equipment.  Maintenance and service revenue is derived from hardware andsoftware maintenance and from services consisting of telephone support,installation, training and engineering services. The Company’s softwarelicenses are always sold as part of an arrangement that includes a maintenanceand support arrangement and often installation and training services.Engineering services consist of software modification or development servicesthat are sold separately to OEMs.  TheCompany generally sells hardware as part of a system sale, but occasionallysells hardware as part of a system upgrade or additional product sale.

 

TheCompany recognizes revenue in accordance with AICPA Statement of Position(“SOP”) 97-2,  Software RevenueRecognition,  as amended by SOP 98-4 andSOP 98-9, as well as Technical Practice Aids issued from time to time by theAmerican Institute of Certified Public Accountants and Staff AccountingBulletin (SAB) No. 104.  The Companyrecognizes revenue when it is realized or realizable and earned.  The Company considers revenue realized orrealizable and earned when it has persuasive evidence of an arrangement, theproduct has been shipped or the services have been provided to the customer,the sales price is fixed or determinable and collectibility is probable.

 

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

 

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

 

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

 

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

 

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

 

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

 

*Multiple-Element Arrangements. *TheCompany enters into arrangements with customers that include a combination ofsoftware products, system hardware, specified upgrades, maintenance and supportor installation and training services. For such arrangements, the Company recognizes revenue using the residualvalue method.  The Company allocates thetotal arrangement fee among each element of the arrangement based on therelative fair value of each of the undelivered elements determined based onvendor-specific objective evidence. The fair value of maintenance and supportservices is based upon the renewal rate for continued service arrangements.  The fair value of installation and trainingservices is established based upon separate pricing for the services. Insoftware arrangements for which the Company does not have vendor-specificobjective evidence of fair value for all elements, revenue is deferred untilthe earlier of when vendor-specific objective evidence is determined for theundelivered elements (residual method) or when all elements have beendelivered.

 

*Research and Development Costs*

 

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

 

*Income Taxes*

 

The Company accounts forincome taxes using the asset and liability method.  Deferred income tax assets and liabilities are determined basedon differences between financial reporting and tax bases of assets andliabilities and are measured using the enacted tax rates and laws that will bein effect when the differences are expected to reverse.  Valuation allowances are established whennecessary to reduce deferred tax assets to the amounts expected to be realized.

 

*Computation of Net Income (Loss) PerShare*

 

Net income (loss) pershare - basic is computed using the weighted average common shares outstandingduring the period.  Net income (loss)per share – diluted is computed using the weighted average common sharesoutstanding and common share equivalents shares outstanding during theperiod.  Common share equivalents arenot included in the net income (loss) per share calculations if they areanti-dilutive.  Common share equivalentsconsist of warrants and options.

 

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

 
|                                                                        |   | **For the  Years Ended December 31,** |       |
|-----------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                        |   | **2003**                                   |       | **2002** |   | **2001** |   |
|                                                                        |   |                                       | ** ** |   | ** ** |   | ** ** |
| Numerator:                                                                  |   |                                       |       |   |   |   |   |
| Net  income (loss)                                                          |   | $                                          | 8,131,670  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
|                                                                        |   |                                       |       |   |   |   |   |
| Denominator:                                                                |   |                                       |       |   |   |   |   |
| Denominator  for weighted average common shares outstanding – basic    |   | 10,189,114                                 |       | 8,861,132 |   | 7,074,906 |   |
|                                                                        |   |                                       |       |   |   |   |   |
| Dilution  associated with common stock warrants                             |   | 59,389                                     |       | 59,984 |   | — |   |
|                                                                        |   |                                       |       |   |   |   |   |
| Dilution  associated with the company’s stock based compensation plans |   | 1,599,765                                  |       | 900,682 |   | — |   |
|                                                                        |   |                                       |       |   |   |   |   |
| Denominator:                                                                |   |                                       |       |   |   |   |   |
| Denominator  for weighted average common shares outstanding – diluted  |   | 11,848,268                                 |       | 9,821,798 |   | 7,074,906 |   |
|                                                                        |   |                                       |       |   |   |   |   |
| Net  income (loss) per share – basic                                   |   | $                                          | 0.80       |   | $ | 0.09 |   | $ | (0.14 | ) |
|                                                                        |   |                                       |       |   |   |   |   |
| Net  income (loss) per share – diluted                                 |   | $                                          | 0.69       |   | $ | 0.08 |   | $ | (0.14 | ) |

 

Options to purchase69,000 and 81,000 shares in 2003 and 2002, respectively, and options andwarrants to purchase 2,892,000 shares in 2001 were not included in thecomputation of earnings per share assuming dilution because their effect onearnings per share would have been antidilutive.  All common shareequivalents are antidilutive in periods where the Company generates a net loss.

 

*Stock-Based Compensation*

 

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

 

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|                                                                                                                                    |        | **For the  Years Ended December 31,** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------|-------------|--------------------------------------------|------------|
|                                                                                                                                    |        | **2003**                                   |       | **2002** |   | **2001** |   |
|                                                                                                                                    |        |                                       | ** ** |   | ** ** |   | ** ** |
| Net  income (loss), as reported                                                                                                         |        | $                                          | 8,131,670  |   | $ | 789,508 |   | $ | (1,011,977 | ) |
|                                                                                                                                    |        |                                       |       |   |   |   |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  method for all awards, net of related tax effects |        | (1,479,341                                 | )          | (1,560,508 | ) | (1,210,023 | ) |
|                                                                                                                                    |        |                                       |       |   |   |   |   |
| Pro  forma net (loss)                                                                                                                   |        | $                                          | 6,652,329  |   | $ | (771,000 | ) | $ | (2,222,000 | ) |
|                                                                                                                                    |        |                                       |       |   |   |   |   |
| Net  income (loss) per share                                                                                                            |        |                                       |       |   |   |   |   |
| • basic                                                                                                                            | As reported |                                       | $          | 0.80 |   | $ | 0.09 |   | $ | (0.14 | ) |
|                                                                                                                                    | Pro  forma  |                                       | $          | 0.65 |   | $ | (0.09 | ) | $ | (0.31 | ) |
|                                                                                                                                    |        |                                       |       |   |   |   |   |
| Net  income (loss) per share                                                                                                            |        |                                       |       |   |   |   |   |
| • diluted                                                                                                                          | As reported |                                       | $          | 0.69 |   | $ | 0.08 |   | $ | (0.14 | ) |
|                                                                                                                                    | Pro  forma  |                                       | $          | 0.56 |   | $ | (0.09 | ) | $ | (0.31 | ) |

 

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

 

*RecentAccounting Pronouncements*

 

In May 2003, the FASB issued SFAS No. 150, Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 requires that an issuer classify certain financialinstruments within its scope as a liability (or an asset in somecircumstances). Effective July 1, 2003, the Company adopted SFAS No.150.  Adoption of this interpretationdid not have an impact on the Company’s financial position or results of operations.

 

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

 

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

 

Property and Equipment consisted of the following at December 31:

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

 

**(4) Deferred Revenue**

 

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

 

**(5) Commitments**

 

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

 

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

 

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

 

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

 

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

 

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

 

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**(6)Shareholders’ Equity**

 

*Stock Option Plans*

 

In connection with theDistribution, Bio-Vascular, as the sole shareholder of the Company, approvedand adopted several option plans and stand-alone option grants, which coveredemployees of both Vital Images and Bio-Vascular.  The adopted plans include the Incentive Stock Option AdjustmentPlan, the 1990 Management Incentive Stock Option Plan, the 1992 Director StockOption Adjustment Plan, the 1992 Stock Option Plan, and the 1995 StockIncentive Adjustment Plan (collectively, the “Mirror Plans”).  Each of these plans is intended to mirrorthe provisions of a corresponding Bio-Vascular plan that was in effect at thetime of the Distribution.  As eachBio-Vascular option plan generally provided for the termination of optionsfollowing termination of employment, each of the Mirror Plans, as well as eachof the stand-alone option grants (the “Mirror Grants”), were approved andadopted to provide that the Distribution would not cause a termination of any VitalImages employee for the purposes of such plans or option grant, and thatBio-Vascular options held by Vital Images employees following the Distributionwould remain exercisable following the Distribution, so long as such employeesremain employed by Vital Images or any subsidiary.  Similar provisions were also adopted with respect to Vital Imagesoptions held by Bio-Vascular employees. On the Distribution Date, options to purchase 608,534 shares were issuedin connection with the Mirror Plans and the Mirror Grants (collectively, the“Mirror Options”).  These options hadvesting periods ranging from less than one year up to four years and termsranging from less than one year up to ten years.  No additional grants may be made pursuant to any of the MirrorPlans.

 

In May 1997,Bio-Vascular, as the sole shareholder of the Company, approved and adopted theVital Images, Inc. 1997 Stock Option and Incentive Plan (the “Stock OptionPlan”), which became effective on the Distribution Date.  Under the terms of the plan, the Board ofDirectors may grant options and other stock-based awards to key employees topurchase shares of the Company’s common stock at an option exercise price equalto or greater than 85% of the fair market value on the date of grant.  The options are exercisable at such times,in installments or otherwise, as the Board of Directors may determine.  Generally, these options are incentive stockoptions with a term of eight years and are exercisable as to 28% of the totalgrant one year after the date of grant and 2% per month thereafter.  In May 2003, the shareholders of the Companyapproved an increase of 500,000 common shares, bringing the total number ofshares of common stock that may be issued or awarded under the Stock OptionPlan to 3,500,000.  As ofDecember 31, 2003, there were 920,051 shares available for the grant ofawards under the Stock Option Plan.

 

Also in May 1997,Bio-Vascular, as the sole shareholder of the Company, approved and adopted theVital Images, Inc. 1997 Director Stock Option Plan (the “Director Plan”)(together with the Stock Option Plan, the “1997 Plans”), which became effectiveon the Distribution Date.  The DirectorPlan provides non-employee directors with automatic grants of stock options andallows the Board of Directors to make additional discretionary option grants toany or all directors.  Options that aregranted under the Director Plan are granted with an option price equal to thefair market value on the date of grant, with a term of eight years, arenon-qualified options and become exercisable in three equal annual installmentsbeginning on the first occurring December 31 after the date of grant.  In May 2002, the shareholders of the Companyapproved an increase of 90,000 common shares, bringing the total number ofshares of common stock that may be issued or awarded under the Director Plan to300,000.  As of December 31, 2003,there were 43,000 shares available for the grant of awards under the DirectorPlan.

 

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

 

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

 

*Non-Employee Options*

 

In December 2000,the Company granted options to purchase 10,000 shares to a non-employeeconsultant.  Options to purchase 5,000shares vest over a four-year period, and the remaining options vestedimmediately when a specified milestone was achieved, which occurred in May2003.  The options to purchase 5,000shares that vested in May 2003 were exercised in June 2003.  In December 2001, the Company grantedoptions to purchase a total of 4,000 shares to two non-employee consultants andin December 2002, the Company granted options to purchase an additional 4,000shares to two non-employee consultants. These options vest over a four-year period.  All of the non-plan options have a term of eight years and weregranted at exercise prices at least equal to fair market value of the Company’scommon stock on the date of grant. The Company records compensation expenserelated to these arrangements based upon the fair values of the options duringthe periods the consultants provide services. Such fair values are measuredusing the Black-Scholes option-pricing model. The Company recorded $137,000, $18,000 and $10,000 of compensationexpense related to these options for each of the years ended December 31,2003, 2002 and 2001, respectively.

 

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

 
|                                            |   | **Shares  Underlying  Options** |   | **Weighted-  Average  Exercise Price  Per Share** |   |
|-------------------------------------------------|--------|---------------------------------|--------|---------------------------------------------------|--------|
|                                            |   |                            |   |                                              |   |
| Total outstanding as of December 31, 2000  |   | 2,076,024                       |   | $                                                 | 3.87   |   |
|                                            |   |                            |   |                                              |   |
| Options  granted                                |   | 323,250                         |   | 5.43                                              |   |
| Options exercised                               |   | (50,013                         | )      | 3.07                                              |   |
| Options  canceled                               |   | (60,805                         | )      | 4.93                                              |   |
|                                            |   |                            |   |                                              |   |
| Total  outstanding as of December 31, 2001 |   | 2,288,456                       |   | 4.08                                              |   |
|                                            |   |                            |   |                                              |   |
| Options  granted                                |   | 677,750                         |   | 7.21                                              |   |
| Options  exercised                              |   | (288,008                        | )      | 3.49                                              |   |
| Options  canceled                               |   | (216,354                        | )      | 4.44                                              |   |
|                                            |   |                            |   |                                              |   |
| Total  outstanding as of December 31, 2002 |   | 2,461,844                       |   | 4.98                                              |   |
|                                            |   |                            |   |                                              |   |
| Options  granted                                |   | 618,750                         |   | 12.04                                             |   |
| Options  exercised                              |   | (574,381                        | )      | 3.55                                              |   |
| Options  canceled                               |   | (65,241                         | )      | 7.31                                              |   |
|                                            |   |                            |   |                                              |   |
| Total  outstanding as of December 31, 2003 |   | 2,440,972                       |   | $                                                 | 7.05   |   |
|                                            |   |                            |   |                                              |   |
| Options  exercisable as of:                     |   |                            |   |                                              |   |
|                                            |   |                            |   |                                              |   |
| December 31,  2001                         |   | 1,462,761                       |   | $                                                 | 3.41   |   |
| December 31,  2002                         |   | 1,505,069                       |   | $                                                 | 3.83   |   |
| December 31,  2003                         |   | 1,407,347                       |   | $                                                 | 5.09   |   |

 

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

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

 

*Employee Stock Purchase Plan*

 

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

 

57

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ESPP covers substantiallyall employees, subject to certain limitations. Each employee may elect to have up to 10% of his or her base paywithheld and applied toward the purchase of shares in each such offeringperiod.  Purchases under the ESPP for2003 were 12,995 shares, generating proceeds to the Company of $151,000 at anaverage purchase price of $11.59; purchases for 2002 were 24,539 shares,generating proceeds to the Company of $131,000 at an average purchase price of$5.32; and for 2001, there were 25,487 shares purchased, generating proceeds tothe Company of $92,000 at an average purchase price of $3.60.  As of December 31, 2003, there are101,453 shares of common stock reserved for purchases under the ESPP.

 

*Stock-Based Compensation*

 

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

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

 

The weighted average fairvalues for the 1997 Plans and the non-plan options were based on the fairvalues on the dates of grant.    Thefair values for the 1997 Plans and the non-plan employee options werecalculated using the Black-Scholes option-pricing model with the followingassumptions:

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

 

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

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

 

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

 

*Warrants*

 

In December 1999,the Company completed a private placement of 1,650,000 units at $3.25 perunit.  Each unit consisted of one shareof the Company’s common stock and a redeemable, five-year warrant to purchase anadditional share of common stock at $3.75 per share.  The warrants were immediately exercisable with an expiration datein December 2004.  The warrantscould be redeemed by the Company at any time before December 2004 at aredemption price of $.01 per warrant, upon notice of such redemption, providedthat (i) the closing bid price of the Company’s common stock exceeded $5.75 pershare for any thirty consecutive trading days prior to such notice and (ii) aregistration statement covering the resale of the warrant shares had been filedby the Company with the Securities and Exchange Commission and was effective asof the date of such notice. The Company satisfied the conditions for redemptionof the warrants on December 7, 2000. In 

 

58

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

 

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

 

*Rights Plan*

 

In April 1997,the Company declared a dividend distribution of one Preferred Stock PurchaseRight for each outstanding share of the Company’s common stock (the“Rights”).  With certain exceptions, theRights become exercisable only if one of the following events occurs: (i) anacquiring party accumulates 15% or more of the Company’s common stock, (ii) aparty announces an offer to acquire 15% or more of the Company’s common stock,or (iii) the acquisition of a substantial amount of the Company’s common stockby a person whom the Board of Directors has determined is an “Adverse Person”as defined in the underlying Rights Agreement. Each Right entitles the holder to purchase one-thousandth of a share ofthe Company’s Series A Junior Preferred Stock at a price of $20.00 (the“Exercise Price”).  If a person or groupbecomes the beneficial owner of 15% or more of the Company’s common stock orthe Board of Directors determines that a person is an Adverse Person, eachholder of a Right shall thereafter have the right to receive preferred stockhaving a fair market value equal to two times the Exercise Price.  Upon the occurrence of certain mergers,combinations or acquisitions of the Company’s assets, each holder of a Rightshall thereafter have the right to receive that number of shares of commonstock of the acquiring company which equals the Exercise Price of the Rightdivided by one-half of the current market price of such common stock as of thedate of the occurrence of the event.  TheCompany is generally entitled to redeem the Right at $.001 per Right at anytime until ten days following the acquisition of 15% or more of the Company’scommon stock or ten days after the point at which the Company’s Board ofDirectors determines that a person is an Adverse Person, as defined by theRights Agreement.  The Rights expire onApril 30, 2007, if not previously redeemed or exercised.

 

**(7) Income Taxes**

 

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

 
|                                 |   | **For the  Years Ended December 31,** |       |
|--------------------------------------|--------|--------------------------------------------|------------|
|                                 |   | **2003**                                   |       | **2002** |   | **2001** |   |
| Current  income taxes:               |   |                                       |       |   |   |   |   |
| Federal                              |   | $                                          | —     |   | $ | — |   | $ | — |   |
| State                                |   | 79,000                                     |       | 22,000 |   | 12,000 |   |
|                                 |   |                                       |       |   |   |   |   |
| Deferred  income taxes:              |   |                                       |       |   |   |   |   |
| Federal                              |   | (7,830,000                                 | )          | — |   | — |   |
| State                                |   | 1,244,000                                  |       | — |   | — |   |
| Provision (benefit) for income taxes |   | $                                          | (6,507,000 | ) | $ | 22,000 |   | $ | 12,000 |   |

 

59

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

 
|                                                |   | **December 31,** |      |
|-----------------------------------------------------|--------|-----------------------|-----------|
|                                                |   | **2003**              |      | **2002** |   |
| Net  operating loss carryforwards                   |   | $                     | 8,295,000 |   | $ | 6,830,000 |   |
| Research  and development tax credit carryforwards  |   | 1,063,000             |      | 995,000 |   |
| Depreciation                                        |   | 287,000               |      | 322,000 |   |
| Accrued  expenses and allowances                    |   | 276,000               |      | 246,000 |   |
| Deferred  compensation                              |   | —                |      | 230,000 |   |
| Other,  net                                         |   | 1,000                 |      | (25,000 | ) |
| Net  deferred tax assets before valuation allowance |   | 9,922,000             |      | 8,598,000 |   |
| Less  valuation allowance                           |   | (147,000              | )         | (8,598,000 | ) |
| Net  deferred tax assets                            |   | $                     | 9,775,000 |   | $ | — |   |

 

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

 
|                                                            |   | **For the  Years Ended December 31,** |       |
|-----------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                            |   | **2003**                                   |       | **2002** |   | **2001** |   |
| Tax  provision (benefit) computed at the federal statutory rate |   | $                                          | 553,000    |   | $ | 276,000 |   | $ | (340,000 | ) |
| State  taxes, net of federal benefit                            |   | 95,000                                     |       | 24,000 |   | (52,000 | ) |
| Increase  (decrease) in tax from:                               |   |                                       |       |   |   |   |   |
| Research  and development tax credits                           |   | (85,000                                    | )          | (186,000 | ) | (147,000 | ) |
| Business  meals and entertainment                               |   | 34,000                                     |       | 26,000 |   | 20,000 |   |
| Change  in valuation allowance (1)                              |   | (7,171,000                                 | )          | (111,000 | ) | 545,000 |   |
| Other,  net                                                     |   | 67,000                                     |       | (7,000 | ) | (14,000 | ) |
| Provision (benefit) for income taxes                            |   | $                                          | (6,507,000 | ) | $ | 22,000 |   | $ | 12,000 |   |

 

----

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

 

During 2003, the Company concluded that it is more likely than not thatsubstantially all of its net deferred tax assets would be realized, and theCompany reversed substantially all of its valuation allowance for net deferredtax assets, which resulted in the recording of a net tax benefit in 2003.  The reversal of the deferred tax assetsvaluation allowance is based upon the Company’s historical operatingperformance and management’s expectation that the Company will generate taxableincome of at least $25 million in future periods to allow it to realize itsdeferred tax assets resulting from the tax benefits associated with its netoperating loss (“NOL”) carryforwards and a significant portion of its researchand development tax credit carryforwards, as well as certain other tax benefitsrelated to book and tax income timing differences. The reversal of thevaluation allowance resulted in a tax benefit of $7,171,000.  This reversal net of other current year stateand federal income taxes resulted in a net tax benefit of $6,507,000 in 2003.

 

The Company’s netoperating loss and research and development tax credit carryforwards of $22.9million and $1.1 million, respectively, will expire in varying amounts between2004 and 2023.

 

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

 

As a result ofBio-Vascular’s acquisition of the Company in May 1994, the Company experiencedan ownership change as defined by Section 382 of the Code.  Under the Code, the amount ofpre-acquisition net operating loss carryforwards and research and developmentcredits that can be used to offset future taxable 

 

60

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

 

**(8) Major Customers and GeographicData**

 

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

 
|                               |   | **Significant  Customer**            |   | **Revenue** |       | **Percentage  of  Total Revenue** |   |
|------------------------------------|--------|--------------------------------------|--------|-------------|------------|-----------------------------------|--------|
| Year  ended December 31, 2003 |   | Toshiba Medical Systems  Corporation |   | $           | 11,200,000 |                              | 42     | % |
|                               |   |                                 |   |        |       |                              |   |   |
| Year  ended December 31, 2002 |   | Toshiba Medical Systems  Corporation |   | $           | 7,246,000  |                              | 34     | % |
|                               |   |                                 |   |        |       |                              |   |   |
| Year  ended December 31, 2001 |   | Toshiba Medical Systems  Corporation |   | $           | 4,163,000  |                              | 27     | % |

 

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

 

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

 

Export revenueaccounted for 13%, 10% and 8% of total revenue for the years endedDecember 31, 2003, 2002 and 2001, respectively.  Substantially all of the Company’s export sales are negotiated,invoiced and paid in U.S. dollars.

 

Export sales bygeographic area are summarized as follows:

 
|           |   | **For the  Years Ended December 31,** |      |
|----------------|--------|--------------------------------------------|-----------|
|           |   | **2003**                                   |      | **2002** | ** ** | **2001** | ** ** |
|           |   |                                       |      |   |   |   |   |
| Europe         |   | $                                          | 2,328,000 |   | $ | 1,094,000 |   | $ | 706,000 |   |
| Asia-Pacific   |   | 846,000                                    |      | 709,000 |   | 300,000 |   |
| Middle  East   |   | 183,000                                    |      | — |   | — |   |
| Canada         |   | 73,000                                     |      | 161,000 |   | 207,000 |   |
| Latin  America |   | 58,000                                     |      | 11,000 |   | 14,000 |   |
| Other          |   | 65,000                                     |      | 38,000 |   | — |   |
|           |   | $                                          | 3,553,000 |   | $ | 2,013,000 |   | $ | 1,227,000 |   |

 

**(9) Employee Benefit Plan**

 

The Companymaintains the Vital Images, Inc. Salary Savings Plan (the “Plan”), which isintended to qualify under Section 401(k) of the Internal Revenue Code, asamended.  The Plan covers substantiallyall employees.  Each employee may electto contribute to the Plan through payroll deductions of up to 25% of his or hersalary, subject to certain limitations. At the discretion of the Board of Directors, the Company may makematching contributions equal to a percentage of the salary reductioncontributions or other discretionary amounts. There were no contributions to the Plan by the Company in 2003, 2002 and2001.

 

61

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**(10)Licensed Technology**

 

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

 

**(11) Development Agreements**

 

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

 

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

 

**(12)Private Placement**

 

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

 

**(13) Purchase Commitments**

 

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

 

62

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**(14)Quarterly Financial Data (Unaudited)**

 

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

 
|                                      |   | **First  Quarter** |      | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |      |
|-------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|---------------------|-----------|
| **2003:**                                 |   |               |      |                |   |               |   |                |      |
| Total  revenue                            |   | $                  | 6,791,000 |                | $      | 7,529,000          |   | $                   | 7,243,000 |   | $ | 5,212,000 |   |
| Gross  margin                             |   | 5,176,000          |      | 5,496,000           |   | 5,466,000          |   | 3,566,000           |      |
| Net  income                               |   | 654,000            |      | 666,000             |   | 6,805,000          |   | 7,000               |      |
| Earnings  per share – basic          |   | 0.07               |      | 0.07                |   | 0.62               |   | 0.00                |      |
| Earnings  per share – diluted        |   | 0.06               |      | 0.06                |   | 0.53               |   | 0.00                |      |
|                                      |   |               |      |                |   |               |   |                |      |
| **2002:**                                 |   |               |      |                |   |               |   |                |      |
| Total  revenue                            |   | $                  | 4,443,000 |                | $      | 4,874,000          |   | $                   | 5,593,000 |   | $ | 6,206,000 |   |
| Gross  margin                             |   | 3,094,000          |      | 3,331,000           |   | 4,034,000          |   | 4,349,000           |      |
| Net  income (loss)                        |   | (247,000           | )         | 201,000             |   | 419,000            |   | 417,000             |      |
| Earnings  (loss) per share – basic   |   | (0.03              | )         | 0.02                |   | 0.05               |   | 0.05                |      |
| Earnings  (loss) per share – diluted |   | (0.03              | )         | 0.02                |   | 0.04               |   | 0.04                |      |

 

**(15) Subsequent Event**

 

OnFebruary 18, 2004, the Company completed the acquisition of HInnovation,Inc. (“HInnovation”) in accordance with the terms and conditions of anAcquisition Agreement and Plan of Reorganization (the “Acquisition Agreement”)dated as of January 8, 2004. HInnovation is a provider of software solutions that allow physicians to use PCs ornotebook computers to access 2D, 3D and 4D medical imaging applicationssecurely over the Internet.  Theacquisition of HInnovation was made to acquire products and technology thatwill enable the Company to more effectively compete in the Web-enabled marketfor 3D medical imaging software.

 

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

 

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

 

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**SCHEDULE II**

 

VITAL IMAGES, INC.

VALUATION ANDQUALIFYING ACCOUNTS

 
| **Description**                    |   | **Balance as  of  Beginning  of Period** |    | **Charges  to  Cost and  Expenses** |   | **Deductions/  Write-Offs** |   | **Balance  as of End  of Period** |    |
|------------------------------------|--------|------------------------------------------|---------|-------------------------------------|--------|-----------------------------|--------|-----------------------------------|---------|
|                               |   |                                     |    |                                |   |                        |   |                              |    |
| Allowance  for doubtful accounts:  |   |                                     |    |                                |   |                        |   |                              |    |
|                               |   |                                     |    |                                |   |                        |   |                              |    |
| Year  ended December 31, 2003 |   | $                                        | 240,000 |                                | $      | 46,000                      |   | $                                 | 51,000  |   | $ | 235,000 |   |
|                               |   |                                     |    |                                |   |                        |   |                              |    |
| Year  ended December 31, 2002 |   | $                                        | 185,000 |                                | $      | 64,000                      |   | $                                 | 9,000   |   | $ | 240,000 |   |
|                               |   |                                     |    |                                |   |                        |   |                              |    |
| Year  ended December 31, 2001 |   | $                                        | 215,000 |                                | $      | 114,000                     |   | $                                 | 144,000 |   | $ | 185,000 |   |

 

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**VITAL IMAGES, INC.FORM 10-K**

 

**INDEX TO EXHIBITS**

 
| **Item No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                            |
|--------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 2.1          |   | Acquisition Agreement and  Plan of Reorganization by and among Vital Images, Inc., HInnovation  Acquisition, Inc., HInnovation, Inc. and Hui Hu and JMS Co. Ltd. Dated as of  January 8, 2004  (incorporated by  reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on  February 26, 2004 (File No. 0-22229)). |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 3.1          |   | Articles of  Incorporation of the Company (incorporated by reference to Exhibit 3.1 to the  Company’s registration statement on Form 10 (File No. 0-22229)).                                                                                                                                                                                          |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 3.2          |   | By-laws of the Company  (incorporated by reference to Exhibit 3.2 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                                                                                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 4.1          |   | Form of common stock  certificate of the Company (incorporated by reference to Exhibit 4.3 to the  Company’s registration statement on Form 10 (File No. 0-22229)).                                                                                                                                                                                   |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 4.2          |   | Rights Agreement, dated  effective as of May 1, 1997, between the Company and American Stock Transfer  and Trust Company, which includes as Exhibit B the form of Rights Certificate  (incorporated by reference to Exhibit 4.4 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                              |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 4.3          |   | Certificate of  Designation, Preferences and Rights of Series A Junior Preferred Stock of the  Company (incorporated by reference to Exhibit 4.5 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                                                             |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.1         |   | Form of Distribution  Agreement, effective as of May 2, 1997, between Bio-Vascular, Inc. and the  Company (incorporated by reference to Exhibit 10.1 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                                                         |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.2         |   | Form of Employee  Benefits Agreement, effective as of May 2, 1997, between Bio-Vascular, Inc.  and the Company** (incorporated by reference to Exhibit 10.2 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                                                  |
|         |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.3         |   | Form of Tax Sharing  Agreement, effective as of May 2, 1997, between Bio-Vascular, Inc. and the  Company (incorporated by reference to Exhibit 10.3 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                                                          |

 

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| 10.4   |   | Form of Transition  Services Agreement, effective as of May 2, 1997, between Bio-Vascular, Inc.  and the Company (incorporated by reference to Exhibit 10.4 to the Company’s  registration statement on Form 10 (File No. 0-22229)).       |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                            |
| 10.5   |   | Incentive Stock Option  Adjustment Plan** (incorporated by reference to Exhibit 10.5 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                              |
|   |   |                                                                                                                                                                                                                                            |
| 10.6   |   | 1990 Stock Option  Plan** (incorporated by reference to Exhibit 10.6 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                              |
|   |   |                                                                                                                                                                                                                                            |
| 10.7   |   | 1992 Stock Option  Plan** (incorporated by reference to Exhibit 10.7 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                              |
|   |   |                                                                                                                                                                                                                                            |
| 10.8   |   | 1992 Director Stock  Option Adjustment Plan** (incorporated by reference to Exhibit 10.8 to the  Company’s registration statement on Form 10 (File No. 0-22229)).                                                                          |
|   |   |                                                                                                                                                                                                                                            |
| 10.9   |   | 1995 Stock Incentive  Adjustment Plan** (incorporated by reference to Exhibit 10.9 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                |
|   |   |                                                                                                                                                                                                                                            |
| 10.10  |   | Employee Stock Purchase  Plan** (incorporated by reference to Exhibit 10.10 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                       |
|   |   |                                                                                                                                                                                                                                            |
| 10.11  |   | 1997 Stock Option and  Incentive Plan** (incorporated by reference to Exhibit 10.11 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                               |
| 10.12  |   | 1997 Director Stock  Option Plan** (incorporated by reference to Exhibit 10.12 to the Company’s  registration statement on Form 10 (File No. 0-22229)).                                                                                    |
|   |   |                                                                                                                                                                                                                                            |
| 10.26  |   | Lease agreement dated October 19, 1999 between St. Paul  Properties, Inc. and the Company (incorporated by reference to Exhibit 10.27  to the Company’s Form 10-Q for the quarter ended September 30, 1999  (File No. 0-22229)). |
|   |   |                                                                                                                                                                                                                                            |
| 10.27  |   | Vital Images, Inc. and Toshiba America Medical Systems, Inc. Reseller  Agreement * (incorporated by reference to Exhibit 10.27 to the Company’s Form  10-Q for the quarter ended September 30, 2000 (File No. 0-22229)).              |
|   |   |                                                                                                                                                                                                                                            |
| 10.30  |   | Form of Change in Control Agreement between the Company and Gregory S.  Furness** (incorporated by reference to Exhibit 10.30 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2000 (File No.  0-22229)). |

 

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| 10.31  |   | Form of Change in Control Agreement between the Company and Vincent J.  Argiro, Ph.D., Steven P. Canakes, David M. Frazee, Jay D. Miller and Robert  C. Samec** (incorporated by reference to Exhibit 10.31 to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2000 (File  No. 0-22229)). |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.32  |   | Technology License Agreement between PointDX, Inc. and Vital Images,  Inc.* (incorporated by reference to Exhibit 10.32 to the Company’s Form 10-Q  for the quarter ended September 30, 2001 (File No. 0-22229)).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.33  |   | Development, Supply, Marketing and Distribution Agreement between Vital  Images, Inc. and E-Z—EM, Inc.* (incorporated by reference to Exhibit 10.33 to  the Company’s Form 10-Q for the quarter ended September 30, 2001 (File  No. 0-22229)).                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.34  |   | Development and License Agreement between Vital Images, Inc. and  Surgical Navigation Technologies, Inc. (incorporated by reference to Exhibit  10.34 to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2001 (File No. 0-22229)).                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.35  |   | Marketing and  Distribution Agreement between Vital Images, Inc. and Toshiba Corporation,  Medical Systems Company * (incorporated by reference to Exhibit 10.35 to the  Company’s Form 10-Q for the quarter ended March 31, 2002 (File No.  0-22229)).                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.36  |   | Severance Agreement  dated February 9, 2002 between the Company and Albert Emola  (incorporated by reference to Exhibit 10.36 to the Company’s Form 10-Q for  the quarter ended March 31, 2002** (File No. 0-22229)).                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.37  |   | Marketing and Distribution  Agreement between Vital Images, Inc. and Toshiba Corporation, Medical Systems  Company* (incorporated by reference to Exhibit 10.37 to the Company’s Annual  Report on Form 10-K/A (Amendment No. 1) for the year ended December 31,  2002 (File No. 0-22229)).                         |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.38  |   | Product  Distribution Agreement between Vital Images, Inc. and R2 Technology, Inc.*  (incorporated by reference to Exhibit 10.38 to the Company’s Annual Report on  Form 10-K/A (Amendment No. 1) for the year ended December 31, 2002 (File  No. 0-22229)).                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                          |
| 10.39  |   | Employment Agreement  dated February 9, 2002 between the Company and Jay D. Miller**  (incorporated by reference to Exhibit 10.39 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2002 (File No. 0-22229)).                                                                       |

 

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

 

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

 

**          Indicates a managementcontract or compensatory plan or arrangement.

 

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